May 27 (Reuters) - Banc of America forecast a second-quarter loss for Lehman Brothers Holdings LEH.N and cut its earnings outlook for Morgan Stanley (MS.N) and Goldman Sachs (GS.N), and said brokers may continue to underperform in the current challenged credit environment.
Shares of Lehman fell more than 3 percent to $34.99 before the bell, after closing at $36.11 Friday on the New York Stock Exchange.
"On top of weaker activity levels across many areas of investment banking this quarter, this quarter 'basis risk' or the divergence between cash and derivatives spreads is the issue driving substantive mark-downs for the I-banks versus spread widening," Banc of America analyst Michael Hecht said in a research note to clients.
Hecht said a slowing economic growth and large balance sheet exposure to residential and commercial mortgages suggested a lackluster, low-visibility environment for the large investment banks through 2008.
The rationale for larger markdowns this quarter is hedging ineffectiveness, Hecht said, and added that Lehman, Goldman and Morgan Stanley would likely see decent sized markdowns for the second-quarter.
Brokers for several years had benefited from growth of hedge funds as well as the expansion of the mortgage markets, trends no longer fueling Wall Street earnings.
In more recent months, pressures on the brokerage industry have risen because of the economy, slowing investment banking activity and, perhaps most importantly, more evidence of faulty risk management.
The analyst also said severance charges would weigh on results for the investment banks.
He, however, said he was neutral on the large investment banks and preferred asset managers, given their positive operating leverage to above-average organic growth and positively trending equity markets.
"While asset managers' valuations are above historical norms by a wider gap than the brokers, we favor names with accelerating growth prospects and potential to expand margins," Hecht said.
The analyst said he expected Goldman to have the best relative second-quarter results, while he forecast Lehman to have the worst quarter.
Hecht said Merrill Lynch & Co MER.N remained his top pick among the large investment banks in the near-term due to the stock's lower "basis risk" -- or the risk that the price of a future will vary from the price of the underlying cash instrument as the future's expiration date approaches -- versus its peers.
Following are the second-quarter and fiscal 2008 earnings estimate changes, and the price target changes made by Hecht on the banks: Name Rating Q2 EPS view 2008 EPS view Price target
New Old New Old New Old Goldman Sachs Neutral $3.45 $3.75 $15.14 $16.08 $176 $185 Lehman Brothers Neutral -$0.50 $0.76 $2.30 $4.69 $43 $50 Morgan Stanley Buy $0.95 $1.40 $5.21 $5.99 $57 $62 Shares of Goldman were trading at $171.70 before the bell after closing at $172.64 Friday, while that of Morgan Stanley was trading at $41.20 after closing at $41.83 on Friday. (Reporting by Ramya Dilip in Bangalore; Editing by Jarshad Kakkrakandy)