Big lenders begin to find stable ground

America's banks and other financial institutions, frayed by the housing crisis, appear to be on the mend.

Stronger financial institutions are purchasing weaker banks and lenders. Some of the largest banks and brokers are getting injections of billions of dollars of new capital – much of it crucial as they report massive losses this week. There are indications, too, that trust is returning to the capital markets.

"We are continuing to see signs the major wounds are beginning to heal," says Jeffrey Kleintop, chief market strategist at LPL Financial Services in Boston.

But few expect the improvement to be instant – and the US economy may still undergo a downturn.

It could take months, or perhaps a year, before the elements of the financial markets return to normal, many analysts say. In fact, the stock market, down about 11 percent from highs last October, is still taking losses. The Dow Jones Industrial Average fell 246.79 points on Friday as investors worried about lower earnings.

Despite those short-term concerns, David Kotok, chairman of Cumberland Advisors in Vineland, N.J., says, "The important thing is that we are heading in the right direction, not the wrong direction."

The latest signs of change came Friday when Bank of America announced it would purchase Countrywide Financial, the largest US mortgage lender, for about $4 billion. "It shores up what had been the poster child for the subprime mess," says Bill Knapp, investment strategist at New York Life Investment Management in New York.

At the same time, reports have emerged that JPMorgan Chase is in discussions to purchase Washington Mutual, another financial institution damaged by losses in the housing market. "It's a case of the stronger players coming in to pick up the spoils," says Mr. Knapp.

Financial experts anticipate yet more consolidation, especially among the companies that analyze and insure loans. "Some of those bond insurers are very attractive to major investors," says Fred Dickson, chief market strategist at D.A. Davidson & Co. in Lake Oswego, Ore. "There is some speculation that Warren Buffett might want to pick one up."

Mr. Buffett, an investor based in Omaha, Neb., has recently started his own bond-insurance company.

The acquisitions and potential deals come as the Federal Reserve is likely to be more aggressive in dropping interest rates. Such reductions provide the economy with lower-cost capital.

The financial markets expect the Fed to lower rates by half of a percentage point when it meets at the end of the month. Further rate cuts are expected through June. "The markets are beginning to believe the Fed gets it," says Mr. Kotok.

Even longer-term interest rates are coming down. Mortgage rates have hit their lowest level in two years.

In the first week of January, mortgage applications rose more than 30 percent over the previous week. "There seems to be some pent-up demand," says Knapp.

This week, financial analysts will watch the earnings reports of many financial institutions. Merrill Lynch, American Express, and other banks have already indicated they expect to take large losses.

"They are writing off years of earnings in some cases," says Mr. Kleintop, who says it's important the financial institutions write off their bad loans quickly. "The Japanese kept all their bad loans on their books, and so they were unable to make new loans. So they went through a decade-long recession," he recalls. "You are better off making it quick and painful instead of long and slow."

To replace capital, many banks are courting foreign investors. "There is nearly $1 trillion in sovereign government funds," says Mr. Dickson. "Some of those funds will be used to launch minority stakes in these firms."

In fact, foreign governments have already invested $27 billion in financial institutions, according to The Wall Street Journal. Some of the new funds are from Asian governments such as Singapore, and some are from the Middle East, where governments are flush with oil revenue.

"There has been some consternation in Washington from the more nationalistic folks, but Treasury Secretary [Henry] Paulson says it's good to have the money, and I agree with that," says Knapp.

Yet another indication that the markets are improving is the interest-rate differential between the federal funds rate, which is the rate that banks lend one another money in the US, and LIBOR (London interbank offered rate), which is a global measure of bank lending. This past fall, when banks reported losses on subprime loans, banks became very wary of lending to one another. The LIBOR rate skyrocketed from a normal five basis points to 75 basis points over the fed funds rate. After massive liquidity injections by the Fed and the European Central Bank, it has now returned to the pre-August level.

"It appears there is some level of comfort coming back to the markets," says Dickson.

Despite the improvement, challenges still lie ahead, analysts point out. "Does the economy deteriorate into a recession?" asks Dickson.

For one, the housing crisis is far from over, analysts note. In the next 12 months, the interest rates on some 1 million adjustable-rate mortgages will be reset higher. Some banks have agreed to make adjustments to prevent foreclosures, but many homeowners will receive higher bills.

"Housing is going to take a bit longer to recover with all the inventory and shadow inventory [people who would like to sell their homes but are holding them off the market]," says Kleintop. "Housing is not coming back for some time."