The most powerful Wall Street banks are used to getting their own way, especially with politicians, but New York’s attorney general is trying to turn the tables on them. Eric Schneiderman is digging into the accumulating evidence of massive fraud and false documentation revealed by the foreclosure mess and asks a potentially explosive question: How bad is it?

The answer could prove devastating for some of the largest financial institutions in the land, confronting them with huge new losses and maybe renewing the banking crisis the Obama administration thought it had resolved. Perhaps that’s why law-enforcement agencies, state and federal, have not undertaken a thorough investigation of the scandal—they’re afraid of what they might find. The newly elected New York AG has been obliquely warned that his inquiry could “blow up the economy,” but he ignores the scare talk. If the evidence is there, it should definitely put the banks on the defensive, for a change.

In recent months, Schneiderman’s office has dispatched requests for records and information from seven of the biggest banks (Bank of America, JPMorgan Chase, Wells Fargo, Goldman Sachs, UBS, Royal Bank of Scotland and Deutsche Bank). One way or another, they were the leading players in the housing bubble, either by originating subprime mortgages of dubious quality or by packaging the mortgage-backed securities that turned into toxic assets for unwitting investors.

Schneiderman has further requested information from four bond insurers that backed the investment paper, a Buffalo law firm known as a mortgage mill and two private equity firms that owned processing firms in the mortgage market. Most important, however, is his request to see files from the two leading banks—Deutsche Bank and Bank of New York Mellon—that acted as trustees for the mortgage securities, certifying that all complied with property-law requirements and provided the proper documentation.

The storm of foreclosure litigation during the past year strongly suggests the opposite. Around the country, lawyers for homeowners have won scores of cases blocking banks from foreclosing on their clients. Courts have held that mortgages or securities were fatally flawed and therefore void. Banks filed false affidavits and unsupported documents, in effect defrauding the courts. When judges asked for backup evidence of ownership, lawyers went to the trustees and found that the mortgages and liens were not in the files. Bankers couldn’t prove they owned the homes they were seizing. Often they couldn’t even establish who owned the loans or whether borrowers were actually in default. Many documents were signed by untrained functionaries who didn’t bother to examine what they were signing.

Officials in Washington at first downplayed the implications, suggesting that bureaucratic sloppiness by the banks was not a reason to intervene in the foreclosure process. But the essence of this scandal goes to the heart of capitalism—the American system of property law. The most prestigious financial firms abused and distorted that system in their rush to accumulate greater profit, with less responsibility for the results.

The Congressional Oversight Panel, led by Elizabeth Warren, investigated the mess last year and warned in its report, “If documentation problems prove to be pervasive…the consequences could be severe.” The details are complicated, but the essential meaning was described by Damon Silvers, AFL-CIO associate general counsel and deputy chair of the COP. “Here’s why all this is so dangerous,” he explained. “Property law requires very precise documentation at every step in the process because the whole economy comes apart if you can’t be certain who owns what. When you buy a house, the bank insists you comply with the property-law regime, and you sign pages and pages of agreements to do so. And you can lose your home if you fail to comply. Yet in this situation the banks did not comply themselves—that’s what’s mind-boggling.”

The legal fallout promises to produce a nightmare of litigation, as indebted homeowners and defrauded investors press their arguments that the bankers’ claims are fraudulent or at least void because they do not fulfill legal requirements. The New York Times reported recently that the pace of foreclosures is slowing this year, even though the number of underwater homeowners grows steadily larger.

Civil lawsuits by injured investors and creditors have already piled up approximately $200 billion in claims against leading banks, cases that are working their way through the courts. Some $47 billion in claims are lodged against Bank of America alone—more than its total capital. Despite the return of fat executive bonuses, the balance sheets of banking behemoths remain fragile. In the extreme case, a deeper investigation may establish criminal liability for executives if they knowingly consented to deceiving investors, borrowers, bankruptcy courts or regulators.

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If this were a movie, we could cast Schneiderman as Gary Cooper in High Noon—the lonely sheriff who stands up to the outlaw gang while frightened townspeople are afraid to challenge the banksters. The AG was known as a gutsy reformer when he was a progressive state senator representing New York City’s Upper West Side. He fought bosses in both political parties, took on hard fights like repealing the Rockefeller drug laws and was sometimes dubbed “the smartest guy in the room,” definitely not “one of the boys.” He won a tough, come-from-behind race for attorney general in 2010.

In this saga, Schneiderman is definitely not with the crowd. As facts about the banks’ ugly behavior gathered headlines, the fifty state attorneys general came together to demand reforms. The effort was chaired by Democrat Tom Miller of Iowa and actively coached by Washington officials from the Justice Department and HUD. The Obama administration is eager to get a settlement, fearing that state-by-state litigation will injure the banks and maybe derail the foreclosure process.

The AGs first suggested a settlement of $20–25 billion—even though the true public loss would probably be much greater—plus a commitment from the banks to clean up their procedures. In exchange, the AGs would agree to release the banks from potential liabilities that states might pursue. The banks’ counteroffer was a trivial $5 billion, which suggests that they are not taking the AGs too seriously. Besides, the banks are already facing a potentially more formidable reformer in the new Consumer Financial Protection Bureau, which they are fighting fiercely to disable [see Ari Berman, “Disarming the Consumer Cop,” June 20].

Schneiderman agreed to participate with other AGs, but warned from the start that New York would refuse to give up its right to hold banks liable—to sue and collect damages or impose court-ordered reforms. Other strong states, including California and Massachusetts, evidently agree. That alone would presumably doom the deal-making, since any settlement that does not include New York and California would probably not be worth much to the bankers. Schneiderman’s complaint is that the other AGs are proceeding backward, negotiating with bankers before the AGs have done a serious investigation that shows how pervasive the malpractice was and how gravely the public has been injured. Without that, it’s like selling your house before you have any idea what it’s worth.

How bad is it in banking? Schneiderman hopes to find answers from his broader inquiry. The investigation is intended to give the state leverage with bankers in any subsequent negotiations to work out their crime and punishment. If the facts are as ugly as the private lawsuits seem to indicate, the evidence may suggest formal charges at various levels of the industry before anyone thinks about negotiated settlements. For obvious reasons, Schneiderman and staff will not discuss details, and certainly not the potential terms of a settlement.

Genuine relief for the mortgage scandal should help stanch the slow bleeding of failing debtors, but relief should also help the economy to recover. The operative principle should be that everyone takes a hit, with creditors as well as debtors sharing the pain. But that’s not how the Obama administration has proceeded. Government interventions have generally tried to shield banks and other creditors from swallowing the cost of their financial follies, presumably because officials think that would damage the economy.

The banker-friendly logic has not been confirmed by events. Housing prices are still falling, and more and more families are sinking under water. The housing sector, long the backbone of the national economy, remains moribund. Banks are healing but still not lending.

A major intervention in housing might look like this: compel the banks to take a big hit—a much bigger price tag than anything now discussed. In exchange, homeowners would have to agree that the banks have a valid claim or negotiate away their differences. The bankers’ billions would essentially pay for a mandatory debt workout program for drowning households—reducing the principal and interest payments on mortgage debt so they can gradually recover. Families that are too far gone for a workout should be given the chance to stay in their homes as renters, with a buy-back provision if the economy turns up and they regain viable income.

Banks have naturally resisted any settlement like this (so has Treasury Secretary Tim Geithner). Maybe the banks and their political cheerleaders will be softened up if Eric Schneiderman and other AGs begin to nail them with hard facts and costly legal judgments. Which poison do they prefer? The housing crisis is not going away until some political force finds a way to move it off dead center.

If the federal government muscles state governments into accepting a cheap settlement, that still doesn’t relieve the banking industry of treacherous legal threats. As Damon Silvers has pointed out, the core problem in this mess involves property rights—rights that belong to citizens and cannot be given away by government. If necessary, people themselves will continue their fight with the bankers, with gathering force and ingenuity. Bankers may eventually decide they are better off settling.

If government fails to moderate the suffering and steer the economy toward a gentler recovery, sooner or later the markets will solve things for us, perhaps violently and irrationally. If that happens, the next crisis will not be about debt and deficits but about the gradual unraveling of the entire financial system.