Bank of America Corp shares posted their steepest drop in 2-1/2 years on Tuesday as investors worried that the biggest U.S. bank might face big writeoffs.

The cost of insuring the bank's debt against default spiked to record levels.

Bank of America shares closed 1.9 percent lower at $6.30 after falling as much as 6.4 percent during the day. The shares pared losses, and credit swaps largely retraced, as a broader stock market rally helped assuage investor fears about the economy.

In a blog post on Tuesday, former securities analyst Henry Blodget said the bank could have $100 billion to $200 billion of writeoffs and troubled assets to sort through. These potential write-offs could eat into a substantial portion of the bank's $222 billion of book value.

That's why Bank of America's stock is tanking. The owners of that stock will be the first folks to get hit if Bank of America has to raise more capital, Blodget wrote on Business Insider, his collection of blogs.

Bank of America fired back at Blodget in a statement, calling his claims exaggerated and unwarranted, echoing language the U.S. Securities and Exchange Commission used in a 2003 complaint against Blodget. Blodget, a former Internet analyst at Merrill Lynch, was barred from the securities industry as part of a settlement with the SEC over alleged conflicts in his research.

Bank of America said the exposures that Blodget identified as the source of possible losses were inaccurate, with his sovereign exposure being off by a factor of 10.

The volley between Bank of America and Blodget was the latest example of analysts and investors disagreeing with the bank. Since June, a number of analysts have said Bank of America needs to boost its capital levels by about $50 billion to comply with new global standards. At least some of that extra capital could come from issuing stock, several analysts have said.

The bank itself says it can reach target capital levels by selling assets and earning more money. The bank has some time to comply with the Basel III capital rules, which are to be phased in from 2013 through 2019.

Some analysts agree. Rochdale Securities analyst Dick Bove told television news outlets on Tuesday that the bank does not need to raise capital, whatever happens to its share price, and that Bank of America has ample liquidity.

Chief Executive Brian Moynihan told investors on a recent conference call that the bank did not view issuing more shares as an option, after having already diluted its shareholders so much during the financial crisis.

Some analysts have suggested the bank will need to raise capital if the proposed $8.5 billion settlement over Countrywide Financial Corp-created mortgage-backed securities falls apart.

Outside investors have been pushing for the bank to repurchase toxic mortgages from the securities, amid allegations the loans do not meet initial guarantees made when the securities were bought, and now total $100 billion in unpaid principal.

Others said pressure on the bank is increasing the chances of a capital raise.

In a note to clients, JPMorgan Chase & Co analysts upgraded Bank of America's stock to neutral from underweight, on the belief the declining stock price and rising debt insurance costs will force a capital raise.

We think it is getting more difficult for management to ignore this sentiment, JPMorgan Chase analysts Kabir Caprihan and Matthew Hughart said in a research note.

Regulators seem generally unconcerned.

At a news conference on Tuesday, the Federal Deposit Insurance Corp's acting chairman said he is comfortable with the overall amount of capital at U.S. banks.

As a general matter I would say the answer to that is yes, Acting Chairman Martin Gruenberg said in response to a question about the amount of capital banks are holding.

DOWNWARD SPIRAL

The drop in the bank's shares on Tuesday was their fourth consecutive daily decline.

It's on a self-fulfilling downward spiral. I don't know what's going to make BofA go up, said Mark Coffelt, head portfolio manager at Austin-based money manager Empiric Advisors.

The shares fell even as the KBW Bank Index <.BKX> and the S&P 500 Index <.SPX> rose 3.3 percent and 3.1 percent, respectively.

Credit default swap insurance on the bank's unsecured debt jumped as much as 65 basis points to 435 basis points, before retracing to 385 basis points, meaning it would cost $385,000 per year for five years to insure $10 million in bonds, according to Markit.

The level is just under the record level of 386 in March 2009, Markit data show.

Traders said weakness in credit derivatives helped fuel downward pressure on the shares, as markets feed off each other. Bank of America shares closed Tuesday at levels not seen since March 2009.

The key arteries of the financial system -- the ability of banks and other institutions to borrow from one another on a short-term basis -- continued to show rising stress on Tuesday, but not at levels associated with the panic of 2008.

The cost for a bank to borrow from another bank for three months in U.S. dollars, known as the London Interbank Offered Rate, continued to rise, hitting 0.31178 percent Tuesday morning from 0.30300 on Monday.

The pressures were most acute at European banks, which continued to pay more than other banks for short-term funding. Most European institutions paid more than the LIBOR fixing.

(Reporting by Joe Rauch; additional reporting by Lauren LaCapra, Jonathan Spicer, Karen Brettell and David Gaffen in New York and Dave Clarke in Washington; editing by John Wallace, Matthew Lewis and Bernard Orr)