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Moody's Cuts Lehman; S&P Backs Merrill
Lehman has limited capacity for additional preferred securities in its capital structure, Moody's says.
July 18, 2008
Moody's Investors Service lowered the long-term senior rating of Lehman Brothers to A2 from A1 on expectations the brokerage will see further mark-to-market losses on its residential and commercial mortgage portfolios. Moody's also lowered the ratings on the senior long-term debt of Lehman's principal rated operating and guaranteed subsidiaries. Lehman's Prime-1 short-term rating was affirmed, but Lehman's rating outlook is negative.
Meanwhile, Standard & Poor's Ratings Services affirmed its ratings on Merrill Lynch and all related entities. The outlook is negative.
Moody's s said its rating actions reflect its expectations for additional mark-to-market losses on Lehman's residential and commercial mortgage portfolios, which continue to pose a significant challenge to the company's ability to return to an acceptable level of ongoing profitability, a material rating concern.
Given Lehman's recent capital raises, including $4 billion of common and $2 billion of convertible preferred issued in June, Moody's believes Lehman is well positioned to absorb potential valuation marks that are within Moody's stress-case expectations. However, the firm remains exposed to uncertainty, and its financial flexibility has become more limited. This is due to Moody's view that Lehman has very limited capacity for additional preferred securities in its capital structure, and the difficult market environment for Lehman in raising common equity capital. This limits its ability to respond to further unexpected losses.
Meanwhile, Standard & Poor's affirmation of Merrill follows the company's announcement of a large net loss from continuing operations of $4.6 billion for second-quarter 2008. The loss primarily reflected write-downs and impairment charges totaling $9.4 billion pretax related to Merrill Lynch's exposure to US super senior asset-backed collateralized debt obligations, hedges with monoline insurance companies, residential mortgage whole loans, and other mortgage-related positions.
"These charges were greater than we had previously anticipated, pointing up the severe pressures that continue to weigh on the mortgage markets," said Standard & Poor's. However, with Merrill having been downgraded on June 2, S&P said it believes there is sufficient leeway in the current rating to sustain it, albeit that leeway is now diminished.
Merrill Lynch has made substantial progress in de-risking its balance sheet through extensive asset sales across its problematic asset categories, including a 51% reduction in US Alt-A residential mortgages and a 29% reduction in US subprime residential mortgage net exposures during the quarter.
The outlook for Merrill is negative. The rating takes account of the likelihood of further weak financial performance during the next few quarters, with potential additional write-downs overshadowing underlying operating results.
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