ORLANDO, Fla. -- Many in the lending industry were taken aback when Federal Reserve Chairman Ben Bernanke chided lenders to think about forgiving a portion of outstanding mortgage debt.

Bernanke's speech at the Independent Community Bankers of America's Annual Conference on March 4 marked the first time he spoke of lenders writing down the principal owed on loans as a means of stemming the current flood of foreclosures. "I was surprised when I saw that," said CUNA Economist Bill Hampel. "I think this was more moral suasion on the part of the Fed. It seems to be clear evidence that the problem has become more serious, and it could be evidence of frustration."

"In recent mortgage vintages, small down payments were combined with other risk factors, such as a lack of documentation of sufficient income to make the required loan payments," said Bernanke, noting weak underwriting principles as one reason for the problems. But the unexpected slump in home values--after homeowners had borrowed heavily against the equity in those homes--has made for a cascading crisis that has forced the Fed to pump more money into the credit system to shore up shaky markets. Because borrowers with little or no equity are more likely than others to fall behind in their payments, the large number of outstanding mortgages with negative amortization features may exacerbate the problem, he said.

"This situation calls for a vigorous response," Bernanke said. "Measures to reduce preventable foreclosures could help not only stressed borrowers but also their communities and, indeed, the broader economy. At the level of the individual community, increases in foreclosed-upon and vacant properties tend to reduce house prices in the local area, affecting other homeowners and municipal tax bases. At the national level, the rise in expected foreclosures could add significantly to the inventory of vacant unsold homes--already at more than two million units at the end of 2007--putting further pressure on house prices and housing construction."

The Fed chairman spoke of loan workout efforts and refinancing where possible, but failing that, "the next-best solution may often be some type of loss-mitigation arrangement between the lender and the distressed borrower. Indeed, the Federal Reserve and other regulators have issued guidance urging lenders and servicers to pursue such arrangements as an alternative to foreclosure when feasible and prudent." But even that option might not be enough, Bernanke conceded, given the realities of the securitization process and the constraints faced by servicers.

In this environment, principal reductions that restore some equity to the homeowner may be a more effective means of avoiding delinquency and foreclosure. "Lenders tell us that they are reluctant to write down principal," Bernanke said. "They say that if they were to write down the principal and house prices were to fall further, they could feel pressured to write down principal again.... But when the mortgage is underwater, a reduction in principal may increase the expected payoff by reducing the risk of default and foreclosure." Essentially, Bernanke recommended that lenders perform a cost-benefit analysis between holding foreclosed real estate against the value of accepting less money and stabilizing communities by keeping people in their homes.

The idea of lenders becoming more flexible on loan terms struck NAFCU Chief Economist Tun Wai with some amusement. "This whole business of renegotiating terms, extensions and workouts--well, credit unions have been doing that sort of thing all along. Banks are just now discovering that they have to do it? We have a lot of people in this country right now that are really hurting. This problem is pervasive and it's spreading. What Bernanke and the Fed are trying to do is prevent a bottleneck as the numbers rise. He's urging lenders to do something now, to take a look at the long term instead of the short term."

Risking Moral Hazard

Bernanke stressed that "solutions should also be prudent and consistent with the safety and soundness of the lender. Concerns about fairness and the need to minimize moral hazard add to the complexity of the issue. We want to help borrowers in trouble, but we do not want borrowers who have avoided problems through responsible financial management to feel that they are being unfairly penalized."

"People who played by the rules will be asking why?" agreed Wai. "It can be a mixed message. People who are leveraged to the hilt and get a reduction bring up the moral hazard issue, rewarding bad choices. But in the end, it's about what the market will bear. Just look at the recent hearings on CEO pay. Any number of critics have said that [former Fed Chairman Alan] Greenspan kept rates too low for too long, so if you take an action now where people who made bad borrowing decisions are eventually rewarded, it sends a bad message."

Hampel concurred. "Fannie Mae and Freddie Mac have the implied guarantee of the government and now push is coming to shove. There is a moral hazard argument to be made that you shouldn't protect speculative investors, but their behavior has had an effect on those who didn't speculate."

Eva Weber of Boston's Aite Group said that the Fed was reminding lenders that everything, eventually, comes down to a pure business decision. "Getting lenders to write down principal may seem a bit much. I can't imagine lenders are going to jump on this." Weber said that lenders surely don't want a glut of REOs, but neither will they be inclined to reduce principal in an environment where mortgage rates are going up while home prices decline.

"The approach seems to be, 'try anything' or think about it anyway, even if the suggestion may not be taken very far. The Fed seems to be putting pressure on lenders to see if something starts to work. And while no solution will be perfect, out of a mix of ideas one may emerge," Weber said. She added that the Fed was clearly concerned about the mortgage meltdown's effect on other sectors of the economy. "The recent employment figures show that nothing is immune to this." Consumer confidence and spending is also flat or declining and the stock market is fluctuating wildly.

"The flood of liquidity the Fed is pumping into the system isn't working," Hampel said. "It isn't flowing into mortgage rates. The securities market is still very nervous about buying any bonds backed by mortgages."

--cburger@cutimes.com

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Fed Chairman Suggests Lenders Lower Principal to Stem Foreclosures

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