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By Peter G. Gosselin and Marc Lifsher
WASHINGTON — Saying banks must do more to stem rising foreclosures, Federal Reserve Chairman Ben S. Bernanke called on lenders Tuesday to go beyond trimming interest rates on some troubled mortgages by cutting the size of the loans as well.
Unless bankers act quickly, Bernanke warned, a large number of homeowners could walk away from their mortgage debt, reversing the historical pattern of people hanging onto their homes at almost all costs.
The Fed chief's comments were bolstered by a report by Moody's Economy.com that said nearly 9 million homeowners -- or about one in every 10 -- will either have no equity in their homes by the end of this month, or will have mortgage balances that exceed what their homes are worth.
Separately, a study by California regulators found that foreclosures continue to rise while efforts by homeowners to "work out" their troubled loans with their lenders appear to be declining.
"Increasing numbers of borrowers, especially those who paid very little or nothing down or who refinanced out all their equity, and who live in areas of steep home price decline . . . are walking away from their homes," said the report issued by California Corporations Commissioner Preston DuFauchard.
Bernanke's call for outright mortgage cuts is more sweeping than anything he has previously advocated and appears to put him at odds with the Bush administration. Treasury Secretary Henry M. Paulson Jr. contends that homeowners are obligated to keep paying on their home loans.
"Being underwater does not affect your ability to pay your mortgage," Paulson said in a speech Monday. "Any homeowner who can afford his mortgage payments, but chooses to walk away from an underwater property is simply a speculator -- and one who is not honoring his obligations."
But Bernanke argued that lenders might be better off forgiving some of the debt and keeping borrowers in their homes than going through the expense of foreclosure.
"Housing prices are falling in many parts of the country," the Fed chairman told the Independent Community Bankers of America. "The resulting decline in equity reduces both the ability and the financial incentive of stressed borrowers to remain in their homes."
"In this environment," he said later, "principal reductions that restore some equity for the homeowner may be a relatively more effective means of avoiding delinquency and foreclosure."
The back-and-forth between the nation's top two economic policymakers came as new estimates suggested just how extensive the loss of home equity has been during the current slump.
Economy.com, a West Chester, Pa.-based forecasting firm, predicted that by the time the housing slump is over nearly 14 million homeowners, or 16%, will have zero or negative equity.
"This highlights the extreme level of stress that American homeowners are under as house values plunge," said Mark Zandi, Economy.com's chief economist. "The government is going to need to become bolder and put taxpayer money on the line to keep some of these homeowners in their homes.
"Otherwise," he said, "the housing and mortgage market, and the broader economy will continue to slide away."
In California, there were 10,202 foreclosures in January, the state reported, up from 6,736 in December.
At the same time, the number of troubled adjustable-rate mortgages whose payment terms were modified to make them easier to afford dropped from 8,061 in December to 5,630 in January.
"We would be hoping that they would be moving in the opposite direction," said Paul Leonard, executive director of the Center for Responsible Lending in Oakland.
Corporations Commissioner DuFauchard said the data suggested "a troubling new phenomenon is currently at work," in which people abandon their homes rather than make payments on a property that is worth less than they paid for it
He added that although there was "no precise data" to quantify the number of walk-aways, "lenders have expressed sufficient concern to conclude it is real, and not necessarily marginal."
Bernanke's suggestion that bankers start cutting mortgage principal received a tepid reception from key banking groups.
"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," Mortgage Bankers Assn. 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."
By contrast, Bernanke's comments were warmly received by congressional Democrats, who have argued for months that lenders must absorb greater losses and that Washington needs to step in with a program to guarantee a large number of troubled loans to break the downward cycle in housing.
"He recognizes that there's a structural problem that doesn't lend itself to the usual solutions," said Rep. Barney Frank (D-Mass.), chairman of the House Financial Services Committee. "What Bernanke is saying to the banks is 'Take your losses, rewrite your loans realistically and then the government can help.' "
The federal government has generally relied on voluntary efforts by mortgage lenders and servicers to work out arrangements with troubled borrowers, especially those with sub-prime loans made to people with spotty credit histories.
Bernanke said that these efforts had borne some fruit. He said the Hope Now Alliance, a group that includes such lending giants as Countrywide Financial Corp. and Citigroup Inc., reported the number of sub-prime loans adjusted to help people stay in their homes rose from 250,000 in the third quarter of last year to 300,000 during the final quarter of the year.
But critics charge that most of the changes lenders have agreed to thus far have been comparatively minor -- for example, granting delinquent borrowers extra time to catch up on back payments -- and are inadequate considering the scale of the problem.
The Fed chief predicted that the housing crisis would deepen, saying that "delinquencies and foreclosures likely will continue to rise for a while longer" and that "further declines in prices are likely."
"This situation calls for a vigorous response," Bernanke said.
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