Nov. 16, 2010 -- Foreclosure fraud problems could cause the U.S. housing market to collapse, push the "precarious" financial system into disarray and shatter the economy's fragile recovery, a government watchdog warned in a new report due out today.

"Even as the government's response to the financial crisis is drawing to a close, severe threats remain that have the potential to damage financial stability," the Congressional Oversight Panel concluded in the first federal report on the foreclosure fraud problems.

"If documentation problems prove to be pervasive and, more importantly, throw into doubt the ownership of not only foreclosed properties but also pooled mortgages, the consequences could be severe. Clear and uncontested property rights are the foundation of the housing market. If these rights fall into question, that foundation could collapse."

While the Treasury Department has said that evidence to date shows that mortgage-related problems pose no threat to the financial system, the watchdog cautions that such a view is "premature."

While under a best-case scenario, the problems could prove "overblown" -- the work of only "a handful of employees" at mortgage servicers who failed to follow proper procedure -- the panel said there is a "considerably grimmer" outcome.

Under a worst-case scenario, the servicers will not be able to prove that they own the mortgage loans they claim to own. Under such a scenario, the banks, the government and homeowners would all end up hurting, only two years after the 2008 meltdown.

The banks, for instance, could face "significant harm" if the validity of 33 million loans is called into question. If an investor in a mortgage-backed security were to force a bank to repurchase a loan because the firm had misrepresented the quality of that loan, the problems could be severe. One such investor action, the panel said, could force Bank of America to repurchase and absorb partial losses on up to $47 billion in bad loans.

Avoiding Worst-Case Scenario

The government would suffer, too. Treasury's $50 billion foreclosure prevention program has already been deemed a failure by critics, but documentation fraud could mean that some servicers working with the agency might not even have legal rights to modify loans, demand payments or foreclose on homeowners.

Homeowners, of course, would also suffer if the fraud issues prove to be more widespread than anticipated, with their faith in due process challenged and their confidence in the financial system shaken even more than it already has been.

To avoid the worst-case scenario, the panel said, the Obama administration should "explain why it sees no danger" to the $6.4 trillion market and banking regulators should conduct another round of stress tests to see how banks could overcome "a potential crisis."

In a statement in response to the report, a Treasury spokesman denounced foreclosure fraud as "unacceptable" and vowed to "monitor the situation closely."

"We strongly believe that the reported behavior within the mortgage-servicer industry is simply unacceptable, and servicers who have failed to follow the law must be held accountable," Treasury spokesman Mark Paustenbach said. "That's why the administration has led a coordinated interagency effort to investigate misconduct, protect homeowners and mitigate any long-term effects on the housing market.

"The independent regulatory agencies, the Justice Department and [the Department of Housing and Urban Development] are examining servicers' behavior, and we will continue to monitor the situation closely."

The panel, now chaired by outgoing Delaware Sen. Ted Kaufman, will release its report today, the same day the Senate Banking Committee holds a hearing on the documentation problems, as Washington takes aim at the foreclosure fraud issues that have emerged in recent months.

Kaufman last month replaced Elizabeth Warren, who signed on with the Obama administration to oversee the new consumer protection bureau, created as part of this year's sweeping Wall Street overhaul.