Federal Reserve chairman Ben Bernanke on Wednesday responded to questions from the House Financial Services Committee on bankruptcy judges rewriting mortgage terms for borrowers at risk for foreclosure. Bernanke acknowledged the popular “moral hazard” argument against such modifications, but suggested the consequences of doing nothing in the face of sweeping foreclosures would outweigh the moral benefit of forcing irresponsible borrowers to face the music of foreclosure. “We have to trade off the short-term moral hazard issues against the broader good,” he said. We have to consider “going forward in terms of regulation…how we can avoid these problems in the future.” Bernanke referenced regulated underwriting and lending standards — a check on bad lending practices — as a necessary step to prevent another crisis. Committee chairman Barney Frank seemed to agree, also citing the moral hazard argument against foreclosure prevention efforts that states if a person is absolved from the consequences of a mistake, they are likely to make the mistake again. But what people forget is “when we talk about stopping this from repeating itself, we’re not relying on people having had a bad feeling about it, but we’re talking about rules and laws that will make it impossible,” Frank said. “We have an unhappiness on the part of all the citizens who are suffering deeply from the consequences of mistakes which most of them didn’t make — some did,” Frank said. “There are people who took out loans they shouldn’t have taken out, there are people who have been irresponsible in other ways. But fundamentally, people are now being victimized for things for which they are not to blame.” On the issue of moral hazard, Bernanke agreed that although some borrowers supposedly knew what they were getting into when they closed on mortgages they couldn’t afford, there’s also a portion of bad mortgages pushed through by lenders that did not uphold their responsibilities in disclosing all the details of the loans. In such a situation, “there’s a case to unwind some of adverse that on the borrower,” he said. Regardless of who had initial responsibility in bad mortgages, the ultimate issue is a large number of foreclosures that are detrimental to the borrower, the lender, the community and the broader system, according to Bernanke. “I agree with the issue of getting houses back down to their fundamental value…but the problems in the mortgage market combined with the supply of housing…put us in real danger of driving house prices below the fundamental low levels,” he said. In the committee hearing Wednesday, Bernanke also soothed fears of a government takeover of the banking system, saying there are no plans for “anything like” nationalization of major U.S. banks and the elimination of value to shareholders. His comments came just days before Citigroup Inc. (C) announced its agreement to exchange common stock for the preferred securities obtained by the Treasury Department through the Capital Purchase Program (CPP), effectively increasing the government’s share of the company to 36 percent. The announcement stoked investor fears of government ownership in other major banks, and Citi shares consequentially dropped as much as 37 percent of their value in early trading Friday. See archived video of the committee hearing. Write to Diana Golobay at [email protected]. Disclosure: The author held no relevant investment positions when this story was published. Indirect holdings may exist via mutual fund investments. HW reporters and writers follow a strict disclosure policy, the first in the mortgage trade.