S&P Downgrades Foreshadow More Trouble

The Standard and Poor’s rating agency has downgraded the ratings of Morgan Stanley, Merrill Lynch and Lehman Brothers. The reason for the downgrades was the expectation that further write-downs on their mortgage-related businesses lie ahead. While the ratings are still in the investment grade territory, the decline can only be interpreted as a prediction of continued weakness.

Morgan’s ratings fell to A+ long-term (more than a year) and A-1 short-term (less than a year) for its counterparty credit rating from AA-/A1+. The new ratings carry a negative outlook. A negative outlook at S&P means that, while no formal review of the rating is underway, there could be in the coming months and that the direction the rating would take at the end of such a review would be downward or stable rather than upward. Merrill’s ratings went to A/A1 from A+/A1 and outlook on these ratings is also negative. Lehman’s fell to A/A-1 from A+/A-1, outlook negative.

In each case, the downgrade “primarily reflects our concern that the pace and extent of earnings improvement could be considerably more muted than we previously assumed,” said analyst Scott Sprinzen of S&P. His colleague Diane Hinton said of the Lehman downgrade, “Although we expect write-downs in subsequent quarters to be more muted, given the extent of write-downs to date, we are concerned that persistent dislocations in global capital markets could further weigh on core operating performance for the securities industry as a whole.”

This is particularly troubling. The reports out of Wall Street say that the worst appears to be over. However, credit ratings are leading indicators if one knows how to read them, whether they come from S&P, Moody’s or Fitch. If the analysts at these services are correct, these firms have some more bad news ahead, but it can be aggravated by any macroeconomic or financial system difficulties. Only the bravest or the most foolhardy would predict a year of smooth sailing at this stage.

This would be bad enough if it were confined to Morgan, Merrill and Lehman, but it isn’t. Because of the role these firms play in the financial sector globally, their weakness can be contagious. Because the threat to these firms is more systemic than anything peculiar to them, there is little they can do to avoid future trouble other than hope there isn’t any. That’s a bad place to be, at the mercy of the Fates.

© Copyright 2008 by The Kensington Review, Jeff Myhre, PhD, Editor. No part of this publication may be reproduced without written consent. Produced using Fedora Linux.

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