Wall Street firms back at the well

This week, Wall Street brokerage firm Lehman Brothers* announced that they will be seeking an additional $6 billion in capital to shore up their balance sheet.

This is in addition to the $4 billion they raised just over two months ago. Just prior to that March capital raise, the firm's CFO had stated that the $1.9 billion they raised in February of this year had taken care of the firm's capital needs for the rest of the year.

This underscores the fact that even the CFOs and CEOs of those firms do not have a clear picture of the conditions of their own balance sheets; other big Wall Street firms have announced similar additional write-downs this year after what were supposed to be the final write-downs.

The reason the big Wall Street investment banks have this balance sheet problem right now is that they were underwriting a variety of debt-based instruments over the past five years (in order to collect underwriting fees, which is a primary source of revenues for these firms). During the recent period of unusually low interest rates (the product of over-steering by the Federal Reserve, as we have discussed in previous blog posts such as this one), there was a frenzy of such underwriting because of the heightened levels of borrowing and packaging of debt that the low interest rates induced.

When these investment banks could not sell all of the underwritten debt instruments through their sales forces, they took them into their own inventories. But, the accumulation of such instruments has wreaked havoc with their balance sheets, particularly in light of the accounting requirement to "mark to market" daily, and the end result is the situation today where the balance sheets of the biggest Wall Street investment firms are so full of questionable debt instruments that they have to go looking for capital to shore them up, even if they just finished saying that they have raised all they need for the year.

It's as if the manufacturing arm of a business kept cranking out boxes of product even after the sales force was screaming at them that the market was saturated and they could no longer sell any more, but the assembly lines just kept on turning it out, and so the excess was stuffed into the warehouse. So much was stuffed into the warehouse, in fact, that management inspections keep turning up more of it squirreled away in dark corners and underneath old shelves in the back, and a lot of it has been discovered to be rotten.

Those in the salesforces at these big Wall Street firms must be asking themselves how many times the capital market side (the "manufacturing" side in the above analogy) has to ruin things for them, by trying to pile up the underwriting profits during whatever craze is gripping the markets at any given time, setting the stage for yet another downfall. It wouldn't be as big an issue if it weren't such a recurring event (Latin American Debt, Orange County, Long Term Capital Mangement, Asian Currency Crisis, etc.).

In fact, it seems that investors might be better served if these large advisory divisions -- a relic of a bygone era when those firms needed a salesforce to distribute the stock of companies they took public -- separated completely from the big investment banks and became independent. Perhaps in the future the current arrangement of advisory arms at big Wall Street investment banks will be a thing of the past.

* The Principals of Taylor Frigon Capital Management do not own shares of Lehman Brothers (LEH).

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