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.

Rick Sharga, senior vice president of RealtyTrac, which closely monitors foreclosure data, says that in recent months banks had been careful to initiate new proceedings only as quickly as they repossessed and sold other homes. Now that new moratoriums have been implemented, Sharga predicts there will be a superficial decline in foreclosures through at least the end of 2010, followed by an accelerated pace in the spring. In the worst-case scenario - if, say, another nationwide moratorium is put in place for an extended period - Sharga says it could have dire effects for the housing market and broader economy.

"This is one of those cases where you have to manage the recovery and allow these losses to be absorbed in a more gradual manner so you don't accidentally take down the banking system," says Sharga. "We're probably talking about, from peak to trough, a couple trillion dollars in lost value that has to be recognized somewhere."

"If you rip this Band-Aid off," he concludes, "you might tear off the sutures and the patient could bleed to death."

The other lurking danger for big banks is private litigation stemming from the tangled web of mortgage securitization.

At issue is the practice of "robosigning." Bank employees had been scribbling autographs on thousands of foreclosure documents without verifying all the information. Although the homeowner may have defaulted, attorneys general are claiming "crime on the court" because proper procedures weren't followed. Investors who have taken big hits on defaulted mortgage bonds may claim that they still have legal rights to the foreclosed-upon homes.

Joseph Lynyak, a partner in the financial services practice of Venable LLP, says those cases are what should have big banks really worried.

"If you're an investor, you're sitting back, saying, 'Wait a minute. We hired you to do this properly and you haven't done it. We may be sued and you've got to indemnify us,'" says Lynyak, who advises large banks and mortgage servicing firms. "It could get very, very sticky."

As the mounting troubles became clear in recent weeks, big banks hit the "pause" button on foreclosures.

The largest mortgage servicer, Bank of America ( BAC), has halted proceedings completely, while competitors have done so in selected states. JPMorgan Chase ( JPM) is reviewing 115,000 documents for potential errors. GMAC Mortgage faces lawsuits from the Ohio State Attorney General, as well as a group of homeowners in Maine. Citigroup, Wells Fargo ( WFC), PNC Financial Services ( PNC), U.S. Bancorp ( USB) and Goldman Sachs' ( GS) loan servicing division have all gotten roped into the "robo"-scandal in one way or another, too.

"A lot of the banks have really screwed up with this," says Eli Lehrer, national director of the Center on Finance, Insurance and Real Estate at The Heartland Institute, a conservative think-tank based in Chicago.

Meanwhile, the foreclosure freeze has begun to create a chilling effect on the entire housing market.

New buyers have stepped back from the market for distressed property, which now accounts for more than 30% of new transactions, according to RealtyTrac. New owners are worried they don't have a legal right to their homes. Title insurers are worried about their exposure to faulty documents and unwilling to stand behind new purchases. Since title insurance is required for most mortgages, the market is essentially at a standstill.

"Additional uncertainty has been brought to a very fragile market," says Brungardt, of RoundPoint, an origination and servicing shop. "I think the impact should not be underestimated."

So far, the only government lawsuit has been that of Ohio Attorney General Richard Cordray against GMAC. He is seeking up to $25,000 for each affidavit that is found to be fraudulent, along with undefined restitution for affected consumers. Attorneys general in 49 states, including Ohio, have also joined forces to investigate and potentially prosecute other banks as well.

Cordray has said the investigations aren't focused on "mere technicalities," but industry insiders and political observers suspect that government inquiries can be resolved relatively quickly.

"The evidence so far indicates that these were more process screw-ups that should be reasonably easy to correct," says Lehrer, of The Heartland Institute. "So as long as attorneys general don't find actual evidence of criminal wrongdoing and try to make it up for political gain, there's a lot of incentive for everybody involved to bring this to a close very quickly."

James Gomes, onetime adviser to onetime presidential contender Sen. John Kerry (D., Mass.), says foreclosures have taken center stage ahead of the elections. But he doesn't expect the issue to gain much traction on Capitol Hill, even if Republicans get more seats in Congress, as expected.

""There is no mention of mortgage foreclosures in the Republicans' 'Pledge to America,'" says Gomes, who is now director of the Mosakowski Institute for Public Enterprise at Clark University.

The outcome of private court battles - in which interested parties have very different incentives - seems far less predictable.

Lynyak notes that there are several financial parties to most securitized mortgages - servicers, subservicers, special servicers, title insurers and owners - all of whom share the income and costs of mortgage lending.

"The political issue is easy - 'This is horrible, what are these people doing, etc.'," says Lynyak. "But getting into the bushes on the legal rights and obligations of the parties, I think, is going to take time."

With all the parties involved, it's hard to say definitively who should bear the cost of debt gone bad. But because banks serve as central clearinghouses for mortgage debt, and because they have the most cash in the till, they're an easy target for class-action attorneys.

Josh Shein is a reformed mortgage broker of sorts whose Maryland-based company, Great Oak Lending, now keeps loans on its books. Shein says the banking industry has two "daunting tasks" ahead - figuring out who is liable for the trillions of dollars in lost home value and changing the culture of the business.

Shein describes a typical mortgage transaction before lenders were facing the backlash of a mortgage bubble gone berserk: "This loan was sold three times. It was brokered by XYZ Company. At the time there was no licensing involved for that individual loan officer, so we don't even know who actually did this loan. Then there are servicing issues here and there, with a bunch of places handling them. They talked to a loan-modification company to try to work it out - and maybe it did or didn't get somewhere. Then the foreclosure issue comes up and it ends up getting passed to this other company to do that."

"There's all these different players getting involved," Shein concludes. "It confuses and muddies the waters so no one really knows how to resolve this."

-- Written by Lauren Tara LaCapra in New York.

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