Capital Markets

Schizo Ratings for Finance Firms

Morgan Stanley and Wachovia likely will be downgraded, but Bank of New York Mellon gets a surprising lift from Fitch.
Stephen TaubJune 27, 2008

The financial-services industry appears to be entering a new phase of changes to the players’ credit rating. And surprise: despite the current market turmoil, not all the changes are downgrades.

Moody’s Investors Service has placed the long-term ratings of Morgan Stanley and its subsidiaries — currently senior unsecured at Aa3 — on review for downgrade. The short-term Prime-1 ratings were affirmed. The rating agency said the most likely outcome of its review process will be a downgrade of Morgan Stanley’s long-term rating to A1. Moody’s noted that by affirming the Prime-1 rating, its review would not result in a long-term rating below A2.

“Since the onset of the credit crisis one year ago, Morgan Stanley’s financial performance and risk management has been inconsistent, and below the levels expected of a Aa3-rated financial institution,” said Moody’s in a report.

It pointed out that excluding recent gains from asset sales, Morgan Stanley has reported pretax losses of nearly $1.4 billion during the past year. “Markets have clearly been challenging, but the firm has also incurred some expensive trading mishaps during the past year,” said Peter Nerby, a Moody’s senior vice president.

The agency acknowledged that Morgan Stanley is making changes to its risk-management organization, but said it’s premature to conclude that the changes will be effective, considering the complexity of the task.

Moody’s said it will focus on Morgan Stanley’s ability to control risk and generate higher levels of profitability during the next one to two years, during which the operating environment may remain challenging for securities firms. The agency also noted that Morgan has profitable franchises in investment banking, equities, commodities, and prime brokerage, and has improved performance within retail brokerage.

On the other hand, the firm has some risky concentrations in commercial real estate and single-name leveraged loans, Moody’s added. “The critical issue will be for Morgan Stanley to manage these and other concentrations, and their attendant basis risks, such that any losses are well contained within the revenue capacity of the relevant business area,” it stated.

Meanwhile, Fitch Ratings placed the ratings of Wachovia Corp. and its subsidiaries on Rating Watch Negative, citing “continued headwinds facing US consumer asset quality and indications of further meaningful home price deterioration in certain markets.”

Fitch acknowledged that Wachovia built its loan loss reserve by $2 billion in the first quarter; however, it stressed that this represents only about 1.2 percent of Wachovia’s substantial $170 billion residential-mortgage portfolio. Included in the portfolio is $121 billion of option ARM mortgages, a product Fitch said has exhibited more significant deterioration in performance metrics than conventional 30-year or 15-year fixed-rate mortgages.

More than half (58 percent) of Wachovia’s option ARM portfolio — also known as Pick-A-Pay — is in the troubled California market, with much of that in the central part of the state, which has experienced some of the most severe home-value devaluation. “This is expected to increase the pressure on Wachovia at a time when many of its other businesses are still grappling with credit and capital market disruptions,” said Fitch.

The bad news was not ubiquitous for financial-services firms, however. On Friday Standard & Poor’s raised its ratings on Bank of New York Mellon Corp., including the counterparty credit rating, to AA- from A+. S&P also raised its ratings on all of the bank’s related entities.

The rating agency said the upgrade recognizes the company’s significant progress in integrating the operations of Bank of New York Co. with those of Mellon Financial Corp. since the two companies merged on July 1, 2007. “Over the past year, there have been virtually no significant customer defections attributable to the merger, and it seems likely that management will exceed its initial revenue and cost-cutting synergy targets,” said S&P credit analyst Scott Sprinzen.

S&P asserted that Mellon now has a very strong business position. Its Institutional Services businesses have “commanding market shares” in custodial services, corporate trust, depositary receipts, stock transfer, clearing services, and global payments, so it benefits from significant economies of scale.

In addition, S&P said the combined bank is among the largest investment managers in the world and has a sizable wealth-management business. “The advantages of its market position and diversity have been evident since mid-2007, as the company has been able to maintain relatively stable core earnings despite market turmoil,” S&P said. “Although weak investment performance has hurt the earnings of BK’s asset-management business, these have been offset by the contribution of Institutional Services, which includes some businesses — such as custodial services — that benefit from increased market volatility.”

S&P also stated that the outlook is now stable. “The current ratings assume that for at least the next few quarters, overall financial performance could continue to be adversely affected by difficult asset-management market conditions, though mitigated by continuing strong performance of BK’s institutional services businesses,” the rating agency added.