Edge to Bank of America

Its earnings look good, especially compared with Citigroup.
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Second-quarter earnings at

Citigroup

(C) - Get Report

and

Bank of America

(BAC) - Get Report

could signal a changing of the guard when it comes to the banking sector's behemoths.

On Monday, Citigroup, the nation's largest bank, was outclassed on the earnings front by its nearest competitor in size, Bank of America.

But even BofA's better-than-expected results left room for skepticism. At midday, shares of both big banks were lower, with Citigroup down $1, or 2%, to $45.33 and BofA down 69 cents, or 1.5%, to $45.29.

Still, the bottom-line performance clearly favored BofA.

Earnings at BofA rose 12% from a year ago, as both profits and revenue came in ahead of Wall Street expectations. The Charlotte, N.C.-based bank profited from a combination of gains in credit card income and commercial lending, as well as cost cuts stemming from its merger a year ago with Fleet Boston.

In the quarter, BofA earned $4.3 billion, or $1.06 a share, up from $3.85 billion, or 93 cents a share, in the year ago period. Revenue was up 7% to $14.2 billion. The analyst consensus estimate had BofA earning $1.01 a share and tallying revenue of $14 billion.

The latest quarter included a $121 million pretax restructuring charge that reduced earnings by 2 cents a share. A year ago, the company took a 4-cent restructuring charge.

By contrast, earnings and revenue at Citigroup came in well below analyst estimates, as tallied by Thomson Financial. The New York-based financial giant got hammered by a weak trading environment for bonds and other interest-rate sensitive securities, as well as the poor performance by its U.S. credit card division.

In the quarter, Citigroup earned $5.07 billion, or 97 cents a share, compared with $1.14 billion, or 22 cents a share, last year. Total revenue was $20.1 billon, down 3%. Analysts were looking for earnings of $1.02 a share on revenue of $21.41 billion.

Citigroup's earnings quadrupled only because the year-ago quarter included a $4.95 billion charge related to the bank's settlement in the

WorldCom

case. Excluding that, earnings from continuing operations at Citigroup fell 7% from a year ago.

The biggest hole in Citigroup's quarter was a 12% decline in revenue from its capital markets and investment banking group. Notably, Citigroup reported a 28% drop in revenue from fixed-income trading and related activities to $1.8 billion. The big bank showed the same kind of weakness in bond trading that was reported last month at Wall Street securities firms

Goldman Sachs

(GS) - Get Report

and

Morgan Stanley

(MWD)

.

To its credit, Citigroup didn't try to sugarcoat the poor performance of its bond desk. Executives called the quarter a "tough'' one for its capital markets group.

Things weren't any better on the capital markets front at BofA, where trading-related bond revenue plummeted 77% to $105 million. Given that trading represents a relatively small portion of BofA's revenue mix, the impact on the nation's No. 2 bank was far less than it was on Citigroup.

The big difference between the two banks was the wide disparity between the performances of their credit card divisions, with income from cards soaring 25% at BofA while rising 5% at Citigroup. The gap may only grow wider in the coming quarters, with BofA's recent announcement of a $35 billion acquisition of

MBNA

(KRB)

, the nation's biggest independent card company.

Citigroup blamed the poor showing by its card division on the recently enacted bankruptcy reform law, which led to a spike in consumer bankruptcy filings. The bank says it tends to write off loans on which a consumer has filed for bankruptcy faster than other lenders.

"On a comparison basis, BofA did better than Citi on the card business," says Michael Stead, the manager for River Aire Investment, a hedge fund that mainly invests in financial stocks. "But I don't like either company's results."

Stead says he sold his shares in both banks following the earning releases. The hedge fund manager says BofA earnings were padded by a big gain in its venture capital business.

In the quarter, BofA recorded $492 million in equity investment gains, up from $84 million.

Both banks are grappling with the so-called flattening yield curve, the narrowing of the spread between short- and long-term rates. It's a problem the entire industry faces and one that has the potential to impact profits going forward, barring a sudden change in the interest rate environment.

The flattening yield curve puts a big crimp on the ability of banks to make money off their lending and deposit operations, a core business.

At BofA, net interest income totaled $7.75 billion, up just 1% from the year-earlier period. That was a disappointment to many analysts. For instance, Piper Jaffray bank analyst Andrew Collins was looking for net interest income of $8.2 billion.

If the flattening yield curve persists, it will be harder for any bank, big or small, to exceed analyst expectations in the third and fourth quarters.