Worst Wall Street Quarter Since 2001 Tempered by Goldman's Gain

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Worst Wall Street Quarter Since 2001 Tempered by Goldman's Gain


By Christine Harper

Sept. 17 (Bloomberg) -- Wall Street's third quarter would be the worst since 2001 if it weren't for the timely sale of a power company by Goldman Sachs Group Inc.

Bear Stearns Cos. probably will report a 41 percent drop in earnings per share, Morgan Stanley may post an 11 percent decline and Lehman Brothers Holdings Inc. may say profit fell 5.1 percent, according to a Bloomberg survey of analysts. Goldman's earnings probably jumped 33 percent after a gain of as much as $1 billion from the sale of Horizon Wind Energy LLC.

Fixed-income trading, the industry's biggest source of revenue, faltered as sales of mortgage and asset-backed securities dropped 36 percent in the quarter, Lehman estimates. Banks also stopped financing new leveraged buyouts, which provided $8.4 billion of fees in the first half, as they struggle to clear a backlog of $350 billion in loan commitments. While revenue from takeover advice, stock trading and underwriting probably rose, it may not make up for writedowns to reflect the declining value of corporate loans and mortgage bonds.

``This is a more important period than the turbulence of 2001,'' said Peter Solomon, chairman and founder of New York- based investment bank Peter J. Solomon Co. and a former executive at New York-based Lehman. ``This is credit and this is risk. This turmoil is aimed right at the heart of their business, so everybody is interested in how they have managed.''

If the analysts are right, and they've underestimated the firms' profits for the past six quarters, it would be the worst year-on-year decline in earnings per share since the second quarter of 2005. When Goldman is excluded, it becomes the biggest drop since the fourth quarter of 2001.

Trading Whole Companies

UBS AG analyst Glenn Schorr is including Goldman's gain in profit estimates because buying and selling companies now is as much a part of how Wall Street makes money as trading stocks. Goldman's fixed-income revenue in the second quarter of 2006 reflected its profit from selling a power plant in Linden, New Jersey. In the fourth quarter, the New York-based firm included the $500 million made on the sale of Japan's Accordia Golf Co., which now trades on the Tokyo Stock Exchange.

Goldman, the world's largest securities firm by market value, recorded the $2.15 billion sale of Horizon Wind to EDP- Energias de Portugal SA in the third quarter. Analysts have to estimate the size of the gain because Goldman never disclosed how much it paid for Houston-based Horizon Wind in March 2005. Schorr figures it's between $750 million and $1 billion.

While Bear Stearns also runs a merchant-banking business, investors don't expect it to provide enough of a boost to offset the impact of subprime-mortgage defaults. Shares of the New York-based firm, the second-largest underwriter of U.S. mortgage bonds, have lost almost a third of their value this year and are on track for their biggest annual decline since 1987.

 

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Worst Wall Street Quarter Since 2001 Tempered by Goldman's Gain (continued)

Profit Headwind

Lehman has fallen 24 percent, which would be the firm's steepest drop since its initial public offering in 1994. Goldman has fallen 4.4 percent, the biggest decline since 2002, and New York-based Morgan Stanley is down 2.2 percent.

``It's definitely going to be rough,'' said Ralph Cole, who helps manage $2.7 billion, including shares of Goldman and Merrill Lynch & Co., at Ferguson Wellman Capital Management in Portland, Oregon. ``The easiest money has been made. They had an incredible tailwind, but now it all seems like headwind.''

While Cole said the securities industry probably reached its earnings peak for this economic cycle in the first half, when Goldman, Morgan Stanley, Lehman, Bear Stearns and Merrill Lynch reported net income totaling $18.4 billion, he and other investors don't expect results for the fiscal quarter that ended in August will be as bad as analysts are forecasting.

Market Conditions

Wall Street is collecting more investment-banking fees than a year ago, data compiled by Bloomberg show. Completed takeovers rose 35 percent to $861 billion in the fiscal third quarter. Equity offerings climbed 76 percent to $170 billion, and sales of high-yield debt jumped 26 percent to $42 billion.

Trading also has been busier, indicating a probable increase in commissions. The average daily trading volume in mortgage-backed securities rose 55 percent in the past three months from a year earlier, while in corporate debt it swelled by 11 percent, Federal Reserve data show. On the New York Stock Exchange, average trading volume rose 7.6 percent.

The CBOE SPX Volatility Index, which measures the rate of price swings in stocks, averaged 19.3 during the quarter, up 27 percent from last year. Greater volatility typically means bigger trading profits on proprietary positions.

``With the volatility on the equity market and the fact that trading on all of the exchanges has been at record or near- record levels, these companies should all benefit from that,'' said Erin Archer, an analyst at Thrivent Financial for Lutherans in Minneapolis, which manages $75 billion, including shares of all four firms. ``They could all report very strong equity numbers.''

Kitchen Sink Option

There's also the chance that some chief executive officers will use the third quarter as a so-called kitchen sink, aggressively marking down securities holdings and taking as many one-time charges as possible to reduce the drag on future profits. Lehman CEO Richard Fuld, the first to report, on Sept. 18, is spending $72 million to scale back mortgage lending, including costs to fire 2,050 employees.

Merrill, the third-largest firm behind Goldman and Morgan Stanley, said Sept. 14 that ``challenging'' conditions in fixed- income markets required ``fair value adjustments'' in the carrying value of certain investments and financing commitments. Merrill's quarter ends this month and it reports in October.

Trouble is prices for some instruments are either unavailable or unreliable, turning such mark-to-market accounting into guesswork. Many securities have all but stopped trading since the sudden increase in defaults on subprime home loans early this year left investors leery of products with limited transparency, such as mortgage-backed bonds and collateralized debt obligations.

 

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Worst Wall Street Quarter Since 2001 Tempered by Goldman's Gain (continued)

Marking to Market

Two hedge funds run by Bear Stearns collapsed in June partly because the firm couldn't find buyers for CDOs. Others including Wharton Asset Management's Y2K Finance have suspended withdrawals until they can accurately calculate the value of their investments. Securities firms hold many of the same assets.

One index that tracks the value of mortgage securities, the ABX BBB 07-01 Index, fell 51 percent from the end of May to the end of August. Another that reflects speculation on leveraged loans, the LCDX Index, fell about 5 percent during the period, according to David Hendler, a New York-based analyst who covers the securities industry at CreditSights Inc.

``There's going to be some mark-to-market in the securities portfolios, primarily among the mortgage products and fixed- income products that the brokerage firms are holding on their balance sheet,'' said Peter Kovalski, who helps manage about $12 billion, including shares of Morgan Stanley and Goldman, at Alpine Woods Investments in Purchase, New York. ``I think there's going to be a surprise there on the magnitude.''

Setting the Tone

Analysts such as Lehman's Roger Freeman say the approach Wall Street takes to fair value accounting will influence investors' confidence in the stocks.

Lehman will set the tone for this week's earnings reports because it reports first and is expected to post its biggest quarterly profit decline since 2004.

Of the 16 analysts who follow Lehman in Bloomberg's survey, 13 have reduced their third-
quarter earnings estimates in the past four weeks. They expect Lehman, the biggest underwriter of U.S. mortgage bonds, to post profit of $1.49 a share, down from $1.57 a year earlier and $2.21 in the second quarter.

Fuld's Signal

Fuld, 61, signaled that Lehman's prospects may not be as dire as its stock price suggests when he told UBS analyst Schorr that the strains on the firm are less than half as severe as in 1998. That year, market turmoil triggered by Russia's debt default and fanned by the failure of hedge fund Long-Term Capital Management LP pushed Lehman close to insolvency.

Lehman, the fourth-largest U.S. securities firm, surprised analysts in the second quarter with stronger-than-expected revenue from equity trading and faster growth outside the U.S.
``Lehman is pretty well positioned to report a decent third quarter,'' said Thrivent's Archer. ``Fixed-income expectations may have come in too much.''

Morgan Stanley may report on Sept. 18 an 11 percent drop in earnings per share, the first decline since John Mack, 62, returned as CEO in mid-2005, according to the analyst survey.
Some bright spots remain. Morgan Stanley, the industry's second largest by market value after Goldman, managed 81 percent more in stock sales during the fiscal third quarter, Bloomberg data show. Its retail brokerage probably lured more customers and assets, said Douglas Ciocca, who owns Morgan Stanley shares among the $1.4 billion that he manages at Renaissance Financial Corp. in Leawood, Kansas.

Hedge Fund Losses

Goldman and Bear Stearns are scheduled to report on Sept. 20. While analysts expect Goldman CEO Lloyd Blankfein, 52, to say earnings per share rose to $4.35 from $3.26 a year ago, they also anticipate writedowns on the inventory of mortgage-related securities and its commitments to fund leveraged buyouts. Goldman's asset-management unit probably lost revenue after its Global Alpha hedge fund fell 22.5 percent in August and investors notified the firm they planned to withdraw $1.6 billion.

Bear Stearns, the smallest of Wall Street's five largest firms, may report its worst results since the first quarter of 2001, when profit fell 42 percent. Analysts expect earnings per share of $1.79, down from $3.02 a year earlier, according to estimates compiled by Bloomberg.

Mortgage-backed securities and related products provide about 30 percent of fixed-income sales and trading revenue at Bear Stearns, compared with about 20 percent at Lehman, according to Brad Hintz, an analyst at Sanford C. Bernstein & Co. After Bear Stearns's two hedge funds filed for bankruptcy in July, tarnishing the firm's reputation for managing risk, CEO James Cayne, 73, fired his 49-year-old Co-President Warren Spector.

``We know that Bear Stearns will probably have the biggest hit to earnings,'' said Stanley Nabi, who helps manage about $8.5 billion at Silvercrest Asset Management Group LLC in New York. ``I'm expecting a negative quarter, and in some instances, a significantly negative quarter, but nothing that would shake the foundation of any of them.''

To contact the reporter on this story: Christine Harper in New York at charper@bloomberg.net .

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