Bank of America makes money and the stock market ... dives?

What happens when one of the giants in the troubled banking industry reports much better than expected earnings?

If it’s the third Monday in April, the answer is that whole stock market takes a dive, as does the share price of the bank in question.

That was the story as Bank of America said it earned more in the first quarter of 2009 then it did in all of last year.

The problem: That $2.8 billion quarterly profit was dwarfed, in the view of investors, by the risks to the bank posed by rising loan losses on everything from credit cards to commercial real estate.

The Dow Jones Industrial Average lost 290 points, or 3.56 percent, Monday. Bank of America, a part of the Dow index, lost 23.4 percent in the value of its shares.

Setback to a spring rally

It was a setback for a stock market that was enjoying a six-week spring rally. Many Wall Street analysts hope that the low set early in March will mark the bottom for stock prices in the current recession.

That may still be true. The news about Bank of America – the losses lurking beneath its profits – is tempering any nascent enthusiasm, however. It’s a reminder that some tough going still lies ahead for banks and the economy.

“The fact that we were able to post strong, positive net income for the quarter is extremely welcome news in this environment,” Ken Lewis, chief executive officer of the Charlotte, N.C., firm, said in releasing the earnings news. But “we continue to face extremely difficult challenges primarily from deteriorating credit quality.”

The bank’s earnings for the quarter were leagues ahead of Wall Street forecasts: 44 cents per share versus a consensus prediction of 4 cents.

But the profit gains came, to a large degree, from windfalls that can’t necessarily be repeated in coming quarters, such as trading gains and accounting changes on financial instruments tied to the bank’s newly acquired Merrill Lynch division.

Set-aside for loan losses: not big enough?

The core banking business, however, looks weaker. Losses are rising on home loans, credit cards, and other loans.

With an eye on this, the bank set aside $6.4 billion in its loan loss reserve during the quarter. But that wasn’t enough to make Wall Street confident that the firm is well positioned for the rest of the year.

Because loan defaults tend to rise in tandem with the unemployment rate, the problems at Bank of America may not abate soon. Here’s a bit of what the bank reported:

•Nonperforming loans on its books total nearly $26 billion, up from $8 billion in the same quarter last year.
•Sour loans are being charged off at a rising pace: 2.85 percent of all assets (annualized rate) in the first quarter, up from 1.25 percent a year before.
•Credit-card losses are running at an 8.6 percent annual pace, up from 5.2 percent a year before.

Other banks, too, are leaking capital

What’s weighing on the broader stock market is not just that this is happening at Bank of America, but that this mirrors what’s happening more broadly in the industry.

As banks write off losses, their capital reserves are depleted, leaving them with a smaller base on which to make new loans.

Treasury Secretary Timothy Giethner and other bank regulators are analyzing the results of so-called stress tests of large banks, to make sure they have enough capital to keep lending and supporting an economic recovery.

Banks deemed to need more capital will be asked to get it one of two ways: by raising it privately or by accepting an investment from the Treasury itself. Either way, that can mean a dilution for the stock value held by current shareholders. That’s why many bankers would like to avoid such a move.

“We absolutely don't think we need additional capital,” Mr. Lewis said during a briefing with analysts. But with the stress tests pending, the question is “out of our hands,” he said.

With government capital comes more government oversight, as policymakers try to assess whether banks are using public funds to help the economy.

Bank of America pointed to its efforts on this front Monday, saying for example that it modified 119,000 mortgages for at-risk borrowers in the first quarter.

Pace of new lending slows

Still, some analysts worry about a slowing pace of new lending. Some 20 large banks that have already received Treasury capital made $228 billion in loans during February, down from $245 billion in January and $262 billion in October, according to Treasury Department figures.

Despite the squeeze on credit, investors have pushed up stock prices in recent weeks on the hope for a gradual turnaround in the economy. The stocks of financial firms, Bank of America included, are up substantially from where they were in early March, despite the rocky start to this week.