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.

Standard & Poor’s is taking great pains to defend its “A” rating for Lehman Holdings Inc.

The rating company fired off a report Wednesday asserting that the recent collapse of the investment banking firm was a case of negative market sentiment — whether or not grounded in fundamentals — creating significant difficulties that led the company to the point of failure.

“In our view, Lehman had a strong franchise across its core investment banking, trading, and investment management business,” S&P stated. “It had adequate liquidity relative to reasonably severe and foreseeable temporary stresses.”

The ratings service insisted that looking beyond the current downturn, the firm had good earnings-generating ability. “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 with greater levels of certainty,” said S&P credit analyst Scott Sprinzen.

S&P emphasized in the detailed four-page report that, historically, ratings have provided value to the market by taking an intermediate- to long-term perspective primarily based on fundamental credit analysis. It adds that if ratings merely reflected prevailing market sentiment, they would not provide such independent analysis and value to the marketplace.

This said, it does concede there are cases where negative market sentiment — whether or not grounded in fundamentals — can create significant difficulties for a company, and can even precipitate a failure. “Companies that operate in particularly confidence-sensitive businesses and/or place heavy reliance on short-term borrowings are especially vulnerable to this phenomenon,” it added.

It said that this can give rise to a potential “credit cliff,” where credit quality can deteriorate precipitously in a short period. “We view the recent collapse of Lehman Brothers Holdings Inc. as a case in point. In our view, Lehman had a strong franchise across its core investment banking, trading, and investment management business. It had adequate liquidity relative to reasonably severe and foreseeable temporary stresses. And looking beyond the current downturn, the firm had good earnings-generating ability.”

In fact, currently pending negotiations to sell parts of Lehman’s global businesses attest to the strength of Lehman’s franchise, the credit rater noted.

S&P does acknowledge that Lehman has had its share of challenges, too. It said that since the turn in the credit cycle that started in mid-2007, weak business conditions and dislocation in the capital markets had affected Lehman adversely. “In our view, Lehman was affected more than some of its peers among the broker-dealers because of its particular emphasis on leveraged finance underwriting, residential mortgage origination and securitization, and commercial real estate (CRE) finance — business lines that have been hit especially hard by the current slump,” S&P wrote.

And during 2007, Lehman aggressively accumulated residential mortgages, residential mortgage-backed securities, and CRE loans and equity investments on its balance sheet. Although hedges during the second half of fiscal 2007 ended Nov. 30 largely offset deterioration in the value of these assets, hedges were insufficient during the first half of the current fiscal year, S&P adds.

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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