Brokerages Could Take Hedging Hits

Ladenburg Thalmann's Richard Bove slapped sell ratings on Goldman Sachs, Lehman Brothers and Merrill Lynch.
By Laurie Kulikowski ,

Shares of several big brokerages were slipping after analyst Richard Bove reissued sell ratings on three Wall Street firms.

Bove, an analyst at Ladenburg Thalmann, cut his ratings to sell from neutral on

Goldman Sachs

(GS) - Get Report

,

Lehman Brothers

(LEH)

and

Merrill Lynch

(MER)

on the belief that the firms will have disappointing earnings throughout the rest of the year, mainly from lost money on hedging strategies.

The outspoken analyst -- normally a skeptic of the brokerages' business models, particularly as the credit and liquidity crisis intensified last year -- was more optimistic on the sector earlier this year. Bove has since retrenched on that optimism.

"At the moment it appears that the pressures on the brokerage industry have increased for multiple reasons," he writes in an industry note on Thursday. Most notable, "

while I remain convinced that the stress on the financial sector has been alleviated, I am just as convinced that the pressure on the economy has not eased."

In addition, "hedging has always been a 'hit or miss' activity for these firms because, in the main, they do not understand risk management," he writes. "It is askew once again."

Bove kept a neutral rating on

Morgan Stanley

(MS) - Get Report

for valuation reasons, he writes. He significantly lowered earnings estimates for the four brokers and cut his 12-month target prices on them.

Bear Stearns

(BSC)

, which is in the process of being acquired by

JPMorgan Chase

(JPM) - Get Report

, was not discussed in the published notes.

Goldman, Lehman, Morgan Stanley and Bear Stearns end their fiscal second quarters at the end of the month. Merrill's fiscal second quarter ends in late June. Analysts, on average, expect Goldman to post a quarterly profit of $3.61 a share, Lehman to post 64 cents a share, Morgan Stanley to post a profit of $1.08 a share, and Merrill to post a profit of 47 cents a share, according to Thomson Reuters. The Bear Stearns deal is expected to close in the beginning of June.

Goldman Sachs "now has $1.2 trillion in assets and it is simply too large to avoid the developments in the markets that it serves," Bove writes in a company-specific note.

The investment banking behemoth may not have been able to avoid losses related to hedging, due to "a notable divergence" in the cash values of many financial instruments vs. the values of financial indexes meant to mirror cash. Additionally, volumes in the markets outside of commodities and currencies fell, while investment banking activity has also weakened "as a consequence of developments in the equity and fixed income markets."

Merrill has also been unable "to avoid the disruptions in the cash and hedge markets that have developed in the past few months," he writes in a separate note. "The company is also likely to have been impacted by the weakness demonstrated in the volumes in the rate, credit, mortgage and alternative investment sectors."

Among other concerns he has with Merrill's business, Bove also cites weakness in the equity markets as a potential factor in forcing the firm to "cut back the size of its wealth management sales force," he writes. "In sum, Merrill's markets are not conducive to positive outlooks virtually anywhere."

Lehman may also be losing money from its hedges, from "shorting the popular financial indices and on its long cash position," he writes.

David Trone, an analyst at Fox-Pitt Kelton Cochran Caronia Waller, echoed similar concerns about Lehman in a separate note published Thursday.

"For the first time since the credit bust began, Lehman may post a loss

in the second quarter as it gives back a bit of its huge hedging gains from the last few quarters, as certain key indices rallied. However the asset values fell a bit further thanks to discounted bulk sales by peers," Trone writes in a note.

The analyst slashed his quarterly earnings estimate to a loss of 34 cents a share from an expected profit of $1.48 a share. Among other things, Trone expects Lehman to record $1.5 billion in gross writedowns on commercial mortgage backed securities, leveraged loans and Alt-A mortgages. He expects the company to record another $700 million in hedging losses this quarter.

"The recent rally in investment banks/broker stocks has fizzled," Trone writes, "and now turned south, supporting our concern that the group won't be able to muster a sustained rally in the face of negative economic and capital markets momentum." Still Trone prefers Lehman above the other bulge bracket firms.

Shares of Goldman, Lehman and Merrill were falling between 1.8% and 3% in recent trading, while Morgan Stanley's stock was flat.

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