By Scott Lanman and Steve Matthews
March 4 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke, battling the worst housing recession in a quarter century, urged lenders to forgive portions of mortgages held by homeowners at risk of defaulting.
``Efforts by both government and private-sector entities to reduce unnecessary foreclosures are helping, but more can, and should, be done,'' Bernanke said in a speech to bankers in Orlando, Florida, today. ``Principal reductions that restore some equity for the homeowner may be a relatively more effective means of avoiding delinquency and foreclosure.''
Bernanke's call goes beyond the stance of the Bush administration and previous Fed comments, indicating that he sees housing as a serious threat to the economy that can't be addressed by fiscal or monetary policy alone. The Fed's Feb. 27 report to Congress called for lenders to ``pursue prudent loan workouts'' through means such as modifying mortgage terms and deferring payments.
The Fed chief highlighted the threat posed by home values falling below mortgage balances, something Treasury Secretary Henry Paulson played down yesterday. Bernanke said the ``recent surge'' in delinquencies has been ``closely linked'' to the slide of home equity.
Paulson said in an interview with Bloomberg Television yesterday that ``almost too much'' has been made out of concerns about homeowners whose house prices have dropped below their mortgages. He also said the administration's strategy of encouraging lenders to modify loans is ``the right approach and we are making substantial progress.''
``We're not going to dictate'' how lenders should alter mortgage contracts, Treasury spokeswoman Brookly McLaughlin said in an e-mailed response to questions. ``If lenders find that in some cases a principal writedown is less costly than foreclosure, then that is an option they have the incentive to consider.''
Mortgage servicers ``should have a clear basis for concluding'' that borrowers are unable to make their payments, ``rather than simply being unwilling to do so'' before reducing loan principal, the American Securitization Forum said.
The forum, whose members include Goldman Sachs Group Inc. and Citigroup Inc., lobbies for investors, traders, underwriters, accounting firms, ratings companies and other institutions involved in the creation and sale of mortgage-backed securities. The group commented in a statement today.
The Mortgage Bankers Association also stopped short of endorsing Bernanke's call.
``It is not a casual thing to disrupt an existing legal contract, as those contracts are the basis on which our market system is based,'' the group's president, Jonathan Kempner, said in a statement. ``That said, there is an incentive for lenders, borrowers and investors to work together to maximize the value of the relationship.''
The American Financial Services Association, a 350-member trade group for the U.S. consumer-credit industry, is supportive of Bernanke's idea, as long as it's voluntary, said spokeswoman Lynne Strang.
The Standard & Poor's 500 Thrifts and Mortgage Finance Index, based on seven stocks including Fannie Mae and Countrywide Financial Corp., fell 2.5 percent to 42.61 today. That compares with a 0.3 percent drop in the full S&P 500 benchmark stock index.
Democrats in Congress have said relying on lenders to alter loan terms hasn't yielded enough progress and are pushing for a stronger government response.
Bernanke warned today that the housing crisis may deepen.
``Delinquencies and foreclosures likely will continue to rise for a while longer,'' Bernanke said in the comments to the Independent Community Bankers of America. A surfeit of homes for sale indicates ``further declines in house prices are likely,'' he said.
The Standard & Poor's Thrift & Mortgage index, which includes Countrywide Financial Corp. and Washington Mutual Inc. slumped 4.2 percent today to 40.83 at 1:56 p.m. in New York.
Bernanke spoke in a state that's among the worst affected by the housing collapse. Miami home prices have dropped 17.5 percent in the past year, the most of 20 large U.S. cities, according to the S&P/Case-Shiller index. Foreclosures in Florida jumped at more than double the nationwide pace, rising 158 percent in the past year, according to RealtyTrac.
Subprime borrowers are about to see their mortgage rates increase more than 1 percentage point, he said. ``Declines in short-term interest rates and initiatives involving rate freezes will reduce the impact somewhat, but interest-rate resets will nevertheless impose stress on many households.''
In the past, homeowners could refinance, though that option is now ``largely'' gone because sales of bonds backed by subprime mortgages ``have virtually halted,'' Bernanke said. ``This situation calls for a vigorous response.''
Bernanke didn't comment on the outlook for interest rates. Traders expect the Federal Open Market Committee to lower the benchmark rate by 0.75 percentage point by or at the panel's next meeting on March 18, based on futures prices.
Fed Vice Chairman Donald Kohn told lawmakers today that officials are considering whether ``we have adequate insurance'' against the risks of a deeper downturn in growth. He also reiterated policy makers' call for banks to raise capital, and added that they ought to review their dividend plans.
``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.''
The Fed chairman countered that by reducing the amount of the loan, this ``may increase the expected payoff by reducing the risk of default and foreclosure.''
Bernanke also urged investors in mortgage bonds to accept ``short payoffs'' of loans by allowing borrowers to refinance at a lower principal.
For investors, a reduction in principal that's ``sufficient to make borrowers eligible for a new loan would remove the downside risk'' of further writedowns or defaults, Bernanke said. Investors may be able to share in future gains in home prices under some plans, he said, citing a proposal by the Office of Thrift Supervision.
Paulson, by contrast, has declined to endorse the OTS plan. John Reich, director of the OTS, last month proposed a program where borrowers would refinance mortgages at current home values. The lender would receive a ``negative equity'' certificate that could be redeemed if the house is sold.
The Treasury chief yesterday stressed that it's the responsibility of borrowers to get in touch with lenders if they're facing payment problems. He said 80 percent of homeowners who were sent letters by the Hope Now alliance of mortgage servicers haven't responded.
The number of U.S. homeowners entering foreclosure rose 75 percent in 2007, with more than 1 percent in some stage of foreclosure during the year, according to RealtyTrac Inc. of Irvine, California. For the year, more than 2.2 million default notices, auction notices and bank repossessions were reported on about 1.3 million properties.
Yesterday, the Fed and other regulators sent letters to institutions they supervise, encouraging the banks to report on their efforts to modify mortgages at risk of default.
``This will make it easier for regulators, the mortgage industry, lawmakers and homeowners to assess the effectiveness of these efforts,'' Fed Governor Randall Kroszner said in a statement yesterday.