Morgan Merrill and Lehman get Cut Down

The market reacted in the knee jerk fashion you'd expect to the S&P downgrade of big banks Morgan Stanley, Merrill Lynch and Lehman Brothers, by selling them off. Actually it's fair to say the market was already in a knee-jerk "buy the dips" stance until S&P made its move:

Morgan Stanley, the second-biggest U.S. securities firm by market value, was cut to A+ from AA-, S&P said today in a report. Merrill Lynch, the third-biggest, was cut to A from A+, as was Lehman Brothers, the fourth-biggest. Goldman Sachs Group Inc., the largest of the group, was affirmed at AA-. The outlook on all four New York-based companies remains negative, S&P said.

The "actions reflect prospects of continued weakness in the investment banking business and the potential for more write-offs, though not of the magnitude of those of the past few quarters,'' Tanya Azarchs, an S&P analyst, said today in a statement.

And in a move that seems almost ancillary, the rating agency took action on Bank of America, JP Morgan Chase and embattled Wachovia:

S&P said today that it revised its outlook on Bank of America Corp. and JPMorgan Chase & Co. to negative. Citigroup Inc. was taken off review for a downgrade and given a negative outlook, while Wachovia Corp. was placed on review for a downgrade.

The market sell-off was really upon no new information; there was nothing revealed -- the banks were holding plenty of junk before the downgrade and they still are. The banks were 'A' or less before the downgrade (remember the IBs own traders valuing each other's default swaps at junk last winter?) and now S&P is just calling them what they are. The real story is that this puts a dent in "the worst is behind us" fairy tales the Street was gearing up to shill once more, going into Q2 reporting, and now they will have to start from scratch again:

"The market's a little surprised with the timing and the breadth of the actions," said Ricardo Kleinbaum, analyst at BNP Paribas in New York, adding, however: "I didn't see anything in particular that was a revelation."

"To have something like this come out so close to the reporting dates, at least for the brokers, suggests that S&P might be aware of a soft second quarter," Kleinbaum said.

Finally the rating agencies are beginning to offer up the Street in order to save themselves. It is not the best reason to do what's right, but if you wait for major Street players to do the right thing for the right reason you'll wait until Kingdom Come.