Citi, BofA face billions in mortgage penalties

Will Citigroup (C) and Bank of America (BAC) agree to demands from the federal government to pay tens billions in penalties for allegedly misleading investors about mortgage-backed securities they sold before the recent economic meltdown?

The U.S. Department of Justice is reported to be pressuring New York City-based Citigroup to pay as much as $10 billion in penalties for allegedly misleading investors about the quality of mortgages that were bundled into securities. Bank of America, based in Charlotte, N.C., may have to pay out as much as $12 billion, according to media reports. Both companies declined to comment.

For Citigroup, the stakes are especially high because it was the biggest financial institution before the financial crisis, and unlike Bank of America, it has failed the Federal Reserve's stress test twice. Prominent banking analyst Richard Bove has urged Citibank to not knuckle under the government's demands to settle the case.

"No justification has been given as to why Citigroup should pay any fine let alone $10 billion," wrote Bove in an email. He rates Citigroup shares as a hold. "If one compares that bank's mortgage activity with those of its peers and the fines paid by others, it would appear that the bank should not be paying as much as 20% of the supposed demanded number. "

Others disagree.

"Finally, as to whether they were a worse actor, they certainly were terrible," wrote John Campbell, a professor at the University of Denver Sturm School of Law, in an email. "I believe [former Citigroup President Thomas] Maheras testified before Congress that Citi was skeptical of the subprime loans as early as '06 but kept pumping them. Meanwhile, it purchased insurance on them in case they went south. "

Cornell Law School professor Robert Hockett noted in an interview that Citigroup might "be a little more eager" to settle with the government because of its stress test failures. "Surely that is one of the factors in the decision-making process" at the company, he said.

Bloomberg News reported that talks between prosecutors and Citigroup broke down on June 9 after the firm offered $4 billion to settle the case.

According to research from Sanford C. Bernstein cited by Bloomberg, Citigroup sold about $91 billion of mortgage-backed securities from 2005 and 2008, far less than Bank of America, which sold about $965 billion worth during that same period, while JP Morgan Chase (JPM) and its affiliates issued $450 billion. New York-based JPMorgan reached a $12 billion settlement earlier this year. SunTrust Banks (STI) recently reached a $1 billion settlement with the federal government and state officials.

Shares of Citigroup, which have slumped 9 percent this year, were last trading at $47.56. BofA, which is flat for the year, was at $15.55.

The problems at BofA were largely inherited from its acquisitions of Countrywide Financial, one of the biggest players in subprime mortgages, and Merrill Lynch at the height of the financial crisis. Many have argued those subprime mortgages were one of the causes of the financial crisis. However, analyst Bove, who rates the bank as a buy, argues that it has been punished enough.

"BAC has paid $60 billion in penalties, fines, etc. It may now be forced to pay another $15 billion," Bove wrote. "The government has assiduously avoided attacking insiders and management for the wrongs that they believed have been committed. It only attacks shareholders."

Reuters reported that BofA CEO Brian Moynihan has requested to meet with U.S. Attorney General Roy Holder to try coming up with a resolution.

Another reason Citigroup and BofA may want to pay huge legal penalties now is that more lawsuits may be on the way that could uncover even more costly wrongdoing. This could especially be worrisome for Citigroup, according to Cornell's Hockett.

"BofA already has taken a reputation hit," he said. "They have a pretty bad reputation now."