As you have probably heard by now, this past Friday evening Standard and Poor’s downgraded U.S Sovereign Debt from AAA to AA+. This marks the first time in history that the US debt has ever been downgraded since ratings began.
While the pundits and talking heads debate and discuss the political ramifications of our current situation, we want to inform you about what it might mean from an investment perspective, since that is what you entrust us to do. We want to strictly look at the facts surrounding the downgrade, and cut through all the noise around the political issues.
Fact #1 – This was not a major surprise.
This was expected to a certain degree. S&P has been warning for months now that the US needed to get its fiscal house in order. The debt ceiling debate showed the rating agency that the US was willing to come dangerously close to default because of the federal government’s inability to rectify the situation in a timely manner.
Fact #2 – There is not a huge difference between AAA paper and AA+.
Despite all the hoopla, the actual difference between AAA and AA+ ratings is not that wide. Here is the definition of AA+ paper, as stated by S&P:
An obligation rated ‘AA’ differs from the highest-rated obligations only to a small degree. The obligor’s capacity to meet its financial commitment on the obligation is very strong.
S&P has stated that the downgrade had as much to do with the political environment as with our actual ability to pay. It can also be argued that AAA countries like the UK and France are not stronger than the US.
Fact #3 – The ratings agencies made some terrible mistakes during the housing bubble.
We also believe that the ratings agencies have lost quite a bit of credibility since the financial crisis of 2008. Moody’s, S&P, and Fitch were all culpable in bestowing their AAA rating on some of the worst debt issues. This allowed pensions, endowments, and other institutional investors to buy this junk debt filled with subprime mortages. Here is excerpt from an op-ed in the Financial Times, written by Lloyd Blankfein, CEO of Goldman Sachs, discussing how out of hand things got during the housing bubble:
In January 2008, there were 12 triple A-rated companies in the world. At the same time, there were 64,000 structured finance instruments, such as collateralized debt obligations, rated triple A.
This, coupled with the fact that S&P made a $2 trillion dollar error when reviewing the government’s finances, shows that the agencies are far from perfect, and should not be viewed as oracles.
Fact #4 – A downgrade does not automatically lead to higher interest rates.
We do not believe this action will necessarily result in higher interest rates. This chart, created by businessinsider.com, shows what happens after a country gets downgraded. Using several of the most recent examples, we see that after an initial brief spike, interest rates on average moved lower. Japan is the best example; they were downgraded in 2001 and interest rates have just kept going down.
Fact #5 – For investors who covet AAA rated issues, there simply is not a tremendous amount out there for them to buy.
Another issue is the amount of AAA debt available. The chart below, also from businessinsider.com, shows the share of AAA government debt. US debt makes up nearly 60% of all outstanding AAA paper. We believe investors will adjust to the new rating instead of vice versa.
Beyond the facts, there was also some rumblings on Wall Street that S&P leaked this information days before the Friday announcement. This will have to be further investigated to get hard evidence, but if there was a leak, it could explain some of the volatility we saw over the past few trading days.
Overall, we are not pleased with this development, but once the dust settles, we don’t believe that it will have a negative long term impact on the United States. It is our actions as a country that will ultimately determine if the debt of the United States will continue to be as safe and dependable as it has always been.
Although we believe the downgrade is not as significant as the media may suggest, we recognize that there are times when the markets behaves irrationally in response to such information. To that point, we are ready to act and take more defensive measures should the markets continue to show signs of deterioration.
Rush Zarrabian, CFA
For more information, click on this link that takes you to a good Q&A with the editors of Marketbeat, a Wall Street journal blog:
http://blogs.wsj.com/marketbeat/2011/08/06/downgrade-qa-is-aa-so-bad/
Other references:
http://www.standardandpoors.com/ratings/articles/en/us/?assetID=1245303711350
http://www.ft.com
S&P Downgrades US Debt – What does it really mean? – 08/18/2011
As you have probably heard by now, this past Friday evening Standard and Poor’s downgraded U.S Sovereign Debt from AAA to AA+. This marks the first time in history that the US debt has ever been downgraded since ratings began.
While the pundits and talking heads debate and discuss the political ramifications of our current situation, we want to inform you about what it might mean from an investment perspective, since that is what you entrust us to do. We want to strictly look at the facts surrounding the downgrade, and cut through all the noise around the political issues.
Fact #1 – This was not a major surprise.
This was expected to a certain degree. S&P has been warning for months now that the US needed to get its fiscal house in order. The debt ceiling debate showed the rating agency that the US was willing to come dangerously close to default because of the federal government’s inability to rectify the situation in a timely manner.
Fact #2 – There is not a huge difference between AAA paper and AA+.
Despite all the hoopla, the actual difference between AAA and AA+ ratings is not that wide. Here is the definition of AA+ paper, as stated by S&P:
An obligation rated ‘AA’ differs from the highest-rated obligations only to a small degree. The obligor’s capacity to meet its financial commitment on the obligation is very strong.
S&P has stated that the downgrade had as much to do with the political environment as with our actual ability to pay. It can also be argued that AAA countries like the UK and France are not stronger than the US.
Fact #3 – The ratings agencies made some terrible mistakes during the housing bubble.
We also believe that the ratings agencies have lost quite a bit of credibility since the financial crisis of 2008. Moody’s, S&P, and Fitch were all culpable in bestowing their AAA rating on some of the worst debt issues. This allowed pensions, endowments, and other institutional investors to buy this junk debt filled with subprime mortages. Here is excerpt from an op-ed in the Financial Times, written by Lloyd Blankfein, CEO of Goldman Sachs, discussing how out of hand things got during the housing bubble:
In January 2008, there were 12 triple A-rated companies in the world. At the same time, there were 64,000 structured finance instruments, such as collateralized debt obligations, rated triple A.
This, coupled with the fact that S&P made a $2 trillion dollar error when reviewing the government’s finances, shows that the agencies are far from perfect, and should not be viewed as oracles.
Fact #4 – A downgrade does not automatically lead to higher interest rates.
We do not believe this action will necessarily result in higher interest rates. This chart, created by businessinsider.com, shows what happens after a country gets downgraded. Using several of the most recent examples, we see that after an initial brief spike, interest rates on average moved lower. Japan is the best example; they were downgraded in 2001 and interest rates have just kept going down.
Fact #5 – For investors who covet AAA rated issues, there simply is not a tremendous amount out there for them to buy.
Another issue is the amount of AAA debt available. The chart below, also from businessinsider.com, shows the share of AAA government debt. US debt makes up nearly 60% of all outstanding AAA paper. We believe investors will adjust to the new rating instead of vice versa.
Beyond the facts, there was also some rumblings on Wall Street that S&P leaked this information days before the Friday announcement. This will have to be further investigated to get hard evidence, but if there was a leak, it could explain some of the volatility we saw over the past few trading days.
Overall, we are not pleased with this development, but once the dust settles, we don’t believe that it will have a negative long term impact on the United States. It is our actions as a country that will ultimately determine if the debt of the United States will continue to be as safe and dependable as it has always been.
Although we believe the downgrade is not as significant as the media may suggest, we recognize that there are times when the markets behaves irrationally in response to such information. To that point, we are ready to act and take more defensive measures should the markets continue to show signs of deterioration.
Rush Zarrabian, CFA
For more information, click on this link that takes you to a good Q&A with the editors of Marketbeat, a Wall Street journal blog:
http://blogs.wsj.com/marketbeat/2011/08/06/downgrade-qa-is-aa-so-bad/
Other references:
http://www.standardandpoors.com/ratings/articles/en/us/?assetID=1245303711350
http://www.ft.com