Our Take: No End in Sight

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An eFC user recently asked, "Can someone tell when the market will shift?" Unfortunately, our best answer at this point is, "Don't hold your breath."

Banks will begin reporting third-quarter results next week, and there is wide consensus they won't be pretty. Continued profit deterioration augurs further downscaling of 2008 bonus expectations. Worse, important indicators of banks' future profits are weakening at the same time - pushing prospects of a recovery in hiring ever further into the future.

The week of Sept. 15, Lehman Brothers, Goldman Sachs and Morgan Stanley will release results for their August fiscal quarters. Recent weeks have seen a steady drumbeat of downward estimate revisions by analysts who follow those institutions. Meanwhile, market valuations for many credit instruments are making new lows, which raises the risk of further asset write-downs and profit shortfalls down the road.

When outlining a similarly dark outlook for second-quarter results three months ago, we opined that bad numbers might not trigger fresh layoff announcements. "Wall Street layoffs have become such a way of life, managements no longer feel compelled to tie them to quarterly reports," we wrote.

A Season to Clamp Down on Costs

This time around, we can't even offer that marginally consoling thought. September is a traditional crunch time. The expense knives usually swing hardest at this time of year, when firms are preparing the next year's budgets.

Merrill Lynch already announced internally a hiring freeze for the remainder of 2008. Lehman Brothers reportedly will cut 6 percent of its workforce, or about 1,500 positions, before announcing third-quarter results. Even Deloitte & Touche, the Big Four accounting firm, said recently it's laying off 900 U.S. employees, about 2 percent of its workforce.

On the positive side, banks have made great progress working off holdings of leveraged loans - a hangover from the buyout boom that ground to a halt a year ago. While leveraged buyout business remains stalled, strategic M&A deals between corporations are holding not too far below last year's levels, and well above the second-quarter pace. And the sub-prime mortgage mess, which sparked the credit crunch, has all but burned itself out. Standard & Poor's Chief Credit Officer Mark Adelson recently told Bloomberg News that when all is said and done, losses from all bonds and derivatives backed by sub-prime mortgages are likely to total $550 billion. Bloomberg's data indicate banks and brokerages have already written down $508.5 billion in holdings.

That's the good news. On the other hand, the main drivers of bank revenues and profits are stuck in neutral. IPO volume remains stagnant after shrinking 41 percent in this year's first half. Securitization deals are moribund. Some institutions also are seeing slower customer trading activity this quarter.

Along with sluggish revenue growth, banks also face further balance-sheet damage from a growing range of fixed-income assets. As home prices continue to fall, Alt-A and prime residential mortgages face rising delinquency rates that could hammer asset values. Other potentially problematic holdings include commercial mortgage-backed securities and preferred shares of Fannie Mae and Freddie Mac, whose value could be erased by a Treasury bailout.

Consumer-Led Recession Threat Grows

Most worrisome of all, consumer finances look increasingly shaky now that the one-time boost from tax rebates enacted by Congress last spring has faded. The Labor Department reported Friday that the U.S. unemployment rate jumped to 6.1 percent in August, highest in almost five years, while the economy lost jobs for an eighth straight month.

The slumping economy raises the risk that rising default rates will afflict various classes of bonds not tied to real estate. Bonds backed by credit cards and auto loans were the debt market's worst performing sector in August. Asset-backed securities posted a 1.17 percent loss last month, according to Lehman Brothers data reported in a Bloomberg News story. Yield spreads on consumer-sensitive credit card and auto loan debt widened to record highs as investors fretted that consumers lack the wherewithal to repay debts. Should this process extend, banks will face yet more asset write-downs and credit losses, beyond their exposure to the housing sector.

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