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The lawsuits by the Federal Housing Finance Agency, which oversees Fannie Mae and Freddie Mac, came as a surprise to the market and weighed on bank shares. The lawsuits could add billions of dollars to the banks' potential costs at perhaps the worst possible time for the industry.

The FHFA accused major banks, including Bank of America Corp, its Merrill Lynch unit, Barclays Plc, Citigroup Inc and Nomura Holdings Inc of selling bonds backed by mortgages that should have never been packaged into securities.

The biggest banks are already negotiating with the attorneys general of all 50 states to address mortgage abuses. They are looking for a comprehensive settlement that will protect them from future litigation and limit their potential mortgage litigation losses.

"This new litigation could disrupt the AG settlement," said Anthony Sanders, finance professor at George Mason University and a former mortgage bond strategist.

Banks may be more reluctant to agree to a settlement if they know litigation from other government players could still wallop their capital, he said.

Before the FHFA lawsuits had even hit a court docket, financial experts offered blunt expectations for the outcome.

"The lawsuits will be settled. The end result will be a further outflow of cash from the banks, and more importantly an additional black eye," said Sean Egan, managing director of Egan-Jones Ratings Co.

FHFA director Edward DeMarco is looking to minimize future losses for Fannie Mae and Freddie Mac, which are owned by the government after failing in 2008. The firms are pillars of U.S. mortgage finance.

The KBW Bank Index closed down 4.5 percent, nearly doubling the losses of the broader market. Bank of America led the index lower, dropping 8.3 percent.

Bank shares also came under pressure from signs that the Federal Reserve could start selling shorter-term debt on its books and buying long-dated bonds to push longer-term yields lower as a stimulus measure.

Such a move, known as "operation twist," would hurt banks whose profit margin is tied to the short-term rates at which they fund and the longer-term rates at which they invest.

CAPITAL WEAKNESS

Major banks already face potential payouts of tens of billions of dollars to settle regulatory charges of abusive mortgage lending and foreclosure practices, and other investor lawsuits over mortgage debt losses.

Such payouts would reduce earnings and weaken capital levels, perhaps harming the ability of banks to lend money and provide much-needed life to a stalled housing market and weakened economy.

Representatives of the sued banks declined to comment or were not immediately available to comment.

Banks have been walloped by mortgage losses, but so have Fannie Mae and Freddie Mac, which failed after trying to finance too many bad mortgages with too little equity. The two entities guarantee bonds backed by mortgages.

The question of whether to take action for problems related to the mortgage bonds has been under discussion since Fannie Mae and Freddie Mac were placed in conservatorship in 2008, a person familiar with the matter said.

While the ultimate amount FHFA will seek is still unclear, that person said it could top the $20 billion being discussed by the banks and the state attorneys general.

"Defendants falsely represented that the underlying mortgage loans complied with certain underwriting standards and guidelines, including representations that significantly overstated the ability of the borrowers to repay their mortgage loans. These representations were material to the GSEs, as reasonable investors, and their falsity violates (the law) and constitutes negligent misrepresentation, common law fraud, and aiding and abetting fraud," the FHFA said in the suit against Merrill Lynch.

A BLIZZARD

The blizzard of litigation against banks is hurting share prices in the sector because investors feel unable to estimate the ultimate scope of a given bank's legal liabilities.

Bank of America, for example, had intended its proposed $8.5 billion settlement in June with investors in Countrywide mortgage securities to resolve most litigation tied to its disastrous 2008 takeover of that home loan provider.

But many parties are objecting to that settlement, and the deal didn't stop the insurer American International Group Inc from suing Bank of America for $10 billion over its own alleged mortgage securities losses.

Nor did it stop Nevada's attorney general from threatening to withdraw from an $8.4 billion nationwide settlement with the bank. The AG now wants to sue the bank, accusing it of reneging on promises to modify mortgages.

Other banks also face mortgage lawsuits. In May, for example, the U.S. Justice Department sued Deutsche Bank, accusing it of misleading a U.S. housing agency into believing loans it made qualified for federal insurance.

The FHFA's lawsuits follow an initial lawsuit in July against UBS AG seeking to recover $900 million of losses incurred on $4.5 billion of debt.

One legislator praised the expected FHFA lawsuits. Brad Miller, a Democratic congressman from North Carolina, said, "Not pursuing those claims would be an indirect subsidy for an industry that has gotten too many subsidies already."

FHFA and various investors have alleged that banks, while packaging residential home loans into securities sold to investors, failed to conduct adequate due diligence, and hid or misstated the quality of the underlying loans and underwriting as well as borrowers' ability to make payments.

As more borrowers fell behind or went into foreclosure, the value of securities backed by their loans fell, causing losses for investors.

Losses stemming from the precipitous deterioration in subprime and other mortgages pushed the government to take over Fannie Mae and Freddie Mac on September 7, 2008. Since then, taxpayers have spent more than $140 billion to keep the firms afloat.

(Reporting by Margaret Chadbourn in Washington and Jonathan Stempel in New York; additional reporting by Lauren LaCapra in New York; writing by Ben Berkowitz and Dan Wilchins; editing by Matthew Lewis, John Wallace and Andre Grenon)

A weak reading of the payroll data, due at 8:30 a.m. EDT, could stoke concerns the United States is heading toward recession.

The data is expected to show an increase of 75,000, according to a Reuters survey, slowing from July's 117,000 rise.

Banks could be hit after the New York Times reported that the Federal Housing Finance Agency is filing a lawsuit against big lenders like Bank of America (BAC.N), JPMorgan Chase (JPM.N) and Goldman Sachs (GS.N).

The suit relates to mortgages sold during the housing bubble and accuses the banks of failing to perform due diligence required under securities law and missed evidence that borrowers' incomes were falsified or inflated.

Separately in the banking sector, the Wall Street Journal said, citing people familiar with the situation, that the Federal Reserve has asked Bank of America Corp (BAC.N) to show what measures it could take if business conditions worsen.

U.S. securities regulators have requested proprietary algorithmic trading data from high-frequency trading firms as part of an investigation into suspicious market activity.

Merger and acquisition news could be another focus after people close to the matter said AT&T Inc (T.N) is trying to salvage its planned $39 billion acquisition of smaller rival T-Mobile USA blocked by the U.S. government.

Independent refiner Valero Energy Corp (VLO.N) said it would buy Murphy Oil Corp's (MUR.N) Meraux refinery for about $625 million.

The Wall Street Journal reported, citing people familiar with the matter, that U.S. drugmaker Eli Lilly & Co (LLY.N) is in talks to form a partnership with, and potentially invest in, Turkish generic-drug company MN Pharmaceuticals.

Netflix Inc (NFLX.O) fell in after-hours trading following Starz Entertainment saying it would pull all of its movies and television shows from its streaming service early next year.

Earnings news could be in the spotlight, with fourth-quarter results expected from Campbell Soup, the world's biggest soup maker.

European shares fell 1.8 percent in morning trade on Friday on U.S. non-farm payroll data fears, while Athens General .ATG lost 3.3 percent after Greece said on Thursday it will miss its budget deficit targets this year.

U.S. stocks snapped a four-day rally on Thursday on worries about the U.S. jobs report.

The Dow Jones industrial average .DJI fell 1 percent, the Standard & Poor's 500 Index .SPX was down 1.2 percent and the Nasdaq Composite Index .IXIC was down 1.3 percent.

(Reporting by Joanne Frearson; Editing by Erica Billingham)

The Federal Housing Finance Agency, which oversees mortgage giants Fannie Mae and Freddie Mac, is expected to file suit against Bank of America, JPMorgan Chase, Goldman Sachs and Deutsche Bank, among other banks, the Times reported, citing three unidentified individuals briefed on the matter.

The suits stem from subpoenas the finance agency issued to banks last year. They could be filed as early as Friday, the Times said, but if not filed Friday it said the suits would come on Tuesday.

The government will argue the banks, which pooled the mortgages and sold them as securities to investors, failed to perform due diligence required under securities law and missed evidence that borrowers' incomes were falsified or inflated, the Times reported.

Fannie Mae and Freddie Mac lost more than $30 billion, due partly to their purchases of mortgage-backed securities, when the housing bubble burst in late 2008. Those losses were covered mostly with taxpayers' money.

The agency filed suit against UBS in July, seeking to recover at least $900 million for taxpayers, and the individuals told the Times the new suits would be similar in scope.

A spokesman for the Federal Housing Finance Agency was not immediately available for comment.

The Times said Bank of America, JP Morgan and Goldman Sachs all declined comment. A Deutsche Bank spokesman told the Times, "We can't comment on a suit that we haven't seen and hasn't been filed yet."

The practice of subprime lending, wherein mortgage brokers lowered their standards to entice homebuyers to take out large mortgages to buy more expensive homes than they could afford, was a root cause of the mortgage market implosion.

News of the suit could have a negative impact on stocks of the banks in question on Friday. JPMorgan Chase, Bank of America and Goldman Sachs are traded on the New York Stock Exchange, while Deutsche Bank is traded on the German exchange.

S&P 500 stocks index futures were trading down 0.6 percent in Asia. U.S. Treasury futures also ticked higher..

The Times report said investors fear that if banks are forced to pay out billions for mortgages that defaulted, the suit could sap earnings for years and contribute to further losses across the financial services industry.

While the government's closely watched employment report on Friday will likely underscore the frail state of the economy, analysts say the expected hiring slowdown would not be a recession signal given that layoffs are not rising that much.

A strike by about 45,000 Verizon Communications workers will also make a dent in August's nonfarm employment count.

"August was a pretty rough month for the economy," said Ryan Sweet, a senior economist at Moody's Analytics in West Chester, Pennsylvania. "We saw financial markets tighten. I think businesses sort of responded by putting hiring on the back burner."

Nonfarm payrolls likely increased by 75,000 jobs, according to a Reuters survey, after rising by 117,000 in July. The Labor Department will release the report at 8:30 a.m. EDT.

An acrimonious political fight over U.S. debt, which culminated in the downgrade of the country's triple-A credit rating from Standard & Poor's, and a worsening debt crisis in Europe ignited a massive stock market sell-off last month and sent business and consumer confidence tumbling.

Despite the weak employment growth, the jobless rate is expected to have held steady at 9.1 percent as more people gave up the job hunt and dropped out of the official labor force.

With the unemployment rate stuck above 9 percent and confidence collapsing, President Barack Obama is under pressure to come up with ways to spur job creation. The health of the labor market could determine whether he wins a second term in next year's presidential elections .

Obama will lay out a new jobs plan in a speech to the nation on Thursday.

Soft employment data could strengthen the hand of officials at the U.S. central bank who were ready at their August meeting to do more to help the sputtering economy.

The Fed cut overnight interest rates to near zero in December 2008 and it has bought $2.3 trillion in bonds. Many analysts say its arsenal is now largely depleted, although they expect it to do more to try to prop up growth.

"The Fed really has a easing bias," said Jeffrey Greenberg an economist at Nomura Securities International in New York. "If we have a negative report, those members who wanted to do more at the August meeting will become more vocal."

DODGING RECESSION

Although hiring may have cooled, there is little sign companies responded to the darkening outlook by laying off workers. First-time applications for state unemployment benefits have hovered around 400,000 for weeks.

The steady jobless claims, relatively strong consumer spending, continued demand for manufactured goods and increases in industrial production suggest the economy will steer clear of recession.

"We do not expect the economy to slump, but rather to slouch and stagger," said Patrick O'Keefe, head of economic research at accounting firm J.H. Cohn in Roseland, New Jersey.

Still, analysts warn that the economy is so weak, any fresh shock could send it tumbling. In the first half of the year, the economy expanded at less than a 1 percent annual rate, bad news for the estimated 13.9 million unemployed Americans.

Payroll growth has averaged 127,000 per month over the first seven months of the year, far less than the 150,000 jobs needed every month to keep the unemployment rate from rising.

If job growth does not accelerate, it could take more than four years to return to the pre-recession employment level.

So far, only about two million of the 8.7 million jobs that were lost during the 2007-09 recession have been recovered.

According to analysts, the private sector should account for all the job gains in August. Private payrolls are expected to rise 105,000.

Government employment is expected to have contracted for a ninth straight month, but the weakness will be tempered by the return of 23,000 state workers in Minnesota after a partial government shutdown in July.

Within the private sector, service-producing industries should show relative strength, although payrolls in the information sector will be hit by the Verizon strike.

Jobs in finance could shrink again, reflecting a recent wave of layoffs in the sector.

Manufacturing job growth is likely to have been curbed by the slump in business confidence. Factories added 24,000 new workers in July as disruptions to motor vehicle production caused by a shortage of parts from Japan eased.

(Reporting by Lucia Mutikani, Editing by Gary Crosse)