July 28 (Bloomberg) -- Bondholders are demanding the highest interest rates for Wall Street debt since 2000, threatening the industry's business model of acquiring assets with borrowed money.

Lehman Brothers Holdings Inc. has seen borrowing costs for its five-year bonds rise to 7.7 percent, up from 5.2 percent six months ago, the biggest jump of the four largest U.S. securities firms, data compiled by Bloomberg show. The yield offered on Lehman's $1.5 billion of bonds maturing in January 2012 is 4.3 percentage points more than the yield for five-year U.S. Treasury notes, a premium almost double what it was in late January.

Wall Street faced higher debt costs in 2000, when the U.S. Federal Reserve's base lending rate was 6.5 percent. What's different now is the Fed rate is at 2 percent, showing that elevated yields of bank debt are all related to risk premium, or the spread investors demand to lend to brokers rather than the government. Firms like Lehman also rely increasingly on access to capital these days, rather than on fees or commission income.

``This is almost self-induced balance-sheet destruction,'' said Joseph Balestrino, a fixed-income strategist at Pittsburgh- based Federated Investors Inc., which manages about $330 billion. ``This is far beyond just your basic slowdown.''

Merrill Bond Yields

In some debt maturities, Merrill's bond yields are higher than Lehman's. For instance, Merrill debt that matures in April 2018 yielded 8.15 percent as of July 25, compared with 8.01 percent on Lehman notes that mature on May 2018. Merrill's bonds that mature in May 2038 offered 8.76 percent, compared with 8.47 percent on Lehman notes due for repayment the same month.

The last big gain in investment banks' credit spreads occurred in 1998 after Russia defaulted on its debt and the hedge fund Long-Term Capital Management LP collapsed. The yield on a Lehman note issued in April 1998 that matured in 2003 rose to 7.6 percent in October of that year from 5.89 percent in August, a 29 percent increase. Financing costs returned to normal within a few months.

This time, interest rates are staying high for a longer period of time, threatening to undermine bank profits, even though the firms have been trying to reassure investors by selling assets they bought with borrowed money, a process known as deleveraging.

Lowering Leverage

Goldman Sachs Group Inc., Morgan Stanley and Lehman cut their combined assets by about $97.5 billion, or 3.4 percent, in the first half of fiscal 2008, company reports show. The average leverage ratio for the three New York-based firms, which measures gross assets divided by total shareholder equity, fell to 26.1 from 30.1. Still, bond yields climbed in June and July.

``It has not worked,'' said Eileen Fahey, a Chicago-based credit analyst at Fitch Ratings. ``That's the problem. Nobody really knows how long this is going to go on.''

All of the securities firms stored up money when rates were low, allowing them to delay new borrowing for at least a few months in hopes that rates decline.

``They haven't had to issue a significant amount of debt at the higher cost yet,'' Fahey said. If they do, ``it certainly changes their profitability,'' she said.

Ian Lowitt, Lehman's chief financial officer, told investors on June 16 that the firm doesn't expect to return to the bond market this year and has ``completed our funding plan for 2008.'' At the end of May, Lehman was financing $47 billion of its assets through bank subsidiaries, which are able to pay lower rates because they have insured deposits. The company also gets lower rates by lending out securities in exchange for cash loans, known as repurchase, or repo, transactions. Lehman has about $21.6 billion of debt coming due in 2009.

Rolling Over Debt

Morgan Stanley also refinanced all of its debt maturing in 2008, amounting to about $30 billion, according to company spokesman Mark Lake. The firm raised most of its total debt before mid-2007, when it was trading at 35 basis points to 60 basis points above the London interbank offered rate, Lake said. One hundred basis points equal one percentage point.

Since then, the spreads widened to 150 basis points to 250 basis points over Libor. The firm has $20.1 billion of debt coming due next year, Bloomberg data show.

Nelson Chai, Merrill's chief financial officer, told analysts on July 17 that the firm issued $37 billion in long- term debt during the first half and plans to ``look for opportunities'' to issue more debt in the market as necessary. The firm has $30.2 billion of debt maturing in 2008 and $35.8 billion coming due in 2009, according to Bloomberg data.

Broken Business Model

``If you're going to be a big user of capital, then you have to be worried about how you finance your business,'' said William Cohan, a former investment banker at Lazard Ltd. and JPMorgan Chase & Co. and the author of ``The Last Tycoons'' about Lazard. ``A lot of these guys don't know what to do. They're frozen, and they're just hoping that in time things will get better.''

With low interest rates and credit spreads over the past five years, the investment banks became more dependent on revenue from assets they acquired and held on their balance sheets. Now the firms will have to return to depending on revenue from trading commissions and advisory fees, said Shubh Saumya, a partner at The Boston Consulting Group, who advises investment banks.

``The question really is going to become is this spike in spreads a transient phenomenon or something structurally different?'' Saumya said. ``If it's the latter, you're better off building a business model reflecting that reality.''

Unless bond investors become more enthusiastic about lending to Lehman, Merrill Lynch & Co. and Morgan Stanley, those firms will have to roll over their maturing debt at higher rates than they paid over the past decade, Bloomberg data show.

Goldman Escapes

Only Goldman Sachs, the largest and most profitable U.S. securities firm, has escaped the increase in debt yields. The firm's $2.64 billion of 5.25 percent senior unsecured notes that mature on Oct. 15, 2013, last traded at a yield of 5.82 percent, or 2.34 percentage points more than a comparable government bond. Six months ago, the notes yielded 4.55 percent.

Merrill's A credit rating from Standard & Poor's is the lowest in the firm's history, while the A2 senior unsecured rating from Moody's is the lowest since 1991. The New York-based company's $2.25 billion of 5.45 percent 2013 notes yield 7.58 percent, up from 5.33 percent six months ago, according to Bloomberg data. The risk premium has widened to 4.21 percentage points more than U.S. government debt from 2.57 percentage points.

Long-term Debt

``It's going to be harder and harder for them to borrow long-term in this environment, to pay the spreads that investors are going to want,'' said David Hendler, an analyst at CreditSights Inc., a research firm in New York. ``Can they deal with this type of funding environment?''

Long-term borrowing has become more popular on Wall Street, as firms seek to reduce their dependence on overnight, or short- term funding and secure money they don't have to pay back for years. The near bankruptcy of Bear Stearns Cos. in March, before it was rescued in an emergency sale to JPMorgan Chase & Co., taught Wall Street executives what can happen when they lose the confidence of the short-term funding markets.

Lehman's long-term debt outstanding rose to $128 billion from $123 billion in the first half of fiscal 2008, as the firm cut its dependence on overnight funding, company reports show. Morgan Stanley's long-term borrowings totaled $211 billion on May 31, up from $191 billion at the end of November.

`A Black Box'

To roll over that money, the firms depend on investors such as William Larkin, who oversees a fixed-income fund at Cabot Money Management in Salem, Massachusetts. Larkin, whose firm manages about $500 million, said he's ``a little bit wary'' of owning bonds issued by the securities firms.

Bonds issued by banks, brokers and insurance companies make up the largest segment of the debt market, so most investors have already suffered some losses and many are trying to cut their exposure, he said. Another problem is trying to understand how the firms can make up for the lost revenue from structured credit and leveraged lending that have fallen out of favor.

``Their business model is going to morph as the credit markets change, and nobody knows what that new income driver is going to be,'' Larkin said. ``It's like a black box.''

He has restricted his investments in financial firms to bonds from commercial banks such as New York-based JPMorgan and some Merrill Lynch debt that matures in less than a year. Larkin said he's avoiding Lehman, even though he thinks the firm will survive, because he remembers having to pull overnight repurchase loans to the bank when Russia defaulted on its debt in 1998.

Russian Bonds

Today, a decade after the Russian government defaulted on bond payments, the country's bonds are yielding less than Lehman's -- meaning investors have more faith in Russia's prospects than in Lehman's future.

Russia's 11 percent BBB+ rated bond that matures in 2018 yields 5.68 percent, two percentage points less than the Lehman 2012 bond that's rated two notches higher by S&P.

The cost to protect Lehman's debt from default more than doubled this year, a signal of declining confidence in credit markets. Credit-default swaps tied to the firm's senior unsecured bonds climbed 2.38 percentage points to 3.58, meaning it would cost $358,000 a year to protect $10 million of bonds from default for five years, according to data compiled by CMA Datavision. That's up from $120,000 a year at the end of 2007, CMA data show.

Credit-Default Swaps

Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt. They were conceived to protect bondholders against default and pay the buyer face value in exchange for the underlying securities or the cash equivalent should the company fail to adhere to its debt agreements.

The high yields on brokerage bonds have made them more attractive to Federated's Balestrino, who says he is confident the U.S. Treasury and Federal Reserve will stand behind the debt of the country's financial institutions. While Bear Stearns shareholders lost money in the sale to JPMorgan, the bondholders' obligations are safer than ever, he said.

``They do have the Fed as a backstop,'' said Balestrino, whose company owns bonds in Lehman, Morgan Stanley and Goldman Sachs. ``In the meantime you probably are setting records in terms of yield spreads.''

To contact the reporter on this story: Christine Harper in New York at charper@bloomberg.net

Last Updated: July 28, 2008 11:22 EDT