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Wall Street is on course for more downsizing after Merrill Lynch said its holdings of sub-prime and other troubled debt instruments declined in value far more than the bank had estimated less than three weeks ago, leading to a shocking third-quarter net loss of $2.82 per share.

Structured finance, one of the Street's hottest growth areas in recent years, is in the cross-hairs at Merrill and elsewhere. Still, a recruiter we spoke with believes banks will trim rather than slash.

"Despite the headlines, people are carrying on," says Jay Gaines, chief executive of Jay Gaines & Co. "So unless it gets considerably worse, I don't expect a massive bloodletting, or the destruction of human capital that it's taken firms years and years to build."

Gaines expects investment banks to exit non-core businesses, and maybe get tough on "marginal performers" by reducing or withholding bonuses and actually chopping heads. "So you're going to see more layoffs, but I don't expect to see the Street cutting bone," he says.

On the positive side, look for banks to beef up risk management departments, increase emphasis on markets outside the U.S., and build their wealth management franchises.

Merrill Will Downsize Structured Businesses

In a conference call Wednesday, Merrill Lynch chief executive Stan O'Neal both accepted responsibility for lax risk controls and promised to shift emphasis from "structured businesses" toward still-profitable activities, including private equity. He also promised to sell unspecified non-core assets.

Structured finance includes mortgage-backed securities and collateralized debt obligations, the major culprits behind the record $8.4 billion write-down Merrill revealed Wednesday. As recently as Oct. 5, the bank had pegged its CDO and sub-prime mortgage losses at $4.5 billion. The much larger loss figure resulted from additional analysis using "more conservative loss assumptions," O'Neal said. When analysts on the conference call asked for details about Merrill's method of valuing its CDO-related asset-backed securities, O'Neal demurred - stirring concerns that still deeper write-downs might lie ahead.

On a larger scale, Merrill's write-downs mirrored similar revelations from other investment banks in recent weeks. The losses have made 2007 a record year for layoff announcements in finance - 130,000 job cuts announced through October, according to outplacement firm Challenger, Gray & Christmas. However, most layoffs involved retail loan officers working in bank branches and mortgage origination companies directly exposed to this year's plunge in home sales.

Now, bond trading and structuring positions are getting scaled back. Merrill's latest revelations point to additional casualties in those sectors between now and early 2008. An Egon Zehnder managing partner told BusinessWeek that experts believe the cuts to date amount to about 10 percent of Wall Street's work force. That's about half as much damage as occurred after the 2000 stock-market bubble.

The top ranks of fixed-income departments are getting roiled too. Wednesday's New York Post reported the departure of Irvin Goldman, Cantor Fitzgerald's head of debt capital markets. Goldman presided over the rebuilding of Cantor's bond trading and sales business after the 2001 World Trade Center attacks decimated the privately held firm and made its name a household word.

Even as Merrill and its rivals struggle to rein in exposure to sub-prime and other troubled assets, Gaines believes they will maintain the securitization infrastructure that kept profits humming through the middle of this year.

"A lot of valuable expertise lies in the structured finance areas," he says "I just don't anticipate the Street firms are going to cut into the heart of that, as much as around the sides of it."

Who Will Survive and Prosper?

With Merrill and other banks saying "mea culpa" for mismanaging their risk exposures, risk management is a professional specialty that stands to grow in influence and probably in headcount. Private wealth management is another potential winner. Its revenues and profits have held firm through the recent storms, and it does not put a bank's own capital at risk.

Even within structured finance, one sub-segment is prospering amid the wreckage. Trading in the credit default swaps market, led by the iTraxx Crossover index of 50 companies with credit ratings on the cusp between investment-grade and high-yield, has "boomed," according to Financial News. That happened because investors who needed to quickly reduce exposure to corporate credit found it more efficient to trade the index than to sell corporate bonds, which are less liquid.

Structured finance pros who are let go by Wall Street may find their skills in demand on the buy side. "If they are dislocated or find their prospects limited, those are the people that will find their way into hedge funds that are ahead of this curve," Gaines says. A number of funds are raising capital for new vehicles that aim to buy up "distressed" debt cheaply.