Banks may need to cut dividends, Fed warns

By Glenn Somerville and John Poirier

WASHINGTON (Reuters) - Bankers were overly confident about lending risks they took during good times and may need to cut dividends and raise capital to prepare for growing losses, Federal Reserve Vice Chairman Donald Kohn warned on Thursday.

Kohn was on a panel of regulators called before the Senate Banking Committee to answer questions about how the banking sector was faring as a widening sea of problems engulfs the U.S. housing sector and heightens worry about potential bank failures.

The Fed's vice chairman noted that weak earnings and asset value write-downs lie ahead for bankers who didn't prepare in prosperous years for current problems with housing and other loans that he said were going to get worse.

"The housing market bottom isn't here yet. Prices are continuing to fall in many localities," he said. "As long as the housing market is on a downward path, there is a risk that the losses could continue to mount on a variety of loans."

Kohn said the banking industry hadn't prepared adequately.

"The extended period of good times in the banking system bred a sense of overconfidence among many bankers and other market participants, causing them to underestimate risks and not fully consider the potential for those good times to end," Kohn said.

Kohn, when asked about the Fed's role in the rescue of investment bank Bear Stearns in March, said it would do so again if necessary to protect the financial system. But he said investment banks had done a lot in recent weeks to rebuild their liquidity.

DUCKS LEHMAN QUESTION

"I think we have a stronger set of investment banks than we had a month and a half ago," Kohn said. He avoided any specific reference to embattled Wall Street firm Lehman Brothers and said he would not comment on the financial health of any specific institution.

But he added, "If something like this were coming again, I would have to make the same kind of judgments."

One regulator, Federal Deposit Insurance Corp. Chairman Sheila Bair, said some blame for current housing woes lies with regulators themselves.

"Where we did not do as well as we should have was with monitoring underwriting standards," she said.

"We let it get out of control."

Kohn said the worst was not yet over.

"House prices are still declining sharply in many localities and losses related to residential real estate -- including loans to builders and developers -- are bound to increase further, Kohn said.

"Weak economic conditions could well extend problems to other segments of lending portfolios including consumer installment or credit card loans, as well as corporate loan portfolios," he added.

Bair said weakening real estate markets could take down bigger banks than in the past because of their hefty lending for costly commercial projects.

"There is also the possibility that future failures could include institutions of greater size than we have seen in the recent past," Bair said, though she said the bank insurance fund was well prepared to handle any bank failures.

But Kohn said bank loan loss reserves had not kept pace with the growth in problem assets and should be bolstered. He urged banks to actively raise capital.

SHAREHOLDERS MAY SUFFER

"In view of this uncertain outlook, additional capital injections and consideration of dividend cuts are still warranted for some of these companies and we have strongly encouraged supervised bank holding companies to enhance their capital positions," Kohn said.

A gauge of the strain that housing markets are under came from the Mortgage Bankers Association, which said on Thursday that home foreclosures and the rate of homes entering the foreclosure process hit record levels in the first quarter.

Leading the wave of failing loans were so-called subprime borrowers -- people with spotty credit records still able to get mortgages in the boom period before 2006 -- who now cannot keep up their payments.

A record 0.99 percent of U.S. loans were entering the foreclosure process in the first three months of 2008, compared with 0.58 percent in the same period a year earlier, the lenders' lobby group said.

Kohn said banks must pay more attention to the fact that market liquidity "may erode quickly and unexpectedly," so they need to maintain "more robust" liquidity and capital cushions.

"This is a key point supervisors are reinforcing strongly," Kohn said.

(Additional reporting by Joanne Morrison, Lisa Lambert and Emily Kaiser; Editing by Jan Paschal )