Archive for August 2011

A Wake-Up Call for Someone

When I woke up this past Saturday morning and heard the news that Standard & Poor’s downgraded U.S. debt to AA+ status, my fundamental valuation training kicked in and I immediately worked through the impact this decision would have on the risk-free rate in calculating the cost of equity.  I was a bit late to the station on this train of thought.  Steve Schaefer from Forbes.com wrote a great piece on this very topic BEFORE the downgrade.  He mentioned that we may need to look at other types of bonds, specifically municipal bonds, with AAA ratings that may represent a better indication of a “risk-free” investment.

While the idea of moving away from U.S. government debt to other AAA rated debt makes fundamental sense in an academic world where these fundamental theories assume “all other things being equal”, it lacks common sense.  Stepping back, I’m not sure how municipalities and their utility agencies can have less risk than the government that prints the money they use to pay down their debt.  I’m also not sure I can trust a rating agency that messed up so badly (starting at minute 2 in the Jon Stewart video) when it came to putting the same AAA rating on mortgage backed securities.  Even after adjusting for a $2 trillion mistake (yes that is with a “T”) brought up in “negotiations” with the U.S. Treasury, S&P stuck to their guns to downgrade U.S. debt based on its conclusion that it was now “pessimistic about the capacity of Congress and the administration to be able to leverage their agreement…into a broader fiscal consolidation plan that stabilizes the government’s debt dynamics anytime soon.”

So what happened to the markets on the Monday after the downgrade?  Stock markets crashed and money went into (wait for it…) U.S. government securities.  This “flight to quality” perpetuated by the actions of S&P resulted in lowering (not increasing) the yield for government debt.  Maybe Moody’s and Fitch (the other two rating agencies) got it right when they maintained their ratings on U.S. government debt for now with the hope that the recent debt ceiling debate would be a wake-up call to control deficit spending.

No matter how you look at the last week, one thing is crystal clear; the financial world as we know it has changed.  Regardless of the intent or rationale, the consequence of a downgrade is clear.  For the first time in our history, the risk of default has been brought into the equation when it comes to investing in the United States.  Based on our recent spending history, I reluctantly agree that this outcome was all but certain.  But as is almost always the case, it is the means to the end that raises my eyebrows.  Why would our politicians play “chicken” with our credit rating and barely stable economy to push through partisan policy?  How could one rating agency, the leader of a broken system already in line for reform, go it alone on this downgrade and create such a panic selloff of equities (followed by panic buying and then more selloff and…)?  And how, in a financial world ripe for regulation of hedge funds, could investors profit from such a move?  Blogs point to an $850 million bet that was made on the Thursday before the downgrade that, at the end of trading on Monday may have been worth 10x the bet.

Today we got our answer:  The SEC announced that they will investigate S&P over its downgrade.  Now, having my thoughts distracted away from the fundamental issues surrounding risk-free rates, I’m going to head to the microwave, put in some popcorn and watch the drama that will unfold as the plot thickens to one of political wrangling among a debt “super committee” charged with future budget cuts or, quite possibly, the biggest insider trading scandal in the history of financial markets.  Either way, the mood looks pretty sober for the next few years until we digest the events of one crazy summer in 2011.