Mortgage Principal Reduction. Great Idea. How can I sign up!

By Barbara Liston

ORLANDO, Florida (Reuters) - Banks may have to swallow reductions in the principal of some troubled home loans to ward off greater losses that could result from outright default, Federal Reserve Chairman Ben Bernanke said on Tuesday.

Warning that mortgage delinquencies and foreclosures are likely to rise, with more declines in house prices, Bernanke called for active measures from both the public and private sectors to stabilize housing markets.

"This situation calls for a vigorous response," Bernanke said in a speech to the Independent Community Bankers of America, referring to government and private-sector initiatives to slow the rate of home loan failures.

"Measures to reduce preventable foreclosures could help not only stressed borrowers but also their communities and, indeed, the broader economy," he said.

U.S. government bond prices shed early losses and turned higher, while stocks extended their declines and the downtrodden dollar touched another all-time low against a basket of currencies.

Market bets of a Fed rate cut at its March 18 meeting ticked down slightly to roughly a 66 percent chance of a cut in benchmark interest rates by three-quarters of a percentage point from the current 3 percent.

Bernanke's comments come as the central bank grapples with the twin dilemmas of a slowing economy and rising inflation. U.S. economic growth slowed to a sluggish 0.6 percent at the end of 2007 and hiring declined in January. But inflation rose 4.1 percent in 2007, the largest 12-month rise since 1990.

Current housing difficulties differ from past housing market slumps because of the large number of homeowners who owe more on their loans than their homes are worth, Bernanke said. "In this environment, principal reductions that restore some equity for the homeowner may be a relatively more effective means of avoiding delinquency and foreclosure" than reducing interest rates on troubled home loans, he said.

When a mortgage is "under water," a reduction in principal may boost the chances of pay-off by avoiding default or foreclosure, he added.

Analysts said the Fed chairman was advising bankers that it was in their best interest to resolve mortgage problems quickly and to cut their losses.

"The problems in the credit system and problems on consumer balance sheets are such that some of the losses will have to be socialized, either by the market or by the government," said Joseph Brusuelas, chief U.S. economist at IDEAglobal in New York. "And it's highly preferable that between the two, those losses be accepted by the market."

Bernanke also said government-sponsored mortgage finance enterprises Fannie Mae and Freddie Mac could do more to address problems in housing and mortgage markets.

"New capital-raising by the (government-sponsored enterprises), together with congressional action to strengthen supervision of these companies, would allow Fannie and Freddie to expand significantly the number of new mortgages that they scrutinize," he said. "With few alternative mortgage channels today, such action would be highly beneficial to the economy."

Bernanke added that giving greater latitude to the Federal Housing Administration to set underwriting standards and risk premiums for mortgage refinancing would extend help to more borrowers in trouble.

(Writing by Mark Felsenthal, Editing by Dan Grebler)