Financial Worries on Front Burner: S&P Downgrades Big Brokers, Says Outlook "Predominantly Negative"

The theory that the recent calm in the financial sector was the eye of the storm, rather than a sign of turbulence clearing for good, seems to be getting support. The stock market reacted badly to the ouster of Wachovia CEO Kennedy Thompson, seeing it as a harbinger of a report of losses for the second quarter.

But the second dose of bad news was far more significant. Standard & Poor’s downgraded the debt of Merrill Lynch, Morgan Stanley, and perhaps most important, recently on the ropes Lehman. While Goldman was affirmed at AA-, the outlook for all four is negative. While the the S&P report took care not to sound undue alarm, this move, not surprisingly, has implications for profits. From Bloomberg:

The “actions reflect prospects of continued weakness in the investment banking business and the potential for more write-offs, though not of the magnitude of those of the past few quarters,” Tanya Azarchs, an S&P analyst, said today in a statement.

The ratings downgrades may make it harder for the banks to sell derivatives such as credit-default swaps that are tied to bonds or loans, said Brad Hintz, an analyst at Sanford C. Bernstein in New York. Single-A rated firms [only Goldman retains an AA] are less desirable as trading counterparties for fixed-income derivatives that extend longer than five years, he said.

“You’ll see derivatives profitability drop off over a period of time,” Hintz said of the three downgraded investment banks. “We estimate somewhere around 1 percent to 1.5 percent of fixed- income revenues are at risk.”

The firms are also likely to have to post more collateral on the trades they’ve already made with other parties, raising their costs, Hintz said.

Other analysts speculated the announcement bode ill for second quarter earnings. From Reuters:
“

The outlooks on the large financial institutions sector in the U.S. are now predominantly negative,” the credit rating agency said in a statement….

“The market’s a little surprised with the timing and the breadth of the actions,” said Ricardo Kleinbaum, analyst at BNP Paribas in New York, adding, however: “I didn’t see anything in particular that was a revelation.”

“To have something like this come out so close to the reporting dates, at least for the brokers, suggests that S&P might be aware of a soft second quarter,” Kleinbaum said…..

S&P also revised its outlook to negative on Bank of America Corp and JPMorgan Chase. The outlook indicates the likely direction of the rating over the next two years.

S&P removed Citigroup from CreditWatch negative, affirming its ratings, and also changed its outlook to negative.