U.S. securities firms are expected to deliver much lower profits in the third quarter due to recent market volatility, according to Fitch Ratings.

Several of the large, bulge bracket U.S. securities firms are scheduled to announce their earnings in the next couple of weeks. Fitch notes that, “Speculation is rampant as to the potential impact market volatility and valuations of structured credit products may have on this quarter’s results.”

The rating agency says that it anticipates that financial performance for the securities firms was “challenging” in the third quarter, “with an expectation that results may be materially below the last several quarters of record earnings.”

The lack of liquidity and adverse valuations in credit products are expected to negatively affect earnings, it adds. “Earnings may also be constrained due to lower revenue and fee contributions from advisory, prime brokerage and asset management businesses. While client trading volumes are expected to be high, they may not be sufficient to offset these other challenges.”

Fitch says it believes the firms have sufficient capacity to absorb potential mark-to-market losses in the near term. “The timing of losses and lack of price transparency may result in some firms posting losses that translate into very weak reported results,” it says.

“Negative ratings actions are not expected to be taken in such cases,” Fitch notes. “However, negative ratings actions may occur [if] firms experience losses that exceed stress expectations. Negative ratings actions may also be dictated by other factors, including: the extent of revenue declines, the severity of negative valuation adjustments, increasing risk profiles; required vs actual liquidity, rising leverage resulting from a growing base of illiquid/less liquid assets; and/or tangible equity erosion.”

At the same time, Fitch affirmed its ratings on one of the bulge bracket firms, Morgan Stanley, and its subsidiaries. “The affirmation is supported by Morgan Stanley’s prudent management of liquidity and risk appetite with sufficient capital support at this time. The firm has sufficient resources to meet its funding needs including all commitments during this period of market dislocation,” it explains.

However, the rating outlook on Morgan Stanley remains negative, indicating the potential for a downgrade over the intermediate term. “Ratings triggers are longer term for Morgan Stanley and will be based on equity capital and leverage relative to risk appetite and the successful execution of strategies to enhance financial performance. Capital investments have been substantial since year-end 2005 across several bU.S.iness lines and to date had a positive impact on financial performance prior to the current credit market stress,” it adds.

Fitch says it remains comfortable with the level and credit risks assumed by Morgan Stanley. And, it says that the outlook could return to ‘stable’ if it manages well through the liquidity issues in the leveraged lending market and its financial performance is on par with peers. Ratings could be downgraded by one notch should it suffer an unexpected loss or it is adversely affected by a high level of loans pressuring capital.

For the industry overall, Fitch says it will continue to evaluate liquidity and capital in light of the market dislocation. “This stress will be placed in context with the industry’s resilience and demonstrated capacity to absorb shocks over the last few years including the crises in the falls of 1997 and 1998, the 2000 equity market correction and the events surrounding Sept. 11, 2001,” it concludes.