Banks rally despite bad news

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NEW YORK (CNNMoney.com) -- Financial stocks jumped Wednesday, as investors set aside mounting worries about troubled mortgage giants Fannie Mae and Freddie Mae and a bearish report from Goldman Sachs about five key banks.

In an analyst report, Goldman Sachs slashed third-quarter earnings targets for investment banks Morgan Stanley (MS, Fortune 500), Lehman Brothers (LEH, Fortune 500) and Merrill Lynch (MER, Fortune 500), as well as Citigroup (C, Fortune 500) and JPMorgan Chase (JPM, Fortune 500).

Analysts William Tanona, Betsy Miller and Neil Sanyal said they expect the banks' third quarter results will be pressured by declining equity markets around the world, further deterioration in mortgage assets and an ongoing credit crisis.

"For some of our firms, [the] third quarter marks the fourth consecutive quarter of reported losses, clearly an unprecedented streak," the analysts said in a note to investors.

The analysts said a recovery in the sector won't occur until 2009, with more writedown-related pain to come.

But only Morgan Stanley's stock fell, while the other four produced solid gains, led by Lehman's 5.1% rise on the day.

Other financial stocks also rallied Wednesday.

Shares of regional bank Wachovia (WB, Fortune 500) added 4.2%, and Wells Fargo (WFC, Fortune 500) jumped 3.9%. Bank of America (BAC, Fortune 500) rose 4.5%, UBS (UBS) gained 2.3% and insurer AIG (AIG, Fortune 500) added 2.4%.

Even shares of Washington Mutual (WM, Fortune 500) broke even. The stock was down for much of the day on renewed concerns that the nation's largest savings and loan may face challenges if it needs to add capital to cover loan losses. The bank has previously said it is sufficiently capitalized.

One fund manager suggested that the fact many bank stocks were able to head higher was a good sign.

"You know you've hit a bottom when stocks go up on bad news," said Peter Sorrentino, senior portfolio manager at Huntington Asset Management. "There is real belief that the U.S. economy is working its way through its problems."

Sorrentino added that although he doesn't think financials are completely out of the water yet, investors seem to be prepared for more earnings estimate cuts in the third quarter.

The path to recovery may be bumpy, but another analyst thinks that bank stocks don't have much place else to go but up.

"Financials were oversold, so they were due to pick up a bounce," said Matt McCormick, an analyst with Bahl & Gaynor Investment Council, a money management firm. "There's still more volatility to come but they can't get much much worse than they already are."

Increased anxiety over a possible government bailout of Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500) sent investors in those firms ducking for cover Wednesday. Shares of the government-sponsored mortgage finance giants fell for a third straight session on worries that a bailout is unavoidable.

"There's an ongoing fear factor about the credit crunch that continues to drag down some financials," said Peter Cardillo, chief market economist with Avalon Partners. "So the market anticipates some news from the Treasury."

The U.S. Treasury did not offer a comment on speculation that they would announce a capital injection for the two firms Wednesday.

Wall Street has been concerned about Fannie and Freddie's need to raise capital, and a possible government takeover of the firms could make the stocks worthless for private investors.

Freddie lost 22.1% and Fannie shed 26.8%.

The bad news from Fannie and Freddie bled over to other financial services companies with heavy exposure to the mortgage industry.

Shares of three of the largest mortgage insurers, MGIC Investment Corp. (MTG), PMI Group Inc. (PMI), and Radian Group Inc. (RDN), slumped 7.1%, 8.3% and 16.4%, respectively.