2nd UPDATE: Colonial BancGroup Target Of Criminal Probe

Colonial BancGroup Inc.'s (CNB) struggle to find the capital to survive received another severe blow with the bank's announcement that it's the target of a federal criminal investigation.

The bank, which recently acknowledged it may not be able to continue as a going concern, said Friday the Department of Justice is investigating the lending division that originates mortgages the bank doesn't intend to keep, as well as related accounting irregularities over several years.

"It makes the bank radioactive" and a deal with either another bank or private equity investors "very, very challenging," said Lawrence Kaplan, a lawyer with Paul, Hastings, Janofsky & Walker LLP.

Colonial said it received subpoenas from the Securities and Exchange Commission related to the capital it set aside for soured loans and its effort to participate in the U.S. Treasury's Troubled Asset Relief Program, and from the Special Inspector General for the TARP.

Further, the Montgomery, Ala., bank said the Alabama State Banking Board will meet Aug. 12 and ask the bank to consent to be taken into receivership by the Federal Deposit Insurance Corp., should the State Banking Department and the FDIC deem such action necessary. The FDIC usually decides on Wednesdays which banks will be closed the following Friday.

In essence, Colonial put the public on notice that "the patient is in hospice," Kaplan said.

Colonial said it "continues to explore all possible capital-raising alternatives" that would allow it to survive.

Over the past decade, Colonial grew through acquisitions in dangerously hot banking markets such as Florida and Nevada. As the company wrestled with mounting losses from souring loans to residential developers, Robert E. Lowder, who founded the bank in 1981, left abruptly in June.

Colonial became one of the nation's largest warehouse lenders, meaning it makes short-term loans to mortgage banks to tide them over between the time that they make home loans and sell them to other investors.

In March, after the Treasury Department told Colonial to come up with capital before it would get TARP funds, home-loan provider Taylor, Bean & Whitaker Mortgage Corp., which had close ties to Colonial, led a group that pledged to provide the troubled bank with a $300 million equity life line.

The financing deal fell apart last week, just days before U.S. federal agents on Monday raided the Florida offices of Colonial and Taylor Bean. On Wednesday, Taylor Bean closed its mortgage lending business.

Lawyers suspect that the incestuous relationship between Colonial and Taylor Bean attracted the attention of regulators and the Justice Department.

Friday's announcement follows a slew of regulatory action against Colonial, including cease and desist orders and demands by authorities to raise capital quickly. The Federal Reserve ordered Colonial to submit a capital plan by Aug. 21.

"The criminal investigation is not the killer in and by itself, but it may be the straw that breaks the camel's back," said Kip Weissman, a partner with law firm Luse Gorman Pomerenk & Schick PC.

Whether the investigation is an impediment for a buyer is another matter. It makes due diligence much harder, because a buyer would assume that there are more issues that could surface, though the example of the sale of Riggs National Bank a few years ago to PNC Financial Services Group Inc. (PNC) shows a deal is manageable even with the threat of a fine related to criminal charges.

Should Alabama state regulators and the FDIC allow Colonial to fail, any fine would stick with the FDIC, according to Kaplan. In bank bankruptcies, the FDIC sells the branches and as many assets as it can, but the shelf holding company - and its legal obligations - remain under FDIC receivership.

Colonial, with 354 branches and $26 billion in assets, has an attractive branch network and deposit base for a buyer willing to take the risk of bad loans or able to strike a deal with the FDIC to guarantee some of Colonial's expected losses.

So far, the FDIC has had little incentive to let the bank fail because there is apparently no run on the bank's deposits. The bank is running out of equity fast, but "depositors seem to be numb" to the bank's problems, said Sandler O'Neill & Partners LP analyst Kevin Fitzsimmons.

Colonial BancGroup said Friday it plans to cooperate with the investigation. The bank did not return calls seeking further details.

Colonial's shares fell 30% to 49 cents.

-By Matthias Rieker and Tess Stynes, Dow Jones Newswires; 212-416-2471; [e-mail]