Black box brokerages keep investors in the dark

Only one thing is certain about next week's Wall Street earnings: no one outside the companies really has a clue what they'll be.

Investment banking league tables and stock charts tell part of the story, but the lion's share of profit at brokerages like Goldman Sachs Group Inc for years has come from debt and stock trading. Quarterly results are driven by trades and investments made for their own accounts, activities carefully shrouded from public view. This is sometimes referred to as a black box.

These companies have very poor disclosure. Even if they report good numbers, there still may be concern that the numbers aren't believable because it's mark-to-model, said James Ellman, portfolio manager at hedge fund Seacliff Capital in San Francisco. The problem is you really don't know.

Mark-to-model refers to the practice of assigning values to complex securities based on computer-generated models.

In a sign of how off-base analysts have been in the past, Morgan Stanley on average beat analyst forecasts by 26 percent in the past two years, according to StarMine, a firm that tracks the accuracy of analyst forecasts. Looking at Lehman Brothers, Goldman, Morgan, Bear Stearns & Co and Merrill Lynch & Co together, brokers exceeded estimates by 17 percent on average.

In this year's third quarter, even more than in previous periods, analysts have been scratching their heads trying to forecast the impact of this summer's credit crunch on the firms, all of which except for Merrill report earnings next week.

How the firms performed and their outlook will be closely watched by the financial services sector and the broader markets as Wall Street wraps up its worst summer since global credit markets took a nosedive in 1998.

WRITE-DOWNS

The downturn had its genesis in the housing slowdown, which triggered a crisis in mortgage markets and then spread to corporate loans and leveraged buyouts.

Analysts expect brokers to write down mortgages, derivatives and deal-related loans, which have been repriced as investors seek higher yields.

In one recent deal, the buyout of General Motors Corp's Allison Transmission by Carlyle Group and Onex Corp, bankers had to syndicate a $1 billion tranche of loans at a 5 percent discount. That still leaves $2.5 billion of the amount the banks had originally agreed to assume on their balance sheets.

But the full extent of write-downs is unknown because firms can value thinly traded assets based on their own best guess.

Investors will also be watching for more news on job losses.

Lehman recently closed some of its subprime mortgage operations and said it would slash about 9 percent of its employees and take charges. Merrill, which reports next month, warned on Friday that the subprime meltdown put an unspecified dent in its balance sheet.

Market turmoil has also dealt a blow to dozens of hedge funds in recent weeks, including flagship fund managed by Goldman and two Bear Stearns funds which went bankrupt because they had invested in bonds linked to subprime loans. Those stumbles have sparked fears that in-house trading desks using some of the same techniques had also dipped into the red.

GUESSING GAME

That said, after plunging for the past three months, brokerage stocks have rebounded in recent days as worries about a worsening cash crunch eased. The broker sector was a top performer this week, rising more than 4.7 percent, on speculation that earnings won't fall as much as feared.

Certainly investors are used to Wall Street confounding naysayers with trading and investment gains. Goldman, for example, may post a gain of $1 a share from the sale of a wind energy business, Horizon Energy.

Morgan Stanley said earlier this year it made money in mortgages, even as the subprime market began to melt down, after it rightly bet certain mortgage indexes would fall.

Things are so unpredictable that some investors try to divine a firm's performance from the order of announcement dates. Bear Stearns, widely expected to report the weakest results, was the last to announce its release date. Bear will report on Thursday, along with Goldman Sachs.

Lehman chose to kick off the earnings week on Tuesday, which some analysts say suggests results will be solid.

Yet while banks routinely beat estimates, the lack of visibility means investors refuse to pay up for Wall Street earnings, despite several consecutive years of rapid growth.

Goldman Sachs, for example, trades at 8.7 times 2008 estimated earnings, compared with a multiple of 15 for the Standard & Poor's 500 Index.

How much do you want to pay for proprietary trading? The problem is you don't know how they're generated. It's hard to put a multiple on it, said Les Satlow, who helps manage $450 million at Cabot Money Management. That shows very little confidence in the forward estimate.

(Additional reporting by Kristina Cooke)