Bank Stocks Show Signs of a 180

The Fed rescue may mark a turning point for investor confidence.

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The ongoing financial crisis finally has its iconic image, thanks to pranksters at the New York headquarters of Bear Stearns & Co.: a $2 bill, taped to a revolving door.

On March 17, that bank note could have bought a share of Bear's stock under the terms of JPMorgan Chase's Federal Reserve-backed buyout bid. That low-ball price has since been raised, and the shares traded around $11 last week—still a big drop for a stock that fetched $77 when March began. But the sudden, stomach-churning near-failure of the country's fifth-largest investment bank could mark a turning point for the financial sector, the moment when bold action by Fed Chairman Ben Bernanke reminded investors that Wall Street is too big to fail. "Clearly, we're not out of the woods 100 percent, but you can sense we are going to survive," says Andy Brooks, head of equity trading at T. Rowe Price.

The Fed's unambiguous sign that the government would step in to support the financial system, while contrary to Wall Street's supposed free-market mantra, seems to be the crucial difference in restoring confidence to the marketplace. Not only did the Fed agree to back $30 billion worth of Bear assets and temporarily swap some $200 billion worth of its treasury bonds for illiquid mortgage-backed securities, but the central bank for the first time allowed investment banks to borrow at its discount window, a last-resort option formerly open only to commercial banks.

"You have a commitment from the U.S. government and the Federal Reserve to do whatever is necessary to keep the financial system whole," says Richard Bove, banking analyst at Punk Ziegel. "That's extraordinarily important, and it's why we've argued that the financial crisis is over."

Since the Fed's intervention, the dollar has strengthened and treasuries have fallen as investors edged back into riskier bits of the market. Stocks overall have held their ground, but financial issues have surged. From their March 17 close, shares of Goldman Sachs were up 18 percent last week. Morgan Stanley shares have climbed by more than a third. Even Lehman Brothers, whose shares plunged more than 45 percent in just two days on credit worries in mid-March, bounced back.

Cracks. The industry's fundamentals remain fragile, however. Shortly after Bear's fall, Lehman and Goldman Sachs calmed some fears with quarterly earnings reports that were merely less bad than expected. Standard & Poor's still cut their credit rating outlook to negative. Cash-heavy Morgan Stanley showed itself to be well positioned, but cracks continued to appear elsewhere in the marketfollowing Bear's implosion. For example, CIT Group, a major commercial finance company, drew on $7.3 billion in emergency credit lines.

Credit- and mortgage-related losses probably aren't yet expunged from the financial system. Billions in write-downs are still expected in the coming months. Goldman Sachs estimates that leveraged financial institutions—banks, brokers, hedge funds, and government-sponsored entities like Fannie Mae and Freddie Mac—will suffer $460 billion in credit losses. By its estimates, just $120 billion has been revealed so far.

Punk Ziegel's Bove is more upbeat on bank stocks, for a modestly perverse reason. He says the optimistic valuations for mortgage-backed securities that boosted share prices at big banks during the housing boom have become so pessimistic today that they're now weighing falsely on brokers' shares. "I think it bounces right back," he says.

Outside the top-tier investment houses, the slowing economy is catching up with traditional banks. Analysts at Friedman, Billings, Ramsey last week cut their earnings ratings on 21 banks, citing growing losses and valuations that remain well above levels of the last nasty downturn in the early 1990s.

For investment banks, there may also be a price to pay for the Fed's help. By accepting its various life preservers in this crisis, brokers may be forced to succumb to a heavier regulatory hand. Rep. Barney Frank, the Massachusetts Democrat who chairs the House Financial Services Committee, has called for an expansion of the Fed's power to act as a "financial services risk regulator" for the major investment banks. The Treasury Department may release a detailed plan of the future role of state and federal financial regulators in the coming weeks. "I think there's a quid pro quo: We bail you out, but the regulatory oversight gets ratcheted up. We'll look back at early 2008 as a seismic shift, a turning point, when it comes to the role of government," says Greg Valliere, chief strategist at Stanford Washington Research Group.

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  • Kirk Shinkle

    Kirk Shinkle is a senior editor for U.S. News Money and manages the Best Funds portal. Follow him on Twitter @KirkS or email him at