Bank of America's

(BAC) - Get Report

third-quarter results, released Monday, clearly show a bank that's suffering from shrinking lending margins, sluggish revenue growth and a sharply rising number of past-due loans.

Slumping
Bank of America stock in 2000

However, despite those negative developments, the bank managed to post solid-looking profits for the third quarter. Operating earnings, which exclude a restructuring charge, totaled $1.31 a share, 6.5% above the $1.23 recorded in the year-ago period, and 2 cents above analysts' (recently reduced) forecast.

Net operating income growth was weak, meaning the bank relied on its share buyback program, which has cut nearly 100 million shares from the outstanding amount over the past 12 months, to achieve bulk of its per-share increase. Bank of America shares slid $1.25 to $45.31.

Third quarter operating income was $2.18 billion, up 1.1% from the year-ago period's $2.15 billion, and 5.4% ahead of the previous quarter's number. Third-quarter operating income was reduced by $257 million to reflect the falling value in the used-car market of the vehicles for which Bank of America has provided leases.

Bank of America has

struggled to impress investors since it was formed out of the 1998 merger between

NationsBank

and

BankAmerica

. Though having a cheap-looking valuation, the bank's stock is down 7% so far this year, compared with the 5% rise posted by the

KBW Banks Index

, which tracks the nation's 24 largest banks.

Most likely, the bank's third-quarter numbers will do little to counter the skepticism that it can meet its goal of 12%-15% earnings per share growth in 2001. As the nation's second-largest bank, Bank of America has plenty of levers it can pull to produce solid-looking earnings-per-share growth. It appears to have yanked hard on several of them in the third quarter.

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Protection

The quarter won't dispel fears that Bank of America isn't adequately protected against bad loans. Nonperforming loans, credits that are past due but haven't yet been classified as bad loans, jumped nearly 50% to $4.2 billion from the year-ago total. Loan types showing the most deterioration were U.S. corporate loans and consumer finance credits.

Arguably, as nonperformers spike, the bank should be boosting the size of its loan-loss provision, the money it adds each quarter to its loan-loss reserve, which is the money banks keep aside to absorb future bad loans.

The provision totaled $435 million in the third quarter, matching the $435 million in net bad loans booked in the period. Investors would've cheered Bank of America if it had made a provision large enough to boost the overall bad loan reserve as a percentage of loans and leases. But it's letting its reserve drop on this measure. It's now equivalent to 1.67% of loans and leases, compared with 1.96% in the year-ago quarter, and 1.70% in 2000's second quarter.

If Bank of America had increased the size of its provision more than it did, earnings would've suffered, since the provision has to be subtracted from profits. To keep the reserve at its five-quarter average level of 1.79% of loans, Bank of America would need to add an extra $470 million to its reserve. If it had done this in the third quarter, operating earnings would've been reduced by nearly 30 cents per share.

Responding to questions about the loan loss reserve on a conference call Monday, Jim Hance, Bank of America's finance chief, said that the level of reserves was correct for the type of loans that the bank has on its books, and he noted that annualized bad loans, or charge-offs, dropped to 0.43% of loans, which is the lowest number in the last five quarters.

However, he said the charge-offs could rise to close to 0.55% of loans in the fourth quarter. In that period, the bank is expecting to book an estimated $100 million in consumer charge-offs when it applies federal regulators' stricter new loan loss classifications, something

TheStreet.com

warned about.

Flattish

It's not hard to see why Bank of America may have gone light on its reserve to help earnings.

Recurring revenues, which include the negative affect of the bad loan provision and exclude securities gains, totaled $7.79 billion in the third quarter, essentially the same as the year ago period's $7.78 billion. Net income from interest payments to the bank, which made up 53% of revenue in the quarter, was up 1.4%, compared with the year-ago period. However, the profit margin on lending contracted to 3.12%, slimmer than the year-earlier period's 3.46% as well as the previous quarter's 3.24%.

Meanwhile, noninterest income, which includes everything from service fees to brokerage revenue to equity gains, fell just over 2% over the year. Above average equity investment gains of $422 million ($90 million above the five-quarter average) made a sizable 12% contribution to noninterest income.

Some analysts had hoped to see a continuation of the strong results posted by the consumer banking division in the second quarter. However, consumer banking's cash earnings of $1.14 billion, which excludes amortization of goodwill expense, declined by 5% in the third quarter, from second quarter levels (year-ago numbers weren't available).

In addition, the bank is making slow progress on cost reductions. Noninterest expenses of $4.41 billion in the third quarter were 2.6% below the year-ago number, and were more or less in line with the previous quarter. The bank in July

announced a plan to reduce expenses.

Finally, analysts expect Bank of America to take more hits in its auto lease portfolio in coming quarters. Charles Peabody, banks analyst at New York-based

Mitchell Securities

, thinks the bank could take further auto lease-related charges totaling $400 million to $500 million. (Mitchell rates Bank of America a sell and it hasn't done underwriting for the bank.)