Oct. 28 (Bloomberg) -- Time and again during the crisis, executives at hard-hit financial firms balked when they had a chance to raise fresh equity. They worried too much about selling stock at low prices and diluting existing holders.

In some cases, namely Lehman Brothers Holdings Inc. and Freddie Mac, that misstep proved fatal. Now Bank of America Corp. may be in danger of making a similar blunder, even if the consequences might be less dire.

The bank wants to start repaying some of its Troubled Asset Relief Program funds and get the government, and its pay czar, off its back. Fair enough.

Yet the bank thinks it has enough capital to do so without selling new stock. The government thinks otherwise, according to a recent Wall Street Journal article.

Given that Bank of America’s shares have quintupled from March lows, the bank should stop worrying about dilution and bulk up on equity while it can. Even if shareholders get antsy, they’ll eventually come around.

“It is important to differentiate that this capital raise would be viewed as offensive since it would be Bank of America making a decision to repay TARP early, as opposed to defensive capital raises in the past,” Citigroup Inc. analyst Keith Horowitz wrote in a report Monday.

A Bank of America spokesman said only that the bank stands ready to repay TARP as soon as the government determines the right time.

Playing Offense

Bank of America hasn’t played offense in a long time, so it should seize the chance to do so. The bank and taxpayers will be better off for it.

The alternative is to bet that it can withstand future storms without more capital, and then pray that the economy doesn’t put that wager to the test. It will also have to hope that drawing down capital doesn’t leave it in a bad spot should regulatory reform lead to higher capital requirements.

Granted, Bank of America’s fortunes have improved since it and other banks were bailed out by the government. Bank of America notes that it has raised $40 billion in additional equity this year.

Even so, Bank of America is far from having a fortress balance sheet.

In terms of its too-big-to-fail peers, Bank of America lags behind JPMorgan Chase & Co. and Citigroup on some capital measures. Using existing equity to pay back the government would leave it behind the group’s rear flank, Wells Fargo & Co., on one other gauge of bank strength, tangible common equity. During the worst days of the crisis, investors looked to this bare- bones measure, not regulatory capital, to decide if a bank would pull through.

Something Tangible

Investors generally prefer to see tangible common equity of at least 4 percent to 5 percent of tangible assets, which exclude things like goodwill resulting from acquisitions.

At the end of the third quarter, Bank of America’s tangible common equity ratio, excluding mortgage servicing rights, was 3.86 percent. That compared with 5.41 percent at Citigroup, which this summer converted a big slug of the federal government’s preferred stock into common equity.

If Bank of America bought back $20 billion of the government-held preferred stock, its common-equity ratio might drop below 3 percent. That would leave the bank skating on thin ice if trouble emerged.

On the other hand, if Bank of America sold $15 billion in new stock and used that to pay back some of the government’s $45 billion preferred-stock holding, its tangible equity ratio would rise to almost 4.6 percent, putting it ahead of JPMorgan.

Bad Loans

Some investors may figure that, absent a share sale, Bank of America would be able to replenish equity with solid earnings gains. After all, super-low interest rates are helping to bolster bank profits.

Yet this supposes the bank is right to think credit losses on dud loans are peaking. The trouble is that the fate of the housing market, and the consumer, is cloudy at best. Since Bank of America is the financial institution with the biggest exposure to the U.S. consumer, any hiccups in this forecast may prove painful.

Already, Bank of America is kicking the can down the road in terms of possible charges for soured loans. The bank’s reserve for loan losses stood at 110 percent of non-performing assets at the end of the third quarter. That was down from 115 percent the prior quarter.

By letting the reserve ratio dwindle -- a year ago it was 152 percent -- the bank is holding off taking losses in the hope that soured loans are peaking.

No Repeats

If they aren’t, charges to profit will result. Had Bank of America simply kept reserves at the second quarter’s ratio to non-performing assets, its pretax loss for the third quarter would possibly have doubled to about $3.7 billion.

Not that the worst will necessary come to pass for the bank. No one is expecting a repeat of Lehman. It’s just that Bank of America will be better off if it does whatever it can to bulk up its equity.

Given that taxpayers have had to ride to Bank of America’s rescue, the dilution from any share sale should be a small price to pay for the freedom the bank seeks.

(David Reilly is a Bloomberg News columnist. The opinions expressed are his own.)

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To contact the writer of this column: David Reilly at dreilly14@bloomberg.net

Last Updated: October 27, 2009 21:00 EDT