Dec. 15 (Bloomberg) -- Goldman Sachs Group Inc. and Morgan Stanley may find that cutting more than 11,500 jobs, eliminating executive bonuses and reining in risk won’t help shareholders enough as the companies face another year of slumping revenue.

The Wall Street that the two New York-based firms dominated for decades vanished in September, when Lehman Brothers Holdings Inc. went bankrupt and Merrill Lynch & Co. sold itself to Bank of America Corp. Goldman Sachs and Morgan Stanley became banks and took $10 billion each from the U.S. government. Reversing their revenue slide next year will be difficult as the worst financial crisis since the Great Depression limits demand for investment banking services.

“There’s a more radical change in financial institutions today than there was in the early 1930s,” said David Dreman, 72, chairman and chief investment officer of Dreman Value Management LLC, which oversees about $11 billion and doesn’t own shares of Goldman Sachs or Morgan Stanley. “This isn’t an environment for risk-taking, which means the investment bankers are going to have major problems for a while.”

The two firms probably will report fourth-quarter losses this week on shrinking asset values and a decline in fees for businesses ranging from providing merger advice to trading and asset management, according to the average estimate of analysts surveyed by Bloomberg. The loss at Goldman Sachs may be $3.50 a share, the first since the firm went public in 1999. Morgan Stanley probably will report a loss of 19 cents a share, analysts estimate. Executives at the firms declined to comment.

No Revenue Growth

While the average estimate of analysts is for revenue growth at both companies next year, investors are giving little credit to those predictions. Analysts tend to change their estimates as the year progresses, and they rarely prove accurate. In the third quarter, Goldman Sachs’s revenue fell 4.1 percent below the average estimate of 12 analysts surveyed by Bloomberg, while Morgan Stanley’s was 25 percent higher.

“You’re not going to see revenue growth for three years,” said Michael Farr, president of Washington-based Farr, Miller & Washington LLC, which manages $500 million and holds Goldman Sachs shares. “Everyone’s very eager to have it behind us and think about how sunny it’s going to be, but the contraction isn’t done. It’s premature.”

While Michael Aronstein, chief investment strategist at Oscar Gruss & Son, a closely held broker-dealer in New York, foresees a stock market recovery in 2009, he doesn’t expect the big investment banks to benefit. That’s because their reputations have been blemished, he says, and they’re weighed down with illiquid debt securities such as collateralized debt obligations and leveraged loans that have been losing value.

Disastrous Year

“These guys are going to be dragging anchors for a long, long time,” Aronstein said. “These structural problems in finance and real estate, and in all these leveraged businesses, are not going away. They’re going to be with us for years.”

After plunging an estimated 43 percent in 2008, Goldman Sachs’s revenue from its core capital markets activities, including underwriting and merger advice, will drop another 8 percent in 2009, Michael Mayo, an analyst at Deutsche Bank AG in New York, wrote in a Dec. 9 report. Brad Hintz, an analyst at Sanford C. Bernstein & Co., expects the volume of announced mergers and acquisitions to drop 25 percent next year and a further 15 percent in 2010.

The fourth quarter has capped a disastrous year, in which Goldman Sachs and Morgan Stanley lost more than two-thirds of their market value. In the first nine months of the fiscal year, revenue at Goldman Sachs fell 32 percent from a year earlier and net income tumbled 47 percent to $4.44 billion. Morgan Stanley’s revenue dropped 20 percent in the same period, and earnings fell 41 percent to $3.96 billion.

Reducing Leverage

The days of borrowing $30 for every $1 of equity to make investments with the firm’s own money are over. At the end of August, Goldman Sachs had $23.72 of assets for every dollar of shareholder equity, while Morgan Stanley had $27.61 of assets per dollar of equity. Since then, leverage ratios have come down further because the firms boosted equity by selling preferred stock to the government, to Warren Buffett’s Berkshire Hathaway Inc. and to Japan’s Mitsubishi UFJ Financial Group Inc. Goldman Sachs also issued $5.75 billion of common stock to the public.

With the government as a shareholder and Federal Reserve examiners watching over them, both firms will reduce borrowing and take fewer risks with their own capital, say investors and analysts. Sanford Bernstein’s Hintz, the highest-ranked analyst covering the securities industry according to a survey of money managers by Institutional Investor magazine, expects the firms to reduce leverage to about 20 times equity or lower.

Morgan Stanley’s Focus

Principal investments and proprietary trading, where the firms put their own money at risk buying real estate, companies or securities, are among the businesses that Morgan Stanley says it’s scaling back to adapt to the new environment. Instead, Co- President James Gorman, 50, said at a conference in New York last month that the firm is focusing on client-driven businesses such as merger advice and trading currencies and commodities.

Goldman Sachs Chief Executive Officer Lloyd Blankfein, 54, said last month that the firm’s business strategy doesn’t need to change and that the company will continue to invest its own money, sometimes by participating in funds that it offers to outside investors. Blankfein said leverage “has not been the driver of our performance as a public company” and that Goldman Sachs can maintain its long-term returns on equity.

That statement has been questioned by analysts, including Hintz, who estimates that cutting leverage to 20 to 1 will erase 8.5 percentage points from Goldman Sachs’s return on equity.

Making Less Money

Without the income from leveraged investments, the firms will make less money and need to become smaller, said Martin Mayer, guest scholar at the Brookings Institution in Washington and the author of “The Bankers.”

“The big Wall Street houses relied on their ability to bet right more often than other people, and that continues to be a skill that’s there,” Mayer said. “But there’s a limit to how large a structure you can build on it. There will be need for the expertise that these guys have, but they won’t be paid anywhere near as well as they were.”

Morgan Stanley’s revenue from trading and investments fell 52 percent in the first nine months of fiscal 2008 from a year earlier, while investment banking revenue declined 31 percent and asset management 7.1 percent. Trading and investments revenue totaled $6.13 billion in the period compared with $7.74 billion from investment banking and asset management.

Goldman Sachs Revenue

At Goldman Sachs, trading and principal investments accounted for 68 percent of revenue in 2007, dwarfing the contribution from asset management and investment banking. In the first nine months of this year, revenue from trading and principal investments slid 45 percent, while investment banking dropped 26 percent and asset management rose 8.5 percent.

“I don’t think that revenue is going to swarm right back,” said Dreman. “We have a few years of plodding. Even if markets do come back, there’s still the fact that M&A is gone, and proprietary trading is probably gone for some time.”

Dreman has proven to be a better judge of the industry than some other investors recently. A year ago, when funds managed by T. Rowe Price Group Inc. and Legg Mason Inc. were buying stocks such as Lehman Brothers and Bear Stearns Cos., Dreman said it was better to stay on the sidelines because “we don’t fully know the extent of the banks’ subprime problems.”

The U.S. economy entered a recession a year ago this month, according to a committee of the Cambridge, Massachusetts-based National Bureau of Economic Research, making the contraction the longest since 1982. And a median estimate of 57 economists surveyed by Bloomberg News forecasts that gross domestic product will contract by 1 percent in 2009.

Shrinking Workforce

Revenue at both Goldman Sachs and Morgan Stanley fell during the last U.S. recession, which the NBER says lasted from March through November 2001. At Goldman Sachs, revenue was down 5 percent in 2001 and 12 percent in 2002, before reviving in 2003. At Morgan Stanley, it dropped 16 percent in 2001 and 13 percent in 2002.

If analysts’ fourth-quarter estimates are correct, Goldman Sachs’s 2008 full-year revenue will be $25.4 billion, and Morgan Stanley’s will be $26.8 billion, the lowest for both since 2005.

Both firms have been shrinking expenses by slashing jobs, compensation and borrowing costs. Goldman Sachs last month cut 10 percent of its employees, or about 3,200 jobs, which will bring total employment to about 29,300. That’s still more than the firm employed at the end of 2006.

Morgan Stanley last month said it would eliminate 10 percent of the jobs in its institutional securities division and 9 percent in asset management, while adding retail brokers and hiring two executives for a new push into consumer banking.

Blankfein, Mack

Blankfein and six deputies at Goldman Sachs gave up their bonuses this year. Of the seven, the pay of only four was disclosed last year. Blankfein, Chief Financial Officer David Viniar and Co-Presidents Gary Cohn and Jon Winkelried were awarded a combined $259 million in bonuses in 2007 on top of their $600,000 salaries.

Morgan Stanley CEO John Mack, 64, and Co-Presidents Gorman and Walid Chammah, 54, are giving up their bonuses, and the firm is cutting pay for the top 35 executives by an average 65 percent. Mack, who gets an $800,000 salary, didn’t receive a bonus for 2007 either, while Chammah was awarded $8.9 million in stock and Gorman received $7.98 million in stock. Cash bonuses for the two executives weren’t disclosed last year.

Robert Scully, 58, the former co-president who was Morgan Stanley’s highest-paid executive in 2007, announced his retirement last week after 12 years at the company and 34 years working at financial services companies.

Glory Days ‘Gone’

“Good people will start moving out of the industry,” Dreman said. “I don’t see the salaries in the investment banking area being anywhere near what they once were.”

Issuing AAA-rated government-guaranteed bonds is helping the firms lower their debt costs, which climbed in the wake of Lehman’s bankruptcy. That is partly offset by sales of high- dividend preferred stock to the government and investors.

“The question is what price is going to be exacted by the government and by the real world for the kind of insurance that all of these guys need now?” said Mayer. “My hunch is that price is fairly high and that the glory days of the Wall Street investment bank are gone.”

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

Last Updated: December 14, 2008 19:01 EST