Probe Said to Be Squeezing LaBranche - TheStreet

Probe Said to Be Squeezing LaBranche

The firm's warning could reflect new conservatism in the face of the specialist investigation.
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Structural change arrived at the

New York Stock Exchange

even before John Reed.

At least that's how some are interpreting Wednesday's third-quarter profit warning from

LaBranche

(LAB)

, which expects earnings to come in about 80% below expectations.

Skeptics contend the specialist firm has become less aggressive in its proprietary trading because of an ongoing regulatory investigation into the trading practices of it and other Big Board market-makers.

LaBranche, which now expects to earn between 3 cents to 5 cents a share in the quarter, used half the space of its preannouncement release to deny the probe was hurting it at all. The firm said the investigation's impact on its earnings is "statistically insignificant" and is focusing on "a very small fraction" of the firm's trading activity.

Rather, LaBranche blamed its woes on a lack of volatility in the equity markets, which reduced its need to step in as a "principal" and make trades to stabilize prices in a given stock.

Specialist firms, which earn a commission for matching buyers and sellers, also make money from trades made to smooth fluctuations in stock prices. The firms also are permitted to make proprietary trades for their accounts, but not at the expense of any customer.

But skeptics contend the investigation into the trading practices of some specialist firms must be hurting LaBranche more than it's letting on.

"The company blamed tougher trading conditions, but we suspect controls on LAB's actions as the culprit," said Egan Jones Rating, a small corporate debt rating agency in a new research report. "NYSE investigations are bound to restrict the volume and nature of trading activities."

Richard Repetto, a brokerage analyst with Putnam Lovell Securities, reached a similar conclusion. While Repetto noted that volatility in the stock market did decline in the third quarter, he said the investigation has led to more "conservatism" by specialists in making trades and taking proprietary positions in stocks.

"We believe the impact on traders' behavior and the distraction the investigation has caused is much more material,'' said Repetto, in a research note.

What isn't in dispute is that LaBranche's warning is a big miss. The Thomson First Call consensus estimate had the firm earning 17 cents a share in the quarter.

Investors also weren't in a mood to quibble over the reason behind LaBranche's poor performance. In midday trading, the stock was down $1.13, or nearly 8%, to $13.47.

The warning couldn't have come at a worse time for LaBranche, which has seen its stock fall nearly 29% since the controversy over Richard Grasso's eye-popping $139.5 million pay day began making headlines last month. The selloff picked up steam following Grasso's resignation as NYSE chairman and chief executive because Grasso was seen a big defender of the specialist system.

With Grasso gone and Reed promising to make changes in the way the NYSE is run, some are predicting specialists will lose some of their franchise in controlling Big Board trading. Grasso was a strong defender of the specialists against the encroachment of more modern electronic trading systems, which usually can execute trades faster than the specialists.

Besides LaBranche, which oversees trading in about a quarter of the Big Board's listed stocks, there are six other major specialist firms. They include

Goldman Sachs'

(GS) - Get Report

Spear Leeds unit;

Van Der Moolen Specialists

(VDM)

;

Bear Wagner

;

Performance Specialist Group

;

Susquehanna Specialists

; and

FleetBoston's

(FBF)

Fleet Specialists. (

Bear Stearns

(BSC)

is a partner in Bear Wagner.)

Shares of Van Der Moolen, the only other freestanding, publicly traded specialist firm, were off 22 cents, or 2%, to $10.

The irony is that LaBranche's earnings miss comes at a time that the stock market has been posting big gains. Just last week, three Wall Street firms, Goldman Sachs,

Lehman Brothers

(LEH)

and

Morgan Stanley

(MWD)

, each reported a rebound in equity trading, as they posted better-than-expected third-quarter earnings.

Yet the renewed interest in stocks isn't helping LaBranche. The firm said principal trading volume, which includes trades for the firm's own account, totaled about $176 billion for the third quarter, down from $247 billion in the year-earlier quarter. The third-quarter activity is also down from the second quarter, when principal trades totaled $188 billion.

The firm now estimates that principal trading revenues in the quarter will be $40 million, about $16 million less than most analysts were looking for.

Critics of the specialist system contend that firms like LaBranche, which currently trades below its book value of $15.72 a share, may have more earnings disappointments to come. They predict that new trading technologies increasingly will steal market share from the specialists and the Big Board itself.

Also, the introduction of stock trading in decimals rather than fractions continues to reduce the profit margin, or spread, trading firms can reap on each transaction. The U.S. markets went to trading in decimals, or penny increments, three years ago.

"Specialists may be yesterday's newspaper," said Junius Peake, a professor at the University of Northern Colorado College of Business. "The market is changing. I don't think you can stop the onrush of technology."