Fear factor drops at Citi

(Fortune) -- Citi's rally is the latest sign that shoulders are easing a bit in the financial sector.

Despite Friday morning's report of a $5.1 billion loss - and $12 billion in writedowns - Citi's stock was up 7% in heavy trading, advancing $1.64 to $25.66. Other banks and brokerage firms came along for the ride, with Bank of America (BAC, Fortune 500) up 4%, Goldman Sachs (GS, Fortune 500) up 5% and Countrywide (CFC, Fortune 500) up 9%.

The broad rally is a bit surprising. After all, Citi (C, Fortune 500) has been heavily penalized over the past year for lending to buyout shops and dominating the collateralized debt obligation market. Coming to terms with those problems has blown a nearly $40 billion hole in Citi's balance sheet since the debt markets froze up last summer.

But there are signs investors are starting to warm to Citi again. Citi's five-year credit default swaps have been on a tear for the past week, tightening in to the 95-105 range from 145 last Friday. That means the cost of insuring a $10 million block of Citi debt has dropped by nearly a third, to around $100,000, in just a week - suggesting that traders have a rapidly improving view of the mega-bank's balance sheet and cash flow generation prospects.

Citi isn't the only troubled financial firm benefiting from sunnier skies in the credit default swap market. The cost of insuring against a default at big brokerage firm Merrill Lynch (MER, Fortune 500) has dropped to 150 Friday from 210 a week ago, despite Merrill's report Thursday of a $2 billion first-quarter loss.

The very, very tentative thaw could point to a warming trend beyond Citi's beating the worst case scenario consensus from equity analysts.

Perhaps the transparency with which Merrill Lynch yesterday addressed its remaining CDO exposure, especially within the context of its hedging problems, provided a level of comfort that long been lacking. Specifically, the firm addressed the assumptions behind its exposure to financial guarantors - the troubled bond insurers whose capital-raising efforts nearly consumed the market earlier this year - and why it wrote its hedges down to 40 cents on the dollar.

Or more directly, it could be because Merrill chief executive John Thain said that Merrill's return to profitability is "a very reasonable expectation" - a comment that was taken by investors to mean that the multiple quarters of loss-inducing massive writedowns are over.

It isn't just in the fickle equity market where firmer ground is emerging. The mortgage-backed securities market, where the continuing crisis took hold, is also beginning to stabilize. The market for collateralized mortgage obligations, essentially mortgage bonds made from plain-vanilla pass-through bonds, is in pretty good shape, and with a lower cost of funding is actually seeing interest from customers in new deals. BlackRock (BLK) chief Larry Fink said earlier this week that the low yields on safe Treasury debt is starting to force some return-conscious investors back into the market for mortgage-related paper.

Actually, in a weird way, what's left of the once-massive securitized product franchises both Merrill and Citi had built may well prove fairly valuable in coming days. That's because with interest rates low - and soon to go lower if Fed funds futures are to be believed - the cost of funding mortgage securities for institutional clients is dropping sharply. Many hedge fund executives predict the next year will see a robust business develop as hedge funds and Wall Street brokers with cash available compete to buy mortgage bonds whose prices have been sent sharply below their previous historical lows.