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:

http://www.nytimes.com/2011/08/03/business/aaa-rating-is-a-rarity-in-business.html

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...