Goldman and B. Stearn's Mortgage Woes

Goldman Sachs Group Inc. and Bear Stearns Cos. Inc. are learning that it's a tough time to be in the U.S. mortgage business.

But if earnings reports from the No. 1 and No. 5 U.S. investment banks on Thursday show anything, it's the importance of investment banks not keeping too many eggs in one basket.

Both banks suffered from rising mortgage defaults, which made lenders less likely to make home loans and reduced underwriting volumes.

That helped depress fixed income trading revenues 21 percent at Bear Stearns and 24 percent at Goldman Sachs.

But Goldman Sachs, which is more diversified than Bear Stearns, still managed to eke out a profit increase for the quarter, while Bear Stearns' earnings fell 10 percent, or 33 percent including a one-time write-down.

Shares of both brokers fell following the release of results that deflated investor hopes lifted earlier this week by stellar results at Lehman Brothers Holdings Inc. Bear Stearns shares rallied late in the session.

All three investment banks were haunted throughout the week by the debacle in lending to less creditworthy home buyers. Lehman disclosed on Wednesday that it would merge two residential mortgage units, cutting 400 jobs.

And Bear Stearns put $4 billion of mortgage bonds on sale on Thursday to raise cash and cover reported losses in one of its hedge funds, fund managers and other sources said.

Longer term, Goldman's broader array of businesses makes it likely to continue outperforming Bear Stearns, several analysts and portfolio managers said.

I'd rather invest in a company that has a strong international business and equity business, in addition to a strong bond business, said Adam Compton, co-head of global financial stocks research at RCM Global Investors in San Francisco, which has some $150 billion in assets.

Bear Stearns is hiring internationally -- it is doubling its staff in London to more than 2,500 in the next few years, and opening a Paris office in June.

But Bear Stearns is late to the party. Right now, about 85 percent of its revenues are from the United States. Compare that to Goldman Sachs, which generated more than half its revenue outside the U.S. in the second quarter, or Lehman which said on Tuesday that 48 percent of its revenue was international.

Bear also has a proportionately smaller investment banking business than Goldman Sachs. Goldman Sachs's advisory business generated about $709 million in revenue, or about 7 percent of total revenue, compared with $140 million, or about 5.6 percent at Bear. Advisory revenues are key for profits, since a very higher percentage of them end up as profits.

Goldman Sachs shares trade at about 2.8 times their book value, or the accounting value of their assets minus liabilities.

That's far higher than Bear Stearns' 1.6 times, but Goldman Sachs has a much higher return on equity, and so while Bear appears fairly valued, a case could be made that Goldman is undervalued, said Joe Dickerson, analyst at Atlantic Equities.

Bear Stearns' return on equity -- a measure of how efficient the company is at squeezing profits from its net assets -- was 15.6 percent excluding a one-time charge, compared with 26.7 percent for Goldman Sachs.

Bear's return on equity was hurt by the weak U.S. mortgage market, where defaults rose to a record high, an industry group said on Thursday.

SILVER LINING

Bear's profits for the second quarter were $361.7 million, down from $553.7 million a year earlier, while Goldman's were $2.33 billion, compared with $2.29 billion a year earlier.

Bear's results included a $227 million write-down for assets linked to its New York Stock Exchange specialist unit.

Not everything is gloomy for Bear Stearns. Its mortgage revenues rose compared to the first quarter, even if they were well off their levels of the second quarter of 2006, the company's chief financial officer said on a conference call. The company's hedge fund business is growing dramatically, CFO Sam Molinaro said.

And Molinaro said Bear Stearns' exposure was minimal to the fund whose bonds were put on the block on Thursday.

(Additional reporting by Joe Giannone in New York)