Investment Banks' Kitchen-Sink Quarter

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One key factor will be the outcome of the Federal Reserve meeting, scheduled to be announced the afternoon of Sept. 18. The Fed is expected to lower the federal funds rate (BusinessWeek, 9/6/07) by a quarter of a point or perhaps a half-point. That could boost economic activity and possibly give a break to consumers with adjustable-rate mortgages that are about to reset. It also could lower costs for banks that must carry loans they can't sell on their books. That could help investment banks, too. "Economic growth will trend higher as the credit issues eventually ease, and our bet is that the shift in Fed policy will go a long way toward making that happen," said Robert Doll, vice-chairman at money manager BlackRock (BLK).

The hope on Wall Street is that the current fiscal crisis will follow patterns established in 1998 and 2001, when the Fed lowered rates and paved the way for strong recoveries. Former Fed Chairman Alan Greenspan noted that the market's behavior over the last few months reminds him of patterns in the financial crises of 1987 and 1998. "If that's right, then this is a big buying opportunity," said Ed Yardeni, an economist and market strategist in a Sept. 10 note to his clients. "In both financial crises, the Fed lowered the federal funds rate, the economy and profits continued to grow, and stock prices rose to new record highs once the financial panic subsided."

Tricky Balance

Some investors believe the Fed's strategy could backfire, however. They warn that a cut in short-term rates controlled by the Fed could lead to higher long-term rates. The concern is that international investors in countries such as China and Japan will lose confidence in the Fed's willingness to fight inflation and be less willing to buy U.S. debt. That would force the U.S. to boost the rates it pays on long-term debt to persuade investors to buy. Higher rates, of course, would boost costs for borrowers. And the value of the dollar would decline even further, making it more expensive for U.S. consumers and businesses to buy foreign-produced goods and services.

"I think the more the Fed cuts rates, the more painful it will ultimately be for the economy," said Nandu Narayanan, chief investment officer and founder of Trident Investment Management, a hedge fund with about $100 million in assets. Narayanan has profited from early calls (BusinessWeek, 8/27/07) on the troubled subprime mortgage market.

If 10-year Treasury rates rise from the current 4% range to the 6%-to-7% range, investment banks and other lenders could be in big trouble. Mortgage rates could rise in step, and the value of existing mortgages carried on lenders' balance sheets is pegged to the market for new loans. In other words, if the rates for new mortgages rise to 8% or 9%, the resale value of mortgages that carry interest rates of 7% declines, too. Banks must charge that loss to their earnings, in a process known as marking to market. If long-term rates rise, "banks could face huge losses," Narayanan said.

Investment banks may throw in everything plus the kitchen sink this quarter to account for their losses. But there may be still more bad news to add in the months ahead.

Rosenbush is a senior writer for BusinessWeek.com in New York.