ALL BUSINESS: Buffett says economic and credit woes linger

By RACHEL BECK AP Business Writer

NEW YORK (AP) - Warren Buffett's comments on the investment outlook usually resonate, and those over the weekend were no exception: Panic in financial markets may be through, but that doesn't means it's the end of the economic and credit woes.

Buffett's assessment is a much-needed wake-up call to investors who have been pushing stock prices higher and are warming up to owning risky debt again, both big bets that the worst of the credit crisis is over and better times are ahead.

Feeding that shift in sentiment has been better-than-expected economic and financial news, which at first glance does look good. It's when you dig a little deeper that it's more evident why it's not.

Buffett spoke over the weekend during events surrounding the annual meeting in Omaha of his company, Berkshire Hathaway Inc. He said the Federal Reserve's bailout of Bear Stearns in mid-March likely averted a broad financial crisis on Wall Street, which could have spurred a run on other investment banks and crippled the financial system.

The "idea of financial panic" has largely been "fairly well taken care of," he said, but he predicted the pain is far from over for financial institutions. They've already taken more than $200 billion in write-downs on their mortgage-related and other debt assets as their valuations have slumped, and he suggested more bad news could be coming.

Buffett also said that the U.S. economy is in a recession by his definition - when most people and businesses are not doing as well as they were three, six or nine months ago. The commonly used criteria for a recession is two quarters of negative growth.

That contrasts with the upbeat view embraced by investors in recent weeks, who have been taking a glass half-full approach to financial conditions after months of seeing them as only being half empty - or worse.

Just look at the turnaround in the Standard & Poor's 500 stock index: After tumbling more than 13 percent from the start of 2008 through the Bear Stearns mess on March 17, it has gained more than 10 percent since.

Credit investors have also turned more bullish over the last month. The option-adjusted spread on the Merrill Lynch's high-yield corporate bond index - representing the difference in yield between the most speculative corporate debt and risk-free Treasury securities - has narrowed from 840 basis points on March 20, to around 685 basis points last week, according to research firm CreditSights.

Among the data points feeding such gains was the May 1 report from the Commerce Department showing a surprising 0.6 percent growth in gross domestic product during the first quarter. To many investors, it was proof that the economy isn't in a recession and gave then a psychological boost.

That, however, glosses over some land mines in the report - which Merrill Lynch chief North American economist David Rosenberg says are indicative of a "recession beneath the veneer." He points to the 0.4 percent annual decline in real final sales of domestic purchasers, which is considered a solid measure of economic health since it is essentially real GDP without inventories or net foreign trade. It dropped from a 1.3 percent annual growth rate in the fourth quarter and a 2.5 percent pace in the third quarter of last year.

The latest figures on the job market released Friday also came in above expectations. Instead of falling by 75,000 as economists had estimated, payroll employment dropped just 20,000, according to the Labor Department. The unemployment rate fell to 5 percent from 5.1 percent.

But as economists at Goldman Sachs point out, that is hardly good news for an economy that needs at least 125,000 new jobs per month to keep pace with labor force growth. It warned clients in a new report to dig beneath the "not-so-dire headline data" to find out where the continued contraction in the housing market is eating away at the economy.

"We are suspicious of the idea that the economy and markets have entered a fundamental healing process," Goldman Sachs chief economist Jan Hatzius said. "In our view, the most important prerequisite for an end to the macroeconomic malaise is an end to the home price downturn, and the news in this area has been not just bad but considerably worse than even we have anticipated."

That echoed warnings from CreditSights, which told its clients to keep watch for any new signs of "systematic risk" that could result in a "second wave of the financial tsunami."

While subprime loans - those to borrowers with risky credit profiles - were what fed the first leg of this mess, the next could be caused by a deterioration in prime lending. CreditSights advises to keep tabs on prime default rates, especially on those tied to second homes. In addition, patterns in consumer consumption and indebtedness should be closely watched.

Clearly, others are sounding the same warnings as Buffett. But his often are the ones that are heard.

---

Rachel Beck is the national business columnist for The Associated Press. Write to her at rbeck(at)ap.org