Bigwigs' predictions have analysts scratching their heads

The Star-Ledger, May 4th, 2008

The Star-Ledger Archive COPYRIGHT © The Star-Ledger 2008

Date: 2008/05/04 Sunday Page: 001 Section: BUSINESS Edition: FINAL Size: 1256 words

By SAM ALI STAR-LEDGER STAFF

Asking the titans of Wall Street if the financial crisis is over is a lot like asking a barber if you need a haircut.

Of course the answer is going to be "yes."

Many of Wall Street's best and brightest are now proclaiming the worst of the credit storm may have passed. Their comments have come even as many Wall Street firms have announced eye-popping billion-dollar losses on subprime mortgage investments.

One of the more bullish comments came last month from Morgan Stanley Chief Executive John Mack, who assured investors the subprime problem was "in the eighth inning or maybe the top of the ninth."

But even some of his own employees don't seem to agree.

In a research note April 28, Morgan Stanley analysts Betsy Graseck, Cheryl Pate and Justin Kwong said they think the credit markets are only in the "third inning" of the crisis.

Mack isn't alone in his optimism. During the past month, JPMorgan Chase's Jamie Dimon, Goldman Sachs' Lloyd Blankfein, Lehman Bros.' Richard Fuld and Citigroup's Vikram Pandit have piped in with similarly upbeat assessments.

Who knows – maybe they're right.

But aren't these the same guys who didn't see the subprime crisis coming in the first place? The same ones who desperately clung to the notion the carnage would not spread?

To be fair, they're not the same guys. Many of them – most famously Merrill Lynch's Stanley O'Neal and Citigroup's Chuck Prince – have lost their jobs.

But the question remains: Less than a year after the subprime mortgage market triggered what is being described as the nation's worst financial tsunami since the Great Depression, could the storm clouds really be parting?

A number of analysts seem to think financial markets have indeed turned a corner: The credit markets, which ground to a halt in August, are starting to show signs of life again, they say.

Pundits say the mood on Wall Street began to noticeably shift March 16.

That's the day Bear Stearns – once the leading mortgage house on Wall Street – came to the brink of bankruptcy and the Federal Reserve stepped in with a $30 billion line of credit to facilitate the sale of the nation's fifth-largest investment bank to JPMorgan Chase.

While it may sound simplistic to single out one event as the turning point, analysts say the effect of the Fed's rescue of Bear Stearns cannot be overstated.

The knowledge regulators were unwilling to let a major institution go down had a profound effect on market psychology and confidence, analysts said.

"The credit panic ended with the collapse of Bear Stearns, and credit spreads are already much improved since then," Bill Miller, chairman and chief investment officer of Legg Mason Capital Management, said in a letter to shareholders last week.

Among signs the financial storm clouds are starting to clear:

  • Prices for low-risk Treasury bonds are falling, even as yields are rising – an indictor investors' sense of risk aversion is waning, said James Paulsen, the chief investment strategist at Wells Capital Management. Typically, when fear and panic are high, prices for low-risk government bonds climb sharply as droves of jittery investors pile into safe-haven investments, he said.

  • Gold, typically a safe-haven play in times of turmoil, has dropped below $900, after hitting a record $1,000 back in March.

  • Investors are turning to riskier investments that had been all but abandoned earlier this year, such as corporate bonds, said Jeffrey Kleintop, chief market strategist at LPL Financial. And the premium they're demanding for corporate debt – even low-quality speculative-grade, or "junk," bonds – is coming down.

  • Spreads on high-yield bonds – that is, the yield premium investors are demanding to hold riskier bonds over low-risk U.S. Treasuries – have narrowed slightly, to around 6.9 percent, after hitting a whopping 8.5 percentage points at the peak of the panic in March, according to bond rating agencies Standard & Poor's and Moody's.

  • Stocks at the epicenter of the credit crisis, including home building and retail, are among the best-performing sectors on the S&P 500 so far this year.

  • And, finally, the cost of insuring bonds against default has fallen dramatically this month, suggesting investors are less risk-averse, Kleintop said.

When taken together, these indicators suggest the credit markets have settled down, analysts said.

For Kleintop, the main difference between June 2007 and April 2008 is a clearer picture has emerged of how much "toxic" paper banks may still be holding, and investors are more confident someone – namely, the Fed – is finally steering the ship.

Last summer, when a pair of Bear Stearns hedge funds that had highly-leveraged exposure to subprime debt went bust, panic gripped the credit markets because nobody knew what would happen next, and the Fed seemed oblivious to the scope and size of the problem, he said. If Bear Stearns could stumble like that, then all banks were suddenly suspect.

"We have a better sense of how much toxic paper is left on the balance sheets of the major financial institutions," he said. "There is more transparency than last year, and at the same time, we know the Fed is on the case and stands ready to prevent any kind of calamity."

The Fed also has cut its benchmark interest rate seven times since last September and introduced a number of tools to pump money into the economy, such as allowing securities firms to borrow money just like banks.

Still, not everyone is buying all the happy talk.

Like many economists, Peter Morici, a business professor at the University of Maryland, remains skeptical.

During the past year, Wall Street's biggest banks have posted more than $300 billion in write-downs and credit losses tied to the credit and mortgage markets. And as stunning as those bank losses have been so far, more carnage lies ahead, he said. Wall Street banks are still holding billions of dollars in risky securities on their books, and no one knows for sure what they're really worth.

"Bank executives are trying to put a positive spin on their situations," Morici said. "The bottom line is that they don't know how much the securities they own will be worth six months or a year from now, or how large their losses may ultimately be."

Chuck Butler, a currency expert at EverBank, is also a skeptic.

"There are some major players that think the Fed has removed all the risk out of the market with their bailout of Bear Stearns," he said. "But I'm not seeing anything that comes through that points to an economy that is getting stronger or a housing market that is stabilizing."

Earlier this week, the Standard & Poor's/Case-Shiller home-prices report for February showed more rot on the vine, with a 12 percent decline in home prices, he noted. The number of U.S. homes standing vacant has reached a record 18.6 million, due to rising foreclosures, Butler said. The 2.9 percent vacancy rate of homes represents a record going back to 1956, he said.

"You have to have a stable housing market so that banks can feel comfortable about lending money again," Butler said. "Until they feel that way, we are going to have a credit crunch."

Sam Ali may be reached at sali@starledger.com

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