Financial firms make a lot of their money on the spread: The difference between the price they pay to borrow money and the revenue they generate when they lend it. If the cost of borrowing goes up and revenue from lending doesn’t, therefore, the firms make less. And that’s what’s about to happen on Wall Street.
Big firms like Lehman Brothers (LEH), Merrill Lynch (MER), and Wachovia (WB) have a record $891 billion in bonds maturing through 2009. JP Morgan believes that higher credit spreads will cost these lenders as much as $23 billion in additional interest expense when they go back to debt markets to borrow more money.
Put differently, as banks have suffered loss after calamitous loss, investors have demanded higher interest payments on debt. This means that the cost of capital is rising just when banks need it most, and equity raises and debt issuances are growing more painful by the day. Bloomberg:
Investors on average demand yields of 4.14 percentage points more than what they can get on Treasuries to purchase bank bonds, up from the low last year of 0.76 percentage point in January, according to Merrill Lynch index data. Spreads on investment- grade rated bonds overall average about 3.14 percentage points.
Merrill, Wachovia, and Lehman have $62 billion, $34.5 billion, and $30.4 billion, respectively, in debt maturing before the end of 2009. When they issue new bonds to replace this debt, it will be at these painful rates, which will likely erode profitability going forward.
The firms also might react to higher borrowing costs by borrowing less. This, in turn, will further tighten access to capital for the rest of the economy:
“The gears of capitalism are grinding to a halt,” said Mirko Mikelic, senior bond fund manager at Grand Rapids, Michigan-based Fifth Third Asset Management, which oversees $21 billion in assets.