Foreclosure Crisis: The Worst-Case Scenario

NEW YORK (TheStreet) -- Foreclosure delays implemented by big lenders, demanded by politicians and spurred on by the plaintiffs' bar could have a devastating effect on the housing market if dragged out over the next several months.

In the realm of politics, lawmakers and attorneys general have taken a tough stand against banks' practice of "robosigning" foreclosure documents. In an effort to cast themselves as the new "sheriffs of Wall Street," politicians have issued a flurry of anti-bank statements ahead of a highly partisan election battle next month.

"In the midst of a $700 billion Wall Street bailout, Congress still has no answers for struggling homeowners," said Michigan state Sen. Hansen Clarke, a Democrat running for Congress. "Michigan should take this opportunity to set a positive example for our nation by freezing foreclosures for two years, allowing people to stay in their homes and make reduced payments until they get back on their feet."

More prominent politicians haven't gone quite that far in their rhetoric - partly because the Obama administration stands firmly against any mandated moratorium. Nonetheless, lawmakers like Sen. Harry Reid (D., Nev.) and Rep. Adolphus Towns (D., N.Y.) have applauded the steps taken by lenders to halt foreclosure proceedings. The industry took such dramatic steps only after attorneys general banded together threatening legal action.

Politicians may be showing solidarity with constituents' No. 1 concern - the economy. But the foreclosure freeze actually stands to hurt the economy in the long run, especially if it extends beyond year-end. Servicers may end up flooding the market with millions of distressed properties when foreclosure-dams are lifted. That would only depress prices further and drag out the time horizon for improvement.

"This could extend the recovery timeline from anywhere from 6 to 18 months," says Kevin Brungardt, a former Citi Mortgage official who now runs RoundPoint Financial. "I know that's a pretty broad spread. But we've got a foreclosure overhang inventory that's estimated at 7 to 8 million properties right now that are going to come onto the market in next 24 months."

The timing of this foreclosure mayhem is particularly discouraging for the industry.

Foreclosure efforts had initially been delayed because of a nationwide moratorium and modification efforts that were officially "requested" by the government, but effectively mandated. Both initiatives failed to spur a recovery, allowing banks to start pushing distressed property through the foreclosure pipeline -- in a controlled, but aggressive manner.