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

by Scott Sprinzen, Diane Hinton and Tanya Azarchs From Standard & Poor's RatingsDirect

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:

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.