BofA @ MarketWatch

Nov. 11, 2011, 9:39 a.m. EST

Bank of America: Fallen angel or demon?

By Hilary Kramer

The stock I get asked most about right now is unquestionably Bank of America.BAC +2.99%   I don't think there is even a close second. And I get why. BAC crashed from over $50 before the 2008 financial crisis down to $3, recovered with a bounce toward $20 in 2010 and is now back down to its lowest prices since March 2009 when the market bottomed.

At these low prices, the stock must be either a really good opportunity or dying company , and everyone wants to know which.

I view Bank of America as what I call in my new Little Book , a "fallen angel" - a company that was once considered widely owned and admired that has fallen monstrously out of favor with Wall Street and investors. Of course, a fallen angel could in reality turn out to be a money-devouring demon.

To tell the difference, we have to ask two critical questions: 1) What went wrong? and 2) Can it be fixed?

So What Went Wrong With BAC?

Bad mortgages. This wasn't unique to Bank of America. A lot of banks made the same mistakes, one of the reasons for the 2008 financial crisis. BAC and other major banks were holding too many mortgage securities backed by subprime mortgages in an effort to stretch for yield. Making loans to unqualified borrowers is a bad idea no matter how you slice it, and the practice cost BAC and the industry billions.

Bad acquisitions. Coming in the throes of the financial crisis, the acquisitions of Merrill Lynch and Countrywide were certainly ill-timed, but they were ill-advised as well. Then-CEO Ken Lewis coveted Merrill and its franchise with retail investors, which he believed he was getting at a bargain price. However, the acquisition came right when Merrill's business dried up and increased BAC's exposure to subprime mortgages. Making a bad deal even worse, Merrill's last CEO, John Thain, paid many of his bankers, traders and lieutenants bonuses that sparked outrage at a time when public money was being used to bail out banks. The anger was so great that some big public funds needed to sell as a "statement of objection." Countrywide brought in additional mortgage problems and also suffered from ethical challenges to boot.

Bad balance sheet management. BAC did not have sufficient liquidity to meet potential obligations and demands from creditors. This is why Lehman and Bear Stearns went under - and why the whole banking system may have failed without the government's TARP program.

Now, Can BAC Be Fixed?

Yes, and despite the recent PR debacle over debit-card fees , BAC is already making progress. Here's what they're doing and can continue to do to fix the company and boost the stock:

Streamline costs. Banks have often had large bureaucratic structures. Citigroup was criticized before it nearly collapsed because expense growth exceeded revenue growth. Bank of America is in the midst of a core project called "Project New BAC," which could reduce expenses in the consumer unit by $5 billion, or 18%, and produce as much as $7 billion-$8 billion in savings. I would like to see the company go even further and, as Citigroup did, evaluate all business units to determine which ones to keep and which ones to sell or close down. They need to really focus on improving the consumer unit, which is a critical driver for the future, and need to rebuild the public's trust (more on that in a moment).

Boost capital on the balance sheet. Under new Basel III regulations, banks must have a common equity ratio (a measure of the company's tangible equity as a part of its capital base) of 7%, up from 2% previously. Holding on to more cash means less leverage for banks, which will hurt returns in some cases, but it also makes them much safer. BAC has made solid progress with a common equity ratio of 6.25% at the end of the third quarter, the highest in 15 years.

Rebuild trust with consumers and investors. Unlike costs and balance sheets, it's hard to quantify rebuilding trust, but it's the most important challenge facing Bank of America. Increased and more detailed financial disclosures would be a big step, including telling us what is actually in the vaguely defined "other" assets. Executive compensation also needs to be kept in line with performance , and the company needs to deal more effectively with consumers -like being open, honest and smart about fees.

I believe Bank of America is heading in the right direction and is a fallen angel - one that fell particularly hard but is fully capable of flying higher once again. The stock has been extremely volatile because of both the company's own situation as well as the debt crisis in Europe.

I see big upside potential in BAC stock. As investors focus on Europe, BAC is down from highs of $15.30 in January to today's prices just above $6. The situation in Europe is messy, but I expect an acceptable resolution to eventually be put in place. With BAC's ongoing efforts to fix its own problems, I see the stock moving back to $12 in 2012.