Any potential settlement U.S. regulators reach with large mortgage lenders and servicers to modify loans and pay $20 billion or so to help borrowers underwater on their mortgage will do little to help the already fragile market recover, according to Bank of America Merrill Lynch analysts. Discussing details of the settlement first reported by The Wall Street Journal, mortgage-backed securities strategists Chris Flanagan, Vipul Jain and Timothy Isgro said the likelihood of a fine and principal reduction program is low. The Journal cited anonymous people familiar with the negotiations of the settlement, and said the nation’s largest banks have yet to receive any proposal. “We believe that a $20 billion levy on banks to fund principal reduction would bring with it enormous costs that would far outweigh any potential benefits,” the analysts said. Analysts at Keefe, Bruyette & Woods said the suggested amount of the settlement “seems high” and talks are in the early stages, so “it is too soon to draw significant conclusions” regarding companies that could be effected. “We believe the most likely scenario would be a settlement where the servicers agree to a certain amount of money to provide principal writedown as part of mortgage modifications,” Bose George, Jade Rahmani and Ryan O’Steen said in a research note. Meanwhile, the number of foreclosures in 2011 is projected to top the record level of last year and some expect it to take four years to clear the supply of distressed homes on the market. “Since the beginning of the housing crisis, we think that moral hazard cost has been the core issue and challenge related to principal reduction: Why shouldn’t everybody get it and what negative behavior would a borrower need to exhibit in order to qualify for reduction?” the BofAML analysts said in a non-agency MBS research note. The proposed $20 billion fine would do little to address the nation’s aggregate negative equity of $744 billion, as estimated by CoreLogic, according to BofAML. The analysts think banks would tighten private credit availability if this proposed settlement or others come down, “which in turn could damage the housing recovery, and force the government to assume an even larger role in housing finance than its current 94% share.” Admitting that quantifying negative-equity risk is “almost impossible,” Flanagan said BofAML thinks banks “would immediately recognize that they have to incorporate the risk of future levies into the pricing of mortgage credit.” In short, mortgage lending could come to a complete halt. “In our view, this proposal would re-open the property question and create somewhat unquantifiable tail risk to the downside for home prices,” the analysts said. The questions being raised about who has the right to foreclose remain the core issue facing mortgage-backed securities. While only a fraction of borrowers have been able to prove they were improperly foreclosure upon, banks are always seeking to limit exposure to too much risk. “There is a simple way for banks to manage this tail risk: namely stopping mortgage lending, which clearly would be an unacceptable outcome,” BofAML analysts said. Write to Jason Philyaw.