Amid fallout, markets seek confidence lift

By Tom Petruno

March 17, 2008 12 AM PT

Times Staff Writer

Fasten those seat belts. The global financial system this week may face one of its greatest tests since World War II.

With fallout from the U.S. housing market’s downturn spreading far and wide -- and leading to a fire-sale takeover of brokerage Bear Stearns Cos. by JPMorgan Chase & Co. on Sunday -- U.S. and foreign policymakers confront a massive challenge: How to persuade investors that things aren’t spiraling out of control.

“Right now they need to get confidence back in the system,” said Andrew Brenner, a senior vice president at investment firm MF Global Inc. in New York.

Confidence has been ebbing since August as investors have come to grips with falling home prices and soaring mortgage defaults and their effects on the financial health of banks and brokerages, as well as on the economy overall.

Investors’ fears have worsened in recent weeks, threatening a chain reaction that could become hard to halt. As people run for safety, they push stocks and bonds lower, which further weakens major financial institutions by devaluing their assets, which raises the risk of more failures that could provoke more selling in markets.

The best thing about this week on Wall Street may turn out to be that it’s one day short: U.S. markets will be closed on Good Friday, a long-standing investor holiday.

Here are some of the key questions to be addressed this week:

* What’s the outlook for other major financial firms, after Bear Stearns’ demise? Many market pros have contended in recent weeks that share prices of most leading financial companies already were overly depressed and didn’t accurately reflect the long-term prospects of the businesses.

The average financial stock in the Standard & Poor’s 500 index is down 37.5% from the peak level a year ago. By contrast, the S&P; 500 index overall is down 17.7% from its record high.

The rushed takeover of Bear Stearns by JPMorgan Chase was supposed to engender confidence in the financial system by eliminating the possibility of a rapid liquidation of the brokerage -- which could have dumped tens of billions of dollars of mortgage-backed bonds on a market that clearly wants none of them at the moment.

But the shockingly low price of the deal could have the opposite effect. Bear Stearns’ stock closed at $30 on Friday. Yet JPMorgan Chase is paying just $2 a share.

The question investors will wrestle with today: Are they also grossly overestimating the value of other financial firms? If so, those stocks could lead another market rout.

Three major brokerages will report quarterly earnings this week for the period ended Feb. 29. Lehman Bros. will report results today, Goldman Sachs Group Inc. will report Tuesday and Morgan Stanley on Wednesday.

Depending on what they earned or lost in the period -- and what they say about the future -- the brokerages could either help their case with investors or make things much worse.

* What (else) will the Fed do? The central bank has been pulling one rabbit after another from its hat over the last week, trying to show investors that policymakers are intent on getting the financial system over the current fear-induced credit squeeze.

The Fed said Tuesday that it would temporarily swap as much as $200 billion in Treasuries it owns in exchange for mortgage-backed securities on the books of Wall Street securities firms. The idea: Bolster the companies’ capital and give them more confidence to lend to other financial firms.

On Sunday, the central bank said it would lend directly to securities firms that need money, rather than just to commercial banks.

On Tuesday, policymakers will hold a regularly scheduled meeting on interest rates. They are expected to slash their key short-term rate for the sixth time since August, from 3% to at least 2.5%.

Some analysts expect the Fed to make a more dramatic reduction, to show they understand the gravity of the situation markets face. “I think they’ll be cutting a full percentage point,” said John Lonski, economist at Moody’s Investors Service in New York.

But a one-point cut also could backfire as a confidence-builder, some analysts say.

“We may be close to the market viewing the Fed as panicking,” said Gary Schlossberg, senior economist at Wells Fargo & Co. in San Francisco.

For Fed Chairman Ben S. Bernanke, this is a true trial by fire.

* How low can the dollar go? The greenback’s steep slide over the last seven weeks in part reflects the difference between interest rates in the U.S. and abroad: Lower rates here, courtesy of the Fed, mean some investors are taking their money elsewhere for higher rates.

The European Central Bank’s benchmark short-term interest rate, for example, is 4%, a full point above the Fed’s rate. The Australian central bank’s key rate is 7.25%.

But some investors also see the dollar’s latest dive as reflecting a lack of confidence in the U.S. financial system and economy. And as the dollar sinks, it helps drive up the price of gold and other commodities, which are attracting worried investors as an alternative to stocks and bonds.

On Sunday the dollar continued to plunge after the JPMorgan-Bear Stearns deal, suggesting that investors’ perceptions of U.S. assets had worsened, not improved. The dollar fell under 97 Japanese yen in Asia, from 99.21 on Friday. The euro shot to a record $1.584 from $1.567 on Friday.

Some analysts believe it’s absurd for global investors to flee the dollar in favor of the euro, in particular, at this point.

The muscle-bound euro makes Europe’s exports more expensive for American consumers, and “that’s going to crush Europe’s economy,” said Robert Brusca, head of Fact & Opinion Economics in New York.

And that, he said, will simply make it easier for the European Central Bank to begin cutting interest rates, which could have the effect of driving the euro back down and bolstering the dollar.

So far, the European Central Bank has insisted it won’t ease rates because it’s concerned about rising inflation pressures on the Continent. But a continuing plunge in the dollar -- and a deeper sell-off in already battered European stocks -- could change the bank’s tune, some say.

tom.petruno@latimes.com

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This week at a glance

Today

Commerce Department reports on current account for fourth quarter.

Federal Reserve reports on industrial production.

Treasury bill auction.

Quarterly earnings report due from Lehman Bros. Holdings.

Tuesday

Commerce Department reports on February housing starts.

Labor Department reports on producer price index.

Federal Open Market Committee meets to discuss interest rates.