Wall Street banks battered by mortgage and credit losses survived 2007 only to face an even bigger challenge: a U.S. economy on the edge of recession.

Tougher conditions mean investment bank revenues could finally retreat for the first time since 2003, when Wall Street caught hold of a rally that generated a series of record results and only ended last summer.

Goldman Sachs Group Inc stood out last year, profiting by making the right bets ahead of the subprime debacle that bloodied rivals. But if markets worldwide indeed shrink this year, not even Goldman and its trading wizards can keep defying gravity.

If there's a recession, business will slow down for everyone, even the vaunted Goldman Sachs, said James Ellman, president of financial services hedge fund firm Seacliff Capital LLC in San Francisco.

Stocks plunged this week amid worries the United States economy would slow or even shrink. Bank stocks, though, rallied since the Federal Reserve on Tuesday slashed interest rates and fueled optimism that central bankers can stave off recession.

Many analysts and investors say if the economy struggles, Wall Street will start to see declines in merger advisory, underwriting and financing activity. Money management and brokerage businesses will also suffer.

Morgan Stanley said on Thursday it would cut jobs amid concern revenue will slip this year. According to a person briefed on the moves, more than 1,000 jobs, or 2 percent of employees, will go, the latest in a series of job cuts on the Street.

TIED TO MARKET

Wall Street revenue closely follows the global economy. If markets are not expanding, there is less demand for new capital, companies are less eager to pursue deals and assets controlled by fund managers shrink.

Recent record results also included fat gains from underwriting mortgage bonds, creating exotic credit investments and providing big dollops of debt to finance takeovers. These markets have been largely shut down since last summer and are not likely to rebound soon.

Earnings will be under pressure, said David Ellison, president and chief investment officer of FBR Mutual Funds, which manages about $2.5 billion in assets. Underwriting goes through cycles. It's been very juicy and now it will be less juicy. We'll be in a slower period.

The pace of M&A cooled after a red-hot first half of 2007. The credit market impasse halted the gravy train of lucrative leveraged buyouts (LBOs), and among banks, Goldman earned the most from LBO firms, at about $1.5 billion last year.

The challenge for banks now is to replace these cash cows.

Analysts, on average, expect Goldman earnings to fall about 12 percent this year to $22 a share from a record profit last year. Goldman spokesman Lucas van Praag declined to comment.

Goldman's bottom line is also vulnerable to swings in some individual stocks, including stakes in Industrial and Commercial Bank of China Ltd and Japan's Sumitomo Mitsui Financial Group.

But like the rest of Wall Street, Goldman hopes to offset the credit and banking slump by doing more business in emerging markets. More than half of Goldman's revenue came from overseas last year and that percentage will grow.

And better than anyone else, Goldman in recent years has generated standout returns by betting its own capital.

Last year, trading and principal investments generated more than $30 billion in revenue -- including proprietary activity and trades done for clients -- or more than two-thirds of Goldman's total net revenue. Goldman scored billions of dollars of gains betting against subprime mortgages last year, boosting overall results in a year when rivals lost money or made less.

The environment will drag on their results -- it's got to. But they'll be less effected than the others, said Jim Huguet, president of Great Companies Inc Investment Management. They're good traders. They tend to be right a lot more often than they're wrong.

That said, Goldman's challenge is finding new tricks if it hopes to keep its winning streak alive. And no one, not even Goldman executives, feel that is a sure thing.

We like to think we're a little bit better than our peers, Finance Chief David Viniar has said. We don't think we're that much better than our peers, in anything.

(Editing by Braden Reddall)

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