BofA Bailout a Sign of Federal Inconsistency

Bank of America's latest federal bailout raises serious questions about the government's approach to stemming the financial crisis, Wall Street observers say.
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Updated from 12:21 p.m. EST

Bank of America's

(BAC) - Get Report

latest federal bailout announced Friday raises serious questions among Wall Street observers about how successful the government's intervention into the financial system has been.

The Treasury Department and the Federal Deposit Insurance Corp. announced that the two agencies

would provide BofA

with a backstop against as much as $118 billion in loans and other assets, largely tied to its recent acquisition of Merrill Lynch. The Treasury also said it would invest $20 billion in BofA from its $700 billion Troubled Asset Relief Program.

The government aid deal sounds very familiar to what BofA was looking for in September, when it looked at but ultimately backed away from buying

Lehman Brothers

because the federal government was unwilling to provide a guarantee of the reeling investment bank's shakiest assets. The government had provided such a backstop for

JPMorgan Chase

(JPM) - Get Report

when the New York bank bought faltering Bear Stearns in March.

On Sept. 15, the same day Lehman filed for bankruptcy, BofA, and Merrill -- fearing it could suffer the same fate as Lehman and Bear -- agreed to a deal. It closed Jan. 1.

"They don't know what they're doing," Michael Pento, senior market strategist at Delta Global Advisors, says of BofA CEO Ken Lewis, Treasury Secretary Henry Paulson and

Federal Reserve

Chairman Ben Bernanke. "Their whole capacity for valuing these assets is completely flawed."

On Friday,

Paulson

defended his stewardship of the TARP, calling the program "absolutely essential to financial stability." He said that although the bailout had made "real progress," but admitted that there would be additional challenges down the road.

Despite Paulson's confidence, the government guarantees on Merrill's assets indicate the difficulty of assessing the damage wrought to major banks' balance sheets, as assets tied to mortgages and other debt continue to deteriorate amid falling home prices and the worst recession in nearly three decades. It also once again calls into question the wisdom of allowing Lehman to go bankrupt in the first place. Lehman's failure sent a jolt through the credit markets, exacerbating banks' aversion to lending and shaking confidence throughout the financial system.

Now that the government is committing to a massive guarantee of Merrill's assets, it has become increasingly unclear why it didn't make a similar commitment when there was an opportunity to save Lehman.

"I don't know what was on the mind of Mr. Paulson and the rest of the government officials, but certainly I think it was a big mistake letting Lehman fail," says Peter Cardillo, chief market economist at Avalon Partners.

Part of the problem with the current bailout scheme, whereby the government commits to making preferred equity investments in troubled banks and guaranteeing their toxic assets, is that it's extremely hard to assess how much additional money will be needed before the financial system can recover.

"There's not enough capital in the world, given their leverage ratios, to fix this problem," says Paul Mendelsohn, chief investment strategist at Windham Financial.

He says that the current bailout program is designed to buy time, "keeping our fingers crossed that the problem can resolve itself over time." The chief achievement of the TARP program has been that it has prevented another major, Lehman-style collapse and the flight from risk that such an event would entail, he says.

Furthermore, equity investments in large banks by the government aren't necessarily having their desired effect, which is to stimulate lending and jump-start the economy. Banks that have already reported fourth quarter results like

JPMorgan

and

Marshall & Ilsley

(MI)

have shown they are lending less since receiving TARP investments, and continue to face pressure from mounting loan losses.

"All this TARP money is going to capital. It's just going into the vault and being held onto," says Mendelsohn. "The banks don't know what their net capital positions are. They don't know what these securities are worth."

Pento says "the holes in banks' balance sheets will continue to erode" as long as the economy continues to stumble. He says he sees a solution in an alternative, highly ambitious approach.

"The government is going to have to approach banks in the good bank, bad bank scenario," he says. He proposed government purchases of any assets banks no longer want at a high price. "We are going to have to overpay. That will stop the bleeding on their balance sheets and improve their Tier-1 capital."

On the consumer side, Pento says that the government will have to forgive debt to halt foreclosures and defaults on other debt on Main Street. He foresees the incoming Obama administration implementing such a plan for two reasons: First, because it's the only way to solve the problem; and second, because Obama has said that his No. 1 target is to stop home foreclosures.

Mendelsohn says that mark-to-market accounting, whereby banks' assets are set to the price of the most recent sale, is a culprit in the current crisis. Because banks are unwilling to purchase debt, the value of securities originally designed to be held to maturity has declined enormously. He advocates modeling the assets' value.

"

These assets were meant to be held to maturity," he says. "I think that would solve a lot of our problems."

On Thursday, the Senate voted 52-42 to approve use of the second half of the TARP. On the eve of Barack Obama's inauguration, Bank of America's additional need for capital suggests the need to test alternative strategies.

In the meantime, investors will continue to wrestle with uncertainty over what plans officials will cook up will put a severe drag on the markets, says Mendelsohn. He says Bush and Paulson have been committed to stabilizing the equity markets as part of the bailout program.

"The only thing concerning the market right now is whether the Obama team ... is going to follow the same regimen," he says.