It Took Courage

Something unprecedented has happened.

At the end of last week the credit rating agency Standard & Poor's (S&P) issued a research report that downgraded the credit worthiness of the United States Government.  The implications of this report are difficult to overstate.

When I was in business school a mere 5 years ago, US government debt obligations (Treasuries) were considered to offer a "risk free rate of return".  This meant that if an investor purchased a Treasury they did not have to fear the possibility of default.  This had been the case for over 200 years.  According to S&P it no longer is.  To help you understand the implications I will start with a brief summary of why this matters so much to the financial markets.


How it works

Lets say a financial annalist is deciding whether or not to buy bonds issued by Microsoft.  The first thing they do is see how much interest they could make by purchasing US Treasuries.  As an example, we'll say Treasuries are yielding 3%.  That meant the annalist could make 3% on their money without taking any risk.  Knowing that, the annalist then looks at Microsoft and recognizes that there is at least some risk that Microsoft could go out of business and not be able to fully pay back their bonds.  Therefore, in order for the annalist to be willing to buy Microsoft's bonds, they would require more than 3% in return.  The amount over 3% is called the "risk premium".  The higher the annalist believes the risk to be, the more risk premium he will require in order to make an investment.

Let's say the annalist decides that Microsoft bonds are not very risky and therefore he only requires a risk premium of 1%.  He will only buy Microsoft's bonds if they are currently yielding 4% or more. When thousands of other annalists and investors make this same kind of evaluation, the market will naturally set a price for Microsoft's bonds that aggregate the average risk premiums desired by all investors.

The same type of evaluation is done when an analist is evaluating an investment in Microsoft's stock, or the stock of any other company.  Treasuries are still the baseline for how much risk premium should be priced into the stock.  Because stocks are considered to be riskier than bonds (due to the amount and timeline of returns being less certain), a much higher risk premium is usually required.  Certainly there are other factors that go into the price of any given stock or bond, but risk premium is always one of the major considerations, and risk premium has always been based on the return of US Treasuries.

Because of the downgrade Treasuries were not considered to be "risk free" any more (again, at least according to S&P).  Therefore a risk premium now had to be assigned to Treasuries as well.  So if suddenly investors demand that their Treasuries yield them 3.5% rather than 3% because of the perceived risk, they will also require that Microsoft bonds yield them something like 5% rather than 4%.  The amount of risk premium on the Microsoft bonds didn't change, it just increased proportionately to the increase in the yield from Treasuries.  In the same way, investors also suddenly require Microsoft stock to yield something like 13% rather than 10%*.   Because investors now demand a higher rate of return, they will not pay the same price for an investment that they would have previously.  Supply and demand forces take over and prices drop across the board.

I would also like to make mention of the fact that when the equity markets dropped democratically following the news of the downgrade, actually risk premiums did increase.  A world in which the certainty of Treasuries is questioned, is a world that is systematically more risky to invest in.  Therefore in reality there were two negitive forces acting upon equity and bond markets.


Why it's such a big deal

S&P knew what was going to happen when they issued this report.  They knew that investors would start selling both stocks and bonds, and they knew that politicians and other annalists would get mad at them and question their motives.  They knew they would take the blame for what was happening in financial markets.  But make no mistake about it - it is not their fault.

Back in 2008 and 2009 everyone on Wall Street and on Capital Hill wanted to persecute S&P and its fellow rating agencies.  Everyone was up in arms because these agencies had very high credit ratings on mortgage backed securities that turned out to be very risky.  Their rating on many other debt issuers were too high as well.  The criticisms were both numerous and warranted. They were not being intellectually honest, they were not evaluating debt issuers closely enough, they were not taking all the risks into consideration, and they were not willing to make decisions that might cost them business.  This was the common thinking no more than 2 years ago.  How quickly we forget.

By issuing the downgrade of the US Government's credit worthiness, S&P did exactly what Congress and so many others asked them to do: be honest.  They looked closely at the US debt situation and they made a judgement about it.  They gave Treasuries the rating that they believed Treasuries deserved.  Whether or not you agree with S&P is not the point.  The point is that S&P did what they are supposed to do.  They stood up for what they believe to be true regardless of the social and political backlash.

I applaud S&P for their courage.  I hope that one day I will be applauding our political leaders in Washington for their courage as well.  And I hope that that day comes soon. 


*The risk premiums increase exponentially as a percentage of how large they were originally, which is to say that large risk premiums increase proportionately more then smaller one.  The real world application is that stocks decreased even more than bonds.