S&P Warns of More Financial Pitfalls Ahead

A day after S&P lowered its outlook on General Electric (GE) debt, the ratings agency is at it again with downgrades for 11 major U.S. and European banks. The GE debt guidance stated that there is a one-third chance that GE’s coveted AAA rating will drop to AA+ on concerns of deteriorating earnings from GE Capital. In the statement, S&P claimed that GE Capital as a stand-alone entity would be rated A+ (four levels lower). GE, the largest issuer of U.S. corporate bonds, saw its shares slip more than eight percent on the announcement. GE’s CEO Jeffrey Immelt made it clear that he would do all in his power to maintain the conglomerate’s AAA rating, starting with shrinking the company’s leverage ratio to 6 to 1. If this deleveraging is not enough, the obvious next step would be to lower the dividend payout. As of now, the company has reaffirmed its annual dividend of $1.24. per share, but 2009 will be the first year that the company has not increased the dividend since 1977.

This morning brought more bad news for financial stocks, as S&P lowered its debt ratings on 11 banks and issued a warning for one more. Among the firms affected were; Bank of America Corp. (BAC), Barclays PLC (BCS), Citigroup (C), Credit Suisse Group (CS), Deutsche Bank AG (DB), J.P. Morgan Chase & Co. (JPM), Morgan Stanley (MS), Royal Bank of Scotland Group PLC (RBS), UBS AG (UBS), Wells Fargo & Co. (WFC) and Goldman Sachs Group Inc. (GS). S&P’s downgrade places an exclamation mark on a horrific year for financials, with the sector having already reported some$745 billion in write-downs and losses attributable to the credit crisis.

RatingKeeping the news in perspective, none of these companies are a rated below A–which is well above the investment grade level. These downgrades should come as no surprise to anyone. There has been evident weakness in financials for many months as storied brokerages like Bear Stearns and Lehman Brothers have become insolvent and slipped away. The timing of S&P’s action seems a little odd though as the ratings agency seems to be developing a harsher assessment of the financial health of many battered firms just as a sense of calm is returning to the equity markets.

Ratings agencies have come under the microscope recently as they failed to see the devastating risk posed to the system by the mortgage-backed or collateralized debt securities that they were charged with rating. In hindsight, since the ratings agencies are paid to provide ratings opinions by the issuers of the debt, there is natural conflict of interest which might preclude a thoroughly objective and dispassionate opinion. This situation was made even worse by the fact that many analysts within the ratings agencies did not fully understand the risks presented by many of these complex financial instruments. This excellent piece from Money Morning details what has gone wrong in the ratings system and suggests some ways to fix what has become just another “ratings game”.

As for today’s downgrades, they should not substantially change investor’s outlook going forward. There was no new information offered today in what S&P released. There are serious risks in investing in financials right now, as any seasoned investor is well aware. However, that risk may be acceptable to certain investors for the prospect of a substantial long-term reward for enduring what could be a very rocky near-term ride.

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