BofA Sinks Despite Profit Beat

Updated from 2:09 p.m. EDT

Bank of America ( BAC) proved on Monday that it didn't merely return to profitability last quarter -- it soared.

However, when one-time items, preferred dividend payments and unusual gains are stripped out of the whopping $4.2 billion profit BofA reported, the picture becomes significantly bleaker.

On a conference call, BofA executives predicted a few more quarters of strained credit conditions before the economy starts to improve -- a forecast that doesn't bode well for core banking operations. And investors began to realize that booming profits reported of late by financial powerhouses, which sparked a major market rally, may not be hardy enough to sustain it.

Bank of America shares plunged 24.3% to $8.02 at the close Monday, its low for the day. The firm was among the biggest drags for the market, along with other financial stocks like Citigroup ( C), Wells Fargo ( WFC) and JPMorgan Chase ( JPM). The Dow Jones Industrial Average closed down 3.6%.

BofA blew away Wall Street expectations on Monday, reporting a first-quarter profit attributable to common shareholders of $2.8 billion, or 44 cents per share. The figure was 11 times the average analyst estimate of 4 cents per share, according to Thomson Reuters.

Excluding preferred dividend payments, the Charlotte, N.C.-based company would have earned $4.2 billion. During the same period a year ago, BofA posted a $1.2 billion profit, or 23 cents per share.

BofA's results benefitted from its two huge acquisitions of Merrill Lynch and Countrywide, as well as major mark-ups on assets due to an easing of fair-value accounting standards. BofA reported a $2.2 billion positive adjustment to Merrill's troubled assets, as well as a $1.5 billion pretax gain on other debt securities. The firm also posted a $1.9 billion gain on its sale of holdings in China Construction Bank.

Additionally, BofA and its counterparts are reaping rewards from an interest-rate environment in which borrowing costs have plunged and lending rates for some consumer debt has risen. That rate environment has also led to a resurgence of sorts in the housing market, as homeowners flock to refinance mortgages and new home buyers begin to enter a market with declining prices and rates.

BofA extended $85 billion in loans to 382,000 customers for new home purchases or refinances, and is adding 5,000 employees to deal with record application volume.

But while its net interest income climbed 25% to $12.8 billion, credit quality deteriorated across all of BofA's lines of business. The firm's net charge-offs climbed to $6.9 billion, or 2.85% of its loan portfolio, from $5.5 billion, or 2.36% at the end of 2008. BofA also boosted its provision for future credit losses by 57% to $13.4 billion, as nonperforming assets climbed to $25.7 billion, or 2.65% of BofA's book, from $18.2 billion, or 1.96% at the end of last year.

CEO Ken Lewis predicted that charge-offs will "continue to trend upward" through the rest of the year, as the company continues to build reserves, albeit at a slower pace.

"Make no doubt about it: Credit is bad," Lewis said on a conference call. "And we believe credit is going to get worse before it stabilizes or improves."

There has been a raft of speculation over whether BofA -- and other banking behemoths like Citi, Wells and JPMorgan -- would require additional funds to shore up capital levels and tangible common equity. BofA said its TCE ratio -- which has become a closely-watched metric of a bank's financial health -- improved to 3.13% from 2.93% at the end of 2008.

However, reports surfaced Sunday evening that the government may require firms to convert its large cache of preferred stock into common equity. The potential for such a move further stoked fears that existing holders of common stock would be significantly diluted.

Lewis sought to assure investors about the firm's capital needs on Monday, as the market put more weight on BofA's deteriorating credit quality than record first-quarter earnings.

On the call, Lewis said "we absolutely don't need further capital" according to the internal stress tests and analysis BofA has performed. But he also noted that the decision to convert preferred to common equity ultimately rests in the hands of regulators, who have conducted their own stress tests on banks that have received TARP funds.

"It's now out of our hands into others," Lewis said. "So, from all the ways we've looked at it we think we're fine, but again this is in the hands of the regulators."

BofA is the latest financial firm to top expectations, a trend that started with Wells Fargo's ( WFC) preannouncement on April 9, followed up by Goldman Sachs ( GS), JPMorgan Chase ( JPM), Citigroup ( C) and General Electric ( GE), whose finance arm has caused concerns. But while those firms' reports sparked market rallies, it seems that underlying credit trends have became the prime concern among investors on Monday.

"When you look at Bank of America, when you look at Citigroup, you have concerns over what skeletons are still left in their closet," says Matt Lloyd, chief investment strategist for Advisors Asset Management. "Actions speak louder than words. The words are positive -- 'We're not going to need more capital' -- but it's falling on deaf ears."

Lloyd believes that JPMorgan's reported sale of $3 billion in debt to private investors and Goldman's $5 billion stock offering were signals of strength among the banking giants. He believes that the winners will be able to grab market share and investor support, while others work to wean themselves off of the government lifeline.

"Typically, the ones that lead you into it are the ones that lead you out, but I think with financials it will be more Darwinistic," Lloyd says.

On the brighter side, BofA's report may have assuaged some concerns about its big-ticket acquisitions. Merrill contributed over $3 billion to BofA's bottom line, excluding preferred dividend payments, and the integration and cost savings at both divisions are on track or ahead of schedule.

Celent senior banking analyst Bart Narter noted that "Wall Street -- not Main Street" helped to drive BofA's bottom line last quarter. Global banking, global markets and wealth management results delivered $3 billion in earnings, while consumer banking, credit cards, mortgages and insurance operations lost $1.7 billion.

Narter notes that such trading profits can "swing strongly in either direction," as evidenced by the recent dips and peaks in the equity markets. Therefore, he argues, the first-quarter boom holds no guarantee of future profitability.

"Bank of America has a huge retail franchise," says Narter, "and they need to make it profitable."

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