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Feds fight the fear factor

But it's hard to see how attempts to shore up investor confidence can work for long while home prices keep falling.

By Colin Barr, senior writer
Last Updated: July 17, 2008: 7:25 AM EDT

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Efforts to maintain confidence in the financial sector won't prevent investors from scrutinizing the balance sheets of banks and brokerages.

NEW YORK (Fortune) -- Washington is tying itself in knots trying to shore up confidence in the financial sector.

In just the past week, officials have moved to curtail short-selling, promised a crack down on market rumormongers and cooked up a rescue plan for beleaguered mortgage companies Fannie Mae and Freddie Mac - while taking pains to argue that the institutions are sound even as investors dump shares.

Trouble is, banks and brokerage stocks aren't being done in by a cabal of bad guys on trading desks. Bankers who made increasingly reckless bets on the housing market engineered this train wreck. And the damage they wrought on their companies' balance sheets is going to take time - and a lot more pain - to undo.

"This is the unwinding of our bubble economy," says Euro Pacific Capital strategist Peter Schiff, a longtime critic of U.S. fiscal policy and credit market excesses. "Anybody can make loans. But banks are finding the problem right now is getting the money back."

Cox on the case

The Securities and Exchange Commission stunned Wall Street this week with an emergency order that would limit short sales of 19 financial companies, including Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500) as well as brokerage firms Merrill Lynch (MER, Fortune 500) and Lehman Brothers (LEH, Fortune 500).

In a short sale, an investor borrows stock, hoping the price falls so he can profit by returning the shares at a lower price. Until now, shorts have needed only to show they have made an effort to locate shares to borrow. Now they'll need contracts for them.

The new rules, which would take effect Monday and last as long as a month, come on top of SEC Chairman Christopher Cox's announcement Sunday that the agency would "immediately" find the source of untrue rumors about stocks. The basic message: the SEC's cops on the beat will make sure no one is manipulating stock prices.

For now, Cox's announcements seem to be working wonders. Financial stocks did indeed regain their stability Wednesday, soaring as short-sellers bought shares to cover their positions and Wells Fargo (WFC, Fortune 500) posted a stronger-than-expected second quarter. Hard-hit stocks such as Fannie, Freddie and Lehman surged as much as 20%, and the S&P 500 financial index posted its biggest-ever gain.

But the relief is likely to be short-lived.

Bank and brokerage stocks were at multiyear lows before Wednesday's rally because their books are bloated with mortgage loans whose value will plunge as U.S. home prices continue to fall, and because many firms have borrowed heavily to make these bad bets, thus magnifying their losses.

Sooner or later, investors will turn their focus away from scheming short-sellers and back to crummy balance sheets.

Oppenheimer analyst Meredith Whitney, a longtime skeptic of the financial sector, has predicted that share prices will continue to fall, as firms struggle to sell assets and bring down expenses.

She wrote Tuesday that the industry's failure to anticipate the steep fall of home prices could lead to "a material and protracted writedown and capital pressure scenario for the banks well into 2009."

She doesn't expect to see a rebound till banks "get real" about the value of the mortgage-related assets on their books.

Crisis? What crisis?

The banks aren't the only ones that have failed to get real. Indeed, Cox's offensive against short-selling can be seen as just the latest federal effort to downplay the depth of the credit crunch that started last summer.

Back then, Fed chief Ben Bernanke and Treasury Secretary Henry Paulson said the crisis - then linked exclusively to the collapse of subprime mortgage securities - would be contained without damaging the economy.

Since then, credit problems have gotten progressively worse. This spring saw the collapse of Bear Stearns, the mortgage-heavy investment bank that was rescued in a Fed-brokered sale to JPMorgan Chase (JPM, Fortune 500), even as Cox said Bear had sufficient capital.

Then there was Paulson's statement of government support for Fannie Mae and Freddie Mac over the weekend. Their shares had lost nearly half their value over the course of a week as investors fretted over their thin equity cushions and their hefty exposure to souring home mortgages.

The executive branch isn't the only place Pollyannas reside, of course. "These institutions are fundamentally sound and strong," Sen. Christopher Dodd, chairman of the Senate banking committee, said at a Capitol Hill press conference last week, in reference to the steep selloff in Fannie and Freddie shares.

Those who believe Fannie and Freddie are fundamentally unsound have no shortage of ammunition, however. Both firms have more than $800 billion in mortgage loans and other assets on their balance sheets. But Fannie has just $38 billion of shareholder equity - a measure of net worth - and Freddie $16 billion.

With the two companies and other mortgage industry players suffering heavy losses as home prices fall, it's easy to see why some investors might be tempted to bet against the companies, whatever their motives.  To top of page

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