An end to Wall Street's streak of rising profits in the third quarter is built into investor expectations, but the top brokerages' results will still face scrutiny next month to see just how they value assets bloodied by the summer market meltdown.
With turmoil in mortgage markets, a corporate credit squeeze and roller-coaster stock prices, investment bank earnings are expected to take a big hit in the quarter ending Aug. 31. Analysts and investors expect banks to write down mortgage securities, deal-related loans and various illiquid investments, reflecting their lower value as skittish investors flee to the sidelines.
"Business has been bad this summer," said Jon Fisher, who helps manage $1.2 billion for Fifth Third Asset Management in Minneapolis, adding that the market was "negative in June, negative in July and trending flat, at best, for August. The value of any debt instruments on their books, or any debt deal they were working on, has to be reduced."
Investors and analysts expect Goldman Sachs Group, Morgan Stanley, Lehman Brothers Holdings, and Bear Stearns, which report results next month, to reveal declines in fixed-income trading, debt underwriting and mortgages.
The big question, though, is how deep the write-downs will be. It's impossible to predict the actual damage, since much of Wall Street's business is hidden from view. Also, under accounting rules, firms value thinly traded securities based on their own assumptions.
But with dozens of hedge funds facing losses and margin calls in the past month, the Securities and Exchange Commission has been poking around the investment banks to see whether they value their own books the same as they do for clients.
The Financial Accounting Standards Board, the top U.S. accounting rules maker, also is focused on how banks value illiquid assets. "August 31 is coming up and we'll have to see what happens," FASB Chairman Robert Herz told Reuters last week.
Write-downs Are Coming
Recent news suggested that write-downs are coming. Lehman said Wednesday it will shut down subprime unit BNC Mortgage, resulting in 1,200 layoffs and a $52 million hit to earnings.
Banks are also expected to take losses on loans committed to leveraged buyouts. The LBO market has turned sour, as evident in private equity firms trying to slash their takeover price for Home Depot's supply unit by more than $1 billion.
As a result, analysts have been cutting their estimates.
"This is going to be difficult quarter for brokerage firms," Bernstein Research analyst Brad Hintz said, who trimmed his earnings estimates for the group.
Beyond credit woes and asset values, Wall Street's most reliable profit engines -- mortgages, leveraged lending, structured debt securities -- all sputtered.
There are also lingering worries that the losses that caused Goldman's Global Equity Opportunities fund to drop 30 percent in one harrowing week could also put a dent in its proprietary trading results, a key profit engine.
"We haven't yet seen the impact on the underlying business at investment banks," said Ben Wallace, an analyst at Grimes & Co, which manages $725 million. "The question is if they had the same losses in their proprietary trading. But no one knows what's going on in there. It's faith-based investing."
Indeed Wall Street firms routinely confound the naysayers, as proprietary trading and principal investments generate unexpected gains. Earlier this year, Morgan Stanley reported a mortgage profit when the subprime market began to melt down.
And some businesses remained strong. Equity trading and government bonds benefited from the extreme volatility, while stock underwriting held up well, analysts say.
Still, overall earnings likely suffered a big hit as the near-perfect conditions of the past three years were replaced by a more challenging environment.
"We may have seen in 2007 a peak in earnings," said Standard & Poor's equity analyst Matthew Albrecht, who sees earnings falling in 2008 and has sell ratings on Bear and Lehman shares.