States are crafting a scaled-back mortgage abuses settlement with top U.S. banks that would exclude California, one of the states hardest hit by foreclosures and falling home prices.

The smaller settlement would mean that the big banks would pay less in fines. The proposed $25 billion deal could come down by as much as a quarter without California, according to people familiar with the discussions.

But it would also keep the banks exposed to legal claims in that state's large, distressed market.

For homeowners, it could mean that California residents do not get relief as quickly, as the state tries to strike its own deal.

These sources cautioned that there is no deal yet, and expressed some hope that they could still lure California, which left the talks in September, back to the table. But they are planning for an alternative settlement without the state.

California Attorney General Kamala Harris withdrew from negotiations saying the deal under discussion failed to provide enough relief for her state's homeowners and released the banks from too many claims.

The remaining state and federal negotiators met last week in part to hash out the terms of a settlement that did not include California.

We didn't spend the last year to let California decide everything, one member of the negotiating team said.

State attorneys general, the Justice Department, and other federal officials have been talking with the banks for more than a year to settle allegations that they cut legal corners and unlawfully rushed through foreclosure paperwork

Banks involved in the talks include Bank of America Corp , JPMorgan Chase & Co , Wells Fargo , and Citigroup .

The discussions have been bogged down by states concerned the deal was either too lenient or provided the wrong kinds of relief, and by the banks who sought release from mortgage-related claims beyond the original conduct at issue.

The scaled-back deal could also include a cap on how much relief would go to homeowners in states that fail to sign, according to the people familiar with the talks.

Further, the deal could include a most favored nation clause, which would allow the signatory states to reap the benefits of any potential future deal the banks might reach with the other states.

There have been fears that banks would not sign off on a deal that did not provide them legal protection from claims in major markets such as California.

Bank of America, however, said in a statement that it is willing to pursue a speedier, smaller settlement.

While we would prefer to have all 50 states benefit from such an agreement, we are open to discussing alternatives that would allow us to begin delivering additional solutions to our customers in those states that remain active in the settlement discussions, said Dan Frahm, a senior vice president at Bank of America.

Representatives of the other banks had no immediate comment or declined to comment. A spokesman for the attorney general in California had no immediate comment.

One sticking point with a scaled-back settlement is how to divide up the pot of monetary penalties that will also settle federal claims.

The banks are expected to pay their federal penalty in the form of principal reductions and other relief to distressed homeowners around the country.

That federal component could make it harder to make sure homeowners in states signing the agreement get most of the benefits.

(Reporting by Aruna Viswanatha in Washington, D.C. and Rick Rothacker in Charlotte; Editing by Tim Dobbyn)

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