Behind S&P's Negative I-Bank Outlook
On Mar. 21, Standard & Poor's Ratings Services affirmed its ratings on Goldman Sachs Group (AA-) and Lehman Brothers Holdings (A+). At the same time, Standard & Poor's revised its ratings outlook on these companies to negative from stable. Despite some of the bright spots in the first-quarter results announced by Goldman Sachs (GS), Lehman (LEH), and Morgan Stanley (AA-/Watch Neg/A-1+) this week, year-on-year earnings for all three companies declined significantly.
Our negative rating outlooks across the global investment-banking sector reflect our view of the potential for a more precipitous decline in profitability from capital market activities over the near term, if weakening economic conditions and market turmoil weigh on business activity to a greater and longer extent than now assumed.
Here we address key questions about the outlook for investment banks:
What has changed?
Despite relatively good recent earnings announcements, we have become more concerned about the profit outlook for broker/dealers in general given the increased unpredictability of business trends. In particular, our current ratings incorporate a 20%-to-30% decline in revenues for the industry as a whole, but we see increased risk for revenues to decline even further. Nevertheless, the Federal Reserve's recent supportive actions that provide broker/dealers with backstop liquidity give us confidence that immediate, across-the-board rating downgrades are not required.
What is S&P Ratings' view of the Federal Reserve's actions to support broker/dealers?
We view the Federal Reserve's two recently announced programs to bolster market liquidity as positive—both in general terms and for the broker/dealers specifically. The Fed took these important measures to instill confidence in the market. This is a rundown on the two programs:
• On Mar. 11, 2008, the Federal Reserve announced an expansion of its securities lending program (Term Securities Lending Facility; TSLF). Through this, it will lend up to $200 billion of Treasury securities to primary dealers. These will be secured for a term of 28 days (rather than overnight, as in the existing program) by a pledge of other securities, including federal agency debt, federal agency residential mortgage-backed securities (RMBS), and non-agency AAA/Aaa-rated private-label residential MBS. Auctions will be weekly, beginning on Mar. 27, 2008.
• A Primary Dealer Credit Facility (PDCF) by the Federal Reserve Bank of New York was established on Mar. 16, 2008. It will remain in operation for at least six months but could be extended. This overnight funding facility could be collateralized by a broad range of investment-grade debt securities.
Clearly, these two actions lessens our concerns about liquidity at these firms.
Why is S&P Ratings revising the outlooks on Lehman and Goldman Sachs to negative given that profit decline is expected and the Fed is providing new liquidity support?
Both Lehman's and Goldman Sachs' first-quarter earnings results were satisfactory for the ratings, despite a largely anticipated revenue slowdown. Furthermore, we anticipate both firms' underlying business strength—particularly from equities, investment banking, and wealth and asset management activities—will continue to support at least adequate companywide profitability.
We also believe their funding and liquidity profiles are strong and that exposures to troubled assets and other exposures are manageable. Newly granted access to the Fed for liquidity purposes should alleviate liquidity concerns. Because of this expectation, we have affirmed the ratings on both companies.
However, we cannot ignore recent negative market behavior, and the companies' business activities could slow more than what the current ratings could now tolerate.
As our base case, we expect a year-on-year decline in net revenues (adjusting for writedowns) in the order of 20% to 30%, but we see some risk that earnings results could be significantly weaker and most likely could result in downgrades.
What distinguishes the larger brokers from Bear Stearns?
Morgan Stanley (MS) and Merrill Lynch (MER) have been proportionately more subject to writedowns related to subprime loans, ABS CDOs, leveraged finance commitments, and other problematic positions, but near-term earnings prospects for these firms remain sound. Also, first-quarter earnings announcements included disclosure of some significant reductions in exposures accomplished during the quarter.
Depending on business mix, these firms have shown that strengths in some business operations usually offset weaknesses in others. For example, the results of Goldman Sachs and Morgan Stanley have benefited from the strength of equities trading activity, which market volatility has bolstered and which has provided a partial offset to trading sectors hit hard by the market downturn. Results of wealth management businesses (especially significant in the cases of Merrill Lynch and Morgan Stanley) and asset management (a major factor in the cases of Goldman Sachs, Morgan Stanley, and Lehman), though not immune to the economic cycle, have also remained relatively strong. Moreover, the four largest U.S. broker/dealers have consistently maintained longer borrowing maturities. And while experiencing significant widening of credit spreads, they have not seen broad shrinkage of credit availability similar to that experienced by Bear Stearns (BSC).
When does S&P Ratings expect to resolve the current CreditWatches?
We placed the ratings on Morgan Stanley on CreditWatch negative on Dec. 19, 2007. We anticipate to resolve the CreditWatch status of these ratings within the next 30 days. We continue to assess management's current stance with respect to principal risk-taking, including proprietary trading; actions taken to enhance risk-management capabilities; Morgan Stanley's remaining exposures to problematic or potentially problematic asset types and counterparty credit risks, including, for example, commercial real estate; and the outlook for Morgan Stanley's core businesses.
We put the ratings on Bear Stearns on CreditWatch developing on Mar. 17, 2008. We will resolve the CreditWatch status of these ratings when the integration of Bear's activities with JPMorgan Chase (JPM) becomes effective.
When does S&P Ratings expect negative outlooks to result in a rating change?
Outlooks are a medium-term (up to two years) indicator of the possible direction of a rating. The negative outlooks on Merrill Lynch, Lehman, and Goldman Sachs reflect the potential for a more precipitous decline in their profitability from capital market activities during the next few quarters. This could occur if weakening economic conditions and market turmoil weigh on business activity to a greater and longer extent than we now assume and than the current ratings could now withstand. If our expectation for revenues to fall beyond the expected 20% to 30% (which would be consistent with profitability as measured by pretax margin to fall significantly below 20%) comes to pass, a one-notch downgrade is possible.
This, however, is not a foregone conclusion because we would still account for the earnings outlook. However, we anticipate that if a resumption of more normal market conditions and a clearer picture with respect to these firms' profit outlook as economic conditions continue to unfold throughout 2008, this could well result in a return to a stable outlook.