Behind S&P's Negative I-Bank Outlook

The ratings agency addresses current prospects for some of the biggest investment banks. Among its concerns: the weakening profit picture

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

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.