Analyst: Brokerage Outlook Improving

Analyst Richard Bove, long a skeptic for the ailing financial sector, is becoming more comfortable with the outlook for the big brokerage firms.

The outspoken Punk Ziegel analyst took off sell ratings on four brokers as a result of improving market conditions. Bove is particularly optimistic on Lehman Brothers(LEH Quote), which he raised to a buy, while he upgraded Goldman Sachs(GS Quote), Merrill Lynch(MER Quote) and Bear Stearns(BSC Quote) to market perform.

The rating changes hinge on several positive changes that have developed over the past three weeks, according to a new note. Bove writes that a combination of lower interest rates, a return of lenders to the commercial paper markets, a "topping out" of foreclosures in absolute terms, a surge in mortgage refinancing activities and potentially stronger merger and acquisition activity, among other things, have sparked his optimism on the four brokers.

"It now appears that there have been a number of key changes in my views driven by market events," Bove writes.

"In sum, the financial sector is changing," he writes. "The changes will be gradual, except in mortgages, but the changes are all likely to be positive. This makes the brokerage stocks more interesting but in most cases not yet buys. The strength expected in mortgages, however, gives one encouragement that Lehman Brothers might recover faster than its peers. It also means that Bear Stearns is no longer in jeopardy."

The large financial titans -- with the exception of Goldman Sachs, for the most part -- have been saddled with billions of dollars worth of writedowns from leveraged loans and risky securities backed by mortgages that went sour as the credit crunch deepened and the housing sector took a turn for the worse last year. The writedowns were so large for Merrill Lynch and Citigroup(C Quote) that both companies replaced their CEOs in the fourth quarter. Bear Stearns' CEO James Cayne also stepped down from the firm's top spot last month amid poor performance by the brokerage. Cayne remains chairman of the firm.

Still, Bove remains bearish on Morgan Stanley(MS Quote) and kept a sell rating on the company. "The unwillingness to raise the rating on Morgan Stanley is due to a fear that this company's lack of understanding of risk, at a time when its appetite for risk keeps growing, may prove to be chastening," he writes.

Despite the analyst's increased optimism on some firms, brokerage shares lingered in the red for the most part on Monday morning. Shares of Lehman were down 2.4%, Goldman was down 1.7% and Bear Stearns was down 1.4% in recent trading. Morgan Stanley was down less than 1%, while Merrill Lynch's stock was recently up 1.7%.

Bove's opinions of the brokers have varied sharply in the past few months, as the credit crisis worsened. Just two months ago, he had downgraded Bear Stearns, Lehman and Goldman to sell, after upgrading them in November.

He had written in a December note that his rating upgrades were "premature."

"The feared stresses on these markets are being evidenced," Bove wrote at the time. "These problems will not be corrected in one quarter. There will be earnings disappointments and inability to regain record profits for what may be 12 to 18 months."

David Hendler, an analyst at CreditSights, seemed encouraged by the brokers after reviewing several companies' annual reports.

"Bear Stearns remains a viable franchise among the U.S. brokers as it looks to expand beyond its historical U.S. fixed income focus," he wrote in one note on Monday. Lehman "is showing offensive strength amid the credit crunch downturn as it continues to emphasize its diversity beyond fixed income and specifically the mortgage sector," he said in a separate note.