* Profit $340 mln after $1.6 billion litigation expense
* Mortgage banking rev up 25 percent, bond trading rev jumps
* Expenses up 1 percent despite cost-cutting program
* Raises estimate of possible losses tied to soured loans
By Rick Rothacker
Oct 17 (Reuters) - Bank of America Corp's profit fell 95 percent in the third quarter as the second-largest U.S. bank remained haunted by businesses it purchased during the financial crisis.
The bank earned $340 million in the quarter after taking $1.6 billion of litigation charges from a settlement tied to its 2009 purchase of investment bank Merrill Lynch & Co. Its disastrous purchase of mortgage lender Countrywide Financial in 2008 also continues to drag on results.
And Bank of America's overall expenses edged higher, even after a year of cost cutting, including thousands of layoffs.
"This is still a bank that has an awful lot of work to do," said Gary Townsend, chief executive of Hill-Townsend Capital in Chevy Chase, Maryland. "How long of a runway do they need to build up speed to actually take off?"
Chief Executive Brian Moynihan is still struggling to fix Bank of America even as rivals Wells Fargo & Co and JPMorgan Chase & Co show signs they have moved past the financial crisis, reporting a combined $10.6 billion of profits for the quarter.
Like other large banks, Bank of America reported a surge in mortgage banking income as homeowners refinanced at low interest rates, and it set aside less money to cover bad loans. The bank also posted a big increase in bond trading revenue.
Still, for every positive development there seemed to be a corresponding negative. Mortgage investors, for example, requested the bank buy back 12 percent more bad loans than the same quarter last year, portending possible future hits to earnings.
Since the financial crisis, Bank of America has lost nearly $40 billion on repurchase requests and mortgage-related litigation, according to an Oct. 5 Credit Suisse report, the most of seven large banks.
To boost profits, the bank launched a broad cost-cutting program in 2011 that aims to eliminate $8 billion in annual expenses and 30,000 jobs. But legal expenses and the cost of servicing troubled loans blunted the impact of the program, called "Project New BAC."
Non-interest expenses rose nearly 1 percent in the latest quarter to $17.54 billion, excluding merger charges and certain accounting charges.
Chief Financial Officer Bruce Thompson said the bank was "well ahead" of its year-end goal to produce 20 percent of the $5 billion in annual savings called for in the first phase of New BAC.
Excluding the unit that handles troubled mortgages, the bank's work force is down by about 21,000 from a year ago, to about 231,000. But headcount in Legacy Asset Servicing, which focuses on bad home loans, is up almost 5,000 to nearly 42,000. The bank also has 17,000 contractors on the job, up about 4,100 from the same quarter last year.
Thompson told reporters that hiring had stabilized, and the bank should make "real progress" on expenses in the fourth quarter. Bank of America in the past has signaled that expenses were peaking in the servicing unit, only to have costs grow as more work poured in from government settlements requiring loan modifications and servicing improvements.
In a sign Bank of America is working through a backlog of troubled loans, it said it has completed $900 million in first-lien mortgage modifications under a settlement finalized in April with federal officials and state attorneys general. That is an improvement from a report in August by the settlement's monitor, which found the bank had not yet completed any modifications under the pact.
Bank of America issued so many shares during the financial crisis to bolster its balance sheet that its third quarter earnings amounted to nil a share, compared with 56 cents a share a year earlier when it earned $6.2 billion on gains from selling assets and accounting benefits. Analysts' average forecast was a loss of 7 cents per share, according to Thomson Reuters I/B/E/S.
The bank last month said the Merrill Lynch settlement, a UK tax charge and an accounting charge related to the value of its debt would reduce third-quarter earnings by 28 cents per share.
The bank set aside $1.8 billion in the quarter to cover bad loans, down from $3.4 billion a year earlier.
The bank's shares closed on Wednesday down 2 cents, or 0.2 percent lower, at $9.44.
NEW REPURCHASE LOSS ESTIMATE
Bank of America has drastically scaled back its mortgage business after taking billions of dollars of losses from its Countrywide purchase. But in recent quarters, it has been bringing on more loan officers in an effort to recapture some of its lost market share.
Mortgage banking revenue climbed 25 percent from a year ago to $2 billion. In a conference call with analysts, Thompson said he expected the mortgage boom "to continue through the lion's share of 2013."
The bank, however, still faces potential pain from old loans.
In its earnings presentation, the bank said it could lose up to $6 billion above its current reserves on repurchase claims from Fannie Mae and Freddie Mac as well as private investors. It previously said its losses beyond reserves could be up to $5 billion for private investors only.
Thompson said the bank updated its estimate after further discussions with the government-controlled mortgage finance companies. The bank still has disagreements with Fannie Mae over what claims should be paid and has not reached any settlement with the agency, he said.
The bank stopped selling some loans to Fannie Mae earlier this year as the tension over the dispute mounted.
S&P Capital IQ analyst Erik Oja kept a "sell" recommendation on the stock because of the potential costs that lie ahead. He said he was concerned the bank has not been setting aside enough additional money to cover expected losses.
"They've taken very small provisions in the last five quarters," Oja said, adding that the bank has been adding an average of about $300 million to its reserves each period. "That to me points to another large provision."
Bank of America had $16.3 billion in reserves for repurchase claims at the end of the third quarter, up 2 percent from the previous quarter.
In a positive, the bank reported further improvement in its capital ratios, largely by reducing riskier assets on its balance sheet. The bank said its Tier 1 common capital ratio, under proposed new Basel III capital rules, rose to 8.97 percent from 7.95 percent in the second quarter.
Banks are gearing up for another round of stress tests in which regulators will determine whether they are allowed to increase dividends and buy back more shares. Bank of America's quarterly dividend has been stuck at a penny per share since the financial crisis.
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