Today the Fed Chairman offered a novel approach to resolving the credit crisis in the mortgage sector:

Federal Reserve Chairman Ben Bernanke called Tuesday for additional action to prevent more distressed homeowners from falling into foreclosure.

"This situation calls for a vigorous response," Bernanke said in a speech to a banking group meeting in Orlando, Fla.

Source: businessweek.com

Normally a bank will evaluate its investments to estimate their value. If there is reason to believe that a group of investments will fail, the bank must make provisions for those failures and their associated expenses in their accounting. In general, they estimate the cost of the various problems that they anticipate and they reduce the value, Write Down the value, as reflected in their accounting. This gives the share holders a more accurate picture of the bank and its investments.

If a bank chooses to foreclose on a mortgage the resulting loses are significant. Under normal conditions, the bank will sell the house and recover their investment less the costs related to taking over the property and selling it. In the current housing market the banks know in advance that this will not work. Houses have lost a great deal of the value they had a few months ago and, in any case, there aren't enough people looking to buy them.

Bernanke made what normal people would refer to as a sensible suggestion. He begins by pointing out the problem: As the Adjustable Rate Mortgages reset and monthly mortgage payments jump - homeowners are not able to handle the sudden increase. The solution is simply to take steps to keep the monthly payments from jumping. If the bank can find a way to do this they can effectively keep the homeowner in the house and maintain the health of their investment.

Note that the homeowners who are being heavily berated as sub-prime have been making their monthly mortgage payments. The rate of defaults, even after the ARMs reset, has indeed gone up significantly. It is still relatively low, though, in human terms (under 2 to 3%.)

Bernanke then points out that there is a simple way for the banks to accomplish this: They can simply write down a portion of the principal due on the loan. This would result in dramatically reduced write-downs and allow the homeowners to continue living in their homes and making their monthly mortgage payments - to the great benefit of the banks and the overall economy.

Still, this simple and entirely legal form of creative accounting will likely rub many in the financial sector the wrong way. It remains to be seen if they choose to cut off their noses to spite their faces or be pragmatic and do the simple things that allow the financial log-jams to clear-up.

The full text of the speech by Chairman Bernanke is available on the Federal Reserve web site:

http://www.federalreserve.gov/newsevents/speech/bernanke20080304a.htm