INVESTING: How Wall Street firms wounded themselves

There will be plenty of future litigation over the subprime mortgage mess. The city of Cleveland has sued 21 of the nation’s biggest mortgage firms, claiming their s u b p r i m e – l e n d i n g practices created a public nuisance that hurt property values and city tax collections. And the FBI, in conjunction with the Securities and Exchange Commission, is looking into the various players to see if fraud was committed.

While there have been many market participants wounded in the subprime mess, one thing clear is that Wall Street fell on its own sword this time. Less than a decade ago, the big investment banks paid large fines to settle their misdeeds for floating fantasy initial public offerings to the public, and for providing the financial tools that enabled Enron and Worldcom to pull off their heists.

But in this current fiasco, the firms are paying where it really hurts-with the loss of their own capital. As former hedge fund manager Andy Kessler recently wrote in The Wall Street Journal, the investment banks broke “Wall Street’s unwritten ‘sausage rule’ that you sell this stuff to clients, but never own it yourself.”

Since last May, the world’s largest banks have reported cumulative losses of more than $100 billion as a result of holding U.S. subprime mortgages. Three firms-Citigroup, Merrill Lynch and UBS-account for more than $60 billion of the total, and there is more to come.

“Bond king” Bill Gross of PIMCO predicts that, before this is over, there will be at least $250 billion in subprime losses-and an additional $250 billion of losses recorded in the arcane credit-default-swap market.

Back in July, Chuck Prince, the ousted chairman of Citigroup, revealed a certain arrogance, and prescience, when he said this about the credit markets: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

To shore up their capital bases, investment banks are turning to an unlikely source, the sovereign funds of foreign countries. UBS has garnered $11 billion from Singapore; Citigroup $22 billion from a number of sources, including $7.5 billion from Abu Dhabi; Morgan Stanley $5 billion from China; and Merrill Lynch $11 billion from Korea and other countries.

As a recent Fortune magazine points out, the bad news for shareholders of these firms is that that they engaged in the value-destroying process of “buying high and selling low” with their own stock.

For example, in early 2007 Merrill was buying back its own stock on the open market at $84.48 per share. But in December, Merrill turned around and sold $5.6 billion of stock at $48 per share to the government of Singapore. Citigroup, UBS and Morgan Stanley also have sold stock at much lower prices than they were paying to acquire their stock under share-repurchase programs.

Many of the top executives at these firms have been replaced. Merrill’s new CEO, John Thain, recently said that in the future, “we are not going to be in the CDO and structured-credit-type businesses.”