Bank of America's

(BAC) - Get Report

second-quarter earnings met Wall Street's expectations, but sharply rising bad loans and the announcement of an upcoming balance-sheet restructuring will leave a cloud over the nation's second-largest bank.

Operating earnings at the Charlotte, N.C.-based bank totaled $2.06 billion in the second quarter, essentially the same as in the year-earlier period, but down 8% from the first quarter's $2.24 billion.

Matching the

First Call/Thomson Financial

consensus estimate, per-share operating earnings came in at $1.23 in the latest period. That puts the widely watched number 7% above the year-ago figure but 7.5% below first-quarter earnings.

"We don't believe this quarter is enough for investors to feel more positive on this stock," Judah Kraushaar, banks analyst at

Merrill Lynch

, wrote in a research note Monday. (He rates Bank of America neutral and didn't return a call asking whether his firm has done recent underwriting for the bank.)

Bank of America shares slid 7/16 to close at 47 1/16. Reflecting doubts about the bank's

earnings power and fears that bad loans are an issue, its stock has underperformed this year, falling 5% despite a 5% gain in the

KBW Banks Index

, which tracks the 24 largest banks.

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Weak Revenue Growth

Recurring revenue edged up an anemic 0.49% to $7.66 billion in the second quarter from the year-ago period, leaving it 6% below first-quarter levels. Partly due to seasonal factors, revenue from the bank's consumer businesses were well above first-quarter levels, but these gains were offset by much lower trading and private-equity gains. The consumer division's cash earnings, which exclude amortization expenses, jumped an impressive 19% in the second quarter from the year-ago period.

However, taking some of the shine off consumer profits, nonperforming consumer-finance loans soared a disturbing 116% from year-earlier levels, to $826 million. Another concern is that total nonperforming loans rose 30% to $3.69 billion, fast outpacing 10% loan growth. Most of the problems are in commercial loans, where nonperformers jumped to $1.54 billion, a 42% rise from 1999's second quarter. The bank's loan-loss reserve is now equivalent to 175% of nonperforming assets, down from 231% in the second quarter of last year, underlining the bank's more relaxed stance towards future credit problems.

While credit-quality data wasn't good, it wasn't that much worse than market expectations.

Charge-offs were $470 million in the second quarter, or 0.48% of loans, which constitutes only a small uptick from 0.45% in the first quarter. The

loan-loss reserve dropped to 1.7% of loans from 1.79% in the first quarter, which arguably reduces the bank's protection against future bad-loan spikes. Keeping the reserve at 1.79% would've required the bank to add $300 million to its second-quarter provision, which would have lopped 13 cents from per-share earnings.

The Charge-Off Question

Responding to questions about credit quality on a conference call Monday, James Hance, Bank of America's finance chief, said that the 1.7% level was right for a bank that has a lot of mortgage lending, which is currently showing low levels of bad loans. It's also high compared with peers, he stressed. The finance chief said charge offs would probably rise a little this year, but he added: "You'll not see anything like" charge offs at 0.55% of loans this year.

The bank's assurances didn't sit well with some observers. Charles Peabody, banks analyst at New York-based

Mitchell Securities

, finds it odd that the consumer finance division showed a sharply higher level of nonperforming loans, but only slightly higher actual losses (charge offs were $59 million, or 0.97% of loans, in the second quarter, against $57 million, or 1.01% of loans, in the first).

Peabody wonders if the bank, in a bid to avoid a high overall charge-off number this quarter, held off on booking consumer losses. A bank spokesman denies this and explains that nonperforming consumer loans rarely get charged off because a lot of these credits are secured with real estate.

Balancing Act

Hance also mentioned that the bank is "working on an initiative to materially reduce the balance sheet." In essence, this means selling loans that it originates rather than holding them on the bank's balance sheet till they mature. Selling loans through securitization requires a bank to estimate in advance the future profit on the sold loans. This profit is then treated as real income, even though it hasn't really been collected. Investors don't like this method because they have to trust the bank's estimates behind the gains, and in the past they have fled financial firms that have relied on this process.

Hance said the bank was doing the restructuring because current loan growth has to be funded with substantial borrowing, which gets expensive when interest rates rise and squeezes the profit margin on loans. A spokesman declined to say what proportion of earnings would come from such so-called gain-on-sale accounting once the restructuring is underway.

Peabody thinks the restructuring is being enacted to offset a possible revenue slowdown, since it will allow the bank to book gains early. In addition, the analyst thinks it's also connected to the marked deterioration in credit quality at the bank. A spokesman denies both charges. According to Peabody, the restructuring will allow the bank to reduce exposure to large commercial loans, where most doubtful loans reside.

"These are desperate times for Bank of America," Peabody concludes.