UPDATE 2-Hungary PM says banks to foot the bill of fx loan relief
* PM Orban says banks should modify fx loan contracts voluntarily by Nov
* Government will "eliminate" forex loan contracts otherwise
* Govt will avoid measure that could undermine banking system -analyst
* Bank Association says hopes talks with government will continue
BUDAPEST, Sept 6 (Reuters) - Hungary's prime minister, seeking re-election next year, warned the country's banks on Friday that the government would "eliminate" foreign currency mortgages unless banks helped borrowers deal with their losses.
The loans, totalling over 11 billion euros, have become a major burden for households after repayments surged in the wake of the 2008 financial crisis. Viktor Orban's government has now raised the stakes for the country's mostly foreign-owned banks after weeks of talks.
The prime minister said the banks should modify the contracts and bear most of the losses resulting from exchange rate swings on the mortgages, mostly denominated in Swiss francs, by November or else the government would act.
Orban did not specify what he would do, but his Fidesz party said on Thursday the government could convert the loans into forints unless the banks' fulfilled their "moral obligation".
"If the government has to resolve this situation ... it will apply a solution that eliminates foreign currency loans," Orban told public radio, saying the banks had been wrong to make borrowers bear all the risks.
Orban's government has previously imposed taxes on banks to fill budget gaps and made them swallow losses totalling about 1 billion euros on a previous loan relief scheme in 2011.
While Orban wants banks to foot most of the bill, he will likely avoid measures that could undermine the banking system, especially as Hungary faces the risk of capital withdrawals if the U.S. central bank starts reducing its supply of cheap money.
"Looking at what the government is doing - building up state-owned banks - they may keep foreign-owned banks' profitability permanently low but avoid their immediate exit which would raise stability concerns," said Eszter Gargyan, an analyst at Citigroup.
Orban has said he wanted to see Hungarian ownership of over 50 percent in the banking sector and the state earlier this year gained a majority stake in savings banks.
Foreign banks whose Hungarian units may be hit by a new mortgage relief scheme include Austria's Raiffeisen and Erste, Germany's Bayerische Landesbank and Italy's Intesa Sanpaolo.
The Bank Association, which has been in talks with the Economy Ministry about the loans, said the statements from Fidesz and the prime minister came as a surprise, but they hoped negotiations would continue.
Raiffeisen, Erste and Bayerische declined to comment.
More losses for the banks would be the latest in a raft of policy moves by Orban which have seen him lump telecoms and energy companies with a bigger share of the costs of cutting Hungary's budget deficit - to cries of protest from big business, the European Union and some foreign governments.
Resolving the problem of forex loans, which have been a drag on consumption and a big vulnerability if the forint weakened, is another leg of Orban's bid for financial sovereignty after Budapest repaid an earlier IMF loan last month.
Such moves come as Orban gears up for next year's election. Although his Fidesz party is firmly ahead of the opposition in polls, close to half of voters are undecided.
His call could please disgruntled borrowers who staged a small demonstration in Budapest on Friday.
A group of 40-50 people protested, putting stickers on banks' doors saying: "They robbed us, they will rot in jail."
One of them, Magdi Toth, 46, took out a Swiss franc mortgage in 2006 and her repayments have since more than doubled, which her family could not pay and they have lost their home.
"We had to leave our home and now we live in a flat on which my brother has a mortgage so if he cannot pay his loan either, our next step leads into the street," Toth said.
Orban also said the relief scheme should be fair, and those who borrowed in foreign currencies could not be better off than those who took out mortgages in forints.
Uncertainty over the forex loan plans has weighed on the forint in past weeks.
"It is clear that they will make the banking system finance the solution anyway. The main question is whether this will be a one-off shock or there will be time," a trader in Budapest said.
CENTRAL BANK PLAN
While the government has been negotiating with banks, the National Bank of Hungary, led by Orban's close ally Governor Gyorgy Matolcsy, has also made a proposal of its own.
This would lead to a gradual and full conversion of the loans into forints by forgiving part of principal payments on foreign currency mortgages and extending an earlier scheme that allows monthly repayments below the market rate.
Even though the central bank is not part of talks, Matolcsy has the ear of Orban, and as economy minister had been the architect of earlier unconventional economic policies.
Some analysts said the final outcome may be similar to the central bank's proposal.
"The central bank's proposal would be a good option from a stability perspective," said Citigroup's Gargyan.
"In this case the conversion would not be a one-off, but would be spread over time."
The economy ministry has not responded to Reuters questions about the central bank plan.