Mood swings may not be over

Fear and panic may finally be taking their summer vacation.

The mood in financial markets worldwide brightened this week, no doubt to the great relief of the major central banks, which have been trying to halt a deepening credit crunch by pumping huge sums into the banking system.

Never underestimate what hundreds of billions of dollars can do to make Wall Street feel better, at least for a time.

The Dow Jones industrial average rallied nearly 143 points Friday to close at 13,378.87 and was up 2.3% for the week. The rebounds were even stronger in many foreign stock markets this week -- 12.4% in Hong Kong, for example, and 9.1% in Brazil.

In another sign that fear is subsiding, fewer investors have been rushing to park their cash in short-term Treasury bills as a haven. That’s evident because interest rates on those issues have jumped from two-year lows on Monday. With fewer takers, those who are buying can demand higher yields.

By now, no one can doubt that the housing sector’s woes run deep and wide. There is no quick fix -- or maybe any real fix -- for the millions of American homeowners who can’t make their mortgage payments or will join that club soon.

That is what has made investors flee mortgage-backed bonds, and in turn made them question the risk in all sorts of other securities and loans, even those purported to be of the highest quality.

Hence, the Global Credit Panic of 2007: Suddenly, nobody wanted to lend money.

You never know for sure except in retrospect, but investors’ collective mood seemed downright nutty at times in the last few weeks. Although markets always swing between greed (bullishness) and fear (bearishness), the swing this summer was like going from Mt. Whitney to Death Valley.

“Crawling Back From the Lunatic Fringe� was the headline on a weekly wrap-up note that brokerage Goldman Sachs & Co. sent to clients Friday.

The efforts of the Federal Reserve and other central banks to keep credit flowing (“Take our money, please!�) had to help this week. So did Bank of America Corp.’s decision to pump $2 billion into Calabasas-based mortgage giant Countrywide Financial Corp. in return for a future stake in the business.

Interestingly, though, shares of financial services companies were relative laggards this week, after strong gains in the previous two weeks. Countrywide actually lost ground for the five days, ending Friday at $21, down 2% for the week.

Bargain hunters may have had their fill of battered financial stocks for the moment. That, or traders who had “shorted� the shares, betting on lower prices, have stopped closing out those trades, presumably because they’re expecting another decline in prices ahead.

Not surprisingly, almost everybody is cautious about markets now. That’s par for the course after the volatility we’ve seen in recent weeks.

But there are good reasons to question whether the summer tumult has run its course.

For starters, many of the creditors who facilitated the easy money era -- the banks, brokerages, hedge funds and others that will have to record heavy losses on mortgage securities and other high-risk debt -- haven’t stepped forward to admit their sins.

When the stock market finally stops worrying about the housing bust, it will no longer show much reaction to mea culpas and painful write-offs by creditors. It doesn’t seem that we’re there yet.

Beyond the lengthening casualty list, the speed of markets’ recovery will depend on three things, suggests Joe Carson, an economist at money manager AllianceBernstein in New York.

One, he says, is the response of policymakers, such as the central banks. They’re engaged, which is a good sign, Carson says.

Another key variable is what happens with the economy. That’s a bigger risk factor today than during the market upheavals of 1987 (the stock market crash) and 1998 (the failure of the giant hedge fund Long-Term Capital Management) because the domestic economy is not as healthy as it was in those periods, Carson notes.

If U.S. consumers don’t close their wallets in the next few months, Wall Street should feel increasingly optimistic about the chances of weathering the housing bust. But the pressure on consumers’ finances clearly has worsened, with losses on their stock holdings, such as in retirement accounts, compounding the pain of declining home values in much of the country.

The third variable, Carson says, is whether investors and lenders retreat further from risk taking or begin to step back up to the plate.

If we’ve just lived through the greatest credit bubble of all time in the last few years, as some market veterans contend, then it’s highly doubtful we’ve deflated it in a few weeks.

It’s hard to imagine that money market mutual funds, for example, will want to start buying the financial-company short-term IOUs that have gone begging lately. Why take the chance of scaring investors who, for the first time in years, are looking more closely at what’s in money fund portfolios?

The reaction of foreign investors may be more crucial. The U.S. is a debtor nation and our creditors span the globe. We rely on foreign capital to keep our economy going.

U.S. investment bankers have sold hundreds of billions of dollars in mortgage-backed bonds to investors worldwide. Many of those buyers now rue the day they let the salesmen in the door. That means, at least in the near term, that global investors are likely to look at any IOUs Wall Street tries to sell them with greater suspicion.

Even if foreigners don’t want our securities, however, they may still want their own -- particularly if economic growth overseas remains robust. That may explain why many foreign stock markets are rebounding so quickly. And it could reinforce for U.S. investors the benefits of global diversification, something many Americans have smartly taken to heart in the last few years.

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