Saturday, August 6, 2011

Chill, dude! It is not the ratings downgrade.. It is how you react to it!

Sorry about the title, but I am in Southern California, in surfer terriotory! I guess that the debt ceiling debate was not the end game it was made out to be. In spite (or perhaps because) of the fact that the debt ceiling was raised by Congress, S&P decided to downgrade the sovereign rating for the US from AAA to AA+. As the headlines trumpet the news and the airwaves are filled with self-styled experts telling us how this will change the world as we know it, it is useful to step back and ask a few questions about yesterday's momentous events:

1. Was there  "information" in yesterday's ratings change?
Let's see. S&P's rationale for the ratings change is that the US has a lot of debt, that it is adding to with large continuing deficits, that are perpetuated by a dysfunctional political system. Duh! I don't think any of us needed S&P to tell us this... I don't see any news in this ratings change. You may wonder why that rationale cannot be applied to any ratings change, for corporates as well as sovereign ratings. And it can... For well-followed corporates, ratings changes are almost never big news with the bulk of the effect occurring before the change is made. The confirmation of conventional wisdom does carry some weight, but not very much. Ratings agencies are like those guests who show up at the party just as it is breaking up, too late to join in the fun and not early in to make a difference.

2. What do ratings agencies do?
Ratings agencies are "measurers", not "diagnosticians": they can tell you (they think) that something is wrong but they are not very good at telling you why or what to do about it. I think that S&P is pointing to the fact that the default risk in US government debt has increased over the last year and I think that they are right on that count. Beyond that, though, I would not lend too much credence to any of the policy changes that they feel will alleviate the problem... and the answers to the next two questions should explain why...

3. Can bad things follow this downgrade?
Of course, but it is not the downgrade itself that would worry me.. it is the reactions to the downgrade. We have seen the script before and here is the most negative (and unfortunately, most likely scenario). First, you will have representatives of the downgraded entity (in this case, the US treasury) argue that the ratings agencies got it wrong. Second, the same entity will do everything in its power to make the ratings agencies happy so that they can reclaim lost glory.
I cannot predict the end result here, but corporations that have played this game have almost always lost. Fighting a ratings agency just prolongs the effect of the ratings action and gives the ratings agency even more power. You cannot run a healthy business (or economy) with the objective of keeping ratings agencies happy. After all, if a business were run with the sole objective of minimizing default risk, it would not borrow much, it would never take risky investments or pay dividends. It would just be a pile of cash backing up debt obligations. The bankers will be happy but who else would gain? You can draw the analogies to an entire economy yourself....

4. Can good things follow this downgrade?
In a perverse way, a ratings downgrade can free decision makers to focus on what matters. With a business, this would translate into decisions that maximize the value of the business rather than maintain a high rating. An interesting article in the NY Times a few days ago highlights this proposition:
Note that this does not mean that default risk is not a factor in decision making but rather that ratings are an artificial constraint.
Can the same rationale be applied to a government? I don't see why not. Now that the bogeyman of "losing the AAA rating" is out of the closet, it can focus on policies that make the economy more vibrant, with the constraint of keeping default risk (and deficits) under control. If I were Tim Geithner, on Meet The Press tomorrow, I would not waste my time arguing with S&P about whether the ratings downgrade was merited on or not. Instead, I would accept it as a fait accompli and move on to set the agenda for what I would do in terms of economic policy. Am I hopeful that this will happen? Not really... but I am glad that I am not the Secretary of the Treasury at the moment...

At the risk of adding my voice to the cacaphony, here is what I would suggest. The worst thing that investors, analysts, legislators and policy makers is to change the tried and the true (ways to invest, analyze companies or set policy) because S&P has changed a rating. The best thing that they can do is to realize that the world has not changed over the last 24 hours and to use common sense as a guide to good practice. For investors, this will mean staying diversified across asset classes and globally in their asset allocation decisions, and due diligence in picking companies. For analysts, it will require going beyond assuming that the government bond rate is the riskfree rate and using historical risk premiums. So, my advice is that you skip the S&P press conference on Monday, stop reading newspapers for a couple of weeks and take a break... I am...


aquemarropa said...

It's the Tea Party downgrade - from the S&P press release: "Compared with previous projections, our revised base case scenario now assumes that the 2001 and 2003 tax cuts, due to expire by the end of 2012, remain in place. We have changed our assumption on this because the majority of Republicans in Congress continue to resist any measure that would raise revenues, a position we believe Congress reinforced by passing the act."

Aswath Damodaran said...

Trusting S&P to get the cause of the downgrade right is like asking a thermometer the reason for your fever

K2 said...

There is no new information in the past few days which may have changed US creditworthiness. However, this is the first time, it has been 'called'. Officially, on paper.

This has two implications in my view

1) What is truly risk-free? Are all financial instruments inherently risky? And if so, is a return to gold & commodities as true risk free assets the way forward?

2) In this year both Japan and the US have been downgraded. Does this mean the 'developed' world as we know it ending, and the new world order of the BRICs and South Korea coming to the fore sooner than expected?

Jaimin said...

Agree with you on removing the noise. But markets are seldom rationale and you would have to be atleast go with the trend till the dust settles.

I have a couple of questions

1) If its US Sovereign downgrade (not treasury), would the investors still flock to US treasury - thereby making S&P downgrade a laughing stock?

2) If not U.S. treasuries, what do you recommend as investment to earn risk free rate considering Gold / commodities do not yield anything? German Bunds? Swiss franc? Yen? Anything else?

3) How do you think this effects cascading effect on
a) U.S. Banks
b) U.S. Businesses


Oleg said...
This comment has been removed by the author.
Frontpage said...

Thanks for your post!

And what do you think, is it possible that in near future(1 year) USD risk-free rate calculation will be based upon China's borrowing ?


Aswath Damodaran said...

I am not saying that there will be no consequences but that the downgrade happened in investors' minds over many months. S&P called it on Friday but they are not.umpires.. just commentators. The world goes on.. There may be fewer buyers for treasuries and the T.Bond rate may surge..let's see if it happens.

Krishnan said...

Spot on...after the initial brouhaha, the traders trying to take advantage, imbecile politicians giving their two bit it would be back to normal...(hopefully)

What else can investors world over park their money in?
Euro - well thats a joke!
CHF - Depth / liquidity issues
JPY - It's sitting with the Japanese households & they won't let go of it
GBP - HoHoHo!

So it's going to be back to the greenback!

Akshay said...

Does the US rating change affect cost of capital for companies operating in other countries?

Merco said...

Are the rating agencies really a thermometer?

Lav said...

I think today's foreign market reaction to the US treasuries is a slap on the face of S&P, and transmits the message we all already knew: we don't care about your rating, this is still a safe heaven. I don't know why S&P felt the need to do this stupid move. Mostly now, with that huge amount of cash on the bank's BS, which personally I think it's a safety net from the FED, just in case the US can't find enough demand in the markets when they will need to refinance, or there appears something extreme and unpredicted regarding the ability to repay the principals during the next 2 years, which are actually the hardest.

FebSee's gabble said...

Prof. Aswath, what are your thoughts on the state of BAC and C. The stocks of these banks have falled much more than the rest of the market. Typically stock prices predict the future, so are we sitting at the next big shock to the markets caused by a significant event involving these banks?

Waltz Lannes said...

Dear Damodaran.
Nice to read you.
I am happy to see once more that you , as an intelligent person , changed your deterministic approach.

Go back to my old intervention in "We are not ion kansas anymore" criticized by some of your audience and totally disregarded by you.

Empirically: everything I written you is now part of your ...approach.
Among the rest , your "Buy and (h)old" is inapplicable ( is it so since long time , but seemed not for you)

You liquidated my "note " on how complicated is to evaluate Luxury simply ...well I let your audience enjoy your video...

Again, next time I shall stop for a coffee in pane & cioccolata..

Best to you

Waltz Lannes

Cosqui said...

As businessman I admit that when ratings are down I feel stress but well sometimes I think that it's better to keep working than don't do nothing.