Five U.S. banks will pay more than $25 billion in the biggest civil settlement involving states and the federal government to end a probe of abusive foreclosure practices stemming from the collapse of the housing bubble.

The U.S. Justice Department and Department of Housing and Urban Development announced the resolution of the 16-month nationwide state and federal probe today.

Citigroup Inc., Bank of America Corp. and Wells Fargo & Co. are among the banks — the nation’s five largest servicers — participating so far. With 49 state attorneys general on board, U.S. Attorney General Eric Holder called the agreement the largest federal-state civil settlement in U.S. history.

“This agreement establishes significant new homeowner protections,” Holder said at a press conference. “It also provides substantial financial assistance to victim borrowers.”

The $25 billion agreement includes $5 billion in cash for states to pay for foreclosure-prevention initiatives. About $17 billion will pay for mortgage debt forgiveness, forbearance, short sales and other assistance to homeowners. Servicers will refinance $3 billion in refinancings to lower homeowners’ interest rates and pay about $1.5 billion to homeowners harmed by botched foreclosures.

Officials said the current agreement totals more than $25 billion, and is expected to reach $26 billion in a matter of days.

Total May Grow

The total figure could grow to $40 billion if the next nine largest mortgage servicers sign on to the agreement, said Housing and Urban Development Secretary Shaun Donovan. In a best-case scenario, if all banks participate fully, the deal could be worth $45 billion to homeowners and victims of foreclosure.

The settlement does not prevent state and federal authorities from pursuing criminal cases, Holder said.

“Our investigations revealed disturbing practices,” including pushing borrowers into foreclosure, Holder said. “They fueled the downward spiral of our economy.”

The settlement comes more than a year after attorneys general from all 50 states announced an investigation into foreclosure practices following disclosures that banks were using faulty documents to seize homes. The only state not to agree to the settlement at the time of the announcement was Oklahoma, according to a federal website set up to provide information on the settlement.

Not Punishment

The goal is to not just punish banks responsible for botched foreclosures but repair damaged neighborhoods, Donovan said.

“We all recognize you can’t undo the pain of the crisis by writing a check,” Donovan said. The settlement “forces the banks to clean up their acts.”

Borrowers whose loans are owned by banks and haven’t been pooled into mortgage bonds will be most likely to benefit from the agreement, said an administration official who briefed reporters on condition of anonymity in advance of the announcement. Borrowers who suffered foreclosures from the start of 2008 through 2011 will be eligible for payment.

The actual amount of restitution to individual borrowers will depend on how many make claims, with the official estimating that each borrower could get between $1,500 and $2,000.

Banks must spend the money within three years or face a fine. The proposal must be approved by a federal judge. Banks will get extra credit for funds distributed in the first 12 months, the official said.

OCC Settlement

In a separate announcement, the Office of Comptroller of the Currency said four of the largest servicers would pay $394 million in fines in connection with a set of April consent agreements on unsound mortgage servicing.

The four banks — Bank of America, Citibank, JPMorgan (JPM) Chase and Wells Fargo — will be able to satisfy those penalties with actions they take under the larger multistate agreement. The penalties are in addition to any restitution the banks must pay individual victims under the OCC agreement.

New York Attorney General Eric Schneiderman and California Attorney General Kamala Harris agreed to join the settlement yesterday, a person familiar with the matter said.

‘A Huge Deal’

“With California and New York signing on, it’s a huge deal,” said Kurt Eggert, a professor at Chapman University School of Law in California who has been following the talks. “California and New York were the biggest critics of this deal, so if they sign on, that’s a sign that this is a real deal.”

In a press release, California Attorney General Kamala Harris said her state, one of the hardest hit by foreclosures, would get $18 billion under the deal.

The settlement preserves any state and federal criminal claims, claims related to mortgage securitization, including those under New York’s securities fraud statute, and fair lending laws, and claims brought by individual homeowners, among other matters.

Tracking Compliance

The resolution also establishes a monitor, Joseph A. Smith Jr., North Carolina’s top banking regulator, to track compliance with the terms of the agreement.

The 50-state investigation, announced Oct. 13, 2010, came after New York-based JPMorgan, the largest U.S. bank by assets, and Ally Financial (ALLY)’s GMAC mortgage unit said they would stop repossessions in 23 states where courts supervise home seizures, and Charlotte, North Carolina-based Bank of America froze foreclosures nationwide.

Ally, based in Detroit, was first to freeze evictions in September 2010, after depositions in lawsuits challenging foreclosures surfaced showing that employees signed affidavits containing information they didn’t personally know was true. In December 2009, a GMAC employee said in a deposition in a foreclosure case filed in West Palm Beach, Florida, that his team of 13 people signed about 10,000 documents a month without verifying their accuracy.

The attorneys general began negotiating first with the five largest servicers because they held almost 60 percent of home loans, Miller has said.

Bank of America, JPMorgan, New York-based Citigroup, San Francisco-based Wells Fargo and other mortgage servicers have also been required by the Office of the Comptroller of the Currency to improve their foreclosure procedures.

The OCC in April 2011 announced enforcement actions against the companies for “unsafe and unsound” practices related to loan servicing and foreclosures.