Cracks forming on Wall Street?

From Bloomberg:

Goldman, Merrill Almost `Junk,’ Their Own Traders Say

Goldman Sachs Group Inc., Merrill Lynch & Co. and Morgan Stanley, which earned a record $24.5 billion in 2006, suddenly have become so speculative that their own traders are valuing the three biggest securities firms as barely more creditworthy than junk bonds.

Prices for credit-default swaps linked to the bonds of the New York investment banks this week traded at levels that equate to debt ratings of Baa2, according to Moody’s Investors Service. For Goldman, Morgan Stanley and Merrill Lynch & Co., that’s five levels below the actual Aa3 rating on their senior unsecured notes and two steps above non-investment grade, or junk.

Traders of credit derivatives are more alarmed than stock and bond investors that a slowdown in housing and the global equity market rout have hurt the firms. Merrill since 2005 has financed two mortgage lenders that subsequently failed and purchased a third, First Franklin Financial Corp., for $1.3 billion.

“These guys have made a lot of money securitizing mortgages over the years in a mortgage boom time,” said Richard Hofmann, an analyst at bond research firm CreditSights Inc. in New York. “The question now is what is the exposure to credit risk and what are the potential revenue headwinds if they’re not able to keep that securitization machine humming along.”
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Merrill equity analysts two days ago cut their recommendations on Goldman, Lehman and Bear Stearns shares as well as that of European banks Deutsche Bank and Credit Suisse Group to “neutral” from “buy” because they said earnings will probably decline next month as investors become wary.

Bear Stearns’s stake in non-investment grade retained mortgage securities, or what its keeps from packaging loans into bonds, represents about 13 percent of the firm’s “tangible” equity, according to CreditSights.

For Lehman, it’s 11 percent. Goldman, Morgan Stanley and Merrill don’t disclose how much of their total retained securities are rated below investment grade, or junk. Overall, their exposure is in “the low- to mid-teens,” CreditSights said.

“Disclosures are kind of lacking,” Hofmann at CreditSights said in an interview. “They don’t tend to break out the subprime piece of their retained interest.”