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Brokerages Caught in a Bear Trap

Laurie Kulikowski

The stunning and sudden collapse of Bear Stearns(BSC Quote - Cramer on BSC - Stock Picks) has cast an ominous pall on Wall Street as the major brokerages report earnings this week.

The 85-year-old investment bank's stock has plummeted more than 90% from its Thursday close of $57, after a week of rumors about its shaky liquidity position -- and a host of denials from company officials -- ended Friday with a bailout by the Federal Reserve and JPMorgan Chase(JPM Quote - Cramer on JPM - Stock Picks). That turned out to be a prelude to a fire sale in which Bear on Sunday agreed to sell itself to JPMorgan for roughly $236 million, or just $2 a share, with the Fed backstopping illiquid mortgage-related assets. Shares recently were trading at $3.67.

Moreover, the Fed on Sunday cut the discount rate and extended discount-window borrowing to securities dealers, one of several dramatic recent moves to boost liquidity for Wall Street banks as securities tied to mortgages have become all but impossible to trade.

The liquidity concerns are weighing heavily on brokerage stocks Monday morning. Lehman Brothers(LEH Quote - Cramer on LEH - Stock Picks) shares are down more than 22%, after Moody's Investors Service affirmed its rating on Lehman's debt, but lowered its outlook to stable from positive. Goldman Sachs(GS Quote - Cramer on GS - Stock Picks) shares dipped more than 6% and Morgan Stanley(MS Quote - Cramer on MS - Stock Picks) stock was shedding about 9%. Lehman and Goldman are set to report earnings Tuesday morning; Morgan Stanley is slated to report Wednesday.

Bear Stearns has indefinitely postponed reporting its earnings, in light of the deal.

During the three-month period ending in February, the struggling capital markets continued to weaken, making it likely to see even further writedowns at the brokers, whose fiscal year ends in November. Not only are leveraged loans and collateralized debt obligations at risk for writedowns, but securities backed by commercial mortgages and other residential mortgages including Alt-A mortgages and certain prime loans also could inflict pain.

While the four securities firms will attempt to dress up their earnings, analysts predict an extended bleak outlook for the brokers. Earnings for the investment bank and brokerage industry in the S&P 500 index are expected to fall 62% from a year ago, according to Thomson Financial.

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Lehman is expected to record earnings of 72 cents a share, down 63%. Goldman is expected to earn $2.58 a share, down 61%, while Morgan Stanley is expected to make $1.03 a share, down 59% from last year.

"The outlook for the fiscal first quarter ending [in] February is looking pretty grim for the bulge bracket firms," writes Lauren Smith, an analyst at Keefe, Bruyette & Woods in a note earlier this month. Since mid-February, "we have witnessed continued weakness in investment banking as well as increased costs of risk management in the credit markets," she said.

Analysts are becoming increasingly concerned about any writedowns related to the brokers' commercial real estate exposures and other residential mortgages besides subprime.

"In [fourth quarter 2007] the writedowns were centered on subprime mortgages and asset-backed securities CDOs," David Trone, an analyst at Fox-Pitt, Kelton Cochran Caronia Waller, wrote in an early March note. "In [first quarter 2008] we project writedowns across leveraged loans and commercial mortgage (commercial real estate and [commercial mortgage-backed securities]) as well as more residential mortgages (Alt-A, subprime, non-U.S. mortgage and ABS CDOs.)"

He estimates the four brokers will take a combined total of $13 billion in gross writedowns (approximately $7 billion in net writedowns) for the quarter ($5 billion related to Alt-A loans, $4 billion related to remaining leveraged loan exposure and another $4 billion for commercial mortgage exposure). The brokers took a combined net total of $12.1 billion in the fourth quarter, according to Trone.

"Outside of writedowns in both quarters, our [first quarter 2008] composite revenue is 2% lower than the [fourth quarter 2007], reflecting lower projected principal investment gains and investment banking activities, mitigated by increased in equities, asset management and private client businesses," Trone added.

Commercial real estate exposures also pose a threat for the quarter.

"The commercial real estate market is showing evidence that it is suffering from some of the same excesses that plagued residential real estate like higher prices and more aggressive underwriting standards," KBW's Smith wrote. In addition, "[t]here has been significant deterioration in the market for commercial mortgage-backed securities as evidenced in part by the sharp decline in the CMBX index, which tracks the performance of commercial-real-estate bonds with different credit ratings."

Smith estimates that the brokers will mark down their commercial mortgage-backed securities by about 5%. She writes that Lehman has the most exposure to commercial real estate with $39.5 billion of whole loans and securities, while Bear has the least exposure of the four firms.

But to be fair, the commercial market is "unlikely to experience the same domino effect that we have witnessed in the subprime residential arena as CDO investments are not as prevalent in commercial mortgages," she cautioned.

Shares of Bear Stearns plummeted by more than 50% on Friday on news of the bailout. Lehman's stock fell by 11%. Other brokers including Goldman, Morgan Stanley and Merrill Lynch(MER Quote - Cramer on MER - Stock Picks) fell between 4% and 5% on Friday.

Perhaps the most disconcerting thing about the Bear Stearns news to shareholders of brokerages is how quickly things can change.

Bear Stearns executives said in a conference call that it was "comfortable" with the range of earnings estimates by analysts. Analysts polled by Thomson Financial expected the firm to post earnings of 84 cents a share for the first quarter, down 78% from earnings reported a year earlier.