WASHINGTON/NEW YORK (Reuters) - Bank of America Corp was rescued by the U.S. government on Friday through a $20 billion bailout and a guarantee for almost $100 billion of potential losses on toxic assets to cushion the blow from a deteriorating balance sheet at Merrill Lynch & Co, its recently acquired brokerage.

A taxi speeds past a Bank of America branch in New York's Times Square January 11, 2008. REUTERS/Brendan McDermid

The bailout makes Bank of America the biggest recipient of taxpayer money next to Citigroup as the government pours cash into the nation’s banks to plug holes left by bad loans. The worst housing crisis since the Great Depression and the worst recession in many years have hammered U.S. banks.

The capital is on top of $25 billion that Bank of America previously got from the Treasury Department’s Troubled Asset Relief Program (TARP) in October and is the latest indication that authorities are still struggling to come to grips with the financial crisis that began about 18 months ago.

In another bid to shore up banks in general, the government’s Federal Deposit Insurance Corp. said it would propose lengthening the term on bank debt that it is prepared to guarantee to 10 years from three years. Banks must use the proceeds for new consumer lending.

Both Citi and BofA, once the dominant U.S. banks, face mounting pressure from investors who question whether they have enough capital to cope with a tidal wave of bad debts.

This crisis of confidence sent their shares plummeting on Thursday, with Bank of America’s stock sinking as much as 28 percent to $7.35, its lowest in more than 17 years, and Citigroup’s declining 26 percent to just $3.36. They both later recovered some of the losses, with BofA last quoted at $8.89 and Citi at $3.98.

More details about their condition will surface early Friday, when the two banks report quarterly results. Citigroup is widely expected to report a huge loss, and some analysts also expect Bank of America to report a loss. Both brought forward their releases from next week.

In return for the bailout, Bank of America, which just a few months ago was trumpeting the Merrill takeover as a coup, agreed to cut its dividend to 1 cent per share from 32 cents and cap executive pay -- concessions similar to those made by Citigroup when it was rescued in November.

The dividend cannot be increased without government approval in the next three years.

The guarantee also resembles the $306 billion backstop that Citigroup received. Bank of America will assume the first $10 billion loss on a pool of $118 billion of toxic assets, the U.S. government will take the next $10 billion, and the U.S. will assume 90 percent of all further losses, with BofA responsible for the remaining 10 percent. The assets are mainly mortgage-related assets inherited from Merrill.

A U.S. official said President-elect Barack Obama’s transition team had been notified of the Bank of America negotiations. Earlier, a financial policy source told Reuters that both President George W. Bush and Obama, who takes over on Tuesday, have signed off on the package of support.

Bank of America sought the aid to absorb growing credit losses at Merrill, whose acquisition was completed on January 1, creating the largest U.S. bank.

Bank of America is expected to post a quarterly profit of 19 cents per share, according to the average of analysts’ expectations, but some analysts expect a loss.

Citigroup, meanwhile, is expected to post a fifth straight multibillion-dollar quarterly loss, with analysts expecting a loss of $1.32 per share, excluding items.

Citi is also expected to unveil a plan to significantly shrink its balance sheet and business model, a source has said. The bank, which has received $45 billion in TARP money, began that process on Tuesday with a deal to merge its Smith Barney brokerage with Morgan Stanley’s wealth management unit.

“WARDS OF THE STATE”

Analysts have raised the specter that both Bank of America and Citigroup could be nationalized at taxpayer expense.

“They both will likely become wards of the state,” Doug Kass, who heads the hedge fund Seabreeze Partners Management, referring to Bank of America and Citigroup, said before the Bank of America bailout announcement. “They are too big to fail.”

Any effective government takeover would follow similar moves involving mortgage finance companies Fannie Mae and Freddie Mac and banks in Britain and Iceland. Ireland’s government nationalized Anglo Irish Bank Corp Plc on Thursday.

Citigroup denied speculation it might be nationalized, CNBC television reported. A bank spokesman declined to comment.

Analysts said the government would like to avoid a repeat of the downfall of Lehman Brothers Holdings Inc, whose September 15 bankruptcy was viewed as a key trigger in a broad downturn in world economies and equities markets in the latter part of last year.

Some positive news came Thursday from JPMorgan Chase & Co. The No. 2 U.S. bank reported a 76 percent decline in quarterly profit, but still topped some analysts’ expectations.

However, the bank boosted its estimate of potential losses from credit cards and from Washington Mutual Inc, which it took over last September.

Moody’s Investors Service lowered the bank’s credit rating, saying “consecutive quarterly losses in the next 12-15 months cannot be ruled out.”

JPMorgan closed down $1.57, or 6.1 percent, at $24.34.

The KBW Bank Index slid 8 percent, including a 26 percent drop at Marshall & Ilsley Corp. That Milwaukee bank said soured residential development loans, including in Arizona and Florida, led to a surprise quarterly loss.

OVERREACHING?

Bank of America’s need for government help raised questions about whether CEO Kenneth Lewis overreached by buying Merrill for about $19.4 billion, and Countrywide Financial Corp, the largest U.S. mortgage lender, for $2.5 billion in July.

The purchases extended Bank of America’s tentacles throughout the financial system in a period of pronounced economic weakness. Bank of America had already halved its dividend in October as the capital concerns grew.

“This looks, feels and smells like a redux of Lehman,” said Tom Sowanick, chief investment officer of Clearbrook Financial LLC in Princeton, New Jersey, who was speaking before the formal bailout announcement.

The Financial Times said Lewis sent lawyers to examine Merrill’s books in December to determine if results worsened so materially that he could invoke a contractual right to scrap the merger.

Meanwhile, Citigroup CEO Vikram Pandit is expected to shrink the bank by about one-third, after $20.3 billion of losses in the year ended September 30. But investors worry that any plan will dilute shareholder stakes, or not go far enough.

“There is no faith in Bank of America and Citi,” said Todd Leone, head of listed trading at Cowen & Co in New York.

Lawmakers expressed concern about the industry’s fragility.

“They’ll be back for more money” from TARP, said Sen. Bob Corker, a Tennessee Republican. “Our banking system is going to lose hundreds of billions of dollars,” and taxpayer money is “going down the drain.”