Brokers will begin reporting earnings next week, and given potential difficulties for the companies, some analysts think it might make sense to be short the sector. Lehman Brothers, Bear Stearns, and Goldman Sachs will report earnings next week, and while traders were reluctant to single out brokers that may have difficulty, earnings could be weak in the sector because of possible trading losses and higher borrowing costs, traders said.
Whatever happens, brokers' credit spreads are unlikely to blow out. At issue is really how strong the brokers' earnings will be rather than their fundamental stability, traders said. That's why it might make sense to only take a small short position in the sector, but it does make sense to be short, traders said.
"There are a lot of negatives for the brokers now," a trader said.
Several analysts seem to agree. Lehman Brothers credit analyst Vince Breitenbach recently changed his recommendation on the banks and brokerage sector to "underweight."
Bear Stearns credit analyst Ian Jaffe also suggested investors underweight the brokers, but said brokers generally do a good job with risk management, and it is not yet clear how market conditions have affected earnings.
By most accounts, banks have faced unusually difficult market conditions this quarter. In May, Standard & Poor's cut Ford Motor Co's and General Motors Corp's debt ratings to junk status, which deluged the junk bond market with a huge amount of new debt.
That chilled junk bond underwriting and leveraged buyout deals, which could have had an impact on broker's underwriting revenues.
But the Ford and GM downgrades were also rumoured to have spurred big losses from hedge funds that had made bad correlation trades, or trades that credit spreads would broadly move in the same direction. Not only are hedge funds important trading clients for brokers, but many brokers make hedge fund-like bets with their own money.
The flattening yield curve also likely made the quarter challening, traders said. Since last June, the Federal Reserve has been raising the short-term rates at which banks and brokers often fund themselves.
Meanwhile, the longer-term rates at which banks and brokers often invest their funds have stayed low, translating to fewer profit opportunities for companies in the financial sector.