Wanted: A Full Accounting of Wall Street’s Dirty Laundry

Aside from the high-drama being provided later today by the FOMC meeting; another interesting side-show in this week’s circus-like environment is the fact that Wall Street’s top-dogs are scheduled to release their latest earnings reports.

This will give investors the first look at the financial industry fallout from this summer's credit crunch. This is only fitting, since the turmoil has at least in part, been a market shock of Wall Street’s own making.

Big banks and brokerage firms earned a mint in recent years by packaging up and selling the mortgage-backed derivatives that are now at the heart of the credit crunch. So in effect Wall Street sowed the seeds for the sub-prime debacle; and now gets to reap the whirlwind of the credit crunch first-hand.

Wall Street Set to Report Plunging Profits

Lehman Brothers (LEH) leads off the hit-parade of profit (or loss) reports today, followed by heavyweights Morgan Stanley (MS) on Wednesday, and both Bear Stearns (BSC) and Goldman Sachs (GS) report Thursday. A regular rogue’s gallery of Wall Street’s walking wounded!

What investors are looking for out of these brokerage firms’ is not necessarily the bottom line facts and figures – these are most likely dismal to be sure.

In fact, investors are bracing for what Bloomberg says could be “the worst year-on-year decline in earnings per share since the second quarter of 2005” for Wall Street.

If you subtract a one-time gain on asset sales booked by Goldman Sachs last quarter, this could prove to be the biggest decline in Wall Street profitability since 2001!

Bear Stearns for example, which suffered two hedge fund liquidations in June, is likely to report that second-quarter profits fell nearly 50% year over year.

What Investors Really Want from Wall Street

So the negative earnings reports to come are in some respects already reflected in slumping broker share prices; but the question will be: has all of Wall Street’s dirty laundry been aired out yet?

The key, in these reports will be the “forward looking statements” and “guidance” (if any) from the titans of Wall Street... and the key word to search for is: “transparency”. Investors are desperate to know whether Wall Street has yet been able to asses the full extent of sub-prime related losses.

The real bottom line is that financial market participants are suffering from a crisis of confidence in the system itself. Investors are unsure if the checks and balances are in place to limit losses in opaque derivatives tied to sub-prime mortgage loans, and other asset-backed “paper”. When it comes to accounting for the true market value of Wall Street’s credit derivatives, the following excerpt from Bloomberg says it all (emphasis is mine):

“Prices for some instruments are either unavailable or unreliable, turning such mark-to-market accounting into guesswork. Many securities have all but stopped trading since the sudden increase in defaults on subprime home loans early this year left investors leery of products with limited transparency, such as mortgage-backed bonds and collateralized debt obligations.”

A Little Less “Guesswork” and a Little More Transparency Please

What financial markets need to settle down to business as usual again; in fact what they’re demanding, is a full accounting for the supposed value that backs up all those “pieces of paper” floating around the global financial system.

In other words the question is; can Wall Street back up its derivative “promises”?

The shadowy world of complex financial derivatives is a $415 trillion market – equivalent to eight-times the value of the world’s total economic output – and yet it’s a largely unregulated market where transactions are made between, and values fixed by, big banks and brokerage firms with little oversight, and even less transparency.

It is high time Wall Street opened the shades and let a little sunlight shine in on the full extent of sub-prime derivative losses, investors need such transparency to fully regain confidence in financial markets.

In the absence of such candor from Wall Street this week, we are bound to see more market shocks impacting the financial world.