The proposal made by banks yesterday during settlement talks in Washington came after state attorneys general and federal officials offered revised settlement terms. Photographer: Jin Lee/Bloomberg

Bank of America Corp. (BAC) and JPMorgan Chase & Co. (JPM), along with three other U.S. mortgage servicers, proposed paying $5 billion to settle a probe of their foreclosure practices by state and federal officials, two people familiar with the matter said.

The proposal made by banks yesterday during settlement talks in Washington came after state attorneys general and federal officials offered revised settlement terms and a proposal for banks to fund principal writedowns for homeowners.

The probe by all 50 states was triggered by claims of faulty foreclosure practices after the housing collapse, which state officials said may violate their laws. The original settlement proposal offered by states and federal agencies drew criticism from banks and Republican attorneys general opposed to a deal that would reduce principal amounts for borrowers.

In a new proposal, officials called for a fund, administered by state and federal officials, that would in part pay for principal writedowns, said Geoff Greenwood, a spokesman for Iowa Attorney General Tom Miller. Miller, a Democrat, is leading negotiations for the states. Attorneys general haven’t made a proposal for a payment by banks, Greenwood said.

The $5 billion payment proposed by the banks was reported earlier by the Wall Street Journal.

“An amount in that range would be viewed as a positive for the banks, given larger numbers have been referenced previously,” Brian Foran, an analyst with Nomura Securities International Inc. in New York, wrote in a report today. Regulators had previously suggested a $20 billion penalty.

Citigroup, Wells Fargo

State and federal officials have been negotiating with the mortgage servicers, a group that also includes Citigroup Inc. (C), Wells Fargo & Co. (WFC) and Ally Financial Inc. Miller has said the five companies service 59 percent of U.S. home loans.

Rick Simon, a spokesman for Charlotte, North Carolina-based Bank of America, and Teri Schrettenbrunner of San Francisco- based Wells Fargo didn’t return calls for comment after regular business hours yesterday.

Gina Proia, a spokeswoman for Detroit-based Ally Financial, New York-based JPMorgan Chase’s Thomas Kelly and Mark Rodgers, a spokesman for New York-based Citigroup, declined to comment.

The fund for principal reductions could pay for restitution to borrowers whose homes were improperly foreclosed on, Greenwood said.

Loans, Foreclosures

State and federal officials yesterday also revised provisions of their original March term sheet offered to mortgage servicers. That term sheet included requirements for how banks service loans and conduct home foreclosures. The changes aren’t substantially different from the original proposal and incorporate negotiations with the banks, Greenwood said. Those talks continue in Washington this week, he said.

Republican attorneys general criticized the original settlement proposal, saying the plan for principal reductions would encourage borrowers to default on loans to reduce payments. Some of those attorneys general met yesterday in Atlanta to discuss the issue, said Adam Temple of the Republican State Leadership Committee.

Bob Davis, an executive vice president with the American Bankers Association, spoke to the group in Atlanta, telling them principal reductions don’t work, he said in an interview. Loan balances must be reduced so much for borrowers struggling to make payments that it’s a better deal for lenders to foreclose instead, he said.

“Principal reductions don’t substantially improve the cash-flow problem,” Davis said. “You can’t lower principal enough to make it an attractive tool.”

Encouraging Defaults

During a conference call between state officials and the banks, some lenders said they opposed any settlement terms that would reduce loan balances, according to one of the people familiar with the talks. The banks argued a writedown plan would encourage homeowners to default, a notion some attorneys general on the call disputed, the person said.

Bank representatives said they were open to other types of loan modifications, including changing interest payments, said the person. Mortgage servicers have reached agreements with U.S. banking regulators to improve procedures for modifying loans and seizing homes.

Oklahoma Attorney General Scott Pruitt, a Republican, said last month that he may negotiate an alternative accord with the banks if the national settlement turns out to be “inconsistent with our conviction.”

‘Some’ Changes

Pruitt said in a letter to Miller in March that forcing lenders to reduce mortgage balances would take away incentives for banks to loan money and “destroy an already devastated housing market.”

Diane Clay, Pruitt’s spokeswoman, said in an interview that the latest settlement proposal incorporates “some” of the changes sought by the attorney general. She said she hadn’t seen the new terms.

“General Pruitt’s letter certainly helped move the negotiations along,” said Clay, who previously said several “industry representatives” had contacted with her office.

Other state attorneys general who have criticized the proposal to reduce principal balances include those from Florida, Texas, South Carolina, Virginia, Alabama, Nebraska and Georgia. Attorneys general for Florida, Georgia and Alabama were among the officials meeting in Atlanta yesterday, Temple said.

Lauren Kane, a spokeswoman for Georgia Attorney General Sam Olens, has said a bank, which she declined to identify, discussed with her office the federal regulator settlement. Adam Piper, a spokesman for South Carolina Attorney General Alan Wilson, said last month that two banking representatives “shared research” with his office and “pointed out some concerns with certain provisions” of the original proposal.

Jennifer Meale, a spokeswoman for Florida Attorney General Pam Bondi, said last month that her office has “had general discussions with banks about how the matter might be resolved.”

To contact the reporters on this story: David McLaughlin in New York at dmclaughlin9@bloomberg.net; Dakin Campbell in San Francisco at dcampbell27@bloomberg.net

To contact the editors responsible for this story: Michael Hytha at mhytha@bloomberg.net; David Scheer at dscheer@bloomberg.net