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$7B penalty doesn't end Citigroup's legal woes

Citigroup's (C) agreement to pay $7 billion to resolve federal claims that it misled investors about the quality of its mortgage securities may not end the financial giant's legal woes.

U.S. Attorney General Eric Holder and other officials told reporters during a press conference on Monday in Washington, D.C., that the settlement doesn't preclude prosecutors filing criminal charges against the bank and its employees.

Holder, who described Citigroup's conduct in structuring and selling mortgage-backed securities in the run-up to the 2008 financial crisis as "egregious," did not detail the Department of Justice's plans. But the way the agency handled the case may offer some hints.

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According to media reports, talks between the DOJ and Citi, the third-largest bank in the U.S. by assets, were at an impasses recently. The Wall Street Journal reported that the company offered $363 million in May, far below the billions sought by federal prosecutors.

Cornell Law School professor Robert Hockett, describing company's initial offer as "paltry," said whether the government opts to pursue criminal charges depends on whether there is enough evidence to prove that Citi intentionally committed fraud in selling residential mortgage-backed securities, collateralized debt obligations and other instruments.

"DOJ appears to have been confident all along that it has this evidence -- hence its refusal even so much as to consider Citi's first offers," he said.

To date, however, the Justice Department has shown little appetite for pursuing criminal prosecutions of Wall Street banks linked to the housing crash.

Under terms of Citigroup's settlement, the bank will pay a $4 billion civil penalty to the DOJ, the biggest penalty ever collected under the Financial Institutions Reform, Recovery and Enforcement Act, along with a $500 million fine to several states and the Federal Deposit Insurance Corp.

Prosecutors took a harder line with the bank after uncovering evidence that the bank and its employees knew that the mortgages that it bundled into securities and sold to investors were defective. In fact, Citigroup hired an outside firm to grade these mortgages and pressured it to change its ratings and failed to disclose this information to investors.

As a part of the mortgage pact, Citigroup also has agreed to provide $2.5 billion in "consumer relief." That will include principal reduction and mortgage forebearnance for homeowners who owe more on their homes than they are worth. The bank has also agreed to finance affordable rental housing developments for low-income families in high-cost areas.

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"I hope that DOJ through its settlement monitor will push Citi to focus on the last of those -- principal-reduction -- in particular," Hockett said. "The reason is that mortgage forbearance is known to be far less effective in preventing default and foreclosure than principal-reduction, while rental housing for its part might simply become another revenue line for Citi -- a revenue line that is partly dependent on homeowner default and foreclosure itself. It would be a tragic irony if the same behavior that brought a housing price bubble, bust, post-bust negative equity and consequent foreclosure were now to elicit a 'penalty' that enables Citi to profit from foreclosure itself."

Citi shares rose in afternoon trading after the company posted stronger-than-expected second-quarter financial results. The banking firm took a $3.8 billion accounting charge because of the mortgage settlement, erasing most of its profits for the period.

President Obama's Financial Fraud Task Force's RMBS Working Group has to date recovered $20 billion for consumers and investors. But Wall Street critics complain that no high-ranking bank executive has gone to jail for their role in the financial crisis.

Bank of America (BAC) may be the next big bank to reach a settlement with federal authorities over their mortgage practices. Much of the bank's liability stems from its purchase of subprime lender Countrywide Financial and investment bank Merrill Lynch during the height of the financial crisis. As a matter of law, Bank of America is on the hook for any misdeeds done by Countrywide and Merrill Lynch before their acquisitions by the bank.

B of A and prosecutors have reached an impasse, with the government seeking a $17 billion penalty, $5 billion more than what the bank had offered, according to Reuters.

"Government negotiators declined to credit the bank with $6.3 billion Bank of America agreed to pay the Federal Housing Finance Agency in March over misrepresentations in mortgage-backed securities purchased by Fannie Mae and Freddie Mac between 2005 and 2007," the newswire said.

Data from Sanford C. Bernstein cited by Bloomberg News shows that Bank of America and its subsidiaries issued about $965 billion in mortgage bonds between 2004 and 2008, more than double the $450 billion JPMorgan Chase (JPM) and its affiliates issued during the same time. In November, JPMorgan agreed to a $13 billion mortgage settlement.

-- Paula Reid contributed to this report

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