Feds Break Small Lenders Colonial, CIT Group

(MoneyWatch)  For Colonial BancGroup, the story just keeps going from bad to worse. But the conflicts of interest the firm is facing up against are not likely to help.

Winded by the subprime crisis last year, raided by the Feds, and potentially facing receivership as early as this week, the regional bank now faces another hurdle: a lawsuit by a much larger, government-backed giant.

Bank of America today filed a lawsuit against Colonial, claiming that it has in effect, stolen $1 billion in loans and cash. Bank of America is also seeking a temporary restraining order, baring Colonial from selling certain assets.

Only last Friday, Colonial said that it is the subject of a criminal investigation by the U.S. Department of Justice, after federal agents raided the bank's branch in Orlando, Florida. Apparently, detectives suspect the bank of fudging accounting statements related to mortgages. The bank is also the subject of an investigation by the SEC over its participation in the Troubled Asset Relief Program.

Just as with CIT Group, all the headaches prompted by the federal government have caused a near-collapse in Colonial's share price, which even speculators are fast giving up hopes on now of it making a full recovery.

With Bank of America seeking an injunction against Colonial's sale of assets, the federal government finds itself more or less in the position of deciding its own fate. Billions are invested in Bank of America in the form of TARP loans, so the government has every incentive to do whatever it can to ensure that Colonial makes good on the payment, regardless of the reality. Conveniently, the SEC probe might help scrape up whatever is left in the coffers at the end of the day so that it doesn't lose any money on the unpaid TARP check, either.

Admittedly, Colonial smells fishy, but the government's hard-line approach to small to mid-size lenders is in serious danger of backfiring on its own credibility (Thursday, it told CIT to submit a restructuring plan within 15 days to put up or shut up). After all, it's hard to remember policymakers being quite so hard-line with giants such as Goldman Sachs, or even with Citigroup -- and they are the ones who designed the products that got us into trouble in the first place.

Read my BNET Finance colleague Alain Sherter's take on Colonial's woes here.