By Jennifer Ablan and Jonathan Stempel

A deep recession could deplete capital, and some analysts raised the specter that the nation's largest and third-largest banks could be nationalized at taxpayer expense.

That would follow similar moves involving mortgage finance companies Fannie Mae and Freddie Mac, and banks in such countries as Great Britain and Iceland.

Bank of America is seeking billions of dollars of new aid after realizing that credit losses at Merrill Lynch & Co, which it bought on January 1, were much higher than expected, a person familiar with the matter said.

Meanwhile, Citigroup is expected on Friday to post a fifth straight multibillion-dollar quarterly loss, and unveil a plan to significantly shrink its balance sheet and business model.

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

Citigroup denied speculation that is might be nationalized, CNBC television said. A bank spokesman declined to comment.

The banks have already received a combined $70 billion from the U.S. Treasury Department's Troubled Asset Relief Program, but investors worry that soaring losses from consumer and business loans will require further federal assistance.

Bank of America and Citigroup declined to discuss their plans. Treasury declined to comment.

"Developments in the banking system are a reflection of the sustained and considerable headwinds facing balance sheets due to legacy assets and the further deterioration in economic conditions," said Mohamed El-Erian, chief executive of Pacific Investment Management Co, known as Pimco.

AVOIDING ANOTHER LEHMAN

Analysts said the government would like to avoid a repeat of the downfall of Lehman Brothers Holdings Inc, whose September 15 bankruptcy was a key trigger in the worldwide downturn in economies and equity markets.

Sheila Bair, chairwoman of the Federal Deposit Insurance Corp, told reporters in New York that she would be surprised if any large U.S. bank were nationalized, and that her agency had sufficient reserves to cover bank failures. Analysts expect hundreds of such failures this year and next.

Some positive news came Thursday from JPMorgan Chase & Co, the No. 2 U.S. bank, which reported a 76 percent decline in quarterly profit, topping some analysts' forecasts.

However, the bank boosted its estimate of credit card losses and losses from the failed Washington Mutual Inc, which it took over in September [ID:nN1491543]. Bank of America and Citigroup are JPMorgan's main credit card rivals.

In afternoon trading, Bank of America shares were down $1.51, or 14.8 percent, at $8.69, and earlier fell to their lowest level in more than 17 years. Citigroup shares were down 42 cents, or 9.3 percent, at $4.11.

Both banks are in the Dow Jones industrial average JPMorgan, also a Dow component, rose 9 cents to $26.00. The 24-member KBW Bank Index slid 5.2 percent. Wells Fargo & Co, whose purchase of troubled Wachovia Corp made it the fourth-largest U.S. bank, fell 9.41 percent to $20.90.

Marshall & Ilsley Corp also tumbled after the Milwaukee regional bank said soured loans to residential developers, including in Arizona and Florida, led to a surprise quarterly loss.

OVERREACHING

Bank of America's need for government aid raised questions about whether Chief Executive Kenneth Lewis overreached by swallowing Merrill for about $19.4 billion, and Countrywide Financial Corp, the largest U.S. mortgage lender, for $2.5 billion in July.

Neither purchase involved government help, though the bank was awarded $25 billion of TARP money.

Those mergers gave Bank of America tentacles throughout the financial system in a period of economic weakness. The bank now looks more like the "financial supermarket" that Citigroup once aspired to build.

When those mergers were announced, Lewis was hailed as a savior for a troubled banking industry. But many analysts now expect Bank of America to lower its quarterly dividend again, after halving it to 32 cents per share in October.

"This looks, feels and smells like a redux of Lehman," said Tom Sowanick, chief investment officer of Clearbrook Financial LLC in Princeton, New Jersey. "Investors are betting that the government needs to step in, and that will wipe out the equity holder."

Citigroup Chief Executive Vikram Pandit is expected Friday to unveil details of a plan to shrink Citigroup by about one-third. In an internal memo on Wednesday, Pandit said he plans a "long-term transformation" of the bank.

Citigroup lost $20.3 billion in the year ended September 30. It has received $45 billion of TARP money, and the government is capping losses on a $306 billion portfolio of troubled assets.

But investors worry that any recovery plan will dilute shareholders or will not go far enough. It is also possible that the market will not give the bank the time it may need to engineer a turnaround.

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

JPMorgan, widely considered healthier, nonetheless saw its credit rating downgraded on Thursday by Moody's Investors Service, which cited "the poor prospect" of the bank being able to generate capital in the current market.

"Consecutive quarterly losses in the next twelve to fifteen months cannot be ruled out," Moody's said. JPMorgan has also received $25 billion of TARP money.

(Reporting by Jennifer Ablan, Rodrigo Campos, Elinor Comlay, Joseph A. Giannone, Juan Lagorio, Charles Mikolajczak, Jonathan Spicer, Jonathan Stempel and Dan Wilchins and Al Yoon; editing by John Wallace)