Worries about the health of U.S. credit markets are making it an uncomfortably hot summer for financial stocks.

With a record-low default rate, generally healthy corporate balance sheets and strong earnings growth, the financial stocks should by all rights be enjoying healthy gains.

But ever since low-quality debt in the subprime mortgage market hit the skids this spring, the flow of cheap financing that bolstered the buyout boom has started to slow. That slowdown -- and some high-profile scares like the near collapse of two highly leveraged Bear Stearns ( BSC) hedge funds -- has pressured the sector even as the Dow Jones Industrial Average soars to new records and big mergers continue to be announced.

Stocks like Bear, Goldman Sachs ( GS), Merrill Lynch ( MER), Morgan Stanley ( MS) and Lehman Brothers ( LEH) have been hit hard in recent weeks. Bear Stearns has fallen 16% since February and Merrill Lynch has slipped 11% since a January peak. The financial sector of the big-cap S&P 500 is the index's worst performer this year, down 3%.

Even the industry's gold standard, Goldman Sachs, is off 5% since last month -- and some watchers say the worst is yet to come.

"The corrective phase isn't over," says John Roque, senior vice president and technical analyst at Natexis Bleichroeder. "More than likely, it is going to be uncomfortable," he writes in a recent note, like sweltering under "the bakin' Brooklyn sun."

Analysts stress that the big banks are cushioned by extensive hedging, strong liquidity and diversified business portfolios. But investors are worried a big source of recent years' revenue growth -- fees tied to the mortgage and loan securities that are now seeing a kind of a buyers' strike -- could dry up.

The fear is that banks, having collected fat fees to bundle loans and other debt into so-called structured finance instruments, may now be left holding loans they can't sell in the open market without taking losses.

One debt capital markets banker who declined to be named said the loan commitments banks have made to private-equity firms could become an unsavory, multibillion-dollar problem.

The banks, he says, are trying to work with the private-equity firms to get them to agree to tighter covenants that would protect the banks, or to pay higher interest rates, reflecting changed market conditions. But so far little progress has been made, he said.

Others stress that the situation doesn't appear dire.

"We think they are equipped to manage throughout the crisis," says Eileen Fahy, managing director, and credit analyst covering financials at Fitch Ratings. She notes that banks appear less dependent on short-term financing for liquidity in case of a crisis than they were after the collapse of Long Term Capital Management, back in 1998. They have pools of highly liquid, safe assets like government bonds for quick funding, she says.

But Fahy concedes banks could be hurt by declining revenue tied to structured credit securities and prime brokerage, or lending to the ballooning hedge fund industry, she says.

Fahy says going back to the previous downturn in banks revenue growth, Lehman Brothers saw a 30% drop in net income from the end of 2000 to the end of 2001, as revenue dropped 13%. From 2001 to 2002, the firm saw another 22% drop in net income.
In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click here to send her an email.

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