Brokerages Face Perfect Storm Of Subprime And Buyout Woes

For a change, Bear Stearns (NYSE: - ) is not the only brokerage making headlines for bad investments.

Goldman Sachs (NYSE: - ) saw shares sink further Friday after reports that another of its hedge funds was losing money. That fund, North American Equity Opportunities, reportedly lost more than 15% of its value this year through July 27. Similar losses have been reported at Goldman's $9 billion Global Alpha fund.

Goldman fell 1.2% after sliding 6% Thursday. Bear Stearns, Morgan Stanley (NYSE: - ), Lehman Bros. (NYSE: - ) and Merrill Lynch (NYSE: - ) also sold off again.

Unlike Bear Stearns, which saw three hedge funds take a beating from ailing subprime mortgage markets, Goldman's fund losses aren't directly tied to that crisis.

But that's likely little consolation to a sector weakened by the subprime mess and under growing pressure to convince investors there's enough money to stay liquid during the credit crunch.

"The biggest problem hasn't even come yet. That will come when private equity firms are unable to make the payments on their debt," said analyst Richard Bove of Punk, Ziegel. "The brokerages have a big exposure in this area."

Stuck On The Bridge

Of particular concern is the amount of bridge loans on Wall Street firms' books. These are typically used to provide short-term financing while longer-term packages are pursued.

The risk of bridge loans came into focus recently when a pair of high-profile LBO deals -- one involving Chrysler, the other British drug firm Alliance Boots -- saw their financing packages delayed.

Banks involved in those deals include Goldman, JPMorgan Chase (NYSE: - ) and Citigroup (NYSE: - ).

"The immediate fallout is that the banks which initially provided (the loans) are now unable to sell the debt and obtain permanent financing," Banc of America Securities analyst Michael Hecht wrote in a note last week. "They're stuck with these (loans), which will have to be carried on the balance sheet."

Some $300 billion in LBO financing is still needed for already-announced deals.

Private equity loans are particularly risky to investment banks, which lack the financial heft of big money centers like Citigroup, Chase and Bank of America (NYSE: - ). Those three banks already are increasing provisions for loan losses, with little financial impact.

"(The big banks) might see a few more billion dollars in loan losses, but that doesn't matter because they have so much liquidity," Bove said. "For the investment banks, it's different. It could have a profound effect on earnings."

Bear Stearns and Lehman Bros. are a fraction of the size of Citigroup and its peers. But they're exposed to several large LBOs that are struggling to find investors. These include Bear's stake in a $26 billion deal for Hilton Hotels and Lehman's stake in the $31.8 billion buyout of Texas utility TXU.

And while old deals sit on their books, no new buyouts -- and M&A fees -- are on the way.

On Aug. 6, Bear said fixed-income turmoil was the worst it has seen in decades.

Since then, the credit contagion has spread. French banking giant BNP Paribas on Thursday froze $2.2 billion worth of funds tied to U.S. subprime debt, saying a lack of market liquidity made it impossible to assess their value.

SEC Hitting The Books

Friday brought reports that the Securities and Exchange Commission is combing the books of top brokerages to see if they're fairly valuing their subprime assets. Analysts and investors have wondered if unreported losses exist.

Uncertainty valuing these loans has led investment banks to write down and freeze funds that invest in mortgage-backed securities.

Of top brokers, Bear Stearns and Lehman Bros. have the highest exposure to mortgage markets. Chris Carwile, senior analyst at SNL Financial, says 44% of Lehman's portfolio is in mortgage-backed securities. Then come Bear Stearns (35%), Merrill (15%), Goldman (12%) and Morgan Stanley (3%).

"The fact that Bear Stearns is considered experts in this market, many feel like they probably should've known better," Carwile said. "If it impacts them, there's speculation it will impact others."