Not long ago, Yves Smith predicted that the proposed settlement between large mortgage lenders and state attorneys general was “likely to fall apart.” This week’s developments may prove her right.  

Iowa Attorney General Tom Miller has been leading a 50-state working group on mortgage fraud since last October. Critics have accused him of going too easy on the big banks, especially after Miller removed New York’s bulldog Attorney General Eric Schneiderman from the working group’s executive committee. The scope of immunity for major lenders has become an obstacle to a settlement. Schneiderman and some other AGs favor granting only limited immunity to cover so-called “robosigning” of documents. They want leeway to prosecute banks for other fraudulent practices. But as Smith discussed here, banks have little incentive to pay large damages without receiving broad immunity.

Complicating matters, the Federal Housing Finance Agency filed suit last week against more than a dozen major financial institutions over mortgage-backed securities they sold to investors.

“Defendants falsely represented that the underlying mortgage loans complied with certain underwriting standards and guidelines, including representations that significantly overstated the ability of the borrowers to repay their mortgage loans. These representations were material to the GSEs, as reasonable investors, and their falsity violates (the law) and constitutes negligent misrepresentation, common law fraud, and aiding and abetting fraud,” the FHFA said in the suit against Merrill Lynch.

“GSEs” means Government Sponsored Enterprise, in this case Fannie Mae and Freddie Mac, which purchase loans from private banks. The Federal Housing Finance Agency oversees Fannie Mae and Freddie Mac.

FHFA and various investors have alleged that banks, while packaging residential home loans into securities sold to investors, failed to conduct adequate due diligence, and hid or misstated the quality of the underlying loans and underwriting as well as borrowers’ ability to make payments.

As more borrowers fell behind or went into foreclosure, the value of securities backed by their loans fell, causing losses for investors.

Losses stemming from the precipitous deterioration in subprime and other mortgages pushed the government to take over Fannie Mae and Freddie Mac on Sept. 7, 2008. Since then, taxpayers have spent more than $140 billion to keep the firms afloat.

Several of the defendants in the FHFA lawsuits are party to negotiations with Miller’s working group. Citing an unnamed source “familiar” with those negotiations, Massimo Calabresi reported yesterday that five of the banks “cancelled a planned negotiating session” with the AG group this week:

The big mortgage servicers, including Bank of America, Citigroup, JP Morgan and others, were scheduled to meet late this week with the State AG negotiators as part of a separate investigation. Those talks are aimed at a settlement that will address standards for handling past and future mortgages, massive penalties (reportedly as high as $20 billion), and a release from legal liability for the servicers in other mortgage matters.

The State AGs did not foresee releasing the banks from liability for the kinds of violations alleged in the FHFA suit. The AGs are focused on the relationship between the banks and borrowers, while FHFA is focused on the bundled, or securitized, mortgages sold by the 17 firms. The big banks apparently were hoping they would be exempted from suits alleging they fraudulently sold bogus mortgages to investors, knowing they were less safe than advertised.

The Obama administration really, really wants a deal between the state AGs and the banks. Miller has tried to oblige, hurting his own reputation as a consumer advocate in the process. But if his team can’t deliver the big banks from the threat of litigation, there may be no settlement after all.