Investment Banks' Kitchen-Sink Quarter

With expectations already low, Lehman Brothers, Morgan Stanley, and others are likely to throw out all the bad news they can find

by Steve Rosenbush

Investment banks made a fortune during the years of easy credit, which helped fund everything from mortgages to leveraged buyouts. Now investors are steeling themselves for a rough week as the major investment banks are expected to report their worst profits in years. It looks like a kitchen-sink quarter. With expectations at rock bottom, banks are likely to throw in every bit of bad news (BusinessWeek, 9/10/07) they can find in hopes of laying the groundwork for a strong recovery. The tone was set by E*Trade Financial (ETFC) on Sept. 17, when the discount broker slashed its profit forecasts and set aside $345 million for bad loans and writedowns.

All of the numbers are pointing south for the banks' third-quarter reports. Lehman Brothers (LEH) kicked off the season on Sept. 18, posting a 3% decline in net income, to $887 million. Morgan Stanley (MS) is forecast to report an 11% decline the next day. On Sept. 20, Bear Stearns (BSC), which saw two of its hedge funds blow up over the summer (BusinessWeek, 9/24/07), is expected to announce a 40% tumble. Goldman Sachs (GS), which also reports Sept. 20, is the one major investment bank expected to report an earnings increase—but it isn't because the bank's operations are stellar: Goldman's profit boost is from the sale of a power plant in New Jersey. The largest investment bank also will have to answer questions about losses at its Global Alpha hedge fund. Merrill Lynch (MER) isn't scheduled to report until October, but it announced on Friday that it is writing down the value of some of its investments.

The main question now: Is Wall Street facing just one kitchen-sink quarter, or are there more to come? To a great extent investment banks are at the mercy of the finance markets, which are struggling to shake off the current crisis. "Investment banks are in a tough situation," says Steven Persky, founder and managing partner at Dalton Investments, a hedge fund in Los Angeles. "They earned lots of fees from underwriting subprime mortgages, packing those loans as securities, and underwriting leveraged buyouts. And they staffed up to deal with robust lending environments. Now we're seeing pain on Wall Street, and that pain will continue if financing markets don't open up."

Watching the Fed

Whether those financing markets will open up or not is the subject of intense debate. Buyout firms and banks are making compromises to save existing deals, such as the buyouts of First Data (FDC) and Home Depot's (HD) HD Supply unit. The decline in the short-term debt market, known as asset-backed commercial paper, is slowing, too. In that market, companies with less-than-perfect credit ratings can borrow for periods of a few days or a few weeks as long as they put up collateral. The volume of asset-backed commercial paper has declined from about $1.2 trillion to less than $1 trillion. The rate of decline is slowing, according to the latest report from the Federal Reserve. The market declined by about $14 billion in value last week on a nonseasonally adjusted basis, a smaller drop than over the summer. "We have seen the pace of shrinkage in the asset-backed commercial paper market go down.… The market is trying to stabilize," said Sherif Hamid, a credit strategist at Lehman. But those are incremental steps along the path to recovery.