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May 2 (Reuters) - Merrill Lynch lowered its second-quarter earnings estimates for U.S. investment banks Lehman Brothers Holdings Inc LEH.N and Morgan Stanley (MS.N), citing the sharp deterioration in market conditions for the period.
Overall spread widening across many products in March and extreme market conditions generally made for very weak results in that time frame, the brokerage noted.
"The dramatic spread reversal since early April... could actually be damaging because of the impact we believe it has had on correlations between long positions (particularly in both residential and commercial real-estate finance instruments)," Merrill said.
The brokerage cut its second-quarter earnings forecast for Lehman to 82 cents a share from its prior estimate of $1.04 a share. Merrill now expects Morgan Stanley to earn 80 cents a share, down from its prior view of $1.31 a share.
The brokerage said investment banking revenue for the banks appear quite weak this quarter, due to the choppiness in equity markets, the wider spreads for high yield and the risk aversion among underwriters.
"Meanwhile, the M&A business remains globally weak, reflecting both the drying-up of cheap LBO financing after mid-07 and the typical decline in strategic transactions which usually accompanies a recession," Merrill added.
The brokerage maintained its "neutral" ratings on both the firms, saying "sell" ratings were not warranted as it does not expect the stocks to be cheaper 12 months from now.
Merrill, however, said it sees near-term downside potential of 5 percent to 10 percent in each stock as investors adjust expectations to a much weaker second-quarter ahead of normal third-quarter seasonal slowdown.
Shares of Morgan Stanley were down nearly 1 percent to $49.88, while Lehman shares were down 13 cents at $46.80 in afternoon trade on the New York Stock Exchange. (Reporting by Tenzin Pema in Bangalore; Editing by Jarshad Kakkrakandy)