Credit Crunch Rattled Wall St. Powerhouses
Investment Firms' Earnings Are Mixed

By David Cho
Washington Post Staff Writer
Friday, September 21, 2007

Wall Street's most important investment banks amassed about $5 billion in losses from bad loans in three months due to the credit crunch that has been squeezing the financial system.

That figure was just one of several revelations this week from a parade of highly anticipated earnings reports from four of the world's five biggest brokerages -- Goldman Sachs, Bear Stearns, Morgan Stanley and Lehman Brothers.

Their results were a mixed bag for debt investors who had been hoping for a clear sign on the direction of the credit storm that has been roiling the markets since late July.

The news from Morgan Stanley and Bear Stearns was worse than most analysts expected. Lehman Brothers beat lowered expectations. But Goldman Sachs amazed Wall Street by reporting record revenue yesterday despite adverse market conditions.

Taken together, the earnings indicate that debt markets may experience an uneven recovery that could last several months, though the top executives at all four firms said the situation seems to be improving. "The worst is definitely behind us," Samuel Molinaro, chief financial officer at Bear Stearns, said in a conference call yesterday.

Some analysts and investors greeted this optimism skeptically, however, because bank officials refused to give details of their problems. Lehman, for instance, reported $700 million in losses related to the credit crunch, less than many analysts expected. But that figure included several categories of investments, making it hard to see how its individual divisions performed.

"The investment banks did not reveal too much information of what's in their securities portfolios, what strategies they used or what industry the loans were in," said Richard Bove, of Punk, Ziegel & Co, who is bearish on financial stocks. "We are basically told only a minimal amount of information."

Investment banks are a critical bridge between the economy and the credit markets. They provide financial advice for initial public offerings, mergers and private buyouts, and act as brokerages for individuals and firms. Because they operate in many places around the world, they act as a bellwether for how the global markets are doing.

These firms are hardly banks in the traditional sense. When they promise loans, they do not put up the money themselves but instead raise cash by repackaging the loans as complex bonds and selling them to debt investors and hedge funds. They make far more money by charging their clients fees for these services than from directly charging interest.

Selling debt to investors on the credit markets allowed these banks to spread the risk of holding a loan to many partners. But it also encouraged them to back risky behavior. With the investment banks behind them, private-equity firms paid record amounts for struggling companies, and mortgage companies lent to people with shaky credit.

This summer, such excesses came back to bite the investment banks.

Although the firms all made money, they had to write down almost $5 billion in loan commitments: Goldman had a $1.5 billion loss; Lehman Brothers a $700 million loss; while Morgan Stanley and Bear Stearns wrote down $940 million and $250 million, respectively. Merrill Lynch reports next month.

Trading strategies based on mathematical models -- used in so-called quant funds -- generated losses. Morgan Stanley's quantitative trading posted a $480 million loss, while Goldman Sachs said it expects investors to pull at least $1.6 billion out of its $6 billion Global Alpha hedge fund that has suffered substantial losses in recent weeks.

But several of the banks received a soaring amount in fees from global trading activity. Markets have been extremely volatile in recent months, which generates more business for brokerages.

Overall, none did worse than Bear Stearns, which had the most exposure to problems in the credit markets and the mortgage-lending business. The firm posted earnings yesterday of $171.3 million, a 61 percent drop from the comparable period a year earlier. Profit at the firm's fixed-income division, which trades complex bonds on the debt markets, fell 88 percent, to $117.6 million.

Meanwhile Goldman Sachs, the largest and most profitable investment bank, continued to cement its leading status on Wall Street. The firm posted earnings of $2.85 billion, a 79 percent increase over last year, making it the third-best quarter in its history. It also had record revenue in several divisions.

The firm appeared to foresee the credit crunch well in advance of its peers and made a fortune by betting that mortgages and complex debt instruments would fall in value, according to analysts.

"This week really puts us in awe of Goldman Sachs," said Brad Hintz, a former treasurer of rival Morgan Stanley and now an analyst at Sanford Bernstein. "It explains who was on the other side of those fixed-income trading losses."

Not surprisingly, Goldman Sachs allocated $16.9 billion for salaries and bonuses through the first nine months of the year, topping the record for all of 2006, the firm said yesterday. That averages to about $565,730 per Goldman employee.