Rating Itself: S&P Defends Lehman’s “A”

Detailed self-review lets it off the hook for giving the bank high marks during its slide toward bankruptcy. Why? Investor fear did it in.

Largely as a consequence of write-downs, Lehman had only breakeven pretax earnings in the first quarter and incurred a $4.3 billion pretax loss in the second quarter, S&P points out. The write-downs included realized losses on asset sales, as Lehman reversed course and began shrinking its asset base.

S&P pointed out that on March 21, it revised its outlook on Lehman to negative from stable, pointing out that the near collapse of Bear Stearns several days before had highlighted the extent to which capital-market sentiments could hurt securities firms. On June 2, S&P lowered the rating on Lehman to ‘A/Negative/A-1′ from ‘A+/Negative/A-1′), citing the much weaker-than-previously-anticipated earnings outlook for Lehman and its peers. “We assigned a negative outlook to the lower rating, and we stated that we could lower the ratings further if Lehman were to incur substantial additional losses either as a result of depressed business conditions or sizable write-downs,” the S&P report said.

It noted that at the time on the one hand it though Lehman could incur a substantial loss in the third quarter. Yet, it also was making significant progress in reducing its exposure to problematic assets. However, negative market sentiment directed specifically toward Lehman was building.

S&P also said that short selling may have played a role: During the 30-day period when the SEC’s ban on naked short selling was in effect, Lehman’s share price was relatively stable. “We saw that market anxieties intensified with the approach of Lehman’s third-quarter earnings announcement, particularly given uncertainty about the extent of additional write-downs Lehman would need to record to reflect deteriorating asset values,” it wrote.

On Sept. 9, with Lehman’s share price dropping significantly, S&P noted that it placed the ratings on CreditWatch given that, even though it perceived Lehman to have certain fundamental strengths, market sentiments — which seemed to be escalating to the point of panic–would have the real-world effect of making it more difficult for Lehman to raise capital and to maintain competitive funding costs. “At that time, we believed a meaningful possibility remained that with the completion of contemplated actions, Lehman could both remain viable and achieve affirmation of the ratings,” the firm said.

On Sept. 10, in an accelerated preannouncement, Lehman reported a larger-than-anticipated third-quarter adjusted pretax loss of $7.2 billion, after mark-to-market adjustments of $7 billion, including realized losses. Lehman also outlined the key elements of its plan to further “de-risk” its balance sheet.

During the next few days Lehman’s efforts to find a buyer were unsuccessful, perhaps because the U.S. government and other Wall Street firms declined to support such a transaction by providing funding or assuming a portion of the asset value risk, S&P noted.

S&P says it felt that heading into the weekend of Sept. 13-14, Lehman still had substantial excess liquidity to cover near-term funding requirements. However, by then Fannie Mae and Freddie Mac were already bailed out by the federal government and Lehman faced a likely complete collapse in confidence on the part of creditors, counterparties, and customers when it opened for business on Monday, Sept. 15. So Lehman filed for Chapter 11 bankruptcy protection.

“In conclusion, we believe the downfall of Lehman reflected escalating fears that led to a loss of confidence — ultimately becoming a real threat to Lehman’s viability in a way that fundamental credit analysis could not have anticipated,” S&P said.

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