It didn’t matter that he was on holiday. Gorman dropped everything and flew to Beijing last April. He wanted to show up in person to make sure his firm got a piece of what was shaping up to be the biggest initial public offering in history.

In Beijing, Gorman spent hours rehearsing with his team for a half-hour pitch to executives of Agricultural Bank of China (601288.SS: Quote, Profile, Research, Stock Buzz)(1288.HK: Quote, Profile, Research, Stock Buzz), whose IPO would eventually raise $22 billion.

“For a half-hour bake-off, he came all that way,” Wei Christianson, Morgan Stanley’s China CEO, said in an interview last month from her office near Financial Street in Beijing.

As he practiced, the Australian-born CEO debated with colleagues about whether the Chinese bankers would want to hear his stories about farming in the outback.

Gorman was not the only top Wall Street executive looking to get in on the AgBank deal. JPMorgan (JPM.N: Quote, Profile, Research, Stock Buzz) CEO Jamie Dimon and Deutsche Bank CEO (DBKGn.DE: Quote, Profile, Research, Stock Buzz) Josef Ackermann also went to China to make their pitch, and in the end all three banks secured an underwriting assignment for the bank’s Hong Kong offering.

For a while at least, with their eyes dead set on the AgBank pot of gold, global bankers could set aside concerns about the challenges they face in China, a market they are desperately trying to crack but where they are finding more setbacks than successes.

Why they want in is no mystery.

Economists at Goldman Sachs believe that mainland China’s market capitalization will rise to $41 trillion by 2030 from $5 trillion now. That would make China’s stock market the biggest in the world. U.S. market cap is expected to grow to $34 trillion from $14 trillion over that time.

But with China, American financial powerhouses may have met their match. Here, government connections and family ties can trump decades of banking experience and western swagger. So for all their efforts — and kowtowing — this is likely to remain one tough market Wall Street firms.

GOLD RUSH

In Beijing, where the towering gray headquarters of the world’s largest banks — Industrial and Commercial Bank of China (601398.SS: Quote, Profile, Research, Stock Buzz)(1398.HK: Quote, Profile, Research, Stock Buzz), China Construction Bank (601939.SS: Quote, Profile, Research, Stock Buzz) (0939.HK: Quote, Profile, Research, Stock Buzz) and Bank of China (601988.SS: Quote, Profile, Research, Stock Buzz) (3988.HK: Quote, Profile, Research, Stock Buzz) — cast a long shadow, Wall Street banks are still on the outside looking in.

The towers in and around Financial Street wouldn’t look out of place on Wall Street. But looks can be deceiving.

“You can’t just come in here and act like this is New York and try to operate the same way you would in New York,” said Philip Partnow, who heads China M&A for UBS (UBS.N: Quote, Profile, Research, Stock Buzz) (UBSN.VX: Quote, Profile, Research, Stock Buzz).

Global banks trying to jumpstart their China operations are tangled in a web of strict regulation, culture clashes and politics. They worry too that even the sweat equity they are putting into training their partners in the ways of western banking will be lost. Some wonder whether China’s long-term plan includes their foreign guests from Wall Street.

“At some point, the Chinese want to get to the point where they don’t need the foreign investment banks,” said Michael Werner, a Hong Kong-based China banking analyst with Sanford C. Bernstein.

China’s domestic “A Share” IPO market is especially tightly controlled. Even though global banks are actively underwriting listings for Chinese firms on the Hong Kong exchange, they are being shut out of the mainland IPO market.

The China IPO market has reached $56 billion so far in 2010, more than five times what it was a decade ago. Despite such torrid growth, major U.S. banks have moved down the underwriting rankings, while domestic banks have solidified their spots at the top.

Global banking powers like Goldman Sachs (GS.N: Quote, Profile, Research, Stock Buzz), Morgan Stanley and JPMorgan have an investment banking presence in China, which connect Chinese companies, often state-owned entities, with foreign capital. The Chinese banks have not built up their international distribution networks yet, leaving the door open foreign banks to get a piece of the market.

But what happens when China’s banks and its growing ranks of regional securities firms are able to shoulder the load?

Some foreign bankers fear they will be sidelined, with years of investment lost, and invaluable know-how left in the hands of their Chinese partners.

“Basically, it is a big technology transfer that is going on here — and then the Chinese shut the door,” said Gordon Chang, author of the book ‘The Coming Collapse of China’. “They’ve done this so many times.”

CULTURE CLASH

One day a decade ago, during China’s mid-autumn festival, CICC CEO Levin Zhu was the last one to leave the office. He was working late into the night in a smoke-filled room on the China Petroleum & Chemical Corp (Sinopec) (0386.HK: Quote, Profile, Research, Stock Buzz) (600028.SS: Quote, Profile, Research, Stock Buzz) IPO.

By that time, Morgan Stanley’s influence on CICC had shrunk in part because Zhu had wrested control of the bank from the Wall Street firm, reducing it to a passive investor. It was a far cry from the more engaged role that Morgan Stanley had envisioned when helped to launch the joint venture.

When Morgan Stanley began the JV, its majority partner, China Construction Bank, was purely a commercial bank and had virtually no investment banking experience. That’s what Morgan Stanley brought to the table.

Morgan Stanley brought seasoned bankers, its brand, and an invaluable amount of know-how to the joint venture. The information would be critical to CICC getting off the ground.

With CICC, Morgan Stanley found itself on the inside of a successful investment bank, but one that was fraught with culture clashes and internal warring between western bankers and their Chinese counterparts, according to people who worked in the joint venture.

THE RIDDLE

Levin Zhu, who was a riddle to some of his Morgan Stanley counterparts, personified the cultural differences that make or break joint ventures.

Zhu is what is known in China as a “princeling,” the offspring of a powerful politician. The son of former Chinese premier Zhu Rongji, he studied meteorology before going into finance and eventually landing atop CICC.

Some former Morgan Stanley executives remain perplexed by Zhu, who they say understood finance and investment banking, but worked odd late hours and appeared to rely too much on his father’s political ties.

Zhu, with his political clout, succeeded in reducing Morgan Stanley to a passive investor for much of the past decade, removing the Wall Street bank from management decisions and giving complete control of the operation to the Chinese.

Morgan Stanley’s interest in exiting CICC came to light as early as 2007, but the bank is still waiting for approval from regulators to sell its stake. Media reports have indicated that approval could come soon.

The slow-moving process has delayed Morgan Stanley’s plans to apply for a license with a new partner because rules forbid the banks from having two joint ventures simultaneously.

And China does not seem to be in a hurry to create another competitor.

Despite the history, Morgan Stanley refuses to speak ill of its CICC endeavor.

MANY RISKS

In September, Reuters met with a number of executives and investment bankers from global banks, all of which are jockeying for position in the Chinese market.

The executives offered a positive outlook for China and spoke with hope and ambition about building operations there.

With China expected to emerge as the largest market in the world — it’s economy is growing more than 10 percent annually — bankers are careful not to say anything that could catch the attention of regulators and potentially hurt their access.

“A lot of what these people say publicly, that China is going to be great, just cannot be true; there are too many risks,” said Victor Shih, who teaches political science at Northwestern University. Foreign banks are under pressure to appear bullish China because they are trying to sell Chinese investments to clients, he adds.

But if China’s growth goes as expected, there is no doubt it will be a boon to financial intermediaries who stand to see billions of dollars in yearly revenues over the next two decades — making it all the more critical for Wall Street banks to become true players in the market.

LONG-TERM PROSPECTS

Executives from Goldman and UBS, two banks that are among the best-positioned in China, were upbeat about the long-term prospects.

“I think people thoroughly understand that long-term is long-term,” said Mark Machin, co-head of Asia investment banking for Goldman Sachs, who has been in Asia for 16 years.

“These businesses and relationships don’t come in a month or week, they take years. We are building for a very long time. Everybody understands that,” he said.

UBS talks about how it has found success “swimming with the current” in China.

“What are the government’s priorities in China and how can I align my activities with their goals?” UBS’s Partnow said, explaining how his firm has found success in moving with regulators.

Even though some bankers privately share frustrations about the strict hand of Chinese regulators and the pace at which they move, publicly the executives measure their words when talking about the government.

Robert Morrice, Barclays’ Asia-Pacific CEO, says he understands where the Chinese regulators are coming from.

“I try to put myself in their position,” he said. “If I were them I would want to control international entrance to my marketplace because you have to have the right participants.”

THE DANCE

As banks salivate over the possibilities, there are some doubters, however.

One of them is James Chanos, the hedge fund manager known for correctly predicting the demise of Enron. Since the start of 2010 he has been making the case that China is built on a real estate bubble that is likely to burst.

“I don’t see this ending well,” Chanos said from his New York office. “The bulls think the Chinese authorities will slowly let air out of the bubble. History is not on their side.”

The slowdown might be starting already. Property investment is set to grow 26.8 percent for all of 2010, slowing from a rise of 37.2 percent in the first seven months of the year, according to a report from a top China economic planner.

Chanos does not speak Mandarin and he has never been to Beijing. But he knows numbers, and his predictions do not look good for Wall Street banks hoping to find gold in China over the long term. “China is not going to be a driver of their profitability,” he said.

When Gordon Chang, the author, considers how banks are tripping over one another to get an edge in China, it conjures up memories of former Citigroup CEO Charles Prince’s infamous comment before the U.S. housing crisis: “As long as the music is playing, you’ve got to get up and dance.”

“When your competitors do something, you’ve got to do it as well,” said Chang. “But I think they’re all missing something.”

Chang, a lawyer who worked in China and Hong Kong for two decades, also points to the overheated real estate market.

He said he believes that foreign banks are already getting hints that China could be on a course for trouble.

Goldman recently pared its stake in the Industrial and Commercial Bank of China by $2.3 billion.

Earlier, Bank of America pared down its interest in the China Construction Bank to raise $7.3 billion.

“That’s not what you would do if you were truly bullish about it,” Chang said.

(Writing by Steve Eder; Additional reporting by Michael Flaherty in Hong Kong and Kang Xize in Beijing; Editing by Jim Impoco and Ted Kerr)

It didn’t matter that he was on holiday. Gorman dropped
everything and flew to Beijing last April. He wanted to show up
in person to make sure his firm got a piece of what was shaping
up to be the biggest initial public offering in history.

In Beijing, Gorman spent hours rehearsing with his team for
a half-hour pitch to executives of Agricultural Bank of China
(601288.SS: Quote, Profile, Research, Stock Buzz)(1288.HK: Quote, Profile, Research, Stock Buzz), whose IPO would eventually raise $22
billion.

“For a half-hour bake-off, he came all that way,” Wei
Christianson, Morgan Stanley’s China CEO, said in an interview
last month from her office near Financial Street in Beijing.

As he practiced, the Australian-born CEO debated with
colleagues about whether the Chinese bankers would want to hear
his stories about farming in the outback.

Gorman was not the only top Wall Street executive looking
to get in on the AgBank deal. JPMorgan (JPM.N: Quote, Profile, Research, Stock Buzz) CEO Jamie Dimon
and Deutsche Bank CEO (DBKGn.DE: Quote, Profile, Research, Stock Buzz) Josef Ackermann also went to
China to make their pitch, and in the end all three banks
secured an underwriting assignment for the bank’s Hong Kong
offering.

For a while at least, with their eyes dead set on the
AgBank pot of gold, global bankers could set aside concerns
about the challenges they face in China, a market they are
desperately trying to crack but where they are finding more
setbacks than successes.

<^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^

Graphics:

Global equity market cap share r.reuters.com/jux79p

Global banks flock to China r.reuters.com/kux79p

^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>

Why they want in is no mystery.

Economists at Goldman Sachs believe that mainland China’s
market capitalization will rise to $41 trillion by 2030 from $5
trillion now. That would make China’s stock market the biggest
in the world. U.S. market cap is expected to grow to $34
trillion from $14 trillion over that time.

But with China, American financial powerhouses may have met
their match. Here, government connections and family ties can
trump decades of banking experience and western swagger. So for
all their efforts — and kowtowing — this is likely to remain
one tough market Wall Street firms.

GOLD RUSH

In Beijing, where the towering gray headquarters of the
world’s largest banks — Industrial and Commercial Bank of
China (601398.SS: Quote, Profile, Research, Stock Buzz)(1398.HK: Quote, Profile, Research, Stock Buzz), China Construction Bank (601939.SS: Quote, Profile, Research, Stock Buzz)
(0939.HK: Quote, Profile, Research, Stock Buzz) and Bank of China (601988.SS: Quote, Profile, Research, Stock Buzz) (3988.HK: Quote, Profile, Research, Stock Buzz) — cast a
long shadow, Wall Street banks are still on the outside looking
in.

The towers in and around Financial Street wouldn’t look out
of place on Wall Street. But looks can be deceiving.

“You can’t just come in here and act like this is New York
and try to operate the same way you would in New York,” said
Philip Partnow, who heads China M&A for UBS (UBS.N: Quote, Profile, Research, Stock Buzz) (UBSN.VX: Quote, Profile, Research, Stock Buzz).

Global banks trying to jumpstart their China operations are
tangled in a web of strict regulation, culture clashes and
politics. They worry too that even the sweat equity they are
putting into training their partners in the ways of western
banking will be lost. Some wonder whether China’s long-term
plan includes their foreign guests from Wall Street.

“At some point, the Chinese want to get to the point where
they don’t need the foreign investment banks,” said Michael
Werner, a Hong Kong-based China banking analyst with Sanford C.
Bernstein.

China’s domestic “A Share” IPO market is especially tightly
controlled. Even though global banks are actively underwriting
listings for Chinese firms on the Hong Kong exchange, they are
being shut out of the mainland IPO market.

The China IPO market has reached $56 billion so far in
2010, more than five times what it was a decade ago. Despite
such torrid growth, major U.S. banks have moved down the
underwriting rankings, while domestic banks have solidified
their spots at the top.

Global banking powers like Goldman Sachs (GS.N: Quote, Profile, Research, Stock Buzz), Morgan
Stanley and JPMorgan have an investment banking presence in
China, which connect Chinese companies, often state-owned
entities, with foreign capital. The Chinese banks have not
built up their international distribution networks yet, leaving
the door open foreign banks to get a piece of the market.

But what happens when China’s banks and its growing ranks
of regional securities firms are able to shoulder the load?

Some foreign bankers fear they will be sidelined, with
years of investment lost, and invaluable know-how left in the
hands of their Chinese partners.

“Basically, it is a big technology transfer that is going
on here — and then the Chinese shut the door,” said Gordon
Chang, author of the book ‘The Coming Collapse of
China’.”They’ve done this so many times.”

KKR (KKR.N: Quote, Profile, Research, Stock Buzz) is hiring about nine Goldman traders, led by Bob Howard, who heads Principal Strategies for Goldman’s U.S. business. The team will be part of KKR’s asset management unit, which manages $13 billion, and will join early in 2011.

KKR is likely to launch a long/short hedge fund next year, a source familiar with the situation said.

Goldman’s proprietary trading desk was in jeopardy in light of the “Volcker rule,” which limits the extent to which banks can bet with their own capital.

Goldman, in a statement, lauded the “strong performance record with a culture of disciplined risk management” of its former Principal Strategies business.

KKR co-founders Henry Kravis and George Roberts said in an emailed statement that the move is part of a strategic build-out of its asset management platform.

“Our goal has been to add new capabilities and exceptional talent that allow us to strengthen our product offering and better service our clients,” they said. “Bob and his team will be an ideal fit for that objective as we’ve been impressed with their investment experience and performance as well as their ability to manage risk.”

(Reporting by Steve Eder and Megan Davies; editing by John Wallace)

The firm’s $91 million (57 million pound) loss, on weak volumes during one of the most difficult trading quarters in recent memory, came a day after Goldman overcame those same conditions to beat Street estimates with a $1.9 billion profit.

Morgan Stanley shares fell 3.5 percent in morning trading.

“Morgan Stanley is a caterpillar in metamorphosis. It’s either going to turn into a beautiful butterfly or get eaten by a robin,” said Brad Hintz, an analyst with Sanford C. Bernstein.

“You could look ahead and say I’m going to like the future Morgan better than I’m going to like the future Goldman, but you’re still going to have a period that’s pretty rough on the stock.”

Morgan Stanley has been playing catch-up with its arch-rival since the financial crisis. In 2009, Goldman cashed in on windfall trading opportunities to report a record annual profit, while Morgan Stanley, which scaled back risk, reported a loss.

The leading investment banks have gone in different directions since the financial crisis: Morgan Stanley has rebalanced its business to include the largest retail brokerage, while Goldman has stuck to its banking and trading roots.

Analysts say Morgan Stanley still has more work ahead in that transition — and it will never beat Goldman on traditional trading.

“Morgan Stanley has done an adequate job in these terrible markets of not performing very badly. But when you’re competing against Goldman Sachs and there’s a contrast, most times you’re going to look bad, and this is one of those times,” said Mike Holland, founder of Holland & Co in New York, which oversees more than $4 billion of assets.

NOT PROUD

Morgan Stanley knows it has work to do to catch up to Goldman in fixed income trading, which powered the banking industry’s rebound from the financial crisis.

Morgan Stanley Chief Financial Officer Ruth Porat said the bank’s efforts to rebuild its fixed income trading ranks have further to go, and it remains outnumbered by its peers.

Third-quarter fixed income net revenue was down by more than half from a year earlier.

“We have repeatedly said that fixed income is the area we need to build up,” Porat told Reuters in an interview.

She said third-quarter results were hurt by the accounting ramifications of improvements in the bank’s debt prices, but added that the trading results “were nothing to be proud about.”

Porat said Morgan Stanley’s trading desks struggled in a tough environment in which it already had lower market share than some of its rivals.

WEALTH BET

Under Chief Executive James Gorman, who took over on Jan 1, Morgan Stanley has been focussed on building the Morgan Stanley Smith Barney joint venture, the largest retail brokerage.

The bank’s global wealth management business did not offer much relief from the trading woes in the third quarter, reporting net revenues of $3.1 billion, up just 1 percent from a year earlier. [ID:nN20246987] Morgan Stanley said lower levels of client activity weighed on its retail brokerage results.

Porat said Morgan Stanley is still confident the wealth business will help balance the firm’s operations.

“We still see multiple legs of the stool working together to create a more balanced business,” she said.

Morgan Stanley’s strategy of building its wealth business was also designed to help the firm prepare for more stringent regulations on trading.

The bank announced on Wednesday that it was restructuring its ownership of FrontPoint Partners LLC, its hedge fund unit. Morgan Stanley will retain a minority ownership in FrontPoint.

The move, which had been expected, comes after the “Volcker rule” in the new financial reform law restricted the amount of ownership banks can have in hedge fund assets.

The bank reported a third-quarter net loss applicable to shareholders of $91 million, compared with a profit of $498 million a year earlier.

Income from continuing operations was 5 cents a share. Analysts’ average forecast was 15 cents, according to Thomson Reuters I/B/E/S.

Morgan Stanley said its results reflected a writedown of $229 million related to Revel Entertainment Group, a troubled hotel and casino project in Atlantic City, New Jersey.

The bank’s shares were down 77 cents, or 3 percent, to $24.62 in morning trading.

(Reporting by Steve Eder; additional reporting by Maria Aspan; editing by John Wallace)

On a per-share basis, income from continuing operations was 5 cents, well below analysts’ average forecast of 15 cents, according to Thomson Reuters I/B/E/S.

“They’re disappointing, after good results from Citi and JPMorgan, said Cormac Leech, analyst at Canaccord Genuity. “The biggest disappointment was in fixed income and equities.”

Fixed income sales and trading revenues were $846 million, down 57 percent from a year earlier.

The bank reported a net loss applicable to shareholders of $91 million, compared with a profit of $498 million a year earlier.

Morgan Stanley said its results reflected a loss of $229 million on a writedown related to the disposition of Revel Entertainment Group, a hotel and casino project in Atlantic City, New Jersey.

Its global wealth management business did not offer much relief, reporting net revenues of $3.1 billion, up just 1 percent from a year earlier. [ID:nN20246987] Morgan Stanley said lower levels of client activity weighed on its retail brokerage results.

The firm also announced it was restructuring its ownership of FrontPoint Partners LLC, its hedge fund unit. Morgan Stanley will retain a minority ownership in FrontPoint.

Morgan Stanley shares were down 37 cents, or 1.5 percent, to $25.02 in premarket trade.

(Reporting by Steve Eder; editing by John Wallace)

On a per-share basis, income from continuing operations was
5 cents, well below analysts’ average forecast of 15 cents,
according to Thomson Reuters I/B/E/S.

“They’re disappointing, after good results from Citi and
JPMorgan, said Cormac Leech, analyst at Canaccord Genuity. “The
biggest disappointment was in fixed income and equities.”

Fixed income sales and trading revenues were $846 million,
down 57 percent from a year earlier.

The bank reported a net loss applicable to shareholders of
$91 million, compared with a profit of $498 million a year
earlier. (For a table of Morgan Stanley results, see
[ID:nN20186835].)

Morgan Stanley said its results reflected a loss of $229
million on a writedown related to the disposition of Revel
Entertainment Group, a hotel and casino project in Atlantic
City, New Jersey.

Its global wealth management business did not offer much
relief, reporting net revenues of $3.1 billion, up just 1
percent from a year earlier. [ID:nN20246987] Morgan Stanley
said lower levels of client activity weighed on its retail
brokerage results.

The firm also announced it was restructuring its ownership
of FrontPoint Partners LLC, its hedge fund unit. Morgan Stanley
will retain a minority ownership in FrontPoint.

Morgan Stanley shares were down 37 cents, or 1.5 percent,
to $25.02 in premarket trade.
(Reporting by Steve Eder; editing by John Wallace)

Private equity investments have long helped banks generate big profits, but in the future banks won’t be able to rely on them: a new law severely curtails the ability of banks to invest their own money in areas like leveraged buyouts.

Goldman’s (GS.N: Quote, Profile, Research) reliance on private equity shows just how hard it will be for the bank to boost profits in the future.

The bank posted $635 million of gains from corporate principal investments, which after taxes is about $425 million, or about 24 percent of the bank’s $1.74 billion shareholder profit.

The bank’s portfolio of principal investments grew during the quarter to $15.3 billion from $14 billion in the second quarter. It is unclear if Goldman added investments to the portfolio or if some holdings appreciated in value. A Goldman spokesman declined to comment.

But what’s interesting is that the private equity portfolio is growing in a time when the company is working to comply with new U.S. regulations limiting how big banks use their own capital, analysts said

Under the so-called Volcker Rule, Goldman will be required to sell off some of the $15.3 billion portfolio in coming years.

“This is a reminder that Goldman has a massive merchant banking portfolio that they are going to have to liquidate,” said Brad Hintz, an analyst with Sanford C Bernstein.

Hintz said he believes Goldman will be looking for exit opportunities once the mergers and acquisitions market picks up.

“Where the real gains are going to be shown is when Goldman liquidates that portfolio,” Hintz said.

For now, the portfolio’s performance was a boon to otherwise weak third-quarter earnings, which sagged in a difficult trading environment.

Goldman on Tuesday reported net income of $1.9 billion and a chunk of that came from its principal investments unit, which reported net revenue of $754 million, including gains of $635 million from corporate principal investments.

(Reporting by Steve Eder; Editing by Steve Orlofsky)

Private equity investments have long helped banks generate big profits, but in the future banks won’t be able to rely on them: a new law severely curtails the ability of banks to invest their own money in areas like leveraged buyouts.

Goldman’s reliance on private equity shows just how hard it will be for the bank to boost profits in the future.

The bank posted $635 million of gains from corporate principal investments, which after taxes is about $425 million, or about 24 percent of the bank’s $1.74 billion shareholder profit.

The bank’s portfolio of principal investments grew during the quarter to $15.3 billion from $14 billion in the second quarter. It is unclear if Goldman added investments to the portfolio or if some holdings appreciated in value. A Goldman spokesman declined to comment.

But what’s interesting is that the private equity portfolio is growing in a time when the company is working to comply with new U.S. regulations limiting how big banks use their own capital, analysts said

Under the so-called Volcker Rule, Goldman will be required to sell off some of the $15.3 billion portfolio in coming years.

“This is a reminder that Goldman has a massive merchant banking portfolio that they are going to have to liquidate,” said Brad Hintz, an analyst with Sanford C Bernstein.

Hintz said he believes Goldman will be looking for exit opportunities once the mergers and acquisitions market picks up.

“Where the real gains are going to be shown is when Goldman liquidates that portfolio,” Hintz said.

For now, the portfolio’s performance was a boon to otherwise weak third-quarter earnings, which sagged in a difficult trading environment.

Goldman on Tuesday reported net income of $1.9 billion and a chunk of that came from its principal investments unit, which reported net revenue of $754 million, including gains of $635 million from corporate principal investments.

(Reporting by Steve Eder; Editing by Steve Orlofsky)

Goldman Sachs Group Inc (GS.N: Quote, Profile, Research, Stock Buzz) reported that net trading revenues fell by more than a third in the quarter, but the firm’s profits still beat analysts’ estimates.

Trading volumes sank as nervous investors stayed on the sidelines after the “flash crash” and amid volatile markets. Goldman’s trading performance was “not bad, all things considered,” wrote Ticonderoga analyst Douglas Sipkin.

Third-quarter shareholder net income fell to $1.9 billion, or $2.98 a share, from $3.19 billion, or $5.25 a share, a year earlier, hurt by the decline in trading revenues.

But the earnings topped analysts’ average forecast of $2.32 a share, according to Thomson Reuters I/B/E/S.

While Goldman’s numbers were down from a year ago, the firm still looked strong compared to some banking rivals who have been rattled by the foreclosure crisis.

“Even though expectations were lower and even though the EPS numbers were reduced dramatically in the past couple of weeks, it’s still a much more positive release than many of their competitors,” said Matt McCormick, portfolio manager at Bahl & Gaynor Investment Counsel Inc.

TRADING

Investors last week saw signs that trading results might not be as bad as expected when JPMorgan Chase & Co (JPM.N: Quote, Profile, Research, Stock Buzz) reported trading revenues that beat Wall Street estimates.

Goldman reported net revenues in fixed income, currency and commodities of $3.77 billion, down 37 percent from a year ago. The firm cited a challenging environment in which activity levels dropped significantly.

Equities trading net revenues were $1.05 billion, down 43 percent.

Goldman’s chief rival, Morgan Stanley (MS.N: Quote, Profile, Research, Stock Buzz), is due to report earnings on Wednesday.

A bright spot in the earnings report was Goldman’s investment banking division, which reported net revenues of $1.12 billion, up 24 percent.

During the third quarter, Goldman found itself bracing for new rules under the U.S. financial reform that will impact its business.

Goldman is winding down its Principal Strategies Group, a division of proprietary traders that bets with the firm’s own cash. The change is a result of the so-called “Volcker rule,” which limits the extent to which banks can bet with their own capital.

Goldman has also been trying to restore its brand after it was hit with fraud charge by the U.S. Securities and Exchange Commission in April. Goldman paid $550 million to settle the charges.

The firm recently launched a public relations campaign that included advertisements. But the bank did not have its usual conference call with journalists on Tuesday to discuss its results.

Goldman, which has faced a backlash over its pay practices, set aside $3.83 billion for compensation in the third quarter, bringing its total pool to $13.12 billion for the year, down 21 percent from a year ago.

Goldman shares were up $1.00 to $154.70 in early trading.

(Reporting by Steve Eder; Editing by John Wallace)

At risk is not just the health of the banks but also the fragile housing market and the broader economy, which is still struggling to emerge from the worst recession since the 1930s, analysts warn.

All 50 U.S. states have started a joint investigation of the mortgage industry, focusing on allegations that for years banks have not reviewed documents properly or have submitted false statements to evict delinquent borrowers.

The investigation, one of the biggest legal probes of the mortgage industry in decades, has alarmed investors who fear cleaning up the foreclosure paperwork mess could take months, even years.

The fiasco threatens to eat into bank profits by delaying sales of bank-owned properties, drawing fines from regulators, and spawning lawsuits from both homeowners and investors in mortgage-backed securities.

The KBW Banks index dropped 2.6 percent on Thursday while the broad Standard & Poor’s 500 index fell just 0.4 percent.

Bank of America, the largest U.S. mortgage servicer, has temporarily halted evictions nationwide. JPMorgan Chase and others have halted some foreclosures pending reviews, while some have left foreclosure policies in place.

The moratoriums, combined with buyer wariness, could suppress home sales. Nearly one-third of all homes sold in September were in the foreclosure process, according to real estate data company RealtyTrac.

“Banks could be dealing with this on a loan-by-loan basis for years,” warned Jefferson Harralson, a bank analyst at Keefe, Bruyette & Woods in Atlanta.

Mindful of the dangers, federal regulators have pressed banks to quickly complete internal reviews and not slow down foreclosures where the paperwork is in order.

JPMorgan Chief Executive Jamie Dimon said a prolonged investigation by the state attorneys general could slow down the housing recovery. “But we’re hoping it won’t kill it,” he told Reuters on the sidelines of a Business Council meeting in Chicago.

But Bank of America CEO Brian Moynihan played down the impact of the foreclosure document inquiry, calling the housing market “stable” and saying unemployment levels would have a bigger impact.

JPMorgan shares closed down 2.8 percent, Bank of America ended down 5.2 percent, Citigroup fell 4.5 percent and Wells Fargo lost 4.2 percent. The banks are the top four mortgage servicers in the United States.

Officials from Citigroup, BofA and Wells Fargo are likely to face questions on the foreclosure issue when they host conference calls on their quarterly earnings next week.

CALLS FOR MORATORIUM

Despite the White House rebuffing calls by some senior Democratic lawmakers and others for a nationwide moratorium on foreclosures, the issue has mushroomed in the runup to the November 2 congressional elections.

The number of homes taken over by banks topped 100,000 in a month for the first time in September but foreclosures are likely to slow as lenders review their paperwork, RealtyTrac said.

The disclosures that lenders may have engaged in illegal practices to evict delinquent homeowners has reignited simmering public anger with banks, whose excessive risk-taking is blamed for helping cause the financial crisis that plunged the country into the 2007-2009 recession.

The Obama administration says it backs the attorneys general investigation but at the same time it has signaled it is wary of doing anything that could derail any recovery in the housing market, usually a driver of economic rebounds.

Republicans are expected to make big gains in the November elections on the back of growing disapproval over how President Barack Obama and his Democrats are handling the economy.

“MASSIVE, MASSIVE PROBLEM”

Despite the White House’s reluctance to get involved, political pressure is mounting on the top mortgage servicers, which took money from the government’s $700 billion Troubled Asset Relief Program to ride out the financial crisis.

Ted Kaufman, head of the panel that oversees TARP, told Reuters Insider the watchdog is likely to probe the foreclosure paperwork issue, along with the special investigator for TARP and the Government Accountability Office.

“This is a massive, massive problem,” Kaufman said, calling it “a real concern to the economy.”

FBR Capital Markets said the U.S. banking industry faces foreclosure-related losses of $6 billion to $10 billion but is ready to “comfortably” absorb them. Still, the analysts said, mortgage servicers may be in trouble as they have never faced such extensive investigations.

“The real cost to the industry is going to be the drag on the foreclosure process, which could delay any recovery in the housing market,” FBR said. “While we had previously believed that this was an election issue, we now think that this could materialize into a longer-term concern.”

At issue is the use of “robo-signers” — people who sign hundreds of affidavits a day — by banks and companies that collect monthly mortgage payments. It is alleged they did not have time to review the foreclosure documents they signed.

James Barth, an economist at the Milken Institute, said the issue was legal blip that was unlikely to lead to the entire foreclosure process being called into question.

“It’s apparently in many cases more of a legal technicality than a matter in which you will find someone who borrowed money doesn’t really owe the money,” he told Reuters.

(Additional reporting by James B. Kelleher in Chicago, Abhinav Sharma in Bangalore, Julie Haviv and Elinor Comlay in New York, Karey Wutkowski, Dave Clarke and Corbett B. Daly in Washington, and Joe Rauch in Charlotte, N.C.; Writing by John O’Callaghan and Ross Colvin; Editing by Tim Dobbyn)