Wall Street icons likely to bleed red ink

Analysts continue to slash quarterly estimates for battered Wall Street duo Goldman Sachs and Morgan Stanley; losses now expected for both firms.

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By David Ellis, CNNMoney.com staff writer

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Goldman Sachs and Morgan Stanley shares have been hit hard amid the massive upheaval in financial services.
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NEW YORK (CNNMoney.com) -- The outlook for the once venerated investment banks Goldman Sachs and Morgan Stanley has turned increasingly bleak.

Industry analysts have slashed their fourth-quarter expectations for the two Wall Street firms in recent weeks as the financial markets remain under severe strain.

Just two weeks ago, Morgan Stanley (MS, Fortune 500) was expected to report a narrow profit, according to the consensus view of analysts polled by Thomson Reuters. Now, analysts are betting the former stand-alone investment bank, which is due to report results on Wednesday, will post a loss of $351 million, or 37 cents a share.

Analysts fear the worst for Goldman Sachs (GS, Fortune 500) as well. The firm is expected to report a loss of $1.45 billion, or $3.50 a share, when it reports its quarterly results Tuesday. Two weeks ago, analysts were forecasting a loss of $900 million, or $1.82 a share. A loss by Goldman Sachs would be the firm's first since it went public in 1999.

Trouble spots

Both firms have been hit hard by the credit crisis of the past few months.

Trading desks have been whipsawed by extreme volatility in both the equity and commodity markets. Their prime brokerage divisions, a key business for both firms that caters to hedge funds, has come under strain as an increasing number of hedge funds face liquidation or investor redemptions. And fixed income activity remains at a standstill as credit markets remain relatively frozen.

Merger advisory activity has also dried up as businesses across all industries have resisted making any strategic moves. Mergers and acquisition activity is down about a third from a year ago, both domestically and internationally.

And many companies that agreed to acquisitions earlier this year have since suffered a severe case of buyer's remorse, effectively taking billions of dollars off the table for advisory businesses of Goldman Sachs, Morgan Stanley and their investment banking rivals.

Of the more than 1,200 deals that have collapsed so far this year, about a third involved an advisor, according to research firm Dealogic.

"Essentially the flow of business has stopped," said Ryan Caldwell, portfolio manager at Waddell & Reid Financial, which oversees about $14 billion in assets, and owns shares of Goldman Sachs.

Both Goldman and Morgan are also likely to report severance charges this quarter as a result of recent cuts in staff. But each firm is coping with its ailments specific to them as well.

Goldman Sachs is widely expected to take a hit as a result of its equity stake in Industrial and Commercial Bank of China. Shares of the Chinese bank have lost close to a third of their value through November.

There has also been speculation that the 139-year-old firm's proprietary trading operations, which uses the firm's own money to make investments, will weigh heavily on the Goldman's results.

"No one is ever really sure how they made their money with proprietary trading and I think it is fair to say this time it is going to be more challenging to do so successfully," said Les Satlow, a portfolio manager at Money Management in Salem, Massachusetts, whose firm recently sold shares of Goldman Sachs.

Morgan Stanley, on the other hand, has suffered from weakness across its private equity portfolio, analysts have warned. In a note to clients earlier this week, Keefe Bruyette & Woods analyst Lauren Smith said she expected the company to write down at least $1 billion during the quarter as a result of that exposure.

Writing it all down

It doesn't help that both firms are also sitting on massive portfolios laden with securities that continue to tumble in value, such as those backed by residential and commercial real estate loans.

Some analysts have warned that the two firms may be forced to writedown as much as $5.5 billion combined to reflect the lower value of those assets.

Still, both firms managed to raise capital during the quarter by selling stock in an effort to cope with additional deterioration across their books.

Goldman Sachs sold preferred stock to Warren Buffett's Berkshire Hathaway (BRKA, Fortune 500) in late September in exchange for $5 billion.

Morgan Stanley quickly followed that up with a deal that allowed the Japanese financial firm Mitsubishi UFJ (MTU) to take a 21% stake for $9 billion.

Each company also received $10 billion from the Treasury Department as part of the governments bank bailout.

But with it becoming increasingly difficult for banks to raise more capital in this market, experts are skeptical that Goldman and Morgan will aggressively writedown the value of those troubled assets just yet. Instead, the two firms could wait to do that when they report results again in January.

As a result of their conversion to bank holding companies, both Goldman and Morgan will have to report fourth-quarter earnings again for the month of December, what some analysts have termed a "stub" period.

"I think they 'kitchen sink' the stub month in order to clear out expenses and do a lot of heavy lifting they don't want to do in the reported quarter," said Waddell & Reid's Caldwell.

Either way, investors are not hopeful of a turnaround for the firms anytime soon. Goldman's stock has fallen 14% so far this month and is down more than 68% this year. Shares of Morgan Stanley are down 6% in December and have plunged 73% year-to-date. To top of page

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