An Unprecedented Banker’s Request

In my years of being an investor and economist, I thought I had seen it all. That was until yesterday.

On Tuesday, Fed Chairman Bernanke made an unusual request of U.S. banks. He urged them to forgive a portion of the mortgages of homeowners who are in trouble. Here’s exactly what the Fed Chief said in a speech in Orlando, “Principal reductions that restore some equity for the homeowner may be a relatively more effective means of avoiding delinquency and foreclosure.”

This is big news, because no other Federal Reserve chairman, that I’m aware, has ever made such a request. Bernanke is basically asking the banks not to foreclose, to work with defaulting homeowners, to even eat part of their mortgages. Is Bernanke getting paranoid about the economy? Either he knows something we don’t or, as a student of the depression, he’s simply very worried.

Futures traders expect the Fed to bring down interest rates another 75 basis points when it meets for its next scheduled meeting on March 18. That would bring the total decline in rates since January to two full percentage points…another rare event in such a short time period.

According to a recent report from UBS AG, banks remain on the hook for as much as another $203 billion in additional write- downs. And with the S&P 500 Financial Index at the lowest level in six and a half years, I’m not sure U.S. banks are in the mood to forgive loans right now.

Make no mistake about it; the Fed will stand ready to reduce interest rates to spur the economy. When the last recession started in 2001, U.S. interest rates were at 6.5% and the Fed dropped them like a rock, with the discount rate hitting one percent in the summer of 2004. The same will happen again this time around.

Inflation? The falling U.S. dollar? Forget them. Bernanke has made it clear that the priority right now is getting the economy going. Hence, he’ll drop rates and expand the money supply aggressively.

The difference Bernanke sees this time around (compared to the 2001 recession) is the housing mess. Two million default notices didn’t go out to U.S. homeowners in 2001, but they are going out today.

Sure, interest rates can be dropped back to one percent. But will that really help consumer confidence and get American consumers spending again when their houses are declining in value? I think not. Reduced interest rates may be great for businesses, but for consumers, the wounds from the housing bust could take years to heal. Bernanke sees and understands this…and that is why he is asking the banks to go easy on homeowners and not foreclose on them.