Is BofA ready to free itself from TARP?

BofA chief Ken Lewis wants to repay TARP funds. But is his bank healthy enough?

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NEW YORK (Fortune) -- Is Bank of America really doing well enough to get off the government dole?

The Charlotte, N.C., bank is talking with regulators about repaying some of its $45 billion of Troubled Asset Relief Program debts, the Wall Street Journal reported Tuesday.

BofA (BAC, Fortune 500) wouldn't comment about the report. But it's no secret why the nation's biggest bank by assets might want to start wriggling out from under TARP.

Rivals, including JPMorgan Chase (JPM, Fortune 500), repaid the government in June, freeing them from congressional scrutiny. With that backdrop, the mere suggestion that BofA may be ready to write a check to the Treasury was well received by some analysts.

"We think that an initial payment signifies that [Bank of America] is not facing any major setbacks since reporting solid Q2 results," Standard & Poor's equity analysts wrote Tuesday, referring to the bank's better-than-expected profit in the second quarter.

Wall Street was skeptical, though. The stock was down 5% in midday trading Tuesday, a day when bank stocks broadly were leading a market sell-off. And whether BofA is really healthy enough to follow in the footsteps of its peers is an open question.

Though the economy has shown signs of recovering, skeptics contend it's too early for banks such as BofA -- which in January was under such financial stress that it was forced to announce it had lined up $138 billion in federal support -- to give money back to the government.

Whitney Tilson, a fund manager who is betting BofA stock will fall, said he believes the government shouldn't accept TARP repayment from big banks until the economic recovery is further advanced and the possibility of another downturn -- a so-called double-dip recession -- can be ruled out.

"The last thing you want is for banks to pay back money now and then need it later," he said. "You need to show you're really out of the woods. To me, that hurdle is a very, very high one."

To that end, Tilson questions the strength of the summer rebound in housing. He said he believes home prices nationwide aren't likely to hit bottom until next spring at the earliest -- which means more losses for banks such as BofA, which has $590 billion of consumer loans on its books.

There are other signs Bank of America could still be vulnerable should the market optimism that took the broader market up almost 50% fade.

While the bank has been setting aside more reserves for credit losses, problem loans have been growing even faster.

Since the second quarter of 2008, BofA has set aside $47.5 billion to cover credit losses, and its loan loss reserve has doubled. Yet its coverage ratio -- comparing the size of the loan loss reserve to the amount of nonperforming assets -- has dropped to 116% from 187% a year earlier.

And with unemployment at its highest level since the early 1980s, losses on credit card, commercial and residential loans are expected to keep rolling in through next year.

"It would be unwise for people to forget about the problems in their loan book," said Tilson. "They've got an awful lot of exposure."

To be sure, the bank -- like the rest of the economy -- looks a lot healthier than it did six months ago, when its shares traded at multidecade lows. Since then, BofA shares have risen sixfold, fueled in part by the bank's $7.5 billion first-half profit.

The rally has helped BofA raise nearly $40 billion in new capital, more than filling the hole noted in the government's stress test and seemingly bracing the institution against further problems.

Analysts at R.W. Baird wrote in June that the capital raise "should be adequate to enable the company to earn through the current cycle with a low likelihood of needing additional government capital."

Still, Bank of America shares fetch barely half the price they traded for a year ago -- which helps to explain another reason why Lewis might like to start repaying BofA's loans.

A partial TARP repayment would be a feather for Lewis to put in his cap after two unpopular and costly acquisitions, of the Countrywide mortgage and Merrill Lynch brokerage franchises. Shareholders stripped him of his chairmanship in April, largely out of frustration with his handling of the Merrill deal.

"In his mind, this is a good way to resuscitate his legacy," said Eric Jackson, an activist investor who runs hedge fund Ironfire Capital and has no position in Bank of America stock. "He wants people to say the Merrill Lynch deal did work out, the Countrywide merger is producing -- that's where his head is now."