June 3, 2008 - Merrill, Lynch, Lehman Brothers and Morgan Stanley are on the watch list at Standard & Poor's, the rating agency that can make raising money very expensive for companies that get downgraded. Of the three, Lehman appears the most shaky with many expecting it to report a loss for the first time since it went public. Word is that the firm is trying to raise $3 billion to $4 billion to keep its capital base healthy. It's out there competing with many banks and insurance companies working on the same thing. Merrill Lynch already has its money in the bank but may need more.

In a way, there's great irony in this. The Wall Street firms came up with these esoteric structures to sell more securities, for which they get paid handsomely. Now that the reality of those issues is coming back to haunt (bite) everyone who touched them, it seems most appropriate that their originators will suffer along with the buyers.

Here's how the pain works: a Wall Street firm owns the bonds. With no buyers, the bonds go lower in value. The firm has to "mark to market" the bonds to calculate its capital base. Each down tick of the bonds lessens capital. As the bonds go lower, so does the firm's ability to do business, especially new business because it has less capital on which to grow. If the bonds go low enough, the firm's capital is wiped out (see Bear Stearns) and goes out of business. That's why raising new capital is so important to the Street. It's those damn bonds going lower every day that's killing them.

This is exactly what happened to Drexel Burnham, a fine firm for which I worked. We were loaded with "junk" bonds that nobody would buy. Without buyers and a market that was going lower every day, the firm didn't have the capital to continue in business. Of course, the fact that we were investigated by the SEC and every other regulatory body didn't help business either. But the real problem was those bonds. Nobody would touch them.

History is repeating. Only this time, it's another security doing the damage. What's not strange is the nature of it: most of these bonds were backed by subprime mortgages that shouldn't have been made in the first place. In other words, they're junk, too. Name change, same story.

So don't expect the big brokers to bounce right back, even if they raise new capital. Until they can sell some bonds and relieve their capital stress, there will be more mergers and acquisitions on the Street. That heavy inventory also means less capital for Street firms to make markets in stocks, to make bids on them, to buy and hold them. Liquidity in stocks will be less for a while.

To sum up: things are bad, and they're not getting better soon, even with more capital thrown at the problem. The losses yet to come will be less than what we've seen, but they may still be enough to sink some venerable Wall Street names.

- Ted Allrich