The Depths of Wall Street Balance Sheet Destruction Coming into View

This week gave us several new announcements of massive capital requirements, funds needed to bolster eroding Wall Street balance sheets. These revelations came as no surprise. And my sense is that we might finally be getting a handle on the magnitude of the losses truly sustained by the largest broker/dealers, amounts that are at least 2x larger in aggregate than we were led to believe at the outset of the sub-prime crisis. My concerns about the uncertainty of loss amounts were reflected in an earlier post back in December:

The confluence of massive sovereign liquidity in Asia, the marquee names of the institutions willing to receive investment, the ability of the SWFs to actually help the financial institutions' with the exploding business opportunities in the region, Saudi Prince Bin Talal's high-profile success with his Citi investment back in the early 1990s - all of these contributed to the development of the on-balance sheet SWF alternative to the off-balance sheet M-LEC alternative.

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But before anybody claims victory, let's keep a few key things in mind. The problem is far from solved. Liquidity has not yet returned to the market. There is still not a clear bottom to where these mortgage and associated derivatives portfolios will ultimately realize value. And it is this uncertainty that makes the SWFs investments so brave and so bold. Will Merrill need an additional $5 billion? Will Citigroup need another $10-$15 billion? UBS? $5-$10 billion more? Who knows. Maybe so.

The reality of the incremental amounts to be raised, as reported in a Wall Street Journal article from Friday:

Citigroup Inc. and Merrill Lynch & Co., two companies that just named new chief executives after being burned by the troubles in the U.S. housing market, recently raised billions of dollars from outside investors. Now, they are in discussions to get additional infusions of capital from investors, primarily foreign governments.

Merrill is expected to get $3 billion to $4 billion, much of it from a Middle Eastern government investment fund. Citi could get as much as $10 billion, likely all from foreign governments.

Just when you thought $7.5 billion and $5 billion might be enough, Citigroup and Merrill are going back to the well. And they may well go back to it later in 2008. Even Prince Alwaleed is kicking in a few billion as part of Citi's new funding package, a mere 16 years after his initial (and massively successful) foray into bailing out Citigroup. Back then $590 million bought almost 15% of the firm, and he was the largest individual shareholder for years. Why was I so cynical that the capital raises announced in December wouldn't be the last of them? Because most Wall Street balance sheets didn't begin to accurately display the market value destruction that had taken place within their lending and investment books. One could observe the difference between carrying values and credit derivative prices; it didn't take a rocket scientist to figure that one out.

But one other burning issue remains as it relates to SWF's investing so heavily in US financial institutions: political risk. Back in December I posed the political question in the following manner:

And where is that money coming from? Will political realities enable Asian SWFs to buy 20-25% of these damaged firms without causing a huge backlash?  I'm not so sure about that, and it's not a question I'd really like to be compelled to answer. I think we are maybe in the second inning of a game going into extra innings, with a lot of excitement, angst, fear, conflict and greed lying ahead.

Apparently I'm not along in worrying about this issue. Later in Friday's WSJ story they raised some similar concerns:

Typically, passive investments of less than 10% in a U.S. company by a foreign firm wouldn't require a review by the interagency group. But agitated lawmakers could clamor for one and delay a time-sensitive deal. Before Citi announced its capital infusion from Abu Dhabi, the company briefed select lawmakers to assuage potential concerns. When the deal was announced, key lawmakers were either supportive or mum.

The issue is likely to gain more scrutiny this year. Senate Banking Committee Chairman Christopher Dodd is expected to hold hearings on the matter soon, as some lawmakers have raised questions about a lack of transparency in the investors.

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Given the sensitivities, the banks are talking to multiple investors to see that no individual investor gets too large a stake, so as not to alarm politicians and regulators.

We'll see how this plays out, but I think it highly likely that the political issue will both rear its ugly head during 2008 and serve as campaign fodder for some of our more opportunistic and muckraking candidates. And this political gamesmanship will inevitably result in a reality-TV show with the following name: As the Stomach Turns.