Federal Reserve Chairman Ben Bernanke this morning (March 4) suggested to a banking group that a reduction in the principal of troubled mortgages could result in banks netting more money from the loans while easing the nation's rapidly expanding foreclosure crisis.

"When the mortgage is 'under water,' a reduction in principal may increase the expected payoff by reducing the risk of default and foreclosure,"Bernanke told the annual convention of the Independent Community Bankers of America in Orlando. "We could also reduce preventable foreclosures if investors acting in their own self interests were to permit servicers to write down the mortgage liabilities of borrowers by accepting a short payoff in appropriate circumstances. 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. 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."

Bernanke added that such an arrangement could allow the original investors to share in any future appreciation.

The Fed chairmen said that data collected on subprime mortgages foreclosed in the fourth quarter of 2007 indicated that total losses exceeded 50% of the principal balance, with legal, sales, and maintenance expenses alone amounting to more than 10% of principal. "The low prices offered for subprime-related securities in secondary markets support the impression that the potential for recovery through foreclosure is limited," he said.

Still, Bernanke noted the need to "minimize moral hazard" that could arise from programs in which irresponsible defaulters are rewarded while "borrowers who have avoided problems through responsible financial management" are being "unfairly penalized." One way to do that, he said, was the notion of renegotiating the mortgages to allow for the lender to profit from future price appreciation.

"The fact that many troubled borrowers have little or no equity suggests that greater use of principal writedowns or short payoffs, perhaps with shared appreciation features, would be in the best interest of both borrowers and lenders," he said.

Bernanke also called on Congress to pass legislation that would modernize the Federal Housing Administration and better supervise Fannie Mae and Freddie Mac. He also called upon Fannie and Freddie to expand the number of new mortgages they securitize, although he did note that they may face difficulty raising capital in the moribund market for mortgage-backed securities.