Will Financial Stocks Clean Up?

A couple of weeks ago, it seemingly couldn't get any worse for financial stocks, particularly banks. Equity prices hit decade-plus lows because many investors genuinely worried certain bank stocks were worthless—either because the banks were doomed or because the government would take them over.

But sentiment on Wall Street can turn on a dime these days. Stocks, particularly financial stocks, surged on Mar. 23, and the reason most commonly cited was the release of details of the U.S. Treasury's plan to set up a public-private partnership to buy up toxic assets—and remove them from banks' balance sheets. The KBW Bank index (KBX) jumped 18.6% in one day.

But investors who are buying more financial stocks—sometimes for the first time in years—say they're not jumping into the risky sector based on one government plan.

One Piece of the Puzzle

The Treasury's effort is just one part of the solving the subprime puzzle, says Michael Sheldon, chief market strategist at RDM Financial Group. "The plumbing of the financial system is slowly being put back together, piece by piece," he says.

The first signs of springtime for banks appeared a couple weeks ago. On Mar. 10 the head of one of America's most troubled big banks, Citigroup (C) Chief Executive Vikram Pandit, told his employees he was "most encouraged with the strength of our business so far in 2009." He said the bank made a profit in the first two months of 2009.

Whether investors adopted Pandit's rosy outlook or not, his comments reminded investors of one thing that has almost certainly true: If it weren't for all the pesky losses from what the Treasury calls "legacy" assets—the soured derivatives haunting banks' balance sheets—this would be a good time for the basic banking business.

The Federal Reserve has cut short-term interest rates to nearly zero, giving banks a big advantage: They can borrow at low rates and then lend at higher rates, giving them some of their widest profit margins in years.

A Cheery $1 Trillion

A week after the Pandit memo, the Fed said it would devote more than $1 trillion to buy up debt, an effort to perk up credit markets. Financial stocks rose again.

Then, on Mar. 23, the market celebrated new Washington policy again, a huge contrast to its disappointed reaction to Treasury Secretary Timothy Geithner's first attempt to announce a plan to deal with toxic assets on Feb. 18. Back then, Geithner was criticized for being vague and lacking details.

But while the Street seemed positively ebullient on Mar. 23, there are still plenty of doubters. To say there are still unanswered questions is an understatement. And many observers criticized this plan, too, saying it was un-workable or too generous to banks.

But for the first time, says Dan Genter, president of RNC Genter, "everyone is saying, 'Fine, we're at least moving in the right direction.'"

There's no simple way to fix the financial crisis, Genter says. But the basic details of Geithner's new plan remove a major fear: "The major concern," Genter says, "is that the Administration was going to make it worse."

Preserving Shareholder Value

Based on this plan, banks aren't going to be allowed to go under or be nationalized, wiping out shareholder value, he says. The federal government is less likely to change rules that would make loan losses worse at big banks.

You don't need to like the Treasury plan to be buying financial stocks. Scott Armiger, portfolio manager at Christiana Bank & Trust, has been boosting his exposure to banks stocks after months of avoiding the financial sector.

The main reason for his buying, starting in early March, he says: "The value of these companies is significantly more than the price."

Bank stocks had fallen so far, so fast, that they were simply ridiculous by many investors' estimations.

Armiger is buying stronger banks, like JPMorgan Chase (JPM) and Wells Fargo (WFC), which he believes will fare better over the long term. But he notes it is some of the weakest names that have surged lately, as investors' worst fears were eased just a bit.

For example, Citigroup stock has almost tripled in the two weeks since Pandit's memo was released.

Holding On to Bailout Money

Many problems remain for banks, but, says Andy Bischel, chief executive of SKBA Capital Management, "The banks' balance sheets are improving rapidly."

The low interest-rate environment helps, but banks are also gathering cash by cutting dividends and holding on to federal government bailout money, Bischel says. Large, strong banks are also able to take market share from their weaker rivals, he adds.

There are plenty of factors that could derail banks' latest rally.

Banks may be making an operating profit—eaning more money is coming in the door than out. But banks' real profits have been destroyed by huge losses on investments and loans.

These losses are likely to continue as long as the housing market deteriorates and the unemployment rate rises. One big risk to financial sector investors is that the unemployment rate skyrockets and bank losses exceed expectations, Sheldon says. Another risk is that "the government programs proposed so far don't gain traction," he says.

Cover Past Mistakes

Genter says banks and other financial firms need the ability to take their losses over time. Given two or three years, firms may have enough cash flow to cover their mistakes from past years.

Much depends on the minutiae of government policy: accounting rules and details of the way the Fed and U.S. Treasury operate. Investors are still waiting for results of Treasury "stress tests," efforts to gauge the health of banks.

But so much of the financial sectors' recovery depends on time. With the economy still in recession and bank losses still mounting, financial stocks hit their March lows when investors finally seemed to admit that there would be no simple, quick solution to the crisis.

Indeed, amid the market rally inspired by the latest government plan, even the optimists acknowledge that the financial sector's recovery—if and when it comes—will be agonizingly slow and painful.

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