Bank of America Corp., Wells Fargo & Co. and fellow mortgage servicers are more likely to dodge a threatened $20 billion in penalties for faulty foreclosures after U.S. agencies cut ahead of the states by signing deals without fines.

A task force of 50 state attorneys general already was arguing internally over proposed sanctions when people familiar with the talks said the Federal Reserve, Office of the Comptroller of the Currency, Office of Thrift Supervision and Federal Deposit Insurance Corp. began making the deals. While the U.S. watchdogs may yet seek fines, the pacts ease pressure on the banks and erode states’ leverage, said Gilbert Schwartz, a former Fed attorney.

“This puts the attorneys general in an uncomfortable position,” because it reduces the list of outstanding demands and helps firms show progress in fixing lapses, said Schwartz, a partner at law firm Schwartz & Ballen LLP in Washington who is not involved in negotiations. “By settling with the banking agencies, it sets the upper limit on what the banks would be willing to do. This seems to have drawn a line in the sand.”

The first of as many as 14 mortgage servicers signed accords this week agreeing to improve internal controls, communications with borrowers and other processes, said two people familiar with the matter. They are the first sanctions to arise from last year’s probe into so-called robo-signing, in which mortgage firms and their contractors vouched for thousands of foreclosure documents without verifying their accuracy.

Financial Penalties

The U.S. agreements proceeded without the backing of the attorneys general, led by Iowa’s Thomas J. Miller, who undertook joint probe last year and have sought to change servicers’ behavior and extract financial penalties. In early March, the group circulated a 27-page settlement “term sheet” outlining future rules on mortgage servicing and conditions for possible mortgage modifications.

Miller, in an April 4 statement, said he’s “disappointed” to see reports that some U.S. watchdogs may pursue their own accords. Miller said he had hoped the agencies would cooperate because “to work closely with all of us would protect the public interest to the fullest.”

Geoff Greenwood, a spokesman for Miller, said yesterday that the actions of U.S. regulators won’t affect the efforts of the attorneys general.

“We see any settlement they may reach as a floor, not a ceiling,” Greenwood said. “We still don’t know what their agreement would say because we haven’t been notified.”

$20 Billion

The attorneys general previously suggested a $20 billion penalty as part of any deal, a figure cited by Elizabeth Warren’s Consumer Financial Protection Bureau, which said in a Feb. 14 presentation that banks had saved more than that amount by cutting corners during foreclosures. A $5 billion penalty would be “too low,” and banks can afford more, the agency wrote in the document.

Lenders countered with a March 28 draft proposal that didn’t include principal reductions or fines, and after a March 30 meeting with servicers, state officials and federal agencies, Miller said there’s “a long way to go” to reach an agreement.

Spokesmen for the FDIC, Fed, OCC and OTS declined to comment, as did representatives of San Francisco-based Wells Fargo and Bank of America, based in Charlotte, North Carolina.

Writing down principal and imposing fines has been “more of a sticking point with the AGs, and it’s going to be more difficult to come to a resolution with that constituency than it would be with the banking regulators,” said Jason Goldberg, an analyst with Barclays Capital in New York.

Short Sales

The states and the Obama administration are trying to help the almost 25 percent of U.S. mortgage holders who are underwater, meaning the debt is more than the home is worth. Banks have been reluctant to write down principal, and so-called short sales, where a home is sold for less than the loan balance, have lagged home seizures as a lengthy consent process by loan holders deters potential buyers.

Foreclosure filings reached a record 2.9 million in 2010, according to RealtyTrac Inc., an Irvine, California-based data company. After a rebound in the second half of last year, home sales have resumed their decline as foreclosures expand the inventory of unsold properties and push values lower.

‘Good Outcome’

“There appears to be a divergence between the federal agencies and the state attorneys general as to what they consider to be a good outcome,” said Patrick McManemin, a Dallas-based partner at Patton Boggs LLP, a law firm that represents banks, loan servicers and financial institutions.

There’s also a split among the states, with the attorneys general of Oklahoma, Nebraska, Alabama, Virginia, Texas, Florida and South Carolina writing letters to Miller last month voicing their displeasure. Republican lawmakers complained about the proposed settlement and questioned whether the Consumer Financial Protection Bureau has authority to take part in the talks.

“In that initial draft it really did seem like the state AGs were overstepping,” said Stephen F.J. Ornstein, a Washington partner of the law firm SNR Denton LLP. The scope of the original proposal may have delayed any settlement the AGs could have reached, he said.

Acting Comptroller of the Currency John Walsh said in February that the OCC and other U.S. bank regulators were “in the process of finalizing actions” to impose “remedial requirements and sanctions” on mortgage servicers. The OCC sent cease-and-desist orders to servicers that month, according to a person familiar with the matter.

Imposing Penalties

This week’s agreements don’t prevent federal regulators from imposing financial penalties later, and are simply an effort to give near-term relief to borrowers trying to work out loan modifications or avoid foreclosures, said one person familiar with the process.

Regulators continue to be part of negotiations with attorneys general, the Justice Department and banks, and are expected to be a party to any global settlement if one is reached, said three people with knowledge of the process who did not want to be named because the negotiations aren’t public.

“Issues such as principal reduction, treatment of second mortgages, state and federal fines all continue to be in play,” McManemin said.

Banks likely will try to use the agreements with regulators as leverage to undermine the efforts by state attorneys general to reach a universal settlement, Alan White, a law professor at Valparaiso University in Indiana, said in a telephone interview.

‘Turf Protection’

The banks might argue that any state investigation is preempted by the actions of their federal banking regulator, and may be backed in that claim by the OCC, which has taken a “very aggressive” position in the past arguing that federal banking laws preempt state laws, White said.

This settlement “is turf protection, but it’s also a way of supplanting the attorneys general as the people’s representative who can speak and act,” said Ellen Marshall, a partner at Manatt, Phelps & Phillips LLP in Costa Mesa, California. Regulators “have the sweep of the whole nation and so they can reach an agreement.”

One interpretation of the financial penalties imposed by the attorneys general was that it would “undermine safety and soundness at a critical time” for the banks, Ornstein said.

Capital Levels

That was countered by Brian Foran, an analyst with Nomura Holdings Inc. in New York, who said any principal reductions wouldn’t have a large impact on banks’ capital levels. The CFPB presentation showed that a penalty based on the billions of dollars in servicing costs avoided by the banks would reduce Tier 1 capital by 47 basis points at Wells Fargo and 30 basis points for Bank of America. A basis point is one one-hundredth of a percentage point.

“The problem is that a lot of the rhetoric is ‘The banks can afford this, therefore it must be fine to do,’” Foran said in a phone interview. “People would become very worried about what’s next, the banks will probably continue to tighten their mortgage underwriting standards, which is counterproductive, and it leads down a slippery slope.”