How Bad Will It Get on Wall Street?

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It could take years for some banks to complete the painful deleveraging process on their own. They'll sell off healthy assets whenever possible and try to partner up with rivals to cut costs. Some will die. David A. Hendler, an analyst at debt-research firm CreditSights, says Wall Street may be entering an era in which there are fewer investment banks and those that exist aren't as important.

That will open the door to competition from hedge funds and private equity firms. Of course, the deleveraging hangover means they won't be able to shower companies with loans anytime soon. But some private investment pools are beginning to connect companies seeking capital with investors providing it—just as investment banks do. "The Wall Street banks in general are going to lose market share," predicts Jonathan Kanterman, a managing director with money manager Stillwater Capital Partners.

Creating More Problems

The growing market for private placements, for example, is enabling more corporations to sidestep Wall Street stock underwriters and go directly to hedge funds, pension funds, and other big investors to raise cash. Last year private equity giant Kohlberg Kravis Roberts set up its own team to find institutional buyers for large equity stakes in companies it had taken private. Historically, that's been a job handled by Wall Street. With that team in place, there's nothing to stop KKR from offering its services to other private companies looking to place stock.

Hedge funds and private equity firms also have become big providers of so-called mezzanine financing, a type of loan that can be converted into an equity stake in a company. Some of the new players may even try to coax life out of the moribund securitization market over time. Chicago-based hedge fund Citadel Investment Group, for example, recently hired a top JPMorgan Chase (JPM) executive to head its new "securitized products" group.

But a landgrab by big hedge funds and private equity firms might create new problems. The Securities & Exchange Commission and the Finance Industry Regulatory Authority oversee investment banks to some degree, and the Federal Reserve is moving in that direction. But hedge funds are largely unregulated and aren't bound to make any disclosures to anyone but their investors. Even that information is often incomplete. A move by hedge funds into traditional corporate finance would mean even less transparency than exists on Wall Street now. "It's just a swing from one problem to another," says Manhattan College's Geisst.

Lehman's Pain

To see just how stuck in the mud Wall Street is, one need look no further than Lehman. Investors have abandoned the firm in droves on fears of a sudden collapse and the expectation that it will be swallowed up by a larger rival—perhaps Goldman Sachs (GS)—at a bargain price. With shares trading around $16, down 74% for the year, Lehman sports a market value of just under $12 billion.

Lehman has been in full deleveraging mode of late. Its leverage ratio now stands at 24 (through May), down from 31 two quarters earlier. Its mortgage business has all but dried up: Over the six months ended in May, the firm originated just $2 billion in residential mortgages, compared with $32 billion during the same period in 2007, and $4 billion in commercial mortgages, down from $32 billion. "They bought risky securities and they levered up, but the bet didn't pay off," says Brad Golding, a portfolio manager with money manager Christofferson, Robb & Co., who has no position in Lehman's stock. "There's no difference between Lehman and a subprime borrower who bought more house than he could afford."

Much of Wall Street did the same, leveraging up to finance mortgages that could be later repackaged into securities and sold to investors. Just about all of the $48 billion in so-called collateralized debt obligations Merrill Lynch (MER) underwrote in 2007 are either in default or on the verge. Now its chief executive, John A. Thain, is being forced to explore selling off pieces of its choicest assets to fill the gaping balance-sheet holes created by Merrill's bad business decisions. Says derivatives consultant Janet Tavakoli: "They really did create their own problems."

By setting up the housing bust, Wall Street has created problems for the rest of us, too. The real estate meltdown has left consumers vulnerable to soaring gas prices, which are only worsening home foreclosures and bank losses. That's leading to still-more deleveraging and even tighter credit. It's a vicious cycle, and it won't reverse easily.

Henry is a senior writer at BusinessWeek. Goldstein is a senior writer at BusinessWeek.