The Fed has been testing investment banks to see what will become of their balance sheets and liquidity if the credit markets signal another hurricane watch.

According to the FT, "Bankers with knowledge of the recent tests said some focused on sources of funding seen as particularly volatile such as the balances held in their prime brokerage business, which lends money to hedge funds."

Since there are only two long-term solutions to the liquidity puzzle, investors may face another period of significant dilution. The only other way out for investment banks is a simple and relatively permanent calming of the credit markets worldwide. Short-term loans from the Fed only go so far.

Major investment banks like Merrill Lynch (MER), Lehman (LEH), and Morgan Stanley (MS) hope to get by with their balance sheets as they are now. If the Fed were not keen on building an additional buffer, this might work. Dodging the Feds wishes may not be possible.

By some estimates Lehman will have to raise another $5 billion to keep afloat. It could sell Neuberger Berman, its money management operation. If no other company will pay a significant premium, Lehman may have to sell equity instead. Since its market cap is only $13 billion, current shareholders could see the value of their positions drop from $18 to $13 or $14, which is near where Lehman’s stock bottomed in mid-July.

The Fed may be able to save the major investment banks, but it will make certain that their investors pay for every dime of eliminated risk.

Douglas A. McIntyre

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