One of the most disturbing aspects of the credit crisis was the abysmal job done by the ratings agencies in assessing the risks of the securities they rated.  If they had not assigned AAA ratings to subprime collateralized debt, which are now trading at 20 cents on the dollar, a key element that facilitated the crisis would have been eliminated. 

If you are among those who, like Nouriel Roubini in our accompanying article, believe that Lehman is technically insolvent and worth only its franchise value, then it appears that very little has improved with regard to the ratings agencies’ ability to assess risk. The major ratings agencies remain cautiously supportive of Lehman in spite of its troubles.  In a conference call on Friday, hosted by the Argyle Executive Forum, Standard & Poor’s analyst Scott Sprinzen said that “we don’t expect Lehman to fail.”

“The underlying business at Lehman is doing pretty well,” Sprinzen said. Its “basic business franchise is not impaired.”

S&P rates Lehman’s debt A and the Lehman operating group A+, the sixth highest investment grade rating — well above “junk” bond status.  At the same time, credit default swaps (CDS) on Lehman indicate a 35% chance of default, and CDS spreads are wider than they were on Bear Stearns just prior to its takeover by J.P. Morgan.

Friday’s call provided a real-time glimpse into the process and thinking of the ratings agencies at a time when Lehman, one of four major independent investment banks, is in the throes of a struggle for survival.

Views on the Brokerage Industry

Of the three other investment banks, S&P rates Merrill the same as Lehman, Morgan Stanley one level higher, and Goldman Sachs as the best of the bunch, one notch higher still. 

The other analyst on the call, Tanya Azarchs, stood by these ratings, noting that S&P downgraded the brokerage sector a notch on June 2.  S&P has learned its lesson from the recent turmoil, Azarchs said: “Liquidity can dry up rapidly in this kind of environment.”

One factor S&P has built into their analysis is that uncertainty leads to accidents.  ”This has been an extremely prolonged period of lack of market liquidity, driven by fear, uncertainty… that we have never seen before,” she said.  “The longer the period of illiquidity lasts, the more potential there is for accidents to happen.”  Azarchs also said it was an accident that Bear Stearns failed.  “They had cash,” she said, but could not stand a withdrawal of market confidence.

Azarch’s references to “accidents” are telling. The seeds of the credit crisis were sown over the past several years, as investment banks rapidly increased leverage and underwrote increasingly risky debt securities.  It is a worrisome leap to believe that this level of risk assumption could result in failure only by “accident.”

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