As investors shun debt, banks are left holding the bag

In recent years, Wall Street firms have reaped big profits in the scrappy reaches of the credit markets, selling the debt of companies with weak credit ratings to investors who crave higher returns.

But now, as investors have suddenly grown skittish, some big Wall Street banks have been stuck with piles of debt that they are struggling to sell. As a result they are starting to book multimillion-dollar losses as they write down the value of these positions.

The investment banks that focus on this market appear to be sitting on potential losses that may exceed $600 million, according to an analysis by debt market specialists of several deals that are struggling. These deals have not closed yet, but the markings are based on the lower prices investors are demanding. 

A large portion of the paper losses is from debt issued by Veritas, a software entity that the private equity firm Carlyle Group is buying in a $5.5 billion leveraged buyout. Morgan Stanley and Bank of America led this transaction. A lack of demand for the debt has effectively left it on the books of the banks.

None of the banks would comment on the calculations.

If the market recovers, the value of the troubled debt may rise again, shrinking or reversing any losses. The hits are also a fraction of those that the banks suffered in the financial crisis of 2008.

Still, they are a reminder of how Wall Street can be wrong-footed at crucial turns in the market. The problems in the debt markets could also weigh on merger activity. Banks that are unable to sell debt may now become more stringent in their lending for acquisitions.

And the pain may worsen if the debt markets react badly to an increase in interest rates. The Federal Reserve is expected to raise interest rates next month, a potentially seismic move that could limit the flow of money that has buoyed speculative markets in recent years.

Among those markets is the one for leveraged loans, the type of debt that is causing many of the losses right now for the banks.

Banks make these loans to companies that have junk credit ratings in the hope of quickly selling the debt to investors, including mutual funds, hedge funds and entities called collateralized loan obligations.