Several Banks and Brokerages Ready to Pop Up for Air

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 (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.

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.