Earnings: Investment Banks Feel the Chill

Analysts' profit predictions for Wall Street titans keep falling as the credit crisis drags on

The holidays may be around the corner, but the bigwigs who run Wall Street are feeling anything but merry. And there's now a growing belief that giants like Goldman Sachs (GS), Merrill Lynch (MER), Lehman Brothers (LEH) and Morgan Stanley (MS) will continue to feel the pain from the credit crisis for months to come.

A JP Morgan (JPM) analyst, Kenneth Worthington, said Dec. 4 that he now expects lower earnings from those four stocks in future quarters. But those four are certainly not the only large financial stocks under pressure, with Citigroup (C), Bear Stearns (BSC) and Worthington's firm JP Morgan also feeling the pain.

Expect top firms to continue to take losses from exposure to risky credit derivatives tied to the mortgage market, Worthington writes.

In the short term, however, more writedowns might not hurt the big firms' stocks. That's because investors expecting the worst may be relieved to learn the actual extent of losses.

However, Worthington adds, "Large writedowns reflect failed risk management and business strategies and should negatively impact valuation longer term." In other words, the stocks may continue to pay for years for mistakes that led up to the 2007 credit crisis.

The credit crisis has had wide effects, including a sharp slowdown in the previously booming mergers-and-acquisition craze.

On top of steep credit losses, fewer deals will hurt profits because the big firms had raked in huge returns from M&A activity, Worthington writes.

The financial sector as a whole — judging by the Financial Select Sector SPDR (XLF), an ETF or electronically traded fund made up of a wide variety of financial stocks — is already down 20% in the last six month. Financials have felt the most pain more recently, as the mortgage-backed debt crisis seems to drag on and on. The financial ETF hit a two-year low on Nov. 23.

On Dec. 4, following Worthington's report, the financial sector ETF was down another 1.5%.

Along with Worthington, many other analysts are expecting big drops in financial sector profits. In the fourth quarter, analysts expect earnings of the broad S&P 500 to increase 2.1%, according to Reuters Estimates. But financial sector earnings are expected to fall 33% this quarter, even worse than the 28% drop in the volatile third quarter.

However, there are bright spots. Trading volumes at the big brokers are still "robust," Worthington writes, and commodities and currency trading is especially strong.

Also, all the Wall Street firms have pushed to expand internationally. Strong growth in Europe and Asia should help make up for weakness at home.

Worthington's favorite is Goldman Sachs, "the most diversified by product and geography and the least dependent on the mortgage business."

Lehman Brothers is a mixed bag, he says. He praises its culture and its ability to manage the crisis so far, but Lehman has a lot of exposure to both U.S. debt and equity markets. Merrill Lynch may take "two or three quarters to recover" from its $8.4 billion in write-downs last quarter, and Worthington gives Morgan Stanley a similar amount of time to recover from its credit woes.

The big question market for many financial sector analysts is the future direction of interest rates. Financial stocks recently rallied a bit on increased speculation that the Federal Reserve would cut rates again at a Dec. 11 meeting.

Another rate adjustment, especially an unexpectedly large cut, could help financial stocks even more. But the very need for more rate cuts reflects a troubling reality: A weak economy and market turbulence may sap financial earnings for quarters to come.

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