Caution: Crumbling Wall Street earnings ahead

Big brokerage houses expected to post poor results as the credit crisis claims Bear Stearns as a victim.

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By Tami Luhby, senior writer

NEW YORK ( -- This week's quarterly results were going to be bad enough for the major investment banks. But on Sunday, things got worse.

One of four companies scheduled to report results, Bear Stearns Cos., agreed to be sold for just $236 million, or $2 a share, to rival JPMorgan Chase after a serious liquidity crisis forced the firm to get an emergency loan late last week.

As a result, investors will be even more wary when Bear and the three other firms - Goldman Sachs Group Inc., Lehman Brothers Holdings Inc. and Morgan Stanley - put up their numbers and tell where they stand in the midst of the global credit crunch.

Far from winding down, as some of the optimistic had predicted last year, the credit crisis has engulfed even more sectors of the financial services industry since the start of 2008. Investors now are second-guessing the value of debt backed by student loans, municipal bonds, commercial real estate and even mortgages issued by Fannie Mae and Freddie Mac. On top of this, the trading of leveraged loans, a popular way for companies with weak credit ratings to finance the high-flying corporate buyouts of recent years, has lost its appeal.

"Clearly the business has deteriorated pretty significantly in just the last couple of months," said James Ellman, head of San Francisco-based Seacliff Capital, a hedge fund specializing in financial services. "It's probably not going to be pretty."

As the contagion spread, analysts started furiously lowering earnings expectations. Goldman (GS, Fortune 500), which had largely escaped the subprime mortgage bloodbath of 2007, started the year with analysts predicting first-quarter earnings would come in at $5.64, on average, according to Thomson Financial. Now, the average earnings estimate is $2.59.

Bear's (BSC, Fortune 500) earnings estimate has plummeted to 90 cents, from $2.06. Lehman's (LEH, Fortune 500) estimate shriveled to 72 cents, from $1.62, and Morgan's (MS, Fortune 500) to $1.03 cents, from $1.61.

The weak overall market is not making it any easier for the Wall Street firms. Mergers and initial public offerings have dried up, eliminating a source of lucrative fees the companies could have used as a buffer against loan losses. Also, last year's strong first-quarter performance will make next week's announcements look even worse.

"Comparisons are going to be a little bit tough," said Rose Grant, managing director at Eastern Investment Advisors, which owns shares of Goldman.

Goldman and Lehman expected to suffer

For a while late last year, it looked like Lehman and Goldman might sidestep the mortgage meltdown. The two firms had hedged their subprime mortgage positions to protect themselves if the housing market weakened. That allowed Lehman to report profits of $886 million and Goldman earnings of $11.6 billion for the fourth quarter, when their peers at Citigroup Inc. and Merrill Lynch & Co. suffered their largest quarterly losses ever.

But even Lehman and Goldman, which took relatively small $1.5 billion writedowns in the second half of last year, cannot not protect themselves against an across-the-board credit crisis, said Adam Compton, senior research analyst at RCM Capital Management, a San Francisco-based investment manager. Now that defaults are spreading to prime borrowers with good credit backgrounds, firms will have to take even greater writedowns on the value of their holdings.

"It's becoming pretty obvious the writedowns will be bad, and not just in subprime, but across the credit markets," Compton said.

The largest underwriter of mortgage-backed bonds, Lehman has already taken steps to streamline its operations, saying Monday that it is eliminating another 5% of its workforce, or about 1,400 jobs, on top of a similar reduction announced in January.

Lehman and Goldman will also suffer this quarter because they have among the largest leveraged loan portfolios on Wall Street and are big players in commercial real estate. This will result in first-quarter write-downs at the two firms of $1.6 billion and $3.2 billion, respectively, wrote Citigroup analyst Prashant Bhatia in a March 7 report.

Morgan Stanley may do better

Morgan, meanwhile, is expected to take a $1.2 billion writedown, as it takes more lumps from leveraged loans and mortgages, Bhatia said. But some analysts see Morgan faring better than its peers this quarter because it was more aggressive in writing down its subprime portfolio last quarter and its commercial mortgage-backed securities holdings are spread out internationally. Morgan last year took $10.3 billion in writedowns and reported its first-ever quarterly loss, of $3.6 billion, in December.

The firm's quarterly earnings may also be bolstered by strength in several areas, including in its brokerage and asset management divisions and in trading, Ellman said.

But last year's weak performance has prompted a shareholder drive against Chief Executive John Mack. An activist group representing union-sponsored pension funds is calling on Mack to explain how the firm managed its subprime mortgage-risk and is threatening to call for shareholders to vote against his election as chairman.

Bear Stearns crumbles

For Bear, there is no future - at least as an independent investment bank

Bear will be absorbed into JPMorgan Chase (JPM, Fortune 500) in a deal that's expected to close by the end of June. JPMorgan chief financial officer Michael J. Cavanagh said Sunday he expects Bear's various businesses to add about $1 billion a year in earnings once the two firms are consolidated sometime next year.

The end came relatively fast for Bear. The firm posted its first quarterly loss - $854 million - in its 84-year history in December and booted Chief Executive James Cayne soon after.

Questions about its liquidity prompted a deal with JPMorgan and the Federal Bank of New York to provide short-term funding, announced Friday. Chief Executive Alan Schwartz had dismissed the insolvency rumors earlier in the week, but said Friday the firm's liquidity position had "significantly deteriorated."

Bear's problem was that its business model relied on capturing revenue growth in the mortgage markets, wrote analyst Richard Bove of Punk, Ziegel & Co. in a report Tuesday. The credit crisis had driven up Bear's borrowing costs and left it with securities it needed to offload but couldn't sell.

"It may be that finding a merger partner is the best solution," Bove wrote.

It appears he was right. To top of page

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