Financials: After the Fall, Some Look Undervalued

Some analysts advise leavening your portfolio with bigger banks that are ripe for an uptick. But don't overlook deals in beaten-down brokerages

by David Bogoslaw

Financial stocks have taken a drubbing since March, as subprime mortgage defaults have ratcheted up, igniting fears that other, higher-grade securities could eventually be infected. That has yet to be demonstrated, but Bear Stearns' (BSC) failed efforts to salvage two of its hedge funds that were heavily exposed to the low-grade loans has raised questions about the book value of assets on some banks' balance sheets.

So far, impaired assets haven't been a problem in financial companies' second-quarter results. Of 17 major U.S. banks that have reported earnings so far, more than half exceeded Wall Street forecasts and only four came up short.

Tighter Credit Spreads Squeeze Profits

But eventually the group will see profits squeezed by tightening credit spreads, experts say. Credit spread is the difference between the low interest rates paid to banks to borrow money on a short-term basis, and the higher interest earned on money they lend to companies making acquisitions over the longer term. Higher interest rates and stricter lending standards have reduced compensation for high-yield debt securities. Lenders, in a quest for higher returns, have moved into even riskier instruments such as subprime mortgages.

The tighter credit is also causing some companies to cancel debt financing for leveraged-buyout deals and buyback plans because they don't want to pay higher interest rates on the debt. This would hurt brokers and investment banks like Goldman Sachs (GS) and Lehman Brothers (LEH), which make most of their money by advising companies on mergers-and-acquisitions activity and organizing the financing of such deals.

"Five years ago, when credit spreads were really wide, you were really being compensated for the [lower] quality of those portfolios, but since then the credit spreads of corporate debt over Treasury bonds have plunged to around 2.5% from over 10%," says Lincoln Anderson, chief investment officer at LPL Financial Services in Boston.

This year, brokers and investment banking stocks have underperformed the large banks that are more diversified and have bigger balance sheets, says Meredith Whitney, an equity analyst atCIBC World Markets in New York (Whitney owns shares of some of the companies she covers and CIBC does investment banking with brokers). Merrill Lynch (MER) shares are down 14.9% and Lehman Brothers dropped 12.8%, vs. an 8.25% slide in Citigroup (C) and a less than 2% drop in JPMorgan Chase (JPM).