On the Subprime Endangered List

Who's next for the Prince treatment? Bear Stearns' Jimmy Cayne may be vulnerable

Which CEO will be catching subprime heat next now that Citigroup's Chuck Prince is out? It will likely come down to whose losses are biggest.

Given the $24 billion in writedowns from Citi, Merrill Lynch (MER ), and UBS (UBS ), Wall Street's nervous eyes are now fixed on Bear Stearns (BSC ), Lehman Brothers (LEH ), Goldman Sachs (GS ), and Morgan Stanley (MS ), all of which are due to report earnings soon. The firms have had relatively small subprime writedowns so far, but there's a growing sense that more are coming—a worry that continues to weigh on the market.

Bear Stearns' James E. Cayne may be the most vulnerable CEO. The cigar-chomping 73-year-old has come under fire for his distant management style while two Bear hedge funds imploded this summer. Bear's stock has fallen 39% this year, ranking just behind Merrill as Wall Street's worst.

His biggest test, though, may come next month when Bear reports its fourth-quarter earnings. The firm's pain has been limited so far, with just $700 million in writedowns. Yet during the housing heyday, Bear churned out billions in collateralized debt obligations (CDOs), those troublesome subprime-linked securities. David A. Hendler, an analyst with research shop CreditSights, estimates Bear could take a $3.2 billion hit in the fourth quarter. "It's the most vulnerable," says Hendler.

Bear's biggest problem may be its so-called Level 3 assets. That risky group includes all securities that require a lot of guesswork to value—such as mortgage-related debt and assorted corporate loans. Those hard-to-trade assets are susceptible to markdowns—and Bear has $20 billion worth. Bear has offered little hint about the type of Level 3 assets it holds, but analysts think the bulk are mortgage-related. In its recent conference call, Bear said it had $2.4 billion in subprime exposure.

For a company of Bear's size—its market value is roughly $15 billion, vs. $165 billion for Citi and $45 billion for Merrill—a $3 billion-plus hit would be disastrous. It would be nearly triple the $1.1 billion in net income Bear generated in the first nine months of the year. And it would likely tarnish its credit rating, signaling to lenders that the firm has a thinner cushion against potential losses. That, in turn, could make it harder and costlier for Bear to borrow the money it needs to run its day-to-day operations.

Bear isn't the only investment bank facing a possible reality check. Given 30% markdowns on some CDOs in recent weeks, there's a gnawing worry that Goldman, Morgan, and Lehman, which were also big players in those types of investments, will have to take sizable writedowns next month. Morgan Stanley held an impromptu teleconference on Nov. 7 to warn that CDO and subprime losses so far this quarter would reduce earnings by $2.5 billion. CreditSights' Hendler estimates Lehman's losses could approach $4 billion and Goldman's could top $5 billion. A Goldman spokesman said its subprime exposure is limited. Hendler says his estimates could change if the firms disclose more details.

All three firms, and their CEOs, are on better footing than Bear. Lehman earned $3.3 billion in the first nine months of 2007, and its market value is almost three times Bear's. Lehman recently said it held about $6 billion of subprime securities, or less than 20% of its Level 3 assets. Goldman, meanwhile, is a Street standout: Its shares are up 9% this year, and it has socked away $16 billion for bonuses and other compensation.

That doesn't mean their stock prices aren't at risk, however. Says analyst Roger Freeman of Lehman: "Given that all the credit skeletons are probably not out of the closet yet, the fear of the unknown could push stocks down further."

By Matthew Goldstein and David Henry

    Before it's here, it's on the Bloomberg Terminal.