Dec. 11 (Bloomberg) -- After three years of record earnings, the best may have already come and gone for Wall Street.

Goldman Sachs Group Inc., Morgan Stanley, Merrill Lynch & Co., Lehman Brothers Holdings Inc. and Bear Stearns Cos. will be hard-pressed in 2007 to match this year's profits with the U.S. economy growing at the slowest pace in a year and interest rates rising in Europe and Japan. The companies also have to contend with a decline in trading of stocks on the Standard & Poor's 500 Index, a 15 percent drop in sales of mortgage derivatives and concerns about the record amounts of debt being used to finance takeovers.

``It's going to be harder and harder going forward for these firms to show the same rate of growth,'' said Frederick Lane, chairman and chief executive officer of Boston-based investment bank Lane, Berry & Co. and a former co-head of mergers and acquisitions at Donaldson, Lufkin & Jenrette Inc., which is now part of Credit Suisse Group.

Goldman, Morgan Stanley, Merrill, Lehman and Bear Stearns probably will report a 43 percent increase in combined net income this year to $29.1 billion, according to analysts' estimates compiled by Bloomberg. Profits at the top five New York-based firms may slip 0.1 percent in 2007, the first decline in six years. Analysts have underestimated earnings for the past five quarters.

Trading Revenue

``Trees don't grow to the sky,'' said Brad Hintz, an analyst at New York-based Sanford C. Bernstein & Co., who served as chief financial officer of Lehman from 1996 to 1998. ``We can all guess how this will end. We just can't guess when it will end.''

Merrill's Guy Moszkowski, the No. 1-ranked U.S. brokerage analyst by Institutional Investor magazine, estimates the combined profits of Goldman, Morgan Stanley, Lehman and Bear Stearns will fall 5.8 percent in 2007. Revenue will decline about 2 percent, compared with a 31 percent gain this year.

Trading revenue, which accounts for about half of the firms' total, will fall 3.7 percent next year, Moszkowski said. Revenue from investment banking, which includes securities underwriting and providing mergers advice, probably will rise 7.8 percent, he forecast. Asset management will gain 11 percent.

Investment banking executives, including Goldman CEO Lloyd Blankfein, say their traders thrive on price swings. The volatility of U.S. Treasury bonds slipped this year to the lowest in five years and is the lowest in a decade for U.S. stocks, reducing the firms' opportunity to make money on hedging and trading for clients and themselves. Trading volume in stocks on the S&P 500 fell in each of the past three months from a year earlier.

Mortgage Market

As for the U.S. economy, it expanded at an annual rate of 2.2 percent in the third quarter, down from 2.6 percent in the second quarter. A decline in homebuilding erased the most from the growth rate in almost 25 years.

That corresponded with a 19 percent decline in third-quarter sales of collateralized mortgage obligations from a year earlier and a 50 percent drop so far in the fourth quarter. The daily volume of mortgage trading, a market that's propelled earnings at Bear Stearns and Lehman in particular, fell from a year earlier in all but one of the eight months to Oct. 31.

Any reduction in industry earnings probably won't occur until the third quarter of next year, analysts estimate. It will be offset in part by a backlog of demand for initial share sales and mergers advice, two of the most profitable areas for securities firms, particularly in Europe and Asia.

``Mergers and acquisitions, the equity market, and the credit markets all remain robust and receptive, fueled by massive liquidity,'' Moszkowski wrote in a report on Nov. 17. ``Non-U.S. opportunities are seen as most compelling, providing increasingly meaningful diversification and growth.''

`Profit and Innovation'

In addition, firms derive a growing proportion of their revenue from fixed-income sales and trading, which encompasses uncorrelated markets for bonds, mortgages, currencies and commodities and their derivatives. Fixed income accounted for 37 percent of revenue at Goldman, Morgan Stanley, Lehman and Bear Stearns in the first three quarters, up from 16 percent of revenue at the peak of the previous cycle in 2000.

``The market over the last 24 months has come a very long way in profit and innovation,'' Neal Shear, 52, head of fixed- income at Morgan Stanley, said in a Dec. 7 interview. ``Continuing to grow at the market's current compound annual growth rate will prove difficult, but that doesn't mean Wall Street can't have good absolute increases in its numbers.''

Shares of the biggest U.S. and European banks are trading at an average 2.3 times book value, exceeding the historical norm of 2 times book, according to UBS AG analyst Glenn Schorr. Goldman is the most expensive of the top five U.S. brokers at 2.9 times book value and Bear Stearns is the laggard, trading at 2 times assets minus liabilities.

Goldman's Gains

The stocks are trading at about their average for the decade on a price-to-earnings basis, even as combined earnings almost quadrupled since 2001. Securities firms are trading at about 15 times earnings, Bloomberg data show.

``Goldman is getting close to being fully priced,'' said Doug Ciocca, who helps manage $650 million at Financial Advisory Service Inc. in Leawood, Kansas, which owns shares of Goldman and Morgan Stanley.

Shares of Goldman soared 58 percent in the past 12 months as earnings powered ahead on gains from fixed-income, currency and commodity trading. The firm probably will say tomorrow that fourth-quarter earnings jumped 88 percent to $3.06 billion, or $5.88 a share, from a year earlier, according to analysts' estimate compiled by Bloomberg. That would boost full-year profits to about $9.4 billion, more than the combined earnings of the top five firms in 2001. Goldman's stock rose above $200 last month for the first time, buoyed by optimism about earnings.

`Pretty Benign'

Blankfein, 52, told investors at a conference organized by Merrill in New York on Nov. 14 that ``all the visible indices look pretty benign right now.'' Even so, he joked about how he reminds employees at company meetings that they should never become complacent.

``I always tell the crowd: `Gee, I feel terrific, I feel really good. In fact, I haven't felt this good since August of '98,''' Blankfein said. ``And as you recall that was right before the default in Russia and Long-Term Capital and so again, things happen when they're least expected and they happen from unexpected quarters.''

Lehman, led by CEO Richard Fuld, may say Dec. 14 that profit gained 18 percent to $972 million, or $1.67 a share, and Bear Stearns CEO James Cayne probably will say the same day that net income rose 24 percent to $505 million, or $3.28, analysts estimate.

Outside the U.S.

Morgan Stanley CEO John Mack may say Dec. 19 that profit fell 26 percent to $1.83 billion, or $1.71 a share, from last year when the company had a $280 million tax benefit. Merrill reports fourth-quarter earnings next month.

Few industry executives and bankers are calling an end to the boom. At least 15 analysts, including Moszkowski and Hintz, lifted their estimates for fourth-quarter earnings during the past month, citing rising backlogs of takeovers and share sales.

``The industry is in great shape,'' Huw Jenkins, 48, chief executive officer of UBS's investment bank, said in an interview Nov. 28. Mark Shafir, 50, Lehman's head of mergers and acquisitions, said Nov. 30 that the record pace of takeovers probably will extend into next year as ``transaction sizes just seem to get larger and larger.''

Investment banks are increasingly looking outside the U.S. to spur growth. European acquisitions and share sales overtook those in the U.S. in the fiscal year ended in November as governments sold stakes and companies bought rivals in neighboring countries. The value of initial public offerings in China doubled to $46.6 billion, exceeding the value of deals in the top five European nations combined, Bloomberg data show.

Takeover Market

Goldman earns the most of its rivals outside the U.S., last year generating 42 percent of revenue in Europe and Asia. Morgan Stanley and Merrill both reached abroad for a third of revenue.

The value of announced corporate takeovers rose in fiscal 2006 to an all-time high of $3.56 trillion, beating the previous record of 2000 by 21 percent, Bloomberg data show. Equity sales jumped 23 percent to a record $548 billion.

``The overall environment for investment banking is probably a little bit slower next year and there will be fewer mega deals,'' said Mark Machin, 40, Goldman's co-head of Asia investment banking excluding Japan, in an interview. ``We'll still see a robust environment as the underlying economies remain quite strong, particularly in China.''

The biggest risk to earnings is macro-economic instability and the threat of higher borrowing costs, said Benjamin Wallace, who helps manage $600 million at Westborough, Massachusetts-based Grimes & Co., which owns shares of Morgan Stanley.

Derivatives Trading

Bill Gross, chief investment officer of Pacific Investment Management Co., the world's biggest bond fund, said Dec. 1 that a rally in investment-grade corporate bonds may be at an end. Gross said a jump in derivatives trading is distorting debt prices even as the U.S. economy slowed to a rate that can't sustain current profit and job growth. The Federal Reserve hasn't raised rates since June, after 17 increases since mid-2004.

The European Central Bank boosted interest rates on Dec. 7 for the sixth time in a year to keep stronger economic growth from fueling inflation. The Bank of Japan in July raised rates for the first time in almost six years, forecasting sustained growth in the world's second-largest economy and an end to a decade of deflation.

UBS's Jenkins said the amount of debt that leveraged buyout firms can take on may be reaching an upper limit. Company leverage in Europe reached a 10-year record in April, when buyout firms borrowed the equivalent of six times the annual cash generated by companies they acquired, Standard & Poor's reported.

Record LBOs

``This is sustainable in this market, but this market is as good as it gets,'' Jenkins said. ``If there were to be any significant rise in interest rates or widening of credit spreads, it wouldn't be sustainable.''

Record LBOs have prompted scrutiny from regulators, including the U.K.'s Financial Services Authority, which last month said it's monitoring bank loans used to fund buyouts.

High-yield debt offerings from companies with the lowest credit ratings rose 45 percent this fiscal year to $194 billion, according to Bloomberg data. At the same time, the sale of international bonds has declined since reaching a record $862 billion at the start of the year.

``You actually will have seen peak earnings power in the first half of 2006,'' said Charles Peabody, an analyst at New York-based Portales Partners LLC, who recommends selling all of the broker stocks. ``While fixed income has not collapsed the way we thought it would this year, it has acted as a drag. We think fixed income will turn into being a big negative.''

`Turning Point'

Goldman, Morgan Stanley and Deutsche Bank AG are among investment banks that have hired distressed-debt bankers and traders to prepare for a rash of bankruptcies.

``Three months ago, we, along with other pundits, were pondering if the third quarter of 2006 would prove to be a turning point,'' Bank of America Corp. analyst Stan August wrote in a note to investors Dec. 1. ``Any further notion of such an occurrence has been quickly and decisively obviated by a fourth quarter that can best be described as a blowout.''

Goldman still leads the pack, generating higher profit with about half as many employees as Morgan Stanley and Merrill, the second- and third-biggest firms by market value.

``The fundamentals of the brokers remain strong,'' said Mark Bronzo, who oversees about $750 million as managing director of Irvington, New York-based Gartmore Separate Accounts LLC, which owns shares of Goldman and Lehman. ``M&A activity is extremely strong, IPO activities remain strong, fixed-income issuances remain strong, and trading results have been very, very good.''

To contact the reporter on this story: Adrian Cox in London at acox2@bloomberg.net.

Last Updated: December 10, 2006 19:11 EST