Aug. 2 (Bloomberg) -- Mattel Inc., the world's largest toymaker, said a recall of 1.5 million Chinese-made products will reduce second-quarter operating income by almost 50 percent and that it will review the production methods of all its contractors in China.

Withdrawing the toys that may contain excessive lead levels, including Sesame Street dolls, will cut $30 million from Mattel's previously reported operating income of $63.5 million. The company didn't say what the impact on net income would be.

The discovery of lead might force Mattel to find new sources of low-cost goods and may further damage China's reputation as an exporter, following a recall of ``Thomas & Friends'' wooden railroad toys, a U.S. ban on Chinese toothpaste and scandals involving tainted pet food and diseased pork.

Before the recalls, Mattel had been ``a leader in toy- product safety,'' said Bob Goldsborough, who helps manage $14.9 billion, including 4.3 million Mattel shares, at Ariel Capital Management LLC in Chicago. ``Anyone who is making anything in China is going to have to dramatically increase the level of product testing.''

The company is recalling 967,000 Fisher-Price preschool toys sold in U.S. stores since May, including Elmo's Guitar, Dora's Talking House and 81 other products, the U.S. Consumer Product Safety Commission said yesterday.

``There can be no assurance that additional issues will not be identified,'' the company said in a regulatory filing today.

Mattel shares declined 40 cents, or 1.7 percent, to $23.18 as of 4:01 p.m. in New York Stock Exchange composite trading. The stock has gained 2.3 percent this year.

Tainted Products

U.S. officials have raised alarm about tainted products from China, which produces 80 percent of the world's toys, including seafood containing harmful drugs, toothpaste with an ingredient found in antifreeze and pet food containing a chemical used to make plastic.

President George W. Bush last month ordered the creation of a panel to study whether the U.S. needs more stringent safeguards for imported food and other consumer products.

Mattel, which also makes Barbie dolls and Hot Wheels cars, said the toys were made by a contract manufacturer in China that it didn't identify. The El Segundo, California-based company said it's investigating and plans to review manufacturing procedures for all its products made by vendors. About half of Mattel's toys are made in company-owned factories.

More Risk

The perceived risk of owning Mattel debt rose today, according to trading of credit-default swaps, financial instruments used to bet on its ability to repay its debt.

Credit-default swaps on $10 million of Mattel's bonds rose $1,500 to $34,000 in London. A decrease in the five-year contracts signals improvement in the perception of credit quality.

Mattel first learned of a potential problem in early July, according to Jim Walter, Mattel's senior vice president of worldwide quality assurance. It then began a so-called ``fast- track'' recall with the CPSC, its statement said.

No injuries have been reported from the recalled products, the CPSC said. The toys, many geared toward children ages 2 to 5, included dolls, stuffed animals and vehicles featuring Elmo, Big Bird and characters from Viacom Inc.'s Nickelodeon children's network, including Dora and Diego. Fisher-Price toys comprised one-fifth of Mattel's second-quarter sales.

Toys ``R'' Us Inc. removed the products from store shelves and its Web site a few days ago, said spokeswoman Kathleen Waugh. The company, the second-largest U.S. toy seller after Wal-Mart Stores Inc., is examining its safety and testing practices following recent recalls, she said.

Replacement Value

Lead may be toxic if ingested by children and can cause serious health effects, the CPSC said. Consumers should stop using the toys and contact Fisher-Price to arrange a return. They will receive a voucher for a replacement toy of similar value, it said.

Manufacturers of foodstuff, drugs, farm produce and health products that fail quality standards will be fined up to 200,000 yuan ($26,460), according to a Chinese government statement on July 26. Producers may have their licenses revoked and company officials may be jailed, the statement said.

``When it comes to things like food and children's toys, the level of consumer aversion to a health and safety problem is very high,'' said Alan Oxley, managing director of Melbourne-based ITS Global, which advises companies on trade policy.

Production Halt

Mattel stopped producing and shipping the affected toys and began an investigation around July 7, Walter said in an interview. Two-thirds of the toys never hit store shelves, according to spokeswoman Lisa Marie Bongiovanni.

The company has worked with the contract manufacturer for 15 years, said Walter. Mattel said it stopped producing toys with the manufacturer for now, pending results of the inquiry.

``We're taking a very aggressive, different look at the process that we have in place so we are not embarrassed in this form again,'' said David Allmark, general manager of the Fisher-Price Friends unit.

The recall is Mattel's biggest since 2.5 million Fisher- Price baby swings were taken off the market in 2000 after children fell out and were injured, according to CPSC spokesman Scott Wolfson.

Hasbro Inc., the world's second-largest toymaker, said today it screens and tests paint used at factories that make its products. Last month Hasbro recalled 1 million Easy-Bake Ovens after reports of burns. The ovens are made in China.

(For information about the recall should contact Fisher- Price at +1-800-916-4498 or http://www.service.mattel.com)

To contact the reporter on this story: Heather Burke in New York at Hburke2@bloomberg.net.

Last Updated: August 2, 2007 16:18 EDT