Wall Street Hopeful Credit Crisis Easing

With stocks rallying to record highs at the outset of the fourth quarter, and signs of easier conditions in credit markets, a feeling of hope is sweeping Wall Street, suggesting that the worst of this summer's crisis is in the past.

Fueling those hopes, Citigroup Inc. (C) on Monday put a figure on its third quarter credit-market-related pain: earnings will be 60% below the year-earlier quarter. And CEO Charles Prince said business conditions are likely to return to a more normal level in the fourth quarter. Swiss bank UBS AG (UBS), followed by Deutsche Bank AG (DB) on Wednesday, Europe's largest bank, also reported huge write-downs. "Multibillion-dollar write-downs by some of the major global banks are being widely viewed as a sort of capitulation that all the bad news has been priced in, or at a minimum, that there is now more certainty over the extent of the losses," said David Rosenberg, chief economist at Merrill Lynch in a note. The debate is still underway among investors about whether this is over or not. While there are signs that the credit crunch is easing, there are plenty of market observers who say the evidence, including a reduced appetite for junk bond deals and what appears to be a permanently smaller commercial paper market, suggests the markets are not yet out of the woods. The reports from UBS and Citi helped to ease Wall Street's sense of helplessness at figuring out how many subprime-mortgages-gone-bad might be out in the global financial system. The Dow Jones Industrial Average jumped more than 190 points to record highs Monday. And speaking in London on Tuesday, former Fed Chairman Alan Greenspan kept up the upbeat tone: "Is this August-September credit crisis about to be over? Possibly," the Times of London quoted him as saying. Yet, after whistling past the graveyard of subprime mortgages until August - when uncertainty about the amounts and whereabouts of bad home loans in portfolios saw lenders close the door to many borrowers - Wall Street now remains leery of declaring victory too soon. "We seem to have weathered the storm but everybody's outlook is pretty guarded," said Kim Rupert, managing director of fixed income at Action Economics. "There's still a lot of nervousness, even if there are no reports of the illiquidity that we saw in asset markets back in August."

Signs Of Life

Many analysts have reported signs of improvement in credit markets ever since the Federal Reserve began injecting liquidity in the system and then cut official interest rates by a hefty 50 basis points on Sept. 18. Risk aversion throughout the summer sent riskier corporate bonds sharply lower, lifting their yields, which move inversely to price, sharply higher. Corporate spreads, which measure the difference between yields on business loans and those on safe government bonds, widened accordingly. But spreads have now narrowed from 76 basis points in mid-August to 63 basis points at the end of September, signaling investors are embracing more risks, according to Bear Stearns. Meanwhile, investment-grade corporate bond issuance last month reached the highest level for any September, according to Merrill Lynch. "Hence, the credit market is now functioning in a way that is conducive toward economic expansion, certainly much better than was the case in early August," said Tony Crescenzi, fixed-income strategist at Miller Tabak. After nearly drying up in August, the market for commercial paper, or short-term business loans, has also shown signs of life. Back in August, the unwillingness to lend new money caused the price of outstanding commercial paper loans to plunge, sending their yields sharply higher. For instance, the yield on 30-day commercial paper, had surged to above 6% in August. It has now fallen back below 5% and traded Tuesday at 4.97%. Meanwhile, the overall size of the commercial paper market has continued to fall sharply, though at a slower rate. It slid 16.6% from its historic peak of $2.2 trillion in July to $1.857 trillion at the end of September, according to IDEAGlobal. The drop was led by a 22% plunge in commercial paper backed by certain assets, such as mortgages, which are at the very heart of the crisis. But "the rate of decline in asset-backed commercial paper has slowed, after sliding 4% on average on a weekly basis in August," said John Atkins, corporate bond strategist at IDEAGlobal. The London interbank offered rate, or Libor, which is the rate banks charge each other for short-term loans, shot sharply higher to above 5.7% in early September. The three-months Libor now trades at 5.24%. In his London speech, Greenspan cited those improvements to back the possibility that the credit crisis may be over.

Still Whistling

But many of these so-called improvements have to be put in proper perspective, said IDEAGlobal's Atkins. "It's an improvement from horror but it doesn't mean it's encouraging," he said. "Those that say it's over are still whistling past the graveyard." Putting an initial estimate on subprime-related losses, as Citigroup and UBS have done, " is just an initial foray into assessing where we stand, and there is nothing concrete to justify calling the crisis over apart from sheer optimism.," Atkins said. With the size of the overall commercial-paper market having shrunk by nearly 17%, it would take a surge in optimism about credit conditions to reverse the trend and return to an expansionary credit mentality. While issuance of investment-grade, or higher quality, corporate bonds has come back, the market remains wary of risky junk-bond issuance, indicating that the days of 'easy-money' might be over, said Action Economics' Rupert. Merrill Lynch estimates that credit markets have only come back one-third of the way from their peak crisis level in August. The firm noted that the "distress ratio," which measures the high costs of credit for riskier corporate borrowers, tripled in August, possibly signaling corporate credit defaults to come.

Sugar Rush For Stocks?

So are stocks on Wall Street now powered by a false sense of relief? "From our lens, the stock market is doing what it always does in the month after the first cut in the Fed funds rate - and that is to rally on the sugar rush of the liquidity infusion," said Merrill's Rosenberg. The stock market, he said, has risen 100% of the time in the first month following a Fed rate cut and the average increase is about 4%. With stocks up only 2% since their August lows, the rally may therefore have more legs in the short term. But Rosenberg is quick to point out that how the stock market does three, six and 12 months later has to do with how the economy is faring. "And those who believe that [Monday's] huge write-downs mean there are no more skeletons in the closet could be in for a rude surprise," the economist said. "After all, at the root of the market volatility and weakness this summer was the U.S. housing market, and everything from sales to starts to inventories to pricing has become much worse in recent months." On Tuesday, stocks gave back some of Monday's strong gains after news that the mortgage crunch led the pending home sales index, a forward-looking gauge of home sales, to drop 6.5% in August to its lowest level since its inception in 2001. In his October investment outlook, bond giant PIMCO's managing director Bill Gross said that the Fed's rate cuts may help favor corporations and Wall Street, but it will do little to help consumers facing stagnating incomes and tighter credit conditions. "Whereas current yields are not restrictive to investment grade corporations with global opportunities, they are far too high for homeowner Jane Doe and two million of her neighbors facing higher and higher monthly payments in adjustable rate mortgages," he wrote. But Wall Street will likely continue to monitor economic data amid hopes that it will be weak enough to keep the Fed in a cutting mode, while not weak enough to suggest a recession is in the making. The Fed's rate cut followed an unexpected decline in employment in August. "Right now everybody is waiting for Friday's [September] employment report to see if that August decline was a reflection of contagion from the crisis to other parts of the economy, or an aberration," said Action Economics' Rupert. According to IDEAGlobal's Atkins, a key question remains whether economic conditions will deteriorate first, exacerbating conditions in credit markets, or whether new credit problems at financial institutions will surface, tightening credit conditions and further pressuring consumers and the economy.