Financial Crisis Watch January 28, 2009, 5:19PM EST

The Federal Bailout Hasn't Fixed Bank of America

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So far, the government's solution to the problems at BofA and Merrill has been to throw money at them. The U.S. promised the two banks $25 billion back in October. BofA also raised $10 billion from private investors. In November the Federal Reserve quietly bought about $3.3 billion of collateralized debt obligations from Merrill through an entity called Maiden Lane III.

But BofA and Merrill have been burning through the fresh capital. Despite a combined $18 billion loss in the fourth quarter, they paid out $2 billion in dividends to shareholders. Merrill doled out a reported $4 billion in employee bonuses. And BofA upped its stake in China Construction Bank by $7 billion, to $19 billion, in November—only to cut it two months later, by $2.5 billion. With the banks' capital cushion wearing thin, Lewis turned for more money to the government, which complied in January, giving the bank $20 billion and providing guarantees on $118 billion in assets.

The terms of that deal only exacerbate BofA's woes. Most of the government's cash came in exchange for preferred stock, a special type of equity that requires the bank to pay a hefty dividend to the owners. The Treasury did so to protect taxpayers, figuring the government would get at least some return on their money. The downside is that BofA will have to pay out $5 billion a year to the government, which owns $49 billion worth of the bank's preferred equity. That's cash the bank needs to rebuild its capital base, a critical step before it can even think about boosting its lending. The stopgaps prolong the healing process for BofA and the broader economy.

Not Quite Solvent?

Likewise, the loan guarantees may forestall the purging of bad assets and further delay a recovery. The government has forced BofA to cover the first $10 billion in losses on its $118 billion loan guarantee of the toxic assets—largely securities backed by corporate loans and commercial mortgages. The hefty deductible discourages the bank from cleansing its portfolio, which would mean taking more writedowns and raising more capital. Why so? It's not unlike an auto insurance policy that has a $1,000 deductible. If there's a car accident and the repair costs total $3,000, the owner must pay the first $1,000. An individual who lacks the money is likely to continue driving the clunker as long as possible.

More important, the guarantees don't cover some $500 billion of problem assets, according to analyst Richard Ramsden of Goldman Sachs (GS). It excludes $92 billion of loans made by Countrywide, one of the largest suppliers of subprime mortgages to borrowers with poor credit. As the recession grinds on, analysts also expect more credit-card debt and business loans, particularly those to retailers, to rot at BofA.

With so many dubious assets on the bank's balance sheet, there are growing concerns about whether it is effectively, if not technically, insolvent. At last count, Bank of America's assets exceeded its liabilities by about $210 billion, or roughly 10%. A financial institution is considered insolvent when its assets don't cover its liabilities—and a regulator can take over a bank even before that happens. "We are a very liquid bank," says BofA spokesman Robert Stickler.

But there are questions on both sides of the ledger. A small decline in the price of the company's assets could bust the bank. The liabilities may also be understated: The tally doesn't include BofA's obligations to preferred shareholders, an increasingly large group. Already, Wall Street is questioning whether BofA is actually worth the $210 billion on its books. The stock recently traded at 7.35, which puts the company's value at roughly $47 billion.

Time is running out for BofA. Top talent is fleeing, not only legacy bankers from the commercial bank but also top Merrill brokers. Some employees are even volunteering for layoffs, so skeptical are they of the bank's future. Now, critics inside and outside the company wonder if Lewis' days are numbered. Says FBR's Paul Miller: "If there are any other big surprises—another big loss—I think the wall of protection will crumble around Lewis."

Regardless of Lewis' future, one thing is certain: The government can no longer afford to take half-measures or move slowly to prop up BofA and other banks. The economic recovery is hanging in the balance.

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Too Big to Save?

The government continues to pump money into the nation's largest banks. But a piece in the Jan. 26 issue of Institutional Risk Analyst, a newsletter, suggests the U.S. should instead inject funds into smaller banks, which don't have the same level of toxicity. "Nobody in the Congress or the White House wants to acknowledge that the policy prescriptions coming from the Fed and Treasury are badly flawed when it comes to bank solvency," the article says. "But the 'save the big banks' approach by the Fed is just more of the same nonsense that caused the problem in the first place."

To read the article, go to http://bx.businessweek.com/bank-nationalization/reference/.

With Mara Der Hovanesian.
Henry is a senior writer at BusinessWeek. Goldstein is a senior writer at BusinessWeek. BusinessWeek Senior Writer Farzad covers Wall Street and international finance.