US banking giant Citi is coming under pressure to bail out investors in one of its troubled hedge funds, in another embarrassment for a company already among the biggest losers from the credit crisis, according to media reports.

Citi has begun asking private clients to accept a $250 million compensation package, in return for dropping legal claims against the company. Banks which have sunk an estimated $1.6 billion into the fund are also examining their legal options.

The saga underscores the risk that financial firms face the risk of litigation from angry clients who have lost money from the credit crunch.

The problems stem from Citi's Falcon Strategies hedge fund, an investment vehicle that traded mortgage bonds, government debt and a range of credit derivatives, which began experiencing big losses when the credit markets ran into difficulties last summer. Thousands of Citi clients – advised to invest in the fund by brokers at its Smith Barney wealth management division – face being wiped out.

And three big regional banks, including Wachovia, one of the largest in the US, have also been forced to write off large parts of their investments, after putting some internal life insurance money into Falcon.

Wachovia posted a $315 million loss on life insurance assets, largely as a result of its $1 billion exposure to Falcon. Fifth Third of Cincinnati is suing the investment advisors which suggested it sink $612 million into Falcon and which, it alleges, failed to pull the money back out again when the first signs of trouble emerged.

Citigroup is not involved in Fifth Third's lawsuit but it does face a class action from private clients. The action is being led by Robert Zeff, a Smith Barney client in Florida, who put $500,000 into the Falcon fund. He says the fund was marketed to clients as "an extremely low-risk investment".