Downgrades, management shuffles hit banks

Any hope that financial services companies had hit their lowest levels and were poised to start growing again was scuttled Monday when a credit-rating agency downgraded three large investment banks, and two big commercial banks stripped their CEOs of duties.

In a move that raised concerns about whether the investment banking business will ever return to its pre-credit-crunch robustness, Standard & Poor's downgraded Merrill Lynch mer, Morgan Stanley ms and Lehman Bros. leh by one level. The banks still enjoy investment-grade ratings, but the cost for them to borrow money is expected to rise.

S&P also reduced its outlook for Bank of America bac and JPMorgan Chase jpm from "neutral" to "negative," opening up the possibility of a downgrade later.

The news weighed on the stocks and helped shake up the broader market. Merrill fell $1.30 to $42.62, Morgan Stanley lost $1.13 to $43.10, and Lehman fell $2.98 to $33.83. The Dow Jones industrials lost 135 points to 12,504.

Responding to shareholder anger over mortgage-related losses, the board at Wachovia Bank wb fired CEO Ken Thompson Monday. Last month, Thompson was stripped of the chairman title. In a statement, the bank said Chairman Lanty Smith would serve as interim CEO until a new leader is hired.

At Washington Mutual wm, Kerry Killinger remains CEO, but the board announced he would no longer be chairman.

The overarching problem facing the industry is the possibility of a prolonged recession, says David Beim, a Columbia Business School professor. "What economists fear is that nothing is going for consumer demand right now, and everything is against it. What happens to banks has everything to do with that."

For the three investment banks, the S&P downgrade carries a serious cost, says Richard Bove, managing director of Ladenburg Thalmann. The banks carry hundreds of billions of dollars in debt on their balance sheets, and the ratings downgrade likely will increase the cost of that debt. "They've got a problem," says Bove, who expects the three banks to aggressively sell some of their assets.

At Wachovia, Thompson's ouster comes after months of negative earnings announcements and the threat of a reduced dividend. The bad news has helped drive the bank's share price down by more than 50% in the past year.

According to Bob Patten, managing director at Morgan Keegan, Thompson's firing was attributable largely to his $25 billion acquisition of Golden West Financial, a California-based savings and loan, at the height of the real estate bubble two years ago. "The good news is, the board made a tough decision," he says. "The problem is, there are no star replacements out there right now."

Since the real estate market collapsed last year, banks specializing in home loans have recorded mounting losses. The CEOs of Citigroup and Merrill were fired in the fall after the disclosure of billions in mortgage-related losses.