Our Take: Not as Bright as We'd Hoped

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The tentative underpinnings of a financial market recovery, which appeared after the Federal Reserve stepped in to avert a Bear Stearns bankruptcy in March, have eroded in the past few weeks. As a result, we see a growing risk that the hiring climate among investment banks won't improve as soon as many had hoped.

Concerns about the health of major financial institutions are once again on the upswing, just as banks prepare to release second-quarter results. The coming crop of profit and loss announcements might not trigger a fresh wave of layoff news. But that's only because Wall Street layoffs have become such a way of life, managements no longer feel compelled to tie them to quarterly reports.

Lehman Brothers launched the reporting season on a dour note Monday when it pre-announced a net loss of $2.8 billion, or $5.14 per diluted share, and said it would raise $6 billion in new capital. On Thursday, the firm replaced its president and its chief financial officer in a further move to reassure investors its finances are under control.

Inflation, Rate Hikes Loom

Although Lehman has been the most visible, market indicators point to a broader climate of worry that a new phase of the credit crunch will soon descend. Falling share prices and a rising price for default protection across a swath of financial and non-financial companies coincide with perceptions the U.S. and other developed economies face "stagflation" - rising inflation combined with sluggish economic growth. Such a scenario would further damage balance sheets, while all but blocking central banks from injecting liquidity.

The Fed's actions have helped contain the potential systemic damage from the mortgage and credit meltdowns. Now, however, policy makers are running out of room. Inflation pressures are building, as one Fed official after another has warned lately. After a string of interest rate cuts since last September, it's likely the Fed's next move will be a hike, which might come as soon as August.

What's more, some legislators - and even Fed officials themselves - are agitating for Chairman Bernanke to shut the various emergency credit spigots policy makers opened wide in the heat of the Bear Stearns crisis. There are growing concerns about "moral hazard" - the possibility that the expanded safety net may encourage institutions to take imprudent risks, thus worsening the very problems regulators are struggling to bring under control.

Credit Quality Is Deteriorating

Meanwhile, new cracks continue to appear. On June 5, Standard & Poor's lowered the debt ratings of the two largest bond insurers, MBIA and Ambac, from AAA to AA. Their credit strength backs up the ratings of more than $1 trillion of municipal bonds and corporate securities the two companies had guaranteed.

That followed S&P credit downgrades of three bulge-bracket banks amid deteriorating profit outlooks and the prospect of further balance sheet write-downs. The downgrades by themselves reduce financial flexibility, since trading partners can now require the banks to post billions in additional collateral under various derivatives contracts they are parties to. The Financial Times suggested those rating cuts might be aimed at warning the banks to shift their capital-raising efforts from so-called hybrid securities - which combine debt and equity features - to pure stock offerings.

For commercial banks, one potential source of fresh write-downs is loans to home and condo builders. Banks including KeyBank, Wachovia and IndyMac have begun offering discounts of 40 percent to 80 percent in order to sell these loans, The Wall Street Journal reported last week. Research by Zelman & Associates suggests U.S. banks have been procrastinating when it comes to charging off non-performing loans to housing developers, which could total $165 billion within five years. Bank regulators and Treasury officials reportedly fear this could cause a large number of bank failures.

What's the bottom line for your career? With staff reductions now commonplace, we no longer look for every new asset write-down to automatically trigger a fresh layoff announcement. So, we'll simply reiterate what we said in our column of May 23: Hiring won't recover until bank CEOs can confidently foresee "concrete and sustained improvements" for their own companies' profit outlook. That looks unlikely for the balance of 2008. And if inflation concerns force the Fed to tighten credit while corporate cash flows are stagnant, Wall Street's inhibited animal spirits might remain caged well into 2009.

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