The $25 billion settlement with banks over foreclosure abuses may trigger a wave of home seizures, inflicting short-term pain on delinquent U.S. borrowers while making a long-term housing recovery more likely.

Lenders slowed the pace of foreclosures as they negotiated with attorneys general in all 50 states for more than a year over allegations of faulty and fraudulent paperwork used to repossess homes. With today’s agreement, banks are likely to resume property seizures.

“The best thing about the settlement, frankly, is that it will be done,” said Stan Humphries, chief economist for Seattle-based Zillow Inc. (Z), a provider of home-sales data. “The shadow of the settlement hung over the market for a year now.”

The backlog of foreclosures has trapped homeowners in properties they can no longer afford, depressed prices by increasing the number of abandoned properties and led banks to tighten mortgage credit standards because of uncertainty about their potential obligations. Foreclosure starts fell 46 percent in December from October 2010, when the investigation into the so-called robo-signing of mortgage documentation began, according to Irvine, California-based RealtyTrac Inc.

The agreement will direct $17 billion to writing down debt to buffer about 1 million homeowners from foreclosure. About 11 million U.S. homeowners have negative equity, or owe more on their mortgages than their homes are worth, according to CoreLogic Inc. (CLGX), a real estate data provider. That has limited their ability to sell or refinance and reduced the incentive to keep paying.

Strategic Default

Principal reductions may help cut the number of mortgage defaults by improving homeowners’ finances and reducing incentives for so-called strategic default, when homeowners walk away from a property because they have too much negative equity, according to a Federal Reserve report sent to Congress on Jan. 4. Home prices have dropped 33 percent from their July 2006 peak, according to the S&P/Case-Shiller index of values in 20 U.S. cities.

U.S. homeowners have $750 billion in negative equity, Humphries said. The settlement will help the housing market “at the margins, but little more,” according to an analysis late last month by London-based Capital Economics of the impact of the settlement on housing.

Principal was reduced on 10,772 loans, or 7.8 percent of the mortgages with payment modifications, in the third quarter of last year, according to the office of the U.S. Comptroller of the Currency. All of those loans were held by private investors or bank portfolios.

Reductions ‘Seem Small’

“There has been a lot of discussion of principal reductions and whether that’s the one measure the U.S. housing market needs to get it going again,” Paul Diggle, a property economist at Capital Economics, said in a telephone interview this week. “That may well be the case. But the amounts of principal reductions under the settlement seem small.”

The agreement announced today includes $5 billion in cash for states to pay for foreclosure-prevention initiatives. Loan servicers will refinance $3 billion in mortgages to lower homeowners’ interest rates and pay about $1.5 billion to homeowners harmed by botched foreclosures.

About 5 million homes have been lost to foreclosure in the U.S. since 2006, according to RealtyTrac.

Excluding 92 Percent

The agreement may help about 1 million homeowners with mortgage forgiveness, forbearance or loan modifications, according to Housing and Urban Development Secretary Shaun Donovan. About 750,000 more may benefit from direct payments of as much as $2,000 to compensate them for servicing errors.

For California, which has the highest number of properties in the foreclosure pipeline, banks agreed to pay $12 billion to help 250,000 homeowners with principal reductions or short sales, when a lender agrees to a sale for less than owed on the home, according to Kamala Harris, the state’s attorney general.

Florida Loan Modifications

Borrowers in Florida, the state with the second-most foreclosures, will receive an estimated $7.6 billion in benefits from loan modifications, including principal reduction, according to state Attorney General Pam Bondi.

The money set aside for mortgage-debt forgiveness also can be used for short sales. Banks have been stepping up the sales by pre-approving deals, streamlining the closing process, forgoing their right to pursue unpaid debt and in some cases providing as much as $35,000 in “relocation” incentives. The deals accounted for 33 percent of financially distressed transactions in November, up from 24 percent a year earlier, according to Santa Ana, California-based CoreLogic.

The total value of the agreement with lenders including Citigroup Inc. (C), Bank of America Corp. and Wells Fargo & Co. may grow to $40 billion if the next nine largest mortgage servicers sign on to the agreement, Donovan said. In a best-case scenario, if all banks participate fully, the deal might be worth $45 billion to homeowners and victims of foreclosure.

Testing Effectiveness

The money may have an added benefit: It will test the effectiveness of principal forgiveness in preventing defaults, and may spur a larger-scale program if successful, Diggle said.

After a six-year slide in home prices, demand is showing signs of strengthening, bolstered by a jobless rate that fell to 8.3 percent last month. The number of Americans who signed contracts to buy previously owned homes in December held near a 19-month high, indicating that stabilization in the market that began in late 2011 may continue this year.

The surge of home seizures may drive down home values, at least for a while, in a fragile market. The number of new foreclosure filings fell 34 percent last year, according to RealtyTrac, building up a backlog of homes that now may flood the market with low-cost properties.

“All of this will result in more foreclosure pain in the short term as some of the foreclosures that should have happened last year instead happen this year,” Daren Blomquist, a RealtyTrac vice president, said in an e-mail today.

About 1 million foreclosures with be completed this year, up 25 percent from 2011, according to the firm.

‘More Price Weakness’

“I think there’ll be more price weakness, because we’ll see the number of distressed sales pick up,” said Mark Zandi, chief economist for Moody’s Analytics Inc. in West Chester, Pennsylvania. “But I think the price declines will be modest. I think the banks themselves are going to be very sensitive to market prices. I don’t think they’re just going to dump property. That wouldn’t be in their best interest.”

Lenders are unlikely to flood the market because it will damage prices for all properties, according to Sam Khater, senior economist for CoreLogic. Banks may be limited by their own capacities to process foreclosures. The settlement prohibits the practice of robo-signing, which employed assembly lines of workers to sign thousands of foreclosure documents at a time without verifying them.

“You can’t dump all these properties at the same time,” Khater said. “That would be disastrous. You have to release them in a slow and measured fashion, so the market can absorb them.”

Obama Administration’s Programs

The settlement adds to a series of recently expanded government steps to protect consumers and encourage lenders to refinance homes and modify payment terms for homeowners facing foreclosure.

President Barack Obama this month proposed plans to expand loan modifications for delinquent homeowners to include some principal reductions through his administration’s Home Affordable Modification Program, or HAMP. Underwater homeowners would be able to refinance at current low interest rates through the Home Affordable Refinance Program, or HARP. Some of the refinancing plans require Congressional approval.

Programs under the administration’s Making Home Affordable program had $29.9 billion in aid pledged as of Jan. 30.

Bulk Home Purchases

Separately, Fannie Mae (FNMA), the mortgage company under U.S. conservatorship, invited investors to apply for a new program to buy foreclosed homes in bulk to be managed as rental properties, under another program announced by the Federal Housing Finance Agency. The goal of that program is to reduce the inventory of foreclosures while providing rental homes to people who can’t qualify to buy or don’t want to own.

“No action, no matter how meaningful, is going to by itself entirely heal the housing market,” Obama said at an appearance with state attorneys general in Washington today. “But this settlement is a start. And we’re going to make sure that the banks live up to their end of the bargain.”

There remains a danger that “a wave of foreclosures” may destabilize the housing market, said Susan Wachter, professor of real estate and finance at the University of Pennsylvania’s Wharton School.

“The logjam has to be unleashed and it has been -- this will do that,” she said. “That’s a good thing. But then there needs to be methodical loan-by-loan determination of the best resolution.”

Demand for Rentals

Investors are likely to buy many of the foreclosed homes that come on the market to take advantage of low prices and demand for rentals, Zandi said. About 21 percent of home sales in December were investor purchases, according to the National Association of Realtors.

Private equity funds including Los Angeles-based Oaktree Capital Management LP (OAKTRZ) and New York-based GTIS Partners announced plans in January to buy $2.5 billion of foreclosed single-family homes to manage as rentals, focusing on states with the highest number of foreclosures, such as California, Florida and Nevada.

“There’s pretty strong investor demand, particularly in some markets where prices have overshot,” Zandi said. “They’ve gone well below what you’d expect given incomes and rents.”

To contact the reporters on this story: Prashant Gopal in New York at pgopal2@bloomberg.net; John Gittelsohn in Los Angeles at johngitt@bloomberg.net

To contact the editor responsible for this story: Daniel Taub at dtaub@bloomberg.net