Ever since the robo-signing scandal erupted in October 2010, large U.S. banks have slowly come to realize that their practices are under ever-increasing scrutiny. A “Duh!” observation for most people, but not, apparently, for bankers.

Belatedly, the bankers took a closer look at their internal procedures for handling defaulted mortgages. It did not take long for them to discover that something significant was amiss. By mid-2011, most of the major money center banks had put the brakes on their normal foreclosure machinery: “What was all this sturm und drang over some bums who don’t pay their bills? Perhaps we better look into it.”

Their internal review of how mortgages in default were handled revealed a surprising amount of chicanery. Indeed, most of what was going on had elements of something wrong. The banks might have been better served had they asked the question: “Are we doing anything legally?”

As it turned out, not very much.

Large banks had long used outside law firms and third-party service processors to pursue recoveries from debtors. What made this cycle so different was the sheer volume: A massive increase in foreclosures combined with a big upsurge in outside vendors to process them. The combination ran roughshod over centuries of property laws, to say nothing of well-established banking procedures and legal practices.

(The Washington Post/Source: RealtyTrac)

Using third parties did not protect the banks from liability. As it turns out, subcontracting fraud does not insulate your organization from the illegal behavior of your hires. This created a problem for the banks.

Eventually, some smart executive figured out exactly how rampant the illegal robo-signings had become and halted the runaway foreclosure process. Even though it was temporary, it gave the banks some time to try to clean up their acts. While there was hope of a settlement (as opposed to prosecution), the banks stopped processing defaulted home loans. This voluntary foreclosure abatement continued even as negotiations plodded on with the U.S. attorney general. Thus, with the foreclosure pipeline shut down for well over a year, home prices stabilized and distressed sales fell as a percentage of total home sales.

Ultimately, the attorneys general settlement amounted to a mere slap on the wrist for the banks in light of the institutionalized fraud that occurred.

With all that legal unpleasantness behind them, the voluntary foreclosure abatements quietly ended. This year, the banks began to once again review unpaid home loans. It takes a while for the creaky, wheezy, inadequate machinery of processing defaulted mortgages to rumble back to life. So it has — and we should expect to see signs of increasing foreclosures and distressed sales any day now.

The first data point supporting this was April’s existing-home sales. That gave us an early clue about what was to come. During the abatement period, distressed home sales, including foreclosures and short sales, had fallen substantially. They were down to 28 percent of existing-home sales for April – significantly less than the 37 percent a year earlier.

Distressed homes tend to sell for about 20 percent less than non-distressed sales.

The voluntary foreclosure abatement not only reduced the number of foreclosures, but also created the appearance of improving home prices. In reality, it was merely temporarily removed low-price, distressed properties from the overall pool of homes for sale.

That fortuitous set of circumstances appears to be over. Current foreclosure filings — default notices, scheduled auctions and bank repossessions — increased in May by 9 percent, according to the RealtyTrac monthly foreclosure report.

This was right on cue. With the abatements over, foreclosure starts are creeping up again. As the foreclosure machinery ramps up, the negative ramifications they bring will expand. More distressed sales, lower prices and increasingly tough comparable appraisals are likely over the next 12 months.

To give you an idea of what is in store, consider this amazing statistic, courtesy of Laurie Goodman, housing analyst at Amherst Securities: 2.8 million Americans are 12 months or more behind on their mortgages. That degree of delinquency leads to an overwhelming percentage of foreclosure starts. It is reasonable to expect that 95 percent of these will end up as a foreclosure, distressed sale or walkaway.

As you might imagine, Goodman is not expecting a quick housing turnaround. An “L”-shape recovery is the most likely outcome, she says. Home prices still have 3 to 5 percent more downside. And, Goodman notes, they are likely to stay flat for three to five more years.

Credit availability is another factor holding housing activity down. In a May 30 research report, Goodman analyzed the credit scores of existing homeowners. “Since 2007, 19 percent of all borrowers (about 9 million mortgagees) have gone more than 90 days delinquent on their mortgages, or have had their mortgage liquidated,” she wrote. “Based on this delinquency alone, nearly all of these borrowers would be unable to qualify for credit today.”

Why does this matter? Consider what removing one in five people who qualified for a mortgage not too long ago does to the demand side of the housing market. The 90-day delinquency on their credit reports prevents them from qualifying for a mortgage. Removing those people as potential home buyers amounts to a huge reduction in demand.

After an era of easy credit and no-documentation loans, the pendulum has now swung in the opposite direction. Despite the cheapest housing prices in a decade and the lowest mortgage rates on record, potential buyers simply do not qualify for loans at current credit standards.

This does not bode well for an immediate housing recovery.

We are, according to Goodman, “overcorrecting for the sins of the past.”

Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture. You can follow him on Twitter: @Ritholtz