Bank of America: Doubts Remain

The bank's better-than-expected quarter bolsters arguments that it can manage the credit crisis. But analysts worry about more losses from its Countrywide unit

Bank of America (BAC) Chairman and Chief Executive Kenneth Lewis strongly believes that his bank, the largest in the U.S., is successfully navigating the credit crisis.

However, not everyone buys Lewis' story, even if his bank's second-quarter results bolster his case. BofA reported earnings of 72¢ per share, down from $1.28 a year ago, but above the 53¢ that analysts were expecting. It's the latest big bank to beat Wall Street's low expectations this quarter, following Citigroup (C), JPMorgan Chase (JPM), and Wells Fargo (WFC).

As Lewis told analysts on a conference call July 21, those profits arrived despite a sluggish economy and tough credit conditions. "The fact that we can absorb $3.6 billion in credit losses, take $1.2 billion in additional writedowns, add $2.2 billion to our allowance for credit losses, and still earn $3.4 billion should tell investors something about the extent and consistency of our earnings power," Lewis said.

No Imminent Need to Raise Cash

He insisted, however, that he wasn't "in denial" about the extent of problems to come. "Credit losses are still going up, but given what we see today they are manageable," said Lewis. He insisted he doesn't expect the bank to need to raise capital or cut its dividend to raise cash any time soon.

The results were greeted as good news by investors, who sent BofA's stock 3.75% higher on July 21, to 28.52, capping several great days for bank stocks. In the past week, BofA shares have jumped more than 40%.

Among the positive signs in BofA's financial results is evidence that lower interest rates are helping banks like BofA earn wider profit margins on loans. BofA is expanding its commercial lending, and, because of the credit crunch, it's able to charge borrowers higher interest rates and insist on less risky lending conditions, Morningstar (MORN) analyst Jaime Peters points out.

A Boost in Trading Profits

Also, after several tough quarters for BofA's trading desks, profits on trading jumped in the second quarter. Morgan Stanley (MS) analyst Betsy Graseck wrote that strong trading, especially fixed-income trading, was the entire reason Bank of America beat her earnings estimates.

However, trading profits are hard to predict. They're dependent on both choosing the right trading strategies and also the ups and downs of volatile markets. That's why Graseck questioned the "sustainability" of BofA's trading profits. Standard & Poor's equity analyst Stuart Plesser agreed, questioning the "quality of earnings" at BofA.

This is part of the broader issue that continues to loom over BofA shares. The bank can deliver one good quarter to investors, but can BofA keep it up? Most analysts say the main answer to this can be found in credit quality—essentially, how quickly the quality of BofA's loans deteriorate.

Inheriting Countrywide's Problems

Deutsche Bank (DB) analyst Mike Mayo found some hope in evidence that losses haven't spread too far beyond the real estate area. "So far, problems have not yet spread in scope or severity outside of these areas as much as feared," Mayo wrote.

BofA's problems in real estate lending are many. Leading the list are home equity loans, hit hard by the drop in home prices. But the biggest challenge for BofA may be its July 1 acquisition of Countrywide Financial. The purchase of the U.S.

's largest mortgage lender is designed to help BofA dominate the mortgage industry in the long term. But in the near term, the Countrywide buyout brings BofA lots of trouble. The quality of Countrywide's loans is much worse than the loans on BofA's balance sheet. BofA said July 21 it will need to deal with $40 billion in troubled mortgage loans at Countrywide.

When BofA brought Countrywide's loans onto its own balance sheet, it did so at a hefty 15% discount. In other words, BofA is already assuming a sizeable level of future losses on Countrywide's portfolio. So, Countrywide losses won't hurt BofA's bottom line unless they increase beyond this level. Also, BofA has set aside billions of dollars to absorb its own losses in future quarters. BofA issued new stock last quarter, raising about $7 billion in new capital.

Legal Troubles Loom at Countrywide

Even after that move, S&P's Plesser is worried that BofA is still not prepared for large credit losses. He says he's watching three key factors that should determine how far and fast credit quality slides: the unemployment rate, the level of gas prices, and falling home prices.

The Countrywide purchase remains "a big question mark," Morningstar's Peters says. Though future losses on Countrywide's portfolio worry some analysts, Peters says investors' main worry "is the stuff they can't quantify right now," especially a multitude of lawsuits and investigations directed at Countrywide's lending policies.

In the past week, investors have been buying bank stocks that have gotten beaten down. BofA shares are still down 31% from the start of the year. "The market has painted our industry with a broad brush," Lewis at BofA said. "It seems to me that there is a big difference between those banks that are diversified and those banks with a concentration of funding issues."

The Strong Get Stronger

This earnings season may give investors a read on which banks are well-positioned to survive the credit crisis. "The stronger banks are getting stronger," Plesser at S&P says. "And the weaker ones are getting weaker," particularly those banks that might "need to raise capital in this environment."

Unfortunately, the rocky economy, rising credit losses, and especially the acquisition of Countrywide make it tough to be certain just how strong Bank of America really is.

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