* HUD's Donovan outlines deal to reduce mortgage principal
* Deal would resolve allegations of illegal foreclosures
* Settlement would not apply to Freddie Mac, Fannie Mae (Adds comments, background)
By Margaret Chadbourn and Aruna Viswanatha
WASHINGTON, Jan 18 (Reuters) - About one million American homeowners would get writedowns in the size of their mortgages under a proposed deal with banks over shady foreclosure practices, U.S. Housing and Urban Development Secretary Shaun Donovan said on Wednesday.
The deal, which could be struck within weeks, would mark the largest cut in the mortgage load since the start of the credit crisis in 2007 and could pressure the government-sponsored mortgage agencies to also reduce principal on underwater home loans.
"We're very close to a settlement that would both fix the servicing problems, but also help over a million families around the country stay in their homes and get help," Donovan said at a U.S. Conference of Mayors meeting in Washington.
Talks between federal and state officials and major lenders aimed at resolving allegations of illegal foreclosure practices have dragged into their second year.
Some states, including California and New York, have criticized negotiators as being too lenient on the banks and suggested the proposed settlement would not provide enough relief to the housing market.
But the Obama administration has seen the broader foreclosure settlement as an opportunity to help reach more borrowers struggling financially as the five-year collapse in home prices persists. Currently, banks have granted at-risk borrowers principal reductions on a limited basis.
"Principal reduction can have a substantial impact on the housing market nationally," Donovan said.
With more than a 30 percent decline in home prices since 2007 and a huge number of vacant, foreclosed homes flooding the market, the housing sector has struggled to rebuild itself.
About 22 percent of U.S. homes have negative equity totaling about $750 billion, according to CoreLogic.
He said the deal would be "far and away the largest principal reduction of the crisis" and a number families would also "get direct compensation as a result of the settlement."
The settlement would not apply to mortgages owned by Fannie Mae or Freddie Mac, which together own or guarantee most of the U.S. mortgage market. The regulator that controls the two government-sponsored enterprises has resisted cutting their loans, arguing it would cost U.S. taxpayers more money than other options would.
But lawmakers and top administration officials have pushed for a broader principal reduction program, and this settlement could lay the groundwork for that if Fannie Mae and Freddie Mac are swayed to test it out themselves as an alternative to the costly process of foreclosing on struggling borrowers.
Earlier on Wednesday, House Democrats sought to force the housing regulator, the Federal Housing Finance Agency, to explain its calculations in deciding not to offer principal reductions.
In addition, Federal Reserve Chairman Ben Bernanke, in a white paper to Congress, has said writedowns "had the potential to decrease the probability of default" and "improve migration between labor markets."
OBAMA STRATEGY
The Obama administration in coming weeks will step up its efforts to help the ailing housing market by expanding current policies aimed at helping communities plagued by high unemployment and widespread foreclosures, the housing secretary said.
"You will hear a president who is going to be aggressive on housing, on the issues of refinancing and principal write-down," Donovan said.
Obama administration will lay out a strategy in coming weeks that includes pilot programs to test new initiatives, such as a government plan to convert foreclosures into rentals.
He said the White House is aiming to get more creative in how it contends with the excess inventory of unsold foreclosed homes sitting on the books of government-run mortgage giants, Fannie Mae and Freddie Mac.
Regulators have been seeking ways to reduce the number of foreclosed properties by pooling them together for bulk sales to investors. The goal is for investors to then rent them out.
The administration also wants to move ahead with a plan dubbed "Project Rebuild," which is a piece of Obama's American Jobs Act that aims to get construction workers to rehab vacant properties.
Donovan said the $15 billion neighborhood stabilization program would create 200,000 jobs and be used to renovate thousands of vacant homes and properties around the country. (Reporting By Margaret Chadbourn and Aruna Viswanatha; Editing by Neil Stempleman)