Ratings: Why S&P Cut Lehman, Merrill, Morgan Stanley

The rating agency says revenue declines for broker-dealers could worsen, and the industry slowdown could last longer than it had expected

Standard & Poor's Ratings Services on June 2 lowered its ratings on Morgan Stanley, Merrill Lynch & Co. Inc., and Lehman Brothers Holdings Inc., having updated its assessment of the major investment banks and brokers.

Here is a review of S&P's June 2 actions:

Ratings On U.S. Broker-Dealers And Selected Peers
Company To From
Goldman Sachs Group (GS) Unchanged AA-/Negative/A-1+
Lehman Brothers Holdings (LEH) A/Negative/A-1 A+/Negative/A-1
Merrill Lynch & Co. (MER) A/Negative/A-1 A+/Negative/A-1
Morgan Stanley (MS) A+/Negative/A-1 AA-/Negative/A-1+
U.S. Bank Peers  
Citigroup Inc. (C) AA-/Negative/A-1+ AA-/Watch Neg/A-1+
JPMorgan Chase (JPM) AA-/Negative/A-1+ AA-/Stable/A-1+
Non-U.S. Peers  
Barclays PLC (BCS) Unchanged AA-/Negative/A-1+
Credit Suisse Group (CS) Unchanged A+/Negative/A-1
Deutsche Bank AG (DB) Unchanged AA/Negative/A-1+
UBS AG (UBS) Unchanged AA-/Negative/A-1+

Although we evaluated and incorporated each company's unique characteristics, we also identified common considerations that drove these actions:

We believe that broker-dealers' financial performance will be weak during the short-to-medium term. Revenues, for the industry as a whole, could decline further than the previously anticipated 20%-30%, which we had incorporated into our ratings--and/or the slowdown could last longer than we had thought. This drop in revenue excludes potential further writedowns of exposures to impaired mortgage-related assets, leveraged loans, and lending commitments.

Yet, the sector's poor results since second-half 2007 have been largely the result of writedowns related to outsized exposures to these areas, particularly to subprime mortgage-backed securities (MBS). Even though such exposures have been reduced, they remain large, while ongoing global repricing means that market conditions remain fragile. Thus, write-downs will likely continue to depress earnings.

The events of the past year have revealed issues with the risk-management structure at many financial institutions. In particular, institutions have accumulated excessively large risk exposures, while paying insufficient attention to gross versus net positions and failing to employ adequate stress testing.

Amid recent liquidity pressures, we have reassessed U.S. broker-dealers' position of heavier reliance on wholesale funding sources and believe they are at a disadvantage as compared with universal banks. Moreover, we have seen how industry participants' lack of transparency in financial reporting can exacerbate liquidity and funding concerns as investors overreact, at times, to headlines and rumors.

Still, we take comfort in the Federal Reserve's actions to alleviate market concerns by providing funding support directly to the U.S. broker dealers, at least temporarily. The Fed's backstop facilities plus the significant liquidity that other central banks are now providing have stabilized the markets since April and lessened pressure on this crucial facet of the credit profile of broker-dealers. They are highly leveraged and rely on extensive daily use of wholesale funding to do business.

The Fed, the European Central Bank, and the Bank of England have helped contain the damage during this period of exceptional market turbulence and limited downward pressure on the creditworthiness of and credit ratings on broker-dealers and financial institutions in general.

Moreover, we view the actions on the part of most companies to bolster liquidity by boosting cash reserves, refinancing short-term obligations, and seeking out alternative funding sources to be positive credit factors.

We affirmed our ratings on Goldman Sachs because the company significantly outperformed its U.S.-based industry peers, largely avoiding the problems that have beset others. However, the outlook on Morgan Stanley, Merrill Lynch, and Lehman Brothers remains negative, in addition to Europe-based securities companies -- Barclays PLC, Credit Suisse Group, Deutsche Bank AG, and UBS AG -- all of which have considerably more business diversity than the four independent U.S. firms.

Separately, we revised the outlooks on JPMorgan Chase & Co. and Bank of America Corp. (BAC) to negative from stable , while we affirmed the ratings on Citigroup Inc.'s and removed from them CreditWatch. The outlook on Citigroup is negative.

Although these companies participate in the global securities industry, they are also much more diversified than the independent U.S. firms. Earnings pressures stemming from the deteriorating credit cycle, particularly in the U.S., are now more prominent a concern in the case of these companies than developments in their investment banking and trading operations.

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