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.