Sept. 4 (Bloomberg) -- U.S. bank regulators, facing the worst housing slump in 16 years, called on mortgage lenders to stave off foreclosures by cutting or postponing home payments for cash-strapped borrowers.

The Federal Reserve, in a break with the free-market approach honed under former Chairman Alan Greenspan, joined with the Treasury Department in making the unprecedented appeal. They said lenders should try to refinance loans at lower rates to keep families in their homes and even urged banks to consider reducing the principal owed on a property before moving to foreclose.

``Avoiding foreclosures is in everyone's best interest,'' Federal Deposit Insurance Corp. Chairman Sheila Bair said in an interview. ``It's less expensive to modify a loan and try to keep the borrower in their home as opposed to foreclosing a property where the losses can be more significant.''

The regulators' request underscores the growing concern that fallout from the collapse of the subprime-mortgage market will undermine the broader U.S. economy. The looming threat of more defaults when subprime loans ``reset'' to higher interest rates has thrown credit markets into turmoil, stifling home demand and raising borrowing costs for companies across the country.

Late Payments

Late payments on subprime mortgages, those made to homeowners with poor credit histories or heavy debt loads, rose to the highest in more than four years during the first quarter.

The FDIC was among the five regulators that signed the joint statement with the Fed and the Treasury's Office of the Comptroller of the Currency. The agencies are seeking action from companies that service mortgages that have been packaged into bonds. The statement implored the servicing agents, which process and oversee loan payments, to ``determine the full extent of their authority'' to identify borrowers at risk and seek ways to avert foreclosure.

``They are appropriating a decision that should be made by the lenders themselves,'' said Anna J. Schwartz, economist and co-author with Milton Friedman of ``A Monetary History of the United States,'' a book that spurred current Fed Chairman Ben S. Bernanke's interest in policy making. ``This is not a job for the central bank. If the U.S. Treasury wants to do it, that is another thing.''

Bush Plan

Last week, President George W. Bush announced a plan to allow the Federal Housing Administration to help borrowers facing rising mortgage payments stay in their homes.

The number of U.S. homes under foreclosure almost doubled in July from a year earlier as property owners with adjustable-rate mortgages faced larger monthly payments, according to RealtyTrac Inc., the Irvine, California-based seller of foreclosure data.

The public move by the regulators is ``extraordinarily unprecedented'' since they've historically made such recommendations behind the scenes, said Gilbert Schwartz, a former associate general counsel at the Fed who is unrelated to Anna Schwartz.

The banking agencies are taking a voluntary approach since ``securitization transactions are contractual in nature'' and ``regulators can't force institutions to breach these contracts,'' said Schwartz, now a partner at Schwartz & Ballen LLP in Washington.

``This essentially is a signal to financial institutions that we won't criticize you if you incur expenses or losses for providing assistance to borrowers,'' Schwartz said.

Lenders' Help

The regulators urged lenders to identify borrowers at risk of delinquency or default, including those facing interest-rate increases on their loans, and contact them to assess their ability to repay.

Lenders should consider helping homeowners avoid foreclosure by converting loans to fixed-rate mortgages and extending the loan's maturity date, the regulators said.

``We encourage servicers of securitized mortgages to reach out to financially stressed homeowners,'' Fed Governor Randall Kroszner said in a statement.

Other options the agencies offered were the deferral of payments and a reduction or forgiveness of the loan principal, which could lead lenders to take losses on the mortgages.

That suggestion signaled some unusual heavy-handed persuasion by the Fed and other agencies, an analyst said.

``The Fed's institutional culture doesn't lend itself to this,'' said Lou Crandall, chief economist at Wrightson ICAP LLC., in Jersey City, New Jersey. ``They don't get here without sharing some of the anger in general in Washington at the lending practices.''

Banks React

Banks and securities firms, including JPMorgan Chase & Co. and Bear Stearns Cos., say they've already begun contacting high- risk borrowers.

``Earlier this year, as we saw all these resets coming, we wanted to make sure people were aware,'' Tom Kelly, a spokesman for New York-based JPMorgan, said today. ``As the servicer of the loan, our goal is to keep the owner paying the mortgage.''

JPMorgan, which services about $700 billion of mortgages, is presenting borrowers with options including refinancing their loans or simply modifying their interest rate, Kelly said.

Bear Stearns, the second-biggest U.S. underwriter of bonds backed by mortgages, set up a team in April to meet with homeowners having difficulty making payments.

``Wall Street banks don't want to foreclose on properties, because we're not in the real-estate business,'' Tom Marano, head of Bear Stearns's mortgage business, said at the time. He said the so-called ``Mod Squad'' would try to modify borrowers' loan payments to help them avoid foreclosure.

Contractual Obligations

Even if loan-servicing companies want to make changes, their contractual obligations may block them.

Eight of the 31 subprime-mortgage deals that Credit Suisse Group bond analyst Rod Dubitsky looked at for an April report capped the amount of loan modifications that can be done at 5 percent of either the total loan number or their balances.

Banks and borrowers also may be worse off if they delay inevitable foreclosures because slumping home prices may create even lower resale prices, according to Josh Rosner, managing director at the New York investment research firm Graham Fisher & Co.

The U.S. agencies today also encouraged lenders to refer borrowers to non-profit counseling services and government programs that may help them escape foreclosure.

The Office of Thrift Supervision, the National Credit Union Administration and the Conference of State Bank Supervisors also signed onto the regulators' joint statement.

Payment Resets

About 1.3 million subprime mortgages will reset to higher monthly payments this year and another 1.2 million will reset next year, the FDIC's Bair said in a statement.

Bair is among a group of regulators scheduled to testify tomorrow at a U.S. House Financial Services Committee hearing that will explore how regulators are responding to the recent turmoil in the credit and financial markets. Officials from the Securities and Exchange Commission, the Treasury Department and the OCC will also testify.

Senate Banking Committee Chairman Christopher Dodd criticized the regulators' recommendations, saying they were ``very late'' and wouldn't be enough to keep as many people as possible in their homes.

``Subprime homeowners deserve loans that are affordable in the long term,'' Dodd, a Connecticut Democrat seeking his party's presidential nomination, said in a statement. ``We cannot tolerate short-term modifications that put off the day of reckoning until a time when the press' attention is turned elsewhere.''

The SEC in July provided an interpretation of accounting rules intended to help lenders and borrowers avoid mortgage default by allowing financial institutions to modify mortgages posing a ``reasonably foreseeable'' prospect of failure.

The SEC's position lets institutions overseeing bonds backed by subprime and other risky mortgages to keep the assets off their balance sheets and avoid a regulatory requirement to hold more capital in reserve, SEC Chairman Christopher Cox said in a July 24 letter.

To contact the reporter on this story: Alison Vekshin in Washington at avekshin@bloomberg.net.

Last Updated: September 4, 2007 17:49 EDT