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Who's Up, and Down, on the Street

For U.S. financial services firms, it was a lackluster summer. The third quarter was characterized by weaker-than-usual securities markets. Equity markets were soft, with low volatility and volume, resulting in very weak equity principal transactions revenue and commissions for the industry.

However, the fixed-income markets held a few surprises. Despite the Fed's hikes in short-term interest rates and rising commodity prices, the long end of the Treasury curve -- i.e., long-term interest rates -- fell instead of rising. This apparently caught a number of trading desks off guard and resulted in weak fixed-income trading revenues for many firms.

Commodities trading, however, appears to have held up well. Prices for most commodities continued their upward trend. Increased investor interest, particularly among hedge funds, proved to be helpful to firms strong in commodities trading. Firms without significant commodities trading operations are enviously eyeing the market and can be expected to increase their presence.

Investment banking results were generally good during the quarter, with particular revenue growth in M&A advisory. Standard & Poor's Ratings Services believes that the recovery in banking will continue to pick up steam. Retail and investment management segments of the large firms continue to post improved results relative to the situation in 2001 and 2002. However, there is a great deal of price competition among discount brokers, which can only hurt earnings for everyone.

We remain concerned about what appears to be a general increase in market risk appetite within the brokerage industry. Coupled with commodities and currency volatility, trading results in the fourth quarter may again be mixed for the large brokers. Despite the near-term risks, we believe that the U.S. brokerage industry is recovering.

During the third quarter, ratings outlooks for Morgan Stanley and Lehman Brothers Holdings were changed to positive from stable, indicating that if current trends continue, these ratings could be raised over a roughly one-to-two year period. On the other hand, securities markets and the economy in general could underperform, resulting in a period of weak earnings for the sector. Although this is not our expectation, it is something we will monitor closely.

How did rated U.S. brokerage firms perform during the quarter -- and how are their credit outlooks? Here's S&P's report card:

Bear Stearns (BSC)

Rating: A

Outlook: Stable

Bear Stearns had a strong third quarter. Aside from the first and second quarters of this year, pretax income, adjusted for one-time items, was the highest in four years. Net revenues grew in all segments relative to the year-earlier quarter, once investment banking revenues for that quarter have been adjusted to exclude a one-time gain. Bear Stearns continues to perform well and exhibits low trading revenue volatility relative to that of its larger peers.

Charles Schwab (SCH)

Rating: A-

Outlook: Negative

Schwab's efforts to transform its business are reflected in the third quarter's $41 million net loss, namely through its cost reduction charges and losses from the sale of its capital markets business. Excluding these and related nonrecurring charges, operating income was $107 million, still down 26% from the prior year's third quarter.

Schwab garners strength from its conservative balance sheet, good liquidity, and strong capital. Although it is making some headway, the company is still implementing its strategic refocus on retail investors and advisors and its cost-cutting initiative. That program cut operating expenses by 5% from the preceding quarter and may affect future quarters.

In keeping with its commitment to the retail investor, Schwab cut online trading prices for a second time since June to levels in line with those of some of its competitors. Trading revenue dropped by 29% given these price cuts and low daily average revenue trades. Net new assets boosted total client assets to $1 trillion, an increase that reinforces Schwab's brand power. Additionally, nontrading revenue grew by 4%, reaching a record high of $801 million. Schwab's cost-cutting moves, strategic direction, and restoration of profitability will be monitored.

Citigroup Global Markets Holdings

Rating: AA-

Outlook: Stable

The third-quarter results rebounded from the second quarter as this subsidiary of Citigroup (C) bore the brunt of the litigation reserves established by the parent with respect to Enron and WorldCom related issues. Year-to-date losses amount to $1.9 billion. Strong trends in asset management offset additional legal reserve charges and a sharp drop in trading income due the effect of unexpected volatility in interest rates on proprietary trading results. Retail brokerage results were flat to down with continued pressure on commissions though market action, and client fund inflows were favorable. Citigroup Global Markets continues to maintain its leading market position in all areas of investment banking despite the ongoing regulatory scrutiny.

As in the case of the loss due to the litigation charge in 2001, the parent company has maintained the capital strength of this subsidiary with a capital infusion of $3.1 billion year to date, net of a $1 billion dividend paid.

Credit Suisse First Boston (USA)

Rating: A+

Outlook: Stable

CSFB (USA) does not report results separately from its parent, Credit Suisse First Boston (CSFB), until its 10-Q form has been filed with the SEC. However, its quarterly results are similar to those of CSFB, which have already been reported for the third quarter. CSFB continues to experience low profitability relative to that of its peers, with a pretax profit margin of 7.7% in its institutional securities division. Fixed-income trading revenues improved. The quarter's results include the release of 126 million Swiss francs of tax contingency accruals in the institutional securities segment. Equity trading revenues declined and were lower than both the second-quarter 2004 amount and the level of the third quarter of last year. Investment banking revenues were down slightly quarter to quarter; however, M&A revenues grew for the second straight quarter. CSFB (USA)'s ratings depend on the ratings for CSFB and their ultimate parent, Credit Suisse Group.

E*TRADE Financial (ET)

Rating: B+

Outlook: Stable

Third-quarter operating results were mixed, as a wider net interest margin (NIM) in the banking business offset lower trading volumes in the brokerage business. The NIM is benefiting from the influx of lower-cost sweep deposit accounts. Additionally, tight controls on compensation offset lower gains on sales of securities and loans as the higher interest rate environment has sharply curtailed mortgage originations. The net result is that operating earnings and EBITDA were down slightly quarter-to-quarter.

Third-quarter results again demonstrate the value of E*TRADE's diversified business model, an important factor underlying its rating and stable outlook. The company used part of the proceeds of senior debt issued in secondquarter 2004 to retire a large portion of its outstanding subordinated convertible debt in third-quarter 2004. Free cash at quarter-end was essentially unchanged.

Goldman Sachs (GS)

Rating: A+

Outlook: Stable

Pretax operating earnings more than doubled versus third-quarter 2003, but declined relative to the first and second quarters of this year. Results were driven by strong trading revenues in the Fixed Income, Commodities, and Currencies segment, whose net revenues more than doubled as compared to the year-ago quarter. Equity trading results were poor, however. Investment banking revenues were 15% higher than one year ago, but down slightly relative to the second quarter. VaR, a measure of trading risk, declined during the quarter, relative to the second quarter, primarily due to lower equity and currencies VaR, partially offset by a higher VaR for commodities trading. We believe the reduction in trading risk may be only temporary.

Interactive Brokers Group

Rating: BBB-

Outlook: Stable

This is a new rating for the Interactive Brokers Group, whose largest subsidiary, Timber Hill LLC, had its 'BBB-' rating withdrawn at the company's request. The 'BBB-' for IBG represents an upgrade from the implied rating of 'BB+'. IBG's rating is based on its strong franchise in options and futures brokerage, strong liquidity and capital, and high earnings performance, as well as the lower financial flexibility afforded by its legal status as a partnership and the risks of its business model, which relies on trading revenues earned from its pricing models. The monoline nature of the firm's business is also a consideration in the rating.

Jefferies Group (JEF)

Rating: BBB

Outlook: Stable

Jefferies had a good third quarter and posted higher pretax earnings than in the second quarter and only 10% lower than its record first quarter of this year. Jefferies announced that it will purchase the minority interest in its subsidiary Bonds Direct Securities. This electronic bond broker has performed well and the increase in ownership will increase Jefferies' net income.

LaBranche & Co. (LAB)

Rating: B

Outlook: Negative

During the third quarter, LaBranche posted a pretax operating loss of $234,000, which is a low point for operating earnings for the past several years. Additionally, the company also had a special noncash charge of $37.8 million to write down goodwill associated with past acquisitions. Average quarterly operating pretax earnings in 2002 were $41.5 million, followed by $12.2 million in 2003, and $9.0 million for the first half of 2004. The declining trend is due to low volumes and low price volatility, a decline in bid/offer spreads due to decimalization, and, to a lesser extent, declining market share of the NYSE in trades of its listed shares. If operating returns continue at this level, the ratings may be downgraded.

Legg Mason (LM)

Rating: BBB+

Outlook: Stable

Legg Mason continues to post solid results, driven by its well balanced mix of businesses that provide good revenue diversification and growing profitability. The firm's pretax profit margin on net revenues continued to expand and was a strong 26.2% for the quarter ended Sept. 30. The growth reflects improvements in its asset management and investment banking businesses, offset to some degree by a slowdown in commissions and principal transactions. The firm continues its evolution into more of an asset-management company, as the unit contributed 71% of Legg's pretax earnings for the quarter. Through a combination of positive performance and net flow of funds, total assets under management rose to a record $311 billion at Sept. 30, 2004. From a balance-sheet perspective, capital continues to grow and at Sept. 30, 2004 stood at $1,728 billion, up about 5% from the prior quarter.

Lehman Brothers Holdings (LEH)

Rating: A

Outlook: Positive

Lehman had a good third quarter, reporting a pretax profit margin of 27.56%. Although fixed-income trading was reasonably good during the quarter, equity trading results were poor as compared to both the prior quarter and the year-ago quarter. In investment banking, while debt underwriting revenues were stable, equity underwriting results improved and M&A showed very significant improvement from the year-ago quarter. Asset management and private client net revenue rose strongly over the last-year level due to the fourth-quarter 2003 acquisition of Neuberger Berman. Legal and professional expenses rose to $122 million during the quarter, almost doubling. Lehman settled with the plaintiffs in the Newby v. Enron class action for $222.5 million. This occurred after the end of the third quarter and may not affect the firm's profit and loss measures until the fourth quarter.

Merrill Lynch (MER)

Rating: A+

Outlook: Stable

Merrill Lynch's profitability for the third quarter was respectable, with a 24.88% pretax margin. Earnings, however, were lower than the very strong first two quarters of the year but also relative to the third quarter of last year. As compared to the year-ago quarter, lower net revenues in Global Markets and Investments (GMI) were partially offset by higher revenues in other segments. GMI's lower revenues were due to lower equity trading revenues, which is consistent with other brokers, due to the low volume and volatility of equity trading during the quarter. Four former Merrill Lynch employees were found guilty of criminal charges in relation to the electricity barge transaction with Enron. The verdict increases the likelihood of a Merrill Lynch settlement in the Newby v. Enron class action suit. The good news for Merrill Lynch, however, is the jury finding that the defendants cost Enron $13.7 million. Although there is no way to accurately predict a settlement of the Newby civil action, this amount would represent a very affordable settlement for the company.

Morgan Stanley (MWD)

Rating: A+

Outlook: Positive

Excluding one-time legal expenses of $120 million, Morgan Stanley had a decent quarter. Like its peers, its performance was weaker than it was in the first two quarters of this year. As compared to third-quarter 2003, net revenues were 3% higher, with lower trading revenues being offset by higher revenues in investment banking, the Individual Investor Group, Investment Management, and Credit Services. Morgan Stanley had a weak quarter in fixed-income trading, which declined 19% versus third-quarter 2003 and was associated with a high degree of variability in daily net trading revenues as compared to what is typical for Morgan Stanley. Prospects for the Credit Services Division improved recently when the U.S. Supreme Court let stand a lower court ruling that opened the doors for banks to issue the Discover Card. -- from S&P Ratings Services

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