Investment banks seen as 'ground zero' for 3Q

NEW YORK - Wall Street analysts have made some last-minute adjustments to their projections for how U.S. investment banks will fare during the third quarter, and the prognosis isn't all that good.

This past week, Banc of America Securities, Citigroup, and Sanford C. Bernstein & Co. all trimmed earnings estimates for investment banks with the most exposure to the debt market. The global credit turmoil of the past month has inhibited the companies' ability to underwrite bond offerings, and distressed subprime debt remains a worry.

With quarterly results scheduled to be released starting this week, investors, many of them lulled by last year's succession of record-setting profits, are clearly nervous. The reports will give Wall Street the insight it has sought to determine how much the banks have been hurt by the markets' upheaval.

"They are very close to ground zero to the issues that are causing pressure in stock prices, so the extent of those problems will become evident with the numbers being released," said Richard Cripps, chief market strategist for St. Louis-based brokerage Stifel Nicolaus. "Right now, we're in a transparency environment ... open the cupboards and let's see what the problem is."

Indeed, there has been a palpable worry on Wall Street that investment banks are carrying significant losses on their books and now must begin to disclose them. Subprime loans that were merely troubled in previous quarters might need to finally be written off. And, the third quarter could show how much companies have backed away from the normally lucrative business issuing debt in the fixed-income market.

Those worries were enough to make analysts cut projections for both Bear Stearns Cos. and Lehman Brothers Holdings Inc., which have been the two hardest hit on the Street. Goldman Sachs Group Inc., Morgan Stanley, and Merrill Lynch & Co. are considered to be in a stronger position.

Bear Stearns, the nation's fifth-biggest investment bank, announced during the quarter that two hedge funds it managed were rendered worthless through heavy bets on subprime mortgage securities. Lehman, the No. 4 investment bank, announced it was shuttering its subprime mortgage unit and cutting back positions globally.

Analysts said they will be looking to see if the investment banks' diverse mix of businesses - which also include takeover advice, foreign exchange, and equities trading - will be enough to offset the quarter's turbulence, especially Bear Stearns and Lehman Brothers.

"Given Bears' and Lehman Brothers' reliance on fixed income and other structured products, we expect these firms will face performance headwinds greater than their peers over the next two years," said Brad Hintz, an analyst with Bernstein.

Michael Hecht, an analyst with Banc of America Securities, also sees trouble ahead for the two firms. However, he remains somewhat upbeat that the third quarter might put investors more at ease amid all the uncertainty surrounding the financial sector.

"We expect the third quarter to be a stabilizing catalyst for the group," he said. "The outlook is favorable based on our view of above-average economic growth and upward-trending equity markets, particularly as the Fed's tightening cycle may be nearing an end."

He pointed out that the Federal Reserve's moves over the past month to inject liquidity into the banking system and cut the discount rate, the interest it charges banks to borrow money, also might add stability to quarterly results. The central bank will meet Sep. 18 to discuss cutting interest rates, which have been unchanged since last summer.

Beyond the Bear Stearns and Lehman Brothers results, Wall Street analysts have signaled they are most interested in seeing what Goldman reports. The nation's largest investment bank is considered to be the most diversified, and its bankers are seen as the brightest on Wall Street.

"If they had major problems during the quarter, then it will be a very clear sign for the financial markets," Cripps said.

Lehman Brothers will report earnings on Sep. 18, Morgan Stanley on Sep. 19, Bear Stearns and Goldman Sachs on Sep. 20. Merrill Lynch will report results in October.