June 11 (Bloomberg) -- Never mind that Wall Street's profit growth in the second quarter probably was the worst in two years. A new regulation relieving capital restraints may enable the biggest U.S. securities firms to make the rest of 2007 exceptional for shareholders.

Goldman Sachs Group Inc., Morgan Stanley, Merrill Lynch & Co., Lehman Brothers Holdings Inc. and Bear Stearns Cos. have the potential to earn $4.4 billion more annually as early as next year by moving money out of safe investments into higher- returning bets, said Dorothy Leas, a former treasurer at Paine Webber Group Inc. and Cowen Group Inc. The earnings gain, which would equal 14 percent of the New York-based firms' record profits of 2006, follows a rule change that allows them to hold less money in reserve for potential losses.

Investors are underestimating the benefits of ``alternative net capital requirements,'' a regulation passed by the Securities and Exchange Commission in 2004 to keep Wall Street firms competitive with their counterparts in the European Union, said Brad Hintz, an analyst at New York-based Sanford C. Bernstein & Co. Profits will get a boost in the second half of 2007, depending on how fast the five firms shift their capital, he said. U.S. commercial banks are receiving a similar break from the Basel II agreement, set to take effect as early as next year.

``They're all increasing capital at risk because the new capital requirements allow it,'' said Hintz, a former chief financial officer at Lehman. ``As the transition to the new capital rules is completed, they'll have more room to do so, and that will help their profit.''

Old Regime

Goldman, Morgan Stanley, Merrill, Lehman and Bear Stearns, the only firms cleared by the SEC to adopt the new capital- adequacy standards, declined to make executives available for comment.

Under the old regime, securities firms had to reserve a set percentage of every dollar of capital at risk to ensure solvency in the event of a market collapse or failure of a major client. At the end of every week, each firm would calculate the difference between what it owes and what it's owed and have to keep cash on hand to cover any net liabilities.

The new rule takes a more nuanced approach. Reserves are determined according to a combination of risks including losses from credit deterioration, adverse market movements, inadequate internal controls and changes in legislation. They permit securities firms to use non-cash assets, such as derivative contracts, to offset risk.

Risk Management

``Basel II has increased the amount of risk, but that's not troubling,'' said Charles Whitehead, associate professor of corporate law at Boston University. ``There's a large focus on enterprise-level risk management. And the broker-dealers are the pioneers of that because they need to do it best before they can provide the same services to their clients demanding it.''

Hintz expects most of the money that gets freed up as a result to go toward trading or principal investments. Those businesses have fueled a tripling in Wall Street earnings since the investment-banking slump of 2001 and 2002 and now account for about 50 percent of revenue, up from 40 percent two years ago. At Goldman, Wall Street's biggest trader by revenue, they provided 71 percent of the firm's first-quarter revenue.

``The main drivers for surging profits are still in place,'' said Bill Fitzpatrick, who helps manage more than $1 billion at Johnson Asset Management and owns shares of Morgan Stanley and Bear Stearns. ``They're using their own capital and increasing leverage, and as long as funding costs are low, that's very profitable.''

Levering Up

Shares of all five firms rose today. Lehman advanced 2 percent to $75.68, while Morgan Stanley gained 1.7 percent to $88.54. Goldman, Merrill and Bear Stearns all climbed less than 1 percent.

Securities firms, like hedge funds, borrow against their unreserved capital to boost returns. Leas, who in the 1980s served as treasurer of Paine Webber, a Wall Street brokerage that's now part of Switzerland's UBS AG, and held the same role at New York-based Cowen in the 1990s, said leverage, or assets relative to shareholders' equity, may increase to 29.6 times from 25.8 at the end of last year.

That would represent $539 billion in additional borrowing, based on current figures for shareholders' equity. If the firms earned the same 0.82 percent return on assets that they did last year, the increase in leverage would produce $4.4 billion in additional profits.

``This is the earnings potential if they use all the leeway from the new regulations,'' Leas said. ``It's not going to happen overnight, but more likely in a year or two.''

Credit-Rating Hurdle

For now, the SEC's rule change isn't sending earnings to new highs. Goldman, Morgan Stanley, Lehman and Bear Stearns, the four firms that report this month, will post a 3.5 percent increase in combined earnings for the three months ended in May, according to analysts' estimates compiled by Bloomberg. That would be the smallest profit gain in two years. Merrill reports in July.

Analysts expect earnings in the second half to surpass last year's record of $11.7 billion by 2 percent, the survey shows.

Credit-rating services may limit Wall Street's ability to take advantage of the relaxation in capital-adequacy rules. William Forsell, a former Morgan Stanley executive who was involved in talks that set the new standards, said that by increasing leverage to the maximum available under the SEC's new rules securities firms would risk a downgrade by Standard & Poor's or Moody's Investors Service.

Any reduction in credit ratings would increase the cost of borrowing and crimp earnings.

``Rating agencies aren't totally comfortable with this yet,'' Forsell said.

Tolerance Tested

S&P, which raised Goldman and Merrill to AA- from A+ and Bear Stearns to A+ from A in October, considers Basel II insufficient because it allows firms to calculate their own risk, leading to inconsistencies and difficulty in making comparisons. The agency in January said that it will continue using its own models to assess capital adequacy, though it's also drawing on contributions from financial-services firms as it considers revisions.

``We haven't changed our standards,'' Scott Sprinzen, chairman of S&P's new instruments committee, said in an interview last week. ``There's an active dialogue regarding that, but we haven't relaxed our standards yet.''

Leverage ratios show that Wall Street already is testing S&P's tolerance. The average leverage at the five biggest firms climbed to 26.9 in the first quarter from 24.6 at the end of 2005, as the firms began adjusting to the SEC's new capital requirements.

`Great Debate'

The increase explains why trading and principal investing have become the industry's dominant moneymakers, said Richard Bove, an analyst at Punk Ziegel & Co. in Lutz, Florida.

``The great debate is whether the risk-management mechanisms that the firms have in place do actually eliminate risk,'' Bove said. ``The pendulum has swung in the direction of less regulation, and the softening of capital requirements is part of that.''

David Hendler, an analyst at CreditSights Inc. in New York, is skeptical that securities firms will reserve enough when there's so much money to be made by adding leverage and taking risks. Now that so much of their investments are in hard-to-sell assets, such as real estate, ``you can argue that their capital isn't liquid enough for the types of risks they face,'' Hendler said.

Stock prices show that investors agree. Goldman, Morgan Stanley, Merrill, Lehman and Bear Stearns trade at about 11 times earnings, compared with an average of 17.7 for companies in the S&P 500 index. The firms' price-to-earnings ratio has declined from about 13 four years ago, when trading and principal investing made up only 25 percent of revenue.

``The leverage ratios are reflected in the earnings multiples,'' said Johnson Asset's Fitzpatrick.

To contact the reporter on this story: Yalman Onaran in New York at yonaran@bloomberg.net

Last Updated: June 11, 2007 16:16 EDT