Investment Banks' Kitchen-Sink Quarter

With expectations already low, Lehman Brothers, Morgan Stanley, and others are likely to throw out all the bad news they can find

Investment banks made a fortune during the years of easy credit, which helped fund everything from mortgages to leveraged buyouts. Now investors are steeling themselves for a rough week as the major investment banks are expected to report their worst profits in years. It looks like a kitchen-sink quarter. With expectations at rock bottom, banks are likely to throw in every bit of bad news (BusinessWeek, 9/10/07) they can find in hopes of laying the groundwork for a strong recovery. The tone was set by E*Trade Financial (ETFC) on Sept. 17, when the discount broker slashed its profit forecasts and set aside $345 million for bad loans and writedowns.

All of the numbers are pointing south for the banks' third-quarter reports. Lehman Brothers (LEH) kicked off the season on Sept. 18, posting a 3% decline in net income, to $887 million. Morgan Stanley (MS) is forecast to report an 11% decline the next day. On Sept. 20, Bear Stearns (BSC), which saw two of its hedge funds blow up over the summer (BusinessWeek, 9/24/07), is expected to announce a 40% tumble. Goldman Sachs (GS), which also reports Sept. 20, is the one major investment bank expected to report an earnings increase—but it isn't because the bank's operations are stellar: Goldman's profit boost is from the sale of a power plant in New Jersey. The largest investment bank also will have to answer questions about losses at its Global Alpha hedge fund. Merrill Lynch (MER) isn't scheduled to report until October, but it announced on Friday that it is writing down the value of some of its investments.

The main question now: Is Wall Street facing just one kitchen-sink quarter, or are there more to come? To a great extent investment banks are at the mercy of the finance markets, which are struggling to shake off the current crisis. "Investment banks are in a tough situation," says Steven Persky, founder and managing partner at Dalton Investments, a hedge fund in Los Angeles. "They earned lots of fees from underwriting subprime mortgages, packing those loans as securities, and underwriting leveraged buyouts. And they staffed up to deal with robust lending environments. Now we're seeing pain on Wall Street, and that pain will continue if financing markets don't open up."

Watching the Fed

Whether those financing markets will open up or not is the subject of intense debate. Buyout firms and banks are making compromises to save existing deals, such as the buyouts of First Data (FDC) and Home Depot's (HD) HD Supply unit. The decline in the short-term debt market, known as asset-backed commercial paper, is slowing, too. In that market, companies with less-than-perfect credit ratings can borrow for periods of a few days or a few weeks as long as they put up collateral. The volume of asset-backed commercial paper has declined from about $1.2 trillion to less than $1 trillion. The rate of decline is slowing, according to the latest report from the Federal Reserve. The market declined by about $14 billion in value last week on a nonseasonally adjusted basis, a smaller drop than over the summer. "We have seen the pace of shrinkage in the asset-backed commercial paper market go down.… The market is trying to stabilize," said Sherif Hamid, a credit strategist at Lehman. But those are incremental steps along the path to recovery.

One key factor will be the outcome of the Federal Reserve meeting, scheduled to be announced the afternoon of Sept. 18. The Fed is expected to lower the federal funds rate (BusinessWeek, 9/6/07) by a quarter of a point or perhaps a half-point. That could boost economic activity and possibly give a break to consumers with adjustable-rate mortgages that are about to reset. It also could lower costs for banks that must carry loans they can't sell on their books. That could help investment banks, too. "Economic growth will trend higher as the credit issues eventually ease, and our bet is that the shift in Fed policy will go a long way toward making that happen," said Robert Doll, vice-chairman at money manager BlackRock (BLK).

The hope on Wall Street is that the current fiscal crisis will follow patterns established in 1998 and 2001, when the Fed lowered rates and paved the way for strong recoveries. Former Fed Chairman Alan Greenspan noted that the market's behavior over the last few months reminds him of patterns in the financial crises of 1987 and 1998. "If that's right, then this is a big buying opportunity," said Ed Yardeni, an economist and market strategist in a Sept. 10 note to his clients. "In both financial crises, the Fed lowered the federal funds rate, the economy and profits continued to grow, and stock prices rose to new record highs once the financial panic subsided."

Tricky Balance

Some investors believe the Fed's strategy could backfire, however. They warn that a cut in short-term rates controlled by the Fed could lead to higher long-term rates. The concern is that international investors in countries such as China and Japan will lose confidence in the Fed's willingness to fight inflation and be less willing to buy U.S. debt. That would force the U.S. to boost the rates it pays on long-term debt to persuade investors to buy. Higher rates, of course, would boost costs for borrowers. And the value of the dollar would decline even further, making it more expensive for U.S. consumers and businesses to buy foreign-produced goods and services.

"I think the more the Fed cuts rates, the more painful it will ultimately be for the economy," said Nandu Narayanan, chief investment officer and founder of Trident Investment Management, a hedge fund with about $100 million in assets. Narayanan has profited from early calls (BusinessWeek, 8/27/07) on the troubled subprime mortgage market.

If 10-year Treasury rates rise from the current 4% range to the 6%-to-7% range, investment banks and other lenders could be in big trouble. Mortgage rates could rise in step, and the value of existing mortgages carried on lenders' balance sheets is pegged to the market for new loans. In other words, if the rates for new mortgages rise to 8% or 9%, the resale value of mortgages that carry interest rates of 7% declines, too. Banks must charge that loss to their earnings, in a process known as marking to market. If long-term rates rise, "banks could face huge losses," Narayanan said.

Investment banks may throw in everything plus the kitchen sink this quarter to account for their losses. But there may be still more bad news to add in the months ahead.