Nightmare on Wall St.

Huge losses cost Citigroup's Charles Prince and Merrill's Stanley O'Neal their jobs. But more pain is coming.

Compensation experts know who butters their bread, which is why they rarely miss an opportunity for spin. What else can you call praise tossed at Merrill Lynch (NYSE: MER) directors for taking a tough stance with outgoing boss Stanley O’Neal? “They’ve done something quite unusual,” U.S. pay consultant Frank Glassner told the press after the board turfed O’Neal in October without an “egregious multiple” of salary. Instead, he is leaving with stock, options and benefits worth about US$162 million the day his departure was announced. And that, Glassner notes, is almost US$50 million less than what Robert Nardelli took away when he left Home Depot in January.

“Turfed” may not be the right word. After all, O’Neal resigned, and he’ll keep an office for three years — despite the unexpected US$8.4-billion writedown that led to Merrill’s record US$2.2-billion loss in the third quarter. A similar story is playing out at Citigroup (NYSE: C), where Charles Prince isn’t expected to starve after becoming Wall Street’s second high-profile CEO to fall on a sword forged from collateralized debt obligations (CDOs) and sub-prime mortgages. Shareholders, of course, will have a say since severance packages are largely tied to equity valuations. And the outlook isn’t great, because investors seem to be thinking it’s August all over again.

Third-quarter reporting season started relatively well with Lehman Brothers (NYSE: LEH) beating expectations by announcing a benign 3% decline in quarterly profits on Sept. 18. Morgan Stanley (NYSE: MS) posted a 7% profit decline the next day. Goldman Sachs (NYSE: GS) mixed things up by posting record revenue on Sept. 20. After that, the news went south. Heavily exposed to mortgage-backed securities, Bear Stearns (NYSE: BSC) reported a 61% plunge in net income. That was expected — unlike the loss posted by Merrill in late October, which was six times larger than initial company guidance. An estimated fourth-quarter writedown at Citigroup, which could be US$11 billion, also came out of the blue on Nov. 4. When the bank posted a 60% drop in Q3 income, it was “focusing on improving those areas where we performed below expectations.”

As of Nov. 7, when Morgan announced a further US$3.7 billion writedown, the Dow Jones U.S. financial services index had dropped 15.5% on the year. That could spell a buying opportunity. But not according to stock guru Jim Rogers, who recently increased his short position on investment banks. The Quantum Hedge Fund co-founder thinks stocks in the sector face a further 70% drop. Other bears note that off-balance-sheet transactions may have been used to delay bottom-line hits.

Even firms that put out good numbers issued bad news or questionable results at the same time. Lehman, for example, said its so-called Level 3 assets (assets that have to be valued by market bids, not management guesstimates of fair value, after a mid-November U.S. accounting rule change) may rise from 8% to 12%. And Goldman reported US$2.62 billion worth of unrealized gains in Level 3 derivatives positions, which raised eyebrows. “There will be more charges to earnings as CDOs and other esoteric derivative securities decompose,” warns New Jersey–based Cumberland Advisors. “The smell is only going to get worse.”

UBS AG chief executive officer Marcel Rohner agrees. He recently warned that banks face a “very serious market dislocation” in credit markets. How serious? In October alone, more than US$100 billion worth of CDOs were downgraded or put on downgrade watch. That’s due to the tanking mortgage market, where U.S. Federal Reserve officials also see bad news on the horizon. “On average, in each quarter from now until the end of next year, monthly payments for more than 400,000 subprime mortgages are scheduled to undergo their first interest rate reset,” Fed governor Randall Kroszner recently warned. “That number is up from roughly 200,000 per quarter during the first half of 2007. Delinquencies and foreclosures are therefore likely to continue to rise for a number of quarters.” Nobody can seriously say the same for Wall Street stocks.