Standard and Poor's rating services has cut the ratings of Morgan Stanley, Lehman Brothers, and Merrill Lynch. Though it left Goldman Sachs ratings untouched for now, it revised its outlook to negative. The ratings agency said the revision was done in conjunction with its global securities industry review.

Merrill Lynch downgraded
In a statement, Standard and Poor's credit analyst Scott Sprinzen said that in the case of Merrill Lynch, the downgrade reflected concern that the pace and extent of earnings improvement could be considerably more muted than previously anticipated.

Merrill Lynch's financial performance during the past three quarters has been amongst the worst of any company in the broker-dealer sector, primarily reflecting write-downs on its outsized holdings of asset-backed collateralised debt obligations, sub prime mortgages, other mortgage-related exposures, and leveraged-finance commitments, as well as on its hedge positions with mono-line insurers, said the rating agency.

S&P said under new management, Merrill Lynch has sought to downsize notional positions and hedge remaining net exposures; however, its ability to do so has been hampered by persisting difficult market conditions, leaving the company exposed to further write-downs, including as the result of counterparty risk related to its hedges. S&P also revised its outlook to negative, as there were many uncertainties that could affect the future financial performance of the broker-dealer sector.

S&P also warned that Merrill's ratings could be lowered further if it incurred additional large losses, either as a result of depressed business conditions or additional large write-downs; they could also be lowered if additional concerns arise regarding the company's ability to sustain potential liquidity stresses. S&P said that it could revise the outlook to stable if Merrill Lynch's operating performance rebounds to more normal levels.

Lehman Brothers Holdings Inc. Rating Lowered To 'A' From 'A+'
S&P says Lehman's earnings performance in recent quarters has held up relatively well under current market conditions despite write-downs on troubled assets. However, with a first-quarter end in February, the effects of a particularly difficult operating environment in March will only be reflected in Lehman's second-quarter performance.

Consequently, S&P says it expects a relatively meaningful deterioration in Lehman's second-quarter performance owing to a generally slower business environment, additional write-downs on certain troubled exposures, and the negative effects of hedges due to basis risk and de-levering of the balance sheet.

"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," said Standard & Poor's credit analyst Diane Hinton.

Adjusted to exclude write-downs and negative hedges, we expect weakness in Lehman's operating revenues to be tempered by cost-cutting efforts that should begin to positively affect the pre tax margin in third-quarter 2008.

S&P's outlook for Lehman is negative, and its ratings could be lowered further if Lehman were to incur substantial losses either as the result of depressed business conditions or sizeable write-downs. They could also be lowered if the firm's ability to sustain potential liquidity stresses should weaken.

Morgan Stanley Downgraded To 'A+/A-1' with Negative Outlook
S&P is concerned that Morgan Stanley's financial performance during the past three quarters has been weak. For the quarter ended 30 November, 2007, Morgan Stanley reported its first-ever quarterly loss of $5.8 billion pre tax, after write-downs totalling $9.4 billion relating to a decline in the value of its sub prime and other mortgage-related exposures.

S&P says that though Morgan Stanley returned to profitability in the quarter ended 29 February, 2008 ($1.5 billion pre-tax adjusted), profitability measures remained weak. ''Although the company has made significant progress in downsizing its notional positions and hedging its net exposures, its remaining positions are substantial, leaving the company exposed to further write-downs, including as result of basis risk related to its hedges'', S&P said in a statement.

The disproportionate risks Morgan Stanley had taken, with respect to asset-backed securities and collateralised debt obligations in particular, reflected a poorly executed proprietary trading position and revealed shortcomings in its past risk-management practices, said S&P. Morgan Stanley is in the midst of implementing an extensive revamping of its organization and processes to address these shortcomings, says S&P, but as it is still in progress, S&P considers its risk management capabilities to be only adequate.

Revising its outlook to negative, S&P says that in light of measures that Morgan Stanley took to bolster its near-term liquidity, it believes the company would have the ability to survive a harsh funding environment for an adequate period, even without the availability of funding support from the Federal Reserve.

Also, the current rating has sufficient leeway to sustain an extended period of weak profitability. However, the visibility of future financial performance is currently poor across the broker-dealer sector, and the rating could still be jeopardised if Morgan Stanley incurred additional large losses or if capital measures weakened further.

Affirmed 'AA-/A-1+' on Goldman Sachs Group Inc.
S&P says that among major players in the securities industry, Goldman Sachs has one of the heaviest concentrations in trading and investment banking. Although it is one of the largest asset managers, it lacks a presence in the retail brokerage business or other business lines.

Within trading, Goldman Sachs puts particular emphasis on principal investing and proprietary risk taking. S&P views the company as having an aggressive risk appetite, but the extent of Goldman Sachs' reliance on trading is a concern from a credit perspective, given the potential volatility of this revenue source.

"The negative outlook also reflects our opinion that there is potential for a more substantial decline in Goldman Sachs' profitability from capital market activities during the next few quarters," said Sprinzen.

S&P says that this could occur if weakening economic conditions and market turmoil weigh on business activity to a greater extent than we assume for the current rating level. It said that, barring missteps by the company, with the resumption of more normal market conditions and the emergence of a clearer picture with respect to the firm's profit outlook, the outlook could be revised to stable.