S&P Downgrade: What It Means for Business

Four days after Standard & Poor’s made its momentous decision to downgrade the US sovereign credit rating from AAA to AA+, the world’s financial markets had lost up to a fifth of their value before starting to rise again. Despite the downgrade, however, investors fled equities and bought US treasuries as a safe bet; this only highlighted the utter unpredictability of the situation. Is this the first time bond rates have fallen immediately after a downgrade?

It is tempting to conclude that S&P’s history-making has sparked the turmoil but the truth is that markets were already leery of recent economic data (see this Financial Times piece published before the downgrade) and were responding accordingly. S&P has only exacerbated the tension, and its decision is a result of the recent political gridlock that delayed the debt-ceiling decision rather than being a wholly forward-looking one about economic fundamentals. As Reuters blogger Felix Salmon says, S&P’s downgrade is not based on America’s ability to pay its debt but on its willingness to do so.

As we said two weeks ago, America’s woes reflect difficult policymaking conditions as much as they do a struggling economy, which differs starkly from other developed nations (such as some euro zone countries) facing a range of more worrying economic problems.

Short-Term and Long-Term Effects

There are good reasons to believe that there will be no drastic changes in the world’s markets. S&P gave repeated warnings of an impending downgrade before the actual decision and it could be argued that markets had priced this in beforehand. And, as was proved yesterday, investors still see US treasuries as the safest place to store their cash.

There have also been some sensible responses to the news: the G7 group of nations were quick to craft a coordinated response and various agencies have not enforced the knock-on effects that a change in US treasuries’ debt rating should officially incur: for example, in the US banks will suffer no capital penalty for holding US debt, and S&P said that the four US companies that hold triple-A ratings would not be downgraded in line with their host country.

It is also worth remembering that only one out of three of the world’s main rating agencies have downgraded the US, so it is unlikely that much will change in the short term. A number of commentators think the cost of borrowing will rise in the long term given that US treasuries largely underpin these costs worldwide. It is almost inconceivable that a downgrade won’t see at least a small long-term rise in the amount of interest the US government will have to pay on its debt, and this should have a knock-on effect.

But the main problem with the long-term outlook is that we are on untested ground. No one knows what happens when the debt rating of the world’s least risky and most traded asset is changed. US treasuries underpin so many policies, procedures, and decisions in the world’s companies and institutions that the only safe prediction is that there will be unforeseen consequences.

What Managers Should Do Now

1. Revisit risk management processes: Strong liquidity positions provided an effective shield against the most recent financial crisis but already-constrained debt markets will not have much capacity this time around.

   Managers should add nontraditional risk measures to make sure they are capturing emerging risks as quickly as possible. The best firms add a time dimension to risk management to tackle fast-moving risks first, and define clear risk triggers to speed up response. CFO Executive Board (CFO) clients can use these resources to help improve their risk programs; Audit Director Roundtable (ADR) clients should use these resources, and Finance Leadership Exchange-Elite (FLEx-E) clients should use these resources. Treasury Leadership Roundtable (TLR) clients can use these resources to help with financial risk management.

2. Check investment policies: Corporate finance and internal audit teams need to audit the investment policies for their company’s pension and cash investments. Does a downgrade render a lot of their holdings in contravention of the policy? They should seek to understand whether they need to update the policy or the composition of their holdings.

   This requires treasury teams to help audit teams understand the new level of risk in the funds and then for audit teams to craft new policies to deal with the reality, if needed. TLR clients can use this webinar replay to understand how to assess the risk in their cash investments, and this set of resources to help draft an investment policy that reflects the organization’s risk appetite.

   Legal teams should also check any loan covenants they have crafted with their lenders to see whether the collateral they promised to hold has been invalidated by the downgrade.

3. Tighten financial and strategic policy alignment: Senior executives may have been made overly complacent by their firm’s large cash balance in recent times and now be overly risk averse. Finance must help senior executives understand what levels of internal and external funding are now available and how this will help the business meet its near-term and long-term growth goals.

   TLR clients can use these resources to help improve capital planning; CFO clients can use these resources, and FLEx-E clients can use these resources.

   Finance teams should also establish a plan for how to best use their cash in the changed conditions (see immediately below for communication about this). TLR clients should consult our cash allocation playbook to understand the seven most common cash allocation mistakes and how to avoid them. CFO clients can use this version; FLEx-E clients, this version.

4. Tell the right cash story to investors: The average length of ownership in S&P 500 shares has dropped from 26 months in 1990 to six months in 2010, meaning that the market’s timeline has never been more different from the companies they are investing in. In times of uncertainty it is imperative that you communicate a clear story about your level of liquidity and excess cash.

TLR clients can use our Cash Cascade Benchmarking to benchmark their sources and uses of cash and understand how they compare to other firms before drafting communications on this topic. Investor Relations Roundtable clients can use our Message Absorption Diagnostic to understand how well their messages are received by the investor base, as well as these resources on crafting and implementing a messaging strategy.

5. Revisit hedging strategies and policies: The explosion in volatility will raise the cost of options, forward prices, and other instruments used to hedge foreign exchange and commodities. These problems will recede as markets normalize.

   Treasury teams should evaluate and reaffirm risk tolerance targets with the CFO and senior corporate leadership; they should coordinate with Audit and Procurement to identify the most material exposures to the company. TLR clients can use these resources to help with coordinating hedging processes across the firm; clients of other CEB programs should contact us for assistance.

6. Don’t get caught by the next bank failure: Assess credit exposure to your banks and don’t let short-term problems make you neglect long-term contingency planning.

   TLR clients can use these resources to help monitor bank risk, and our Liquidity Edge suite of services to bring quantitative rigor to their counterparty risk assessments.

7. Identify key suppliers at risk: Procurement teams should be ready to tell senior management if any of their critical suppliers would be at risk due to volatile markets or lack of available credit. They should also formulate plans to help troubled suppliers, whether it is guaranteeing orders or providing collateral for loans.

   Procurement Strategy Council clients can use these resources to help with identifying which suppliers are the most critical, and these resources to help with supplier risk management.

8. Run effective scenario sessions to get senior management on the same page: It is important during periods with a lot of data but very little accurate information to not only have the senior management team diagnose what it means for your company but to craft management consensus on an action plan.

   Managers should run a lightly-resourced scenario planning session at senior managers’ earliest convenience to help craft a company response. Corporate Strategy Board clients can use these resources to help create and run such a session.

This is only a broad sweep through the issues raised by S&P’s decision last Friday. Please use the fields below or contact me to leave a comment. And CEB clients are encouraged to contact us if there are resources that they cannot access or if they need our advice on any aspect of this problem.