Subprime and Wall Street's painful December

NEW YORK (Reuters) - Last December's profit feast on Wall Street has turned into a bowlful of mush.

Fiscal fourth-quarter results that will be reported over the next two weeks by Goldman Sachs Group Inc (GS.N), Lehman Brothers LEH.N, Bear Stearns Cos Inc BSC.N and Morgan Stanley (MS.N) are sure to sap Wall Street's holiday cheer. Unlike the third quarter, the full brunt of the credit crisis rattling the globe will be reflected.

Bear Stearns and Morgan Stanley are expected to lose money because of big write-downs on subprime-related securities. Meanwhile, analysts have cut outlooks for Goldman and Lehman.

The four companies last December reported combined net income of $6.9 billion. During year-ago conference calls, only Bear Stearns was grilled about subprime exposure, reflecting how unprepared analysts were for a crisis that would spread throughout Wall Street and the global economy.

"There will be no great Christmas on Wall Street this year," said Meg McMullen, president of New England Research & Management, which manages about $200 million.

Even as subprime defaults escalated throughout early 2007, Wall Street's biggest investment banks convinced investors their exposure to the risky loans was limited.

The conventional wisdom offered by executives was that even though their companies repackaged subprime loans and sliced them up into lucrative securities, they eluded risk because they sold them to institutional investors.

How wrong they were.

Some of the architects of the subprime mortgage crisis now face mega-write-downs, net losses and more high-profile ousters of top executives. Already gone from the CEO suite are Merrill Lynch's Stan O'Neal and Citigroup's (C.N) Chuck Prince.

And the problems are not contained to Wall Street. Subprime borrowers are losing homes so quickly that the White House wants to bail them out. UBS analysts estimate the potential cost of the U.S. subprime-related crisis at $605 billion for American and European banks.

Some analysts said they don't expect a recovery until the second half of next year, or not until Wall Street cleanses balance sheets loaded with subprime mortgage-related assets.

BOTTOM?

"We anticipate that timing to be nearer to the second half of 2008 than the first," CIBC investment banking analyst Meredith Whitney said in a research note.

Analysts cannot call the bottom of the crisis because Wall Street firms themselves are struggling to figure out the value of assets underpinned by subprime mortgages.

Multibillion dollar reductions in the value of collateralized debt obligations are expected in the fourth quarter and early 2008.

What's more, Wall Street faces problems with unfunded commitments on leveraged loans used for corporate takeovers. While some investment banks already have booked losses on these loans, another hit could be coming if market conditions continue to deteriorate.

UBS analysts estimated that another 5 percent hit to Morgan Stanley's LBO portfolio, for example, could reduce 2008 pretax profit by $1.6 billion. Under the same scenario, Goldman's pretax profit would slide by $2.1 billion.

Goldman Sachs brokerage and investment banking analyst William Tanona lowered his estimates on Wall Street company earnings for 2007, 2008 and 2009. He estimated that CDO write-downs will reduce the book value at Morgan Stanley, Bear Stearns and Lehman Brothers by 12 percent, 8 percent and 5 percent, respectively.

Merrill Lynch & Co Inc MER.N, whose fiscal year ends in December, could see a 23 percent reduction in book value from CDO write-downs, he said.

CRUZ QUESTIONS

The November 29 ouster of Morgan Stanley co-president Zoe Cruz has investors and analysts worried that the company's subprime problems may be bigger than previously thought.

Bernstein Research analyst Brad Hintz expects Morgan Stanley to write down $4.9 billion in the fourth quarter on further deterioration of the subprime and CDO markets.

Credit Suisse analyst Susan Roth Katzke expects Bear Stearns to lose $2.45 a share in the fourth quarter, or about $364 million.

In the year-ago quarter, Bear turned a $563 million profit. Bear's estimated loss would stem from subprime-related write-downs of $1.2 billion to $1.6 billion, according to the forecasts of analysts.

Even at Goldman Sachs, whose third-quarter profit growth dwarfed rivals, insiders are steering expectations to less stratospheric levels.

Deutsche Bank analyst Mike Mayo this week cut his earnings per share estimate for Goldman to $6 from $6.20, citing weaker trading of stocks, bonds and commodities.

"Goldman provides limited data on its trading revenues, which comprise two-thirds of total," Mayo said in a research note. "As a result, information risk is higher than for other (financial companies)."

Lehman Brothers is expected to post a profit, too, but industry-wide disruptions in fixed-income trading likely will weigh on results, analysts said.

Hintz, in a research note, said he believes the worst of this summer's credit crisis is past. He said fixed-income market conditions in the broader credit market have improved and investment grade corporate liquidity appears to be back to normal. But he also sees plenty of potential risk.

"If the fixed-income correction we are currently experiencing worsens into a long-term credit crunch and leads to a U.S. economic slowdown, the brokers will find high margin businesses such as M&A and IPO underwriting sharply declining," Hintz said.

"As unemployment rises, retail brokerage activity will slow and new investment flows into asset management businesses and retail brokerage accounts typically shrinks," Hintz said.

(Editing by Brian Moss)