The mortgage mess that lead to foreclosure freezes by several large banks across much of the country may slow down the ability of banks to issue new mortgages, which could push the housing market into a sharp downward spiral.

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Even as banks begin to lift their voluntary moratoriums on foreclosures, the paperwork problems—banks discovering that they often were not producing valid proof of ownership in foreclosure proceedings—that led to the freezes have the potential to stymie new lending.

The paperwork problem is curable. Banks can go back through the chain of ownership of loans and liens to correct lapses.

But this process is time consuming and costly, especially when some of the original mortgage lenders or intermediary owners of the mortgages have gone bankrupt or been merged into other banks.

In the meantime, borrowers who have defaulted on their loans will likely be able to keep their homes for longer than they otherwise could. What’s more, banks are likely to find that more foreclosure actions are contested by borrowers as the public and attorneys eager to collect legal fees by fighting foreclosures become more aware of the documentation problems.

All this means that banks will find themselves with more bad loans on their books. The normal pace of run-off of bad loans—delinquency to default, default to foreclosure, foreclosure to sale—has meant banks have not been able to recover revenue on non-performing loans for upwards of a year and a half in much of the country. The new pace of run-off will likely mean that banks are stuck with the non-performing loans for far longer.

The longer it takes for banks to exit bad loans and recover cash, the higher the level of bad loans on the books of banks will get. As the non-performing loan portfolio grows, banks will need to set aside an increasing amount of capital to balance. This will, in turn, mean banks will make fewer home loans until the backlog of bad loans can be cleared up.

In short, the foreclosure crisis has the potential of creating a liquidity crisis for home loans. The actual number of defaults is not necessarily increasing—it’s just taking longer than usual to clear the old non-performing loans. But this means that banks aren’t generating revenue from the foreclosures. It also means that the loan portfolios will appear to be worsening as the percentages of non-performing loans grow.

This process of a liquidity crunch for the mortgage market could be short-circuited if both investors and regulators are willing to provide some relief to banks. Regulators at the FDIC and the Fed could grant dispensation to banks to keep making new loans despite spiking non-performance rates in the home loan portfolio.

Investors too could look beyond the temporary drop in recovery rates and rising default levels—although this is far from guaranteed. Investors could also panic at the bad numbers and sharply sell-off bank stocks. Bank executives are likely to fear the latter—which would mean that even if regulators grant relief, banks could still hold back when it comes to extending new home loans.

A liquidity crunch in the mortgage market would hit home sales hard. Buyers would discover credit harder to come by and more expensive, which would push down the price of homes even further. Coming after a summer with particularly brutal home sales numbers, this could set the stage for a sharp decline in home prices across much of the country.

And that’s when things will get really scary. A sharp decline in home prices would put even more borrowers underwater. Many buyers who are already underwater but hoping for a home price recovery might lose that hope. Default rates would grow, putting even more pressure on the banks to slow down lending. The further slowdown on lending would put more downward pressure on home prices. Rinse. Repeat.

In short, we could be looking at a downward spiral on home loan lending and home prices, thanks to sloppy paperwork by the banks that, in the rush to make new loans during the housing bubble, failed to make sure they were meeting legal requirements for perfecting and transferring mortgage interests in homes. It’s a mess the banks made—but the price of which may be visited upon many homeowners.

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