Nov. 8 (Bloomberg) -- Morgan Stanley joined Merrill Lynch & Co. and Citigroup Inc. in booking losses on subprime mortgage- related assets and said the outlook for credit markets is bleaker than in September.

The second-biggest U.S. securities firm by market value after Goldman Sachs Group Inc. said it lost $3.7 billion in the two months through Oct. 31. Prices for securities linked to home loans to risky borrowers sank further than traders expected, cutting fourth-quarter earnings by $2.5 billion, the New York- based bank said. The figure may change by the end of the month.

Merrill Lynch, the third-largest firm, said two weeks ago that it wrote down $8.4 billion of leveraged loans and fixed- income securities while Citigroup, the biggest U.S. bank, said Nov. 4 that its holdings lost as much as $11 billion of their value in October. Colm Kelleher, Morgan Stanley's chief financial officer, said markets may take three to four quarters to recover instead of the one or two he predicted in September.

``The healing process will take longer,'' Kelleher, 50, said in an interview yesterday. ``The dislocation in the market has been quite severe, liquidity has dried up.''

Concern about potential writedowns at Morgan Stanley has pushed the stock lower this week, bringing this year's decline to 24 percent. The shares fell 6.9 percent to $51.19 in New York Stock Exchange composite trading yesterday and traded up at $51.35 in Germany as of 11:15 a.m. local time. Citigroup and Merrill are both down more than 40 percent this year.

Profit Wipeout

Credit-default swap contracts on Morgan Stanley climbed 20 basis points to 130 basis points at the close of trading in New York yesterday, Phoenix Partners Group prices show, before the writedowns were announced. CDSs, used to speculate on a company's ability to repay debt, rise as credit quality worsens.

Morgan Stanley's asset writedowns could wipe out fourth- quarter profit. The company was expected to earn $1.93 billion in the period, according to the average estimate of 10 analysts surveyed by Bloomberg. The world's biggest banks have written down more than $40 billion after late payments on U.S. home- loans rose to a five-year high and foreclosures set a record.

Chief Executive Officer John Mack oversaw the expansion of the firm's mortgage business last year with the acquisition of Saxon Capital Inc. for $705 million in December. In addition to being a mortgage provider, Saxon services home loans to people with poor credit histories by collecting payments, maintaining records and foreclosing on delinquent borrowers.

CEOs Step Down

Mack, 62, hasn't faced the kind of investor criticism that preceded the Nov. 4 resignation of Citigroup CEO Charles O. ``Chuck'' Prince III and the ouster of his counterpart at Merrill Lynch, Stan O'Neal, on Oct. 30. Zurich-based UBS AG, the largest Swiss bank, fired CEO Peter Wuffli in July.

Morgan Stanley is eliminating about 300 jobs in the securities division after third-quarter revenue from fixed- income fell 3 percent, a person with knowledge of the decision said last month.

``I would imagine they will have to take more charges and more of their peers will have to take charges also,'' said Jon Fisher, who helps manage $22 billion at Fifth Third Asset Management in Minneapolis. ``Slowly but surely these boards and management teams are starting to come out with forecasts of how much bad paper is on their books.''

AIG Losses

American International Group Inc., the world's largest insurer, said yesterday that third-quarter profit fell 27 percent to $3.09 billion amid the worst U.S. housing recession in 16 years. The New York-based company recorded $864 million in losses on investments before taxes and marked down other holdings by $3.49 billion.

Writedowns of subprime-related assets at U.S. banks and brokerage firms may total $50 billion in the second half of 2007, Deutsche Bank AG analyst Michael Mayo estimated in a note to investors yesterday before Morgan Stanley's announcement. Citigroup analyst Matt King said yesterday the figure may reach $64 billion.

David Trone, an analyst at Fox-Pitt Kelton Cochran Caronia Waller, cut his recommendation on Morgan Stanley to ``in line'' from ``outperform'' on Nov. 6, saying he expected the company to write down as much as $6 billion in securities.

Part of Morgan Stanley's loss stemmed from derivatives its proprietary trading unit wrote earlier in the year, Kelleher said. Derivatives are financial contracts whose value is derived from debt or equity securities, currencies and commodities.

`Risk Exposure Swings'

The traders anticipated a decline in the value of subprime securities, and the contracts made money for the firm in the second quarter, he said. They started losing money when prices fell further than the traders predicted, Kelleher said.

``These exposures did not come out of our client-facing activities, these were a proprietary position we put on,'' Kelleher said in a conference call with analysts yesterday. ``As markets continued to decline our risk exposure swung from short, to flat to long.''

The people responsible for the losses no longer work at the firm, said Morgan Stanley spokeswoman Jeanmarie McFadden. She declined to identify them.

Morgan Stanley's maximum potential losses from subprime- related assets stood at $6 billion at the end of October, down from $10.4 billion at the end of August, the company said. That ``net exposure'' figure assumes that all of the securities default and no money is recovered on any of them.

`Further Deteriorate'

``The fair value of these exposures will frequently change and could further deteriorate,'' the company said in an e-mailed statement yesterday. Morgan Stanley said it doesn't plan to release more information about the positions until it reports fourth-quarter results next month. The firm's fiscal year ends in November.

With the exception of the losses that will affect its fixed-income division, Morgan Stanley said it ``expects to deliver solid results in each of its other businesses.''

Citigroup and Merrill Lynch both reported larger-than- expected losses on subprime-related securities such as collateralized debt obligations. Merrill Lynch reported the biggest loss in its 93-year history on Oct. 24 after writedowns were almost double the firm's forecast three weeks earlier.

``We're getting through the process of these people admitting they have a problem, we're going to spend the first half of '08, and maybe all of '08, figuring out how bad the problem is,'' Fifth Third's Fisher said.

He sold Morgan Stanley shares in the summer, he said. ``It's not a time to buy the stock or any of its peers.''

To contact the reporter on this story: Christine Harper in New York at charper@bloomberg.net .