AIG holding BofA $8.5 billion settlement 'hostage,' investors say

American International Group is holding "hostage" an $8.5 billion deal to compensate investors who bought Bank of America Corp mortgage securities, supporters of the deal said in court filings ahead of a hearing on Wednesday.

The supporters urged the judge overseeing the deal to reject AIG's efforts to delay its approval, according to documents submitted to the court late on Friday.

Bank of America agreed to the settlement in June 2011 to resolve claims by investors who had bought $174 billion of mortgage-backed securities issued by Countrywide Financial before the U.S. housing crisis. The investors said Countrywide, bought by Bank of America in 2008, misrepresented the quality of the underlying home mortgages, which went sour in the crisis.

AIG, one of the investors in the mortgage securities, objected to the deal, saying there was no evidence it provided adequate compensation for losses.

Justice Barbara Kapnick in New York state court approved the deal on January 31, but four days later AIG asked a new judge overseeing the case to delay the decision, saying Kapnick had left some issues unresolved.

The new judge, Justice Saliann Scarpulla, has called a hearing Wednesday to hear arguments on AIG's request.

"The court should not permit AIG to nullify the judgment and hold the entire settlement hostage indefinitely," supporters of the deal said in a filing on Friday. AIG is seeking to delay the settlement as leverage against Bank of America in another case, the supporters said in their court filing. In that case, AIG sued Bank of America over $10 billion of securities fraud claims in August 2011, the same day it intervened to object to the $8.5 billion settlement.

"We're litigating this case solely on the merits," Mark Zauderer, a lawyer for AIG, said on Tuesday.

CONSIDERING WHETHER TO GRANT AIG'S REQUEST

Scarpulla must decide whether to grant AIG's request to further delay Kapnick's judgment or enter the judgment into the court record and leave AIG to appeal if it chooses.

If Scarpulla grants AIG's request, AIG should be required to post $1 million a day that the delay is costing other investors, supporters of the deal said.

Twenty-two institutional investors, including BlackRock Inc, Allianz SE's Pimco, and Metlife Inc, , and Bank of New York Mellon , the trustee for the securities, agreed to the settlement with Bank of America.

In her ruling on January 31, Kapnick said Bank of New York Mellon was concerned that Countrywide would be unable to pay a future judgment that even approached $8.5 billion, and thought it was reasonable to lock in a one-time payment.

Kapnick made one exception in her ruling, withholding her approval from settlement of claims relating to certain loans that had been modified. Bank of New York Mellon should not have settled claims related to mortgages that had been modified without investigating their potential worth, she said.

In its latest court filing, Bank of New York Mellon said it would do nothing about those claims until the settlement is finally approved.

"There is no decision to be made, by anyone, about any action to take with respect to these claims until it is determined whether the settlement agreement is finally approved and appeals are exhausted," the bank and investor group said.

Separately on Tuesday, AIG asked a state appeals court for more time to submit briefs in its appeal of Kapnick's decision to hear the case without a jury. The appeals court is not expected to rule on that request until next month at the earliest.

The case is In re: The Bank of New York Mellon, New York State Supreme Court, New York County, No. 651786/2011.

(Reporting by Karen Freifeld; Editing by Cynthia Osterman)