Market's revelers feel a chill

Easy profits dry up as subprime abyss startles investors

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August 09, 2007|By Walter Hamilton | Walter Hamilton,Los Angeles Times

NEW YORK -- Until a few weeks ago, life on Wall Street was as good as it gets, with a nearly five-year bull market, takeover deals galore, record profits and jaw-dropping bonuses. America's financial princes once again lived up to their image as Masters of the Universe.

But after a market upheaval that has hit like a bad case of whiplash, the fear on the Street is that the good times are coming to an abrupt halt.

Many of the premier names in the Big Apple's financial core are on the defensive as their own stocks have tumbled by as much as a third on the expectation that their revenue and profits could also tumble. Some of these companies have been stuck with billions of dollars in risky debt used to finance corporate buyouts because investors have been unwilling to assume the loans.

And if Wall Street hoped the Federal Reserve would come to its rescue by cutting interest rates, the central bank gave no sign Tuesday that it was entertaining such a move.

"The next 12 to 18 months on Wall Street could be an extremely trying period," said Richard Bove, an analyst at Punk Ziegel & Co.

The reversal of fortune stems from the meltdown in the market for subprime mortgages - home loans taken out by people with poor credit. During the housing boom, Wall Street companies made huge sums by buying pools of home loans, effectively turning them into bonds and selling them to big investors.

But with home prices falling, the demand for such securities has fallen off a cliff, drying up funding for subprime lenders and even some mortgage companies that hadn't touched the subprime sector. That has sparked a crisis of confidence in the corporate bond market, ending an era of easy money that fueled Wall Street's run-up.

Investors, rattled by fears of potentially broad economic damage and no longer able to count on a wave of easily financed corporate takeovers to pump up share prices, have yanked the stock market down from its record highs of less than three weeks ago.

No company has been harder hit than Bear Stearns Cos.

Founded in 1923, the company had a reputation for being able to control the risks it took, especially in its specialty of trading mortgage-backed securities and other bonds. But it might have taken too much risk when it created a unit to manage hedge funds, lightly regulated investment pools of money raised from institutional investors and rich individuals.

Two such funds, which borrowed billions of dollars to buy securities backed by subprime mortgages, collapsed in July. The co-president of Bear Stearns became the highest-level casualty of the unfolding subprime fiasco when he was forced out of his job last week. Bear Stearns shares are down 32 percent from their January peak.

The stocks of other big Wall Street companies, including Lehman Brothers, Citigroup and Goldman Sachs, are also down sharply from their highs this year.

The standstill in the bond market has threatened to derail a boom in private equity, a field in which investment companies use mostly borrowed money to buy companies with the hope of profiting by cashing out years later. Many companies have had to rework their planned financing and pay higher interest rates to complete their deals.

The number of companies able to sell junk bonds, many of them used to pay for buyouts, plunged into the single digits in July from about 40 in June.

Shares of private equity giant Blackstone Group, which sold a stake to public investors in June, have plummeted 20 percent since the initial public offering.

Companies that manage hedge funds also could face a contraction stemming from the subprime woes. Like the two Bear Stearns funds, many are likely to have suffered losses on mortgage-backed debt.

In some cases, the losses have been big enough to lead investors to demand their money back, prompting some funds to bar all such withdrawals. That could make investors think twice about keeping money in any hedge fund, as could the elevated level of general market uncertainty.

Wall Street thrived in recent years as the global economy fed a land rush in corporate mergers and a worldwide stock market rally. The financial industry's profits soared 88 percent last year to $33.1 billion. Record-setting annual bonuses - as high as tens of millions of dollars each for top executives at major companies - bankrolled a luxury spending spree that helped New York's real estate market avoid the downturn affecting much of the rest of the country.

The buoyancy, however, has given way to murmurings of layoffs and a creeping angst that the worst may be yet to come.

"People are definitely concerned," said a person who works in the bond department at a major investment bank. "There are people who have gotten used to the lifestyle that comes along with the boom years, and some of those people are going to be in for a rude awakening."

Walter Hamilton writes for the Los Angeles Times.

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