(For more on analysts' outlook for U.S. financial institutions, double-click on [ID:nBNG327142]) (Adds Fox-Pitt analyst's comments, updates share prices)
By Tenzin Pema
BANGALORE, May 22 (Reuters) - Analyst Richard Bove downgraded Goldman Sachs Group Inc (GS.N), Lehman Brothers Holdings Inc LEH.N and Merrill Lynch & Co MER.N to "sell" from "neutral," saying the largest U.S. investment banks may perform poorly this summer.
Bove, an analyst at Ladenburg Thalmann & Co, also cut his 2008 outlook for the banks, as well as that of Morgan Stanley (MS.N), which he still rates "neutral."
The downgrades reflect expectations that brokerage stocks "will do poorly this summer for three reasons ... weak earnings, clouded secular outlooks, and the seasonal weakness that seems to impact these issues," Bove wrote.
Bove was one of the first banking analysts to recommend selling financial stocks as credit market problems began nearly a year ago. On July 18, Bove recommended selling shares of Bear Stearns Cos Inc BSC.N, Goldman, Lehman, Merrill and Morgan Stanley, saying the financial system was growing at a pace that could not be sustained by economic growth.
The pressures on the brokerage industry have risen because of continued pressure on the economy, lower opportunity for investment banking activity and risk mismanagement, said Bove.
"In the current quarter, it appears that the brokers have not judged risk appropriately once again," Bove said, adding that brokers have been shorting the popular financial indexes against real world cash holdings. "The hedge is not working."
Brokers have benefited in the past few years from several developments including the growth of hedge funds as well as the expansion of the mortgage markets, but "as I see it none of these factors are present at the moment and none of them will be robust for the next few years," Bove said.
He expects that the mortgage markets may take five to six years to recover, and said that hedge funds do not want to borrow aggressively in down markets while most lenders are unwilling to provide as much money as in the past.
LOSSES FROM HEDGING
Bove, the latest in a string of Wall Street analysts to forecast that investment banks will incur losses from ineffective hedging, said cash-market values of many financial instruments have diverged notably from those of indexes meant to mirror cash.
"The indexes have moved up slightly while the cash market has not. This causes losses to develop on hedges," he said, adding that Goldman, Lehman and Merrill may not have avoided this.
Bove forecast a 2008 loss for Merrill and slashed earnings estimates for Goldman, Lehman and Morgan Stanley.
In a separate note dated May 22, Fox-Pitt Kelton analyst David Trone forecast a second-quarter loss of 34 cents a share for Lehman. He earlier expected Lehman to post a profit of $1.48 a share for the period.
"For the first time since the credit bust began, Lehman may post a loss in the second quarter, as it gives back a bit of its huge hedging gains from the last few quarters, as certain key indices rallied," Trone said.
Trone rates Lehman "outperform" and has a $62 price target on the stock.
At midmorning on the New York Stock Exchange, shares of Goldman were up 0.3 percent at $179.15, Lehman was up 0.5 percent at $39.78, Merrill rose 0.2 percent to $45.08, and Morgan Stanley shares were up 1.6 percent at $43.60.
The Amex Securities Broker-Dealer Index .XBD, which was trading up 1.2 percent Thursday, has fallen 20.7 percent this year as the effects of the subprime mortgage crisis, credit crunch and housing slump reverberate.
Following are Bove's ratings, price targets and estimate changes for the Wall Street investment banks: COMPANY RATING PRICE TARGET 2008 SHR VIEW 2009 SHR VIEW
Current Prior Current Prior Current Prior Current Prior Goldman Sachs Sell Neutral $151 $203 $13.96 $14.39 $20.50 $20.58 Lehman Brothers Sell Neutral $35 $38 $2.07 $2.36 $3.50 $3.48 Merrill Lynch Sell Neutral $39 $49 -$0.11 $1.37 $3.44 $3.68 Morgan Stanley Neutral Neutral $41 $53 $4.77 $5.98 $5.24 $6.30 (Editing by Neha Singh and Mike Miller)