It is a common plot point in thriller movies that the hero will seemingly neutralize the bad guy, restore order to the world and prompt the audience to expect the credits to roll. But wait--the person we thought was the bad guy really wasn't and the real bad guy remains at large, plunging the world back into chaos and extending the movie for at least another thirty minutes--or in some cases, setting the table for the sequel(s).
Last week's economic news had that feeling of a thriller with multiple plot twists and, as with many movies, the plot twists may have been predictable on some level but still dizzying. On Monday, the President and Congress announced that they had a deal to allow the debt ceiling to be lifted to avoid default that would have otherwise happened on Wednesday. On Tuesday, the President signed the bill and some may have begun to believe that there would be smooth (or at least smoother) sailing as we dodged that bullet. But then came Thursday's market free fall, fueled in part by concerns about the soundness of the debt of certain European economies. Then came Friday's news that Standard & Poor's lowered its sovereign credit rating on the United States to AA+ from its AAA rating and announced that its outlook on the long-term rating is negative in light of its view that "the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned . . . ." And the story isn't over yet. As this issue of the Financial Services Update goes to press, U.S. and world markets continue to drop.
It is likely that the dust has not yet settled enough to evaluate the extent of the impact these events will have on the financial services industry. Given that many investment guidelines and investment policies proceed from the assumption that U.S. treasuries will have the highest ratings, managers may need to review the implications of the downgrade on compliance with policies and guidelines. In addition, the ratings downgrade will have a ripple effect on other types of securities whose ratings might be pegged or linked to the rating of the U.S., such as securities issued by government-sponsored entities. Thus, the guideline and policy implications of those downgrades will need to be evaluated as well. While not as disruptive as a default would have been, the downgrade nevertheless presents unique circumstances such that all of the consequences may not yet have been determined. Of course, to the extent the downgrade increases the cost of borrowing, that could have implications for a variety of different investment strategies as well.
On the policy front, a key component of the compromise reached on Monday is the creation of a bi-partisan debt-reduction committee which is required to present a proposal to Congress by Thanksgiving, at which point Congress may vote it either "up or down," without the possibility of amendment. While it seems like skepticism is warranted here (how can this bi-partisan committee reach an agreement when the bi-partisan Congress couldn't?), there are considerations on the table that could also have an effect on the financial services sector. For example, one proposal that has been discussed in recent months is a significant reduction in the extent to which employee benefit plan contributions will be tax-free to plan participants and tax-deductible by employers. These proposals, if adopted, could significantly reduce the extent to which employees contribute to retirement plans and the extent to which employers offer them. Given the significant role of employee benefit plan assets in both the retail and institutional marketplace, a reduction in their prevalence could adversely affect financial services providers. While changes like this seem like a long-shot given the dysfunction demonstrated by the most recent negotiations, those of us who work with employee benefit plan assets may nevertheless wish to keep an eye on these developments.
While much is unclear, there is one thing that is clear. The U.S. has not eliminated the bad guy here but has left the directors plenty to work with in the sequel. We can hope that "Debt Crisis II--The Payback" (or perhaps "Debt Crisis II--This Time It's Personal"?) has a happier ending.