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Lehman Gives a Preview of What's Ailing Brokers

Investors want to know where the skeletons are in Wall Street's closet.

Investors are dying to know what's on Wall Street's books.

This week, they'll start to find out.

Lehman Brothers

(LEH)

is scheduled to report earnings Tuesday morning.

Rivals

Morgan Stanley

(MS) - Get Report

,

Bear Stearns

(BSC)

and

Goldman Sachs

(GS) - Get Report

are due to follow this week.

Brokerage firms have booked several years of rip-roaring profit growth, but the news this time around isn't expected to be good. The collapse of the market for subprime mortgages scared investors away from risky debt, which ended the leveraged buyout boom that had been so lucrative for big banks and brokers.

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Now, big players in the merger-and-acquisitions market are desperately trying to find buyers for billions of dollars in buyout loans.

"Until there is a noticeable improvement in capital markets, and banks can demonstrate that all losses on loan inventory have been booked, the negative investor sentiment is likely to continue to weigh on the sector," wrote Camilla Petersen, an analyst in London at Atlantic Equities who cut her rating on the brokerage sector to in line, back on Sept. 12.

According to Thomson Financial, brokerage firms' aggregate third-quarter profit is expected to be flat with the year-ago quarter. Just three weeks ago, analysts were forecasting a 7% profit rise.

Analysts expect Lehman's earnings to fall 10% to $1.47 a share, while Bear's profit is seen plunging 41% from a year ago to $1.78 a share. Goldman Sachs is expected to earn $4.35 a share and Morgan Stanley $1.53 a share.

"Fixed income sales and trading revenues will be the center of attention when the brokers announce earnings this quarter," writes Sanford Bernstein analyst Brad Hintz. "Spreads have increased in all credit sectors. Market concerns about hedge fund exposure, MBS losses, residual mark-to-model risk, CDO exposure, LBO loan commitments and performance declines in sponsored alternative funds caused the credit default spreads on the major brokerage firms to gap out ominously."

The brokers with the most exposure to mortgages include Bear Stearns and Lehman. But a problem for investors looking at financial stocks is that it's impossible to know what the brokers' true exposure to bad loans and the like is. That's likely to continue to be the case even after this week's round of earnings reports.

Actively-traded securities, such as government bonds, are easy to value, "but less active securities with strong derivative features can get extremely tricky, particularly with mortgage-backed securities," says Jim Angel, an associate finance professor at The McDonough School of Business at Georgetown University.

"Some of these things look, act and trade like plain vanilla securities," he says. "Some of them are so complex it's easy to make big errors in valuation, especially when you look at things like prepayment rates, default rates and interest rate volatility. Small changes in those assumptions can make big changes in the value of some securities."

Hedge fund businesses are also likely to contribute more bad news to the brokers asset management businesses.

Bear Stearns pronounced earlier this summer that two of its hedge funds with exposure to the subprime mortgage industry were essentially worthless.

Goldman said in August that it was investing about $2 billion to bolster one of its quantitative hedge funds, Global Equity Opportunities, after the computer-driven stock-trading fund suffered heavy losses. (Other investors, led by billionaire investor Eli Broad and former

American International Group

(AIG) - Get Report

chief Hank Greenberg, are investing about $1 billion.)

On the trading side, Hintz is expecting a big uptick in brokers' so-called VaR, or value at risk. The VaR calculates how much money the firms could lose in one day of trading if all bets were against it. In other words, it's a measurement of how much money a firm is willing to gamble on its proprietary traders.

"One of the major inputs to the value-at-risk is volatility and we saw volatility increase in all markets this quarter," Hintz writes. "So even though the firms were busy reducing their exposure to riskier asset classes, we still expect to see a strong jump in average VaR this quarter for each of the firms, driven by the increase in volatility."