UPDATE 1-Judge says U.S. fraud case vs Bank of America should be tossed

(Adds details from decision, expected U.S. challenge, bylines)

March 27 (Reuters) - A federal judge has recommended dismissal of a U.S. government lawsuit accusing Bank of America Corp of defrauding investors into buying about $855 million of mortgage securities that soured during the financial crisis.

If it stands, Thursday's ruling by U.S. Magistrate Judge David Cayer in Charlotte, North Carolina could mark a serious setback for the U.S. Department of Justice in its effort to fight fraud in the sale of mortgage securities.

The case is one of several in which the government has relied on a law adopted after the 1980s savings and loan scandals, the Financial Institutions Reform, Recovery, and Enforcement Act, to pursue cases against banks. That law has a 10-year statute of limitations, double the usual length in securities fraud cases, which the government took advantage of in its lawsuit against Bank of America.

In the North Carolina case, Cayer reviewed whether the bank misled the former Wachovia Corp, now part of Wells Fargo & Co , and the Federal Home Loan Bank of San Francisco in early 2008 about the risks of 1,191 seemingly high-quality "jumbo" adjustable-rate mortgages. Wachovia and the FHLB-San Francisco bought about 98 percent of the securities.

The government sought civil penalties under FIRREA, based on the bank's alleged violations of laws prohibiting various false statements, and fraud in "loan and credit applications."

Cayer said the government failed to show, as required, that any false statements were "material" to the Federal Housing Finance Board, which regulated the FHLB-San Francisco, or that either ever complained.

He also said the other law had been applied "consistently" to "traditional customer related bank activities such as loans," and therefore did not reach the securities in this case.

Bank of America spokesman Lawrence Grayson said the Charlotte-based bank is pleased with the recommendation.

The Justice Department had no immediate comment, but filed court papers saying it plans to object to Cayer's findings.

U.S. District Judge Max Cogburn will now review Cayer's recommendation. While magistrate judges' recommendations do not bind district judges, they are often followed.

The decision came one day after Bank of America Corp agreed to pay $6.3 billion in cash to resolve separate litigation that it sold defective mortgage securities to Fannie Mae and Freddie Mac.

Cayer's recommendation does not affect a related lawsuit brought by the U.S. Securities and Exchange Commission.

The case is U.S. v. Bank of America Corp et al, U.S. District Court, Western District of North Carolina, No. 13-00446.

(Reporting by Karen Freifeld in New York. Editing by Andre Grenon and Andrew Hay)