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Bank of America back in court over $2.1 billion fraud penalties

* Judge questions if penalties could reach $5 billion

* Government to increase penalties against ex-Countrywide executive

* Bank, executive argue for no penalties

* Was one of few cases stemming from financial crisis to go to trial

NEW YORK, March 13 (Reuters) - A U.S. judge wrestled on Thursday with a U.S. Justice Department request that Bank of America Corp pay $2.1 billion in penalties after being found liable for fraud over defective mortgages sold by its Countrywide unit.

In a second hearing on the penalties to be imposed on the bank, U.S. District Judge Jed Rakoff in New York said he had not yet decided how to rule in what was one of the few cases to go to trial stemming from the financial crisis.

But he tested the government's arguments that it should be awarded penalties based on revenue Countrywide Financial Corp earned selling loans to government-sponsored mortgage finance companies Fannie Mae and Freddie Mac.

Rakoff even asked why the government had not sought even more in penalties, based on the $4.8 billion paid by Fannie and Freddie, rather than seeking just $2.1 billion based on revenue earned only on the defective portion of the loans sold by Countrywide.

"I'm interested in the logic," Rakoff said. "It may be there is logic to the $2.1 billion, but at least to me there is logic under your theory of the case that would lead you to claim a gross gain of $5 billion."

Assistant U.S. Attorney Pierre Armand, meanwhile, suggested the government would increase its request for penalties from Rebecca Mairone, a former Countrywide executive, from $1.1 million to $1.6 million based on a $487,000 bonus she recently earned from her employer, JPMorgan Chase & Co.

The hearing followed a verdict by a federal jury in New York in October finding Bank of America and Mairone each liable for fraud in a civil lawsuit centered on a mortgage lending process at Countrywide called the "High Speed Swim Lane," also called "HSSL" or "Hustle."

Countrywide, which became a poster child for the U.S. mortgage meltdown, was acquired by Bank of America in July 2008.

The Justice Department contends that the Countrywide program, which began in 2007 and which the government says Mairone oversaw, emphasized quantity rather than the quality of loans produced, paying employees based on volume and speed and eliminating loan-quality checkpoints.

Bank of America and Mairone deny wrongdoing. The executive is referred to as Mairone in court papers but now goes by her maiden name, Rebecca Steele, according to Marc Mukasey, her lawyer.

Rakoff initially heard arguments on penalties in December, when the government was seeking $863.6 million based on the gross loss incurred on the loans by Fannie and Freddie.

A request by Rakoff for briefing on an alternative way to calculate the penalty prompted lawyers working in the office of Manhattan U.S. Attorney Preet Bharara to seek the even bigger sum of $2.1 billion based on Countrywide's gross gains.

"The government believes the penalties need to be severe enough to deter financial institutions and executives from engaging in like conduct in the future," Armand said.

But Kenneth Smurzynski, a lawyer for Bank of America, said the government's request for $2.1 billion failed to reflect the costs involved in generating the loans. When costs were factored in, Countrywide actually lost money selling the loans, he said.

"The loans didn't just fall out of the sky," he said.

Mukasey, Mairone's lawyer, urged Rakoff to impose no penalties against his client, calling her a divorced mother of two who has suffered enough from the "nuclear" effect of the verdict.

"She is currently looking for a new job or at least thinking about it and having a hard time because of the negative publicity of this case," he said.

Rakoff, though, called it a "difficult argument to accept," saying it seemed "far fetched" that any punishment should be eliminated in the case of someone who commits fraud.

The case is U.S. ex rel. O'Donnell v. Bank of America Corp et al, U.S. District Court, Southern District of New York, No. 12-01422.

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