Our Take: How Much More Pain?

Everyone asks: Is the credit crisis in the eighth inning, or the second? Our best guess: It's the bottom of the fifth.

Many a career is riding on the answer. That's because Wall Street's near-term and medium-term profit, growth, hiring and compensation outlook is crucially dependent on how things shake out. The extent of further downsizing will be determined by the breadth and magnitude of additional write-downs of banks' fixed-income inventories.

Making predictions in the midst of a crisis is a treacherous business. By definition, in times of flux the best available information is incomplete, and therefore may paint a misleading picture. So our expectations are necessarily tentative, and will be influenced by evolving market conditions and regulatory pronouncements.

But we think most institutions' balance sheets are strong enough to allow them to keep investing in areas they view as promising, even while backing away from businesses that have soured. Bright spots include asset and wealth management divisions, equities trading and alternative investments - although proprietary risk in the latter two could discourage banks from ramping up if overall conditions worsen. Risk management departments, although not a revenue or profit center, are likely to attract added investment and headcounts as well.

Trendwatching

To keep tabs on where things are headed, first, follow the money - in this case, the ABX indexes. Market professionals view that amalgam of credit protection prices for asset-backed bonds as the most reliable indicator of future default levels - and intrinsic values - of the sub-prime mortgage asset class that's at the center of the storm.

The staggering sums written off to date amount to less than 10 percent of the most bearish independent estimates of eventual damage to bank balance sheets - half a trillion dollars, according to a widely cited report by an analyst at Royal Bank of Scotland. That's the worst-case scenario. The best case, in our opinion, is that industry-wide write-downs will total another $50 billion - $70 billion over the next two quarters.

Losses of this magnitude pressure managements to pull in their horns, by shrinking regulatory capital, making it harder to raise funds from money markets and capital markets, and depressing share prices.

The past week's revelations suggest the worst is yet to come. Morgan Stanley said its "subprime related balance sheet exposures" subtracted $3.7 billion from revenue and $2.5 billion from net income for the September-October period, the first two months of its final fiscal quarter. The company held $6 billion of remaining net exposure to sub-prime related assets as of Oct. 31. In the third quarter, Morgan Stanley took a far smaller charge of $1.2 billion. Meanwhile, Citigroup expects to take a fourth-quarter write-down of $8 billion - $11 billion, dwarfing the $6.5 billion it already wrote off for the third quarter. It said the figure could grow still larger.

Few other institutions have yet indicated what they might lose this quarter from various troubled assets they are forced to retain. Look for those confessions to trickle out over the next four to six weeks, in the run-up to the next round of quarterly earnings releases.

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