Done Deals: SPECIAL BANKING REPORT: U.S. Financial Institutions' Problems Still Overshadow Their Positives, S&P Analysts Say

NEW YORK, Aug. 21, 2008--More downgrades are possible for U.S. banks, which perhaps are just halfway through the credit downturn, according to Standard & Poor's Ratings Services analysts who spoke at a financial institutions quarterly teleconference Aug. 13.

(S&P analysts Tanya Azarchs, top right; Victoria Wagner, top left)

However, the rating actions on banks and brokerages will continue to be selective rather than broad. The analysts also pointed to some positive trends, including revenue strength, asset divestitures, capital raising, and regulatory moves.

"What we're really trying to answer in our own minds is which banks are going to have the financial flexibility to deal with some fairly serious problems over the next seven to eight quarters," said Standard & Poor's credit analyst Tanya Azarchs (top right photo). "Obviously, these are very unprecedented times, and so financial flexibility--in the form of the ability to raise capital and/or in the form of the ability to sell assets--is going to be paramount."

Among banks rated by Standard & Poor's, 19% have either a negative outlook or are on CreditWatch with negative implications, a percentage that is "very high for us by historical standards," Ms. Azarchs said.

That's up from 9% in 2007.

"Also, our outlooks on all four of the major broker-dealers are negative. In these difficult times, banks face extremely tight liquidity conditions in the credit markets, especially in the short-term debt market.

"The wild card here is that investor confidence continues to be extremely skittish," Ms. Azarchs added. Loan portfolios of the universal and regional banks are deteriorating "extremely rapidly."

Since the start of 2008, Standard & Poor's rating actions for financial institutions have been overwhelmingly downgrades, mainly because of mark-to-market losses and increasingly from higher-than-expected loan losses.

Although Ms. Azarchs said Standard & Poor's is still "predominantly in downgrade mode," it has raised ratings on five institutions (Northern Trust Co., Countrywide Financial Corp., Bank of New York Mellon Corp., AgFirst Farm Credit Bank, and H&R Block Inc.) since April 1, one following a merger and the other four for fundamental improvements.

Revenue has also been better than expected, and capital raising, which came early in the credit downturn, has helped not just the large banks but also some of the smaller, regional banks.

However, we expect further market dislocation, and we are increasingly concerned about the market for Alt-A mortgage-backed securities (loans made to consumers rated between subprime and prime), in which prices are sliding.

Other concerns include further monoline-related write-downs that banks could have to take, and business volumes, which Ms. Azarchs said have held up "extremely well" during the first half of 2008 but whose future "is not so clear."

The slowing economy's effect on the credit downturn and continued stress in the consumer secto

r could also further worsen some of the credit losses banks will likely face, she said.

Liquidity has continued to improve. For broker-dealers, one important development during the second quarter was the Federal Reserve's extension of the primary dealer credit facility through January 2008.

Standard & Poor's credit analyst Victoria Wagner (top left photo) also noted that the 'AAA' ratings and stable outlooks on mortgage guarantors Fannie Mae and Freddie Mac reflect even stronger explicit U.S. government support, given new laws that create a liquidity backup plan, and expanded mortgage powers for the two government-sponsored enterprises.

The legislation is "a positive for creditors in that it defines better the regulatory structure," Ms. Wagner said. "It also introduces the type of regulation we see for commercial banks--receivership powers, where you can clearly have more subordination risk for investors in preferred stock and subordinated debt."

However, the real issue through the first quarter of 2009 will be reserve building, Ms.

Azarchs said. New accounting guidelines require that reserve levels rise as asset quality continues to deteriorate.

The guidelines will exacerbate the provision requirements to cover higher charge-offs; Standard & Poor's expects these to increase.

To be sure, the credit downturn has affected banks and brokerages' earnings unevenly. Brokers' underlying business activity has been "something of a positive surprise during the past two months," said Standard & Poor's credit analyst Scott Sprinzen. (bottom right photo)

Excluding the effect of write-downs, investment banking and trading have been weak but not as bad as they could have been given the extent of market turmoil.

Another positive is that the four major U.S. broker-dealers (Goldman Sachs Group Inc., Lehman Brothers Holdings Inc., Merrill Lynch & Co. Inc., and Morgan Stanley) were also able to divest about $400 billion in assets collectively during the second quarter, even excluding Merrill Lynch's subsequent $30 billion transaction.

One of the few bright spots for the banking sector has been the raising of capital roughly in line with the amount of net losses through both common stock and hybrid capital issuance.

Although hybrid issuance has declined during the past month and spreads have widened, "there's still capacity in that market for additional capital-raising activity," Mr. Sprinzen said. However, regional banks' ability to continue raising capital remains in question.

The analysts also mentioned some other areas of concern, including the continued deterioration of prime loans, among which charge-offs are now an unprecedented greater than 1% for some banks, and weakness in construction lending, which is extremely important for the smaller regional banks.

Credit cards are also problematic, approaching the peak losses of 1997 and 2002. But Sta

ndard & Poor's doesn't expect levels to rise much higher than that because lending criteria for credit cards didn't get as loose as they did for mortgages.

"What is disturbing is that the receivables are growing," said Ms. Azarchs. "What that says is that, with the home equity spigot having been turned off for consumers, their only recourse is credit card debt to keep themselves going. That perhaps spells trouble for the future and could serve to help keep charge-offs building."

It's just another reason that no one is breathing much easier yet in the banking sector.

S&P Writer: Craig Schneider

For more information, visit http://www.standardandpoors.com/.

(H&R Block headquarters building, New York, bottom right photo)

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Jeff Sexton, New York, (1) 212-438-3448

jeff_sexton@standardandpoors.com