Bernanke to Banks: Get Real or Lose Big

Lenders need to get a more realistic view of the challenges ahead, and be prepared to make deals to avoid lengthening the mortgage crisis, Fed chief Ben Bernanke said Tuesday.

Speaking to bankers in Orlando, Bernanke said he recognized the role that the Congress should play in stepping up to help borrowers, particularly through federal loan guarantee programs.

However, he said, banks must realize that the way forward is not digging in and waiting for the inevitable -- and costly -- wave of defaults.

"Lenders tell us that they are reluctant to write down principal. 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,” Bernanke said.

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"Moreover, were house prices instead to rise subsequently, the lender would not share in the gains. In an environment of falling house prices, however, whether a reduction in the interest rate is preferable to a principal writedown is not immediately clear,” he said.

He suggested that, in a standoff between a pressured borrowed and pressured bank, the bank is likely to lose more than if it were simply to freeze or lower rates first.

"The fact that most mortgages terminate before maturity either by prepayment or default may favor an interest rate reduction,” Bernanke said.

"However, as I have noted, when the mortgage is ‘under water,’ a reduction in principal may increase the expected payoff by reducing the risk of default and foreclosure,” he said.

Bernanke also encouraged investors to step up and accept more so-called "short sales,” where the bank accepts a lower payoff in exchange for avoiding the lengthy foreclosure proceedings.

Already, courts in Florida are adding night shifts to deal with a sudden rise in foreclosure filings, which can take months to more than a year to resolve in each case.

"For example, servicers could accept a principal writedown by an amount at least sufficient to allow the borrower to refinance into a new loan from another source,” Bernanke said.

"A writedown that is sufficient to make borrowers eligible for a new loan would remove the downside risk to investors of additional writedowns or a re-default,” he said.

Bernanke added that a structured approach, recently proposed by the government’s Office of Thrift Supervision, would allow banks to get some upside when property values recover.

"There are, no doubt, tax-related, accounting, and legal obstacles to expanding the use of principal writedowns,” Bernanke conceded.

Investors who hold packaged mortgage loans known as collateralized debt obligations might not benefit equally, among other risks, he said.

Yet, Bernanke said, doing nothing or waiting for government would not necessarily benefit banks more.

In essence, he said, banks won’t see the market change for the better for some time.

"Ultimately, real relief for the mortgage market requires stabilization, and then recovery, in the nation's housing sector,” Bernanke said.

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