Financial Stocks: Is It Safe Yet? (BusinessWeek Online)
09.09.2008 16:25 Finance
Yes, some investors were reassured by the bold, risky move. They hope it hastens the end of the yearlong financial crisis. The stock market, and financial stocks particularly, moved higher on Sept. 8 (with the notable exceptions of Fannie and Freddie, each of which plunged to below $1).
Yet with a range of problems hanging over America's economy and housing and mortgage markets, most fund managers and market experts interviewed by BusinessWeek said they weren't ready as investors to embrace the embattled financial sector.
Spooked by Bear
Some analysts reacted to the Fannie and Freddie news by upgrading their view on financial firms like Goldman Sachs (NYSE:GS - News) and some regional banks.
But by contrast, many other investors cited the Bear Stearns collapse in March, when the Federal Reserve tried to ease the credit crunch by providing liquidity to investment banks. The federal government's actions initially met with Wall Street approval. But the stock market rally was short-lived, and by summer stocks were again tumbling lower.
The best that could be said of the Fannie-Freddie action is that it answers a big question: No, the federal government will not allow these crucial mortgage financiers to fail and potentially cripple the mortgage and housing market in the U.S.
"They've taken a big question mark out of the mortgage market," says Dave Hinnenkamp, chief executive of KDV Wealth Management. "It will stop things from getting worse" for the housing and mortgage industries, says Jeff Layman, chief investment officer at BKD Wealth Advisors.
Lower Mortgage Rates?
And the takeover may even make things better for ordinary Americans, if the government's new guarantees can finally lower mortgage rates. That would make it easier for homeowners to refinance mortgages and allow more new home buyers to enter the housing market.
What worries investors, however, is that banks may still be reluctant to lend. The federal government can't erase the lessons of the past year. As bankers have been the victims of bad loans, they've drastically raised lending standards, making it harder for Americans to qualify for a mortgage.
"The Treasury cannot force banks to lend money," says Matt Kaufler, portfolio manager of the Touchstone Value Opportunities Fund (NASDAQ:CCEVX - News). "The skeptical mindset of bankers will be with us for a while."
Eating Away at Collateral
Investors worried about the financial crisis are increasingly focused on U.S. housing prices. If home prices can stop sliding and foreclosures slow, financial firms can stop reporting huge losses on widely held mortgage-backed debt.
The home price slide is a big worry for bankers because it eats away at the collateral on each home loan. It is hardly clear that the Freddie and Fannie plan, by lowering mortgage rates, can stop the home price slide. "The psychology in the housing markets is not shifting because Fannie and Freddie are getting a bailout," says Michael Church of Church Capital Management. A huge surplus of unsold homes still sits on the market, especially in hard-hit states like Florida and California.
The Fannie and Freddie takeover may even hurt some small, regional banks that held preferred shares in the two mortgage firms. The value of that equity is now in serious doubt.
Financial shares rallied on Sept. 8 on hopes the Treasury plan would at least bolster confidence in the financial system. The Dow Jones industrial average rose 290 points, led by a 7.8% bounce for Bank of America (NYSE:BAC - News) and a 6.6% advance for Citigroup (NYSE:C - News).
Admission of Disaster
Michael Yoshikami, president and chief investment strategist at YCMNET Advisors, praised a "very creative solution" to Fannie and Freddie's problems. "We will look back on this and say this was the first step in the housing recovery, and (restoring) the stability of the financial system," he said.
But even an optimist like Yoshikami said the Treasury action raised almost as many questions as it answered. In some ways, news of the dramatic plan actually undermines confidence.
For example, one of the stated reasons for the Freddie and Fannie takeovers was an audit that showed losses at the mortgage financiers were much worse than previously stated. That raises questions about not just Freddie and Fannie's accounting standards, but the standards of other financial institutions, Yoshikami said. He expects one or two more quarters of firms reporting large losses from bad debt.
While equity investors generally take surprises in stride, investors in debt markets are known for their cautiousness. The Treasury plan jolted their risk-averse sensibilities.
The government hasn't yet disclosed all the problems at Fannie Mae and Freddie Mac, but they were obviously important enough to prompt such a dramatic step, says Bill Larkin, fixed income portfolio manager at Cabot Money Management. "I'm trying to figure out what made them make this giant leap," he says.
It Might Backfire
Investors also worry about the unforeseen consequences of a large government takeover. Larkin worries the plan could actually "backfire." It is no easy feat to take over two of the largest financial institutions in the world. Many details haven't yet been settled, and that is worrying credit markets, he says.
"We're trying to make monumental changes here," Larkin says. "If there's a problem, (investors are) going to go for the exits at the same time."
Jim DeMasi, chief fixed income strategist at Stifel Nicolaus (NYSE:SF - News) wrote on Sept. 8 that it could take "weeks, and possibly months" to "fully assess the ramifications of this weekend's developments." However, he said, "The long-term implications for the financial markets will be profound and the unintended consequences may be significant."
It is notoriously difficult to tell when a slumping financial market has finally hit bottom.
The Freddie and Fannie news is "part of the bottoming process," Kaufler says. "It's not necessarily the bottom."
Still, many market players believe the sector's huge losses will abate -- eventually.
That's why many investors -- even those skeptical of the importance of the Treasury takeover -- say they are slowly buying up financial shares, especially when they believe individual stocks are trading at bargain prices. But even these optimistic investors believe lots of patience will be required before those bets pay off.
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