Bottom Fishing ??? ( Banks )

Hitting Bottom? Several Banks and Brokerages Are Ready to Pop Up for Air

By JACQUELINE DOHERTY

AT LAST, WE MAY BE THERE. AFTER MONTHS OF TURMOIL capped by a run on a leading Wall Street house, banks and brokerage firms may finally have hit bottom. You can thank the multipronged regulatory response to the near-collapse of Bear Stearns. Those measures may well prevent the deeply depressed stocks of many financial outfits from sinking further. The shares may even start to recover, with encouraging implications for the entire market. Yes, after being down on financial stocks for more than a year, we find ourselves unable to resist some real springtime optimism.
Last week, the Federal Reserve slashed short-term interest rates, increasing the difference between short- and long-term rates, which typically boosts lenders' earnings. The Fed also opened its lending window to investment banks, giving them a new, stable, liquid source of funding. And regulators' decision to allow Fannie Mae (ticker: FNM) and Freddie Mac (FRE) to boost their investments in U.S. mortgages by $200 billion gave the mortgage market a big shot in the arm.
The market has yet to appreciate just how powerful those forces could be. Stocks of the industry's strongest players could climb by 10% to 20% over the next year as panic recedes, earnings improve and price-to-earnings multiples expand.
But make no mistake: Headlines will remain negative. Witness CIT Group's (CIT) report Thursday that it had lost access to short-term financing and Credit Suisse Group's (CS) warning of a first-quarter loss. Likewise, Standard & Poor's on Friday placed the debt ratings of Goldman Sachs Group (GS) and Lehman Brothers Holdings (LEH) on "negative outlook" because of earnings weakness. We fully expect economic growth will continue to decline, resulting in further loan losses. We wouldn't be surprised to see some of the weaker banks either go bust or turn to the industry's stronger players for a bailout.
But at this point, most of those risks are reflected in financial stock prices. And it won't be long before investors start looking at the second half of the year, when the worst of the write-downs should be over and earnings comparisons become much easier.
"From here, I think things are getting better, and the government and the Fed will do what they need to do when they need to do it," says Ernie Patrikis, a partner at Pillsbury Winthrop Shaw Pittman and former first vice president of the Federal Reserve of New York.
THE SLIGHTEST INKLING OF PROGRESS could improve the dour sentiment surrounding bank and brokerage stocks, many of which have fallen by more than 50% over the past year. That was clear last week when Lehman, Morgan Stanley (MS) and Goldman Sachs reported quarterly earnings.
While each reported huge declines in profits, their stocks rallied strongly because the earnings had beat analysts' estimates.
Lehman shares had the most dramatic swings. When investors feared for the firm's survival on Monday, shares fell 19%. But thanks to the Fed's moves and the earnings beat, shares ended the week up 24%.
Other signs of rising confidence: The price of gold fell 8.3% from Tuesday's high to Thursday's close of $919.60 per ounce, and the dollar enjoyed its first weekly advance in a month.
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One of the biggest reasons the fortunes of banks and brokers will improve is the steep yield curve. As its name implies, the curve plots the yield of all of Treasury debt, ranging from maturities of three months to 30 years. When the difference between the yield on the 10-year Treasury note and the two-year Treasury note is large, the yield curve is considered steep.
At Thursday's close, the difference stood at 1.78 percentage points, double the 0.88-percentage-point long-term average. Last year, the difference was negative; the two-year note had a higher yield than the 10-year Treasury note.
A steep yield curve "is telling us that we're further along in a recession and suggests the situation will be better six to 12 months from now," says John Lonski, chief economist at Moody's Investors Service.
A steep yield curve also allows financial institutions to borrow short-term money at low rates and lend it out for longer terms at higher rates.
In other words, banks can mint money. The Fed healed the last large banking disaster, in 1990, by engineering a steep yield curve. It's looking like a repeat today.
A steep yield curve is one of the reasons why Jason Trennert, a managing partner at Strategas Research Partners, prefers some of the large commercial banks over the brokerage houses. His picks: JPMorgan Chase (JPM) and U.S. Bancorp (USB). As multiples-to-book-values expand, the shares could climb 25% this year, he figures.
Earnings growth will also improve if the worst of the financials' asset write-downs are behind us. So far, first-quarter write-downs have been manageable. Morgan Stanley's fell to $2.3 billion from $9.4 billion in the fourth quarter. Goldman's write-offs bulked up to $2 billion from $500 million in the fourth quarter and $1.5 billion in the third. Lehman posted a $1.8 billion write-down, an increase from the fourth quarter's $1.2 billion.
"I think we've seen the peak in write-offs from the investment banks," says William Tanona, a Goldman Sachs analyst. He upgraded Lehman and Morgan Stanley stock to Buy from Neutral after Monday's selloff and added them to the firm's Americas Buy list. He has a six-month target of 58 on Lehman, for upside of 21%, and 50 on Morgan, close to where the stock closed Thursday after rallying 37% from Monday's low.
Granted, that doesn't mean the asset woes are over. It just means they will get smaller. Even Citigroup's (C) expected $12 billion write-down in the first quarter compares favorably to its $18 billion fourth quarter write-down.
If the worst of the write-downs are in fact behind us, earnings comparisons stand to get much easier going forward, even assuming little resuscitation in the capital markets. Financial stocks in the S&P 500 are expected to earn $30 billion this quarter; that's down almost 50% from a year earlier, notes Howard Silverblatt, senior index analyst at Standard & Poor's. But by the third quarter, earnings are expected to rise by 34% -- and in the fourth, the industry should produce almost $50 billion of earnings, up from a loss of $23 billion.
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ANALYSTS BEING ANALYSTS, it's entirely possible they're too optimistic. But even if they trim expectations, the trend should still be one of improvement. And, based on preliminary results, it looks like the financials will manage to earn money throughout a cycle that included one of the worst financial crises the industry has ever endured.
"If banks and brokerages can make money through this cycle, they should always trade above book value," argues Thomas Lee, chief U.S. equity strategist at JPMorgan. As of Friday, only Bear Stearns (BSC) and Citigroup traded below book. But most book values are below their mean value over the past five or even 10 years.
Bank and brokerage earnings could also benefit if some of the write-downs on securities get reversed. Many of the securities that brokers own don't trade in the current, locked market environment. To price these securities, firms use industry indexes. The problem: Short-selling strategies used by some investors may be pushing the indexes below the true value of the securities they represent, says Richard Bove, an analyst with Punk, Ziegel. "In my view, the brokerage firms have marked their books too low."
IF HISTORY IS ANY GUIDE, a big scary event like the demise of Bear Stearns is often a signal of a bottom for the broad market. There have been four failures of a major financial institutions over the past 25 years. And stocks have been higher six and 12 months later in each case, points out JPMorgan's Lee.
The lowest returns came after the failure of Drexel Burnham Lambert in February 1990. Six months later, the S&P 500 was up 3%, and a year later it was up 12%, according to Lee's data. The market put in its best performance after the collapse of Long Term Capital Management in September 1998, when it soared 25% over both the six-month and the one-year periods.
Not everyone is convinced that the bottom has arrived. Three-month Treasury bills yielded just 0.51 percentage point by the end of last week. That's the lowest rate in 50 years, and it's lower than their counterparts in Japan, points out James Bianco, president of Bianco Research.
"It's a real sign of stress in the market," he warns. "Equity guys are completely clueless as to how bad it is in the credit markets. They're as bad as they've been since the Great Depression." Banks and brokers, who have written off almost $200 billion in assets, will need to raise hundreds of billions in new equity so that they can make loans available.
But however bad the conditions for financials may be, they strike us as unlikely to get worse. And thanks to the Fed's aggressive moves, the sector's earnings -- and stock prices -- could be appreciably higher this time next year.