Big banks on the chopping block

NEW YORK (CNNMoney.com) -- Wall Street is already betting that next week's earnings at the nation's biggest banks will be dismal. What remains to be seen is just how bad they will be.

"It's probably the most challenging quarter we've seen in a real, real long time," said Sharon Haas, a managing director for Fitch Ratings that covers North American banks.

Wall Street will be watching closely next week when four big banks report third-quarter earnings.

Right now analysts are expecting Citigroup (Charts, Fortune 500), JPMorgan Chase (Charts, Fortune 500), Washington Mutual (Charts, Fortune 500) and Bank of America (Charts, Fortune 500), all of which report results next week, to announce drops in quarterly earnings.

The subprime epidemic, which has spilled over from the housing sector into other areas of the economy since its outbreak this summer, has hit the financial services and banking sector particularly hard.

In recent years, banks made a killing off subprime mortgages - home loans made to borrowers with poor credit. Some of them, such as Citigroup, scored by slicing up and selling bonds backed by those same subprime mortgages. Savings and loans like Washington Mutual, which held such mortgages instead of carving them up into securities, got hurt when people began defaulting on their home loans.

The crisis only worsened when liquidity dried up in the credit markets, derailing the once booming private equity business and endangering the leveraged buyout deals that helped drive results at big banks such as Citi and JPMorgan.

To date, brokerages and banks have racked up nearly $20 billion in losses because of bad subprime bets. As a result, financial sector earnings are expected to decline by 4 percent during the third quarter, compared to the 34 percent growth rate seen during the same period last year, according to Thomson Financial.

Last week, Citigroup and Washington Mutual prepared investors for bad news, announcing a combined $3.7 billion worth of subprime-related writedowns and loan losses.

At the same time, JPMorgan Chase and Bank of America, which are set to report results Wednesday and Friday, respectively, have said nothing about their subprime exposure.

But some analysts, such as Sanford Bernstein's Howard Mason, have estimated that the two combined would report losses totaling more than $3 billion on leveraged loans and mortgage writedowns, with JPMorgan suffering the bigger hit.

Still, the expected loan and mortgage writedowns at JPMorgan and Bank of America will likely be offset by healthy performances in their other key divisions, such as retail banking.

"If there is a silver lining here, it is that even with substantial declines in profitability for the quarter, for many of these institutions, the quarter is still profitable," said Haas.

Of course, the biggest question is one that won't be answered next week: Is the worst of the subprime pain over for these banks and Wall Street?

There have been signs of improvement. The corporate debt market has picked up modestly. In addition, liquidity is returning to short-term lending - the Federal Reserve said Wednesday that the volume of outstanding commercial paper rose by $4.9 billion in the previous week - and banks are starting to move some of their leveraged loans.

But with the broader economy showing soft signs such as retail weakness, the housing market still struggling and mortgage delinquencies and foreclosures at high levels, many analysts are bracing for more struggles at least through the next quarter and possibly into 2008.

The outlook remains cloudy, most analysts say.

"What is it going to be like going forward?" said Frank Braden, an banking industry equity analyst with Standard & Poor's. "Is this the bottom, or are things going to improve from here?"