While experts ponder what might happen to the financial markets and the real economy should the US default – even for a day – on its US Treasury payments, a larger issue is being missed by some: The practical impacts of US Treasury downgrade to AA+.
Default is, of course, more worrisome because it would materially shake a basic assumption upon which markets and, to an extent, modern finance is based. That is, US Treasury debt is ‘credit risk free’. However, whether the US defaults is within US control. Of course, the levers of that control are based upon a democracy in severe conflict, across several dimensions. That kind of analysis is beyond our expertise so we will leave it to the political scientists and other pundits.
However, a credit downgrade is NOT within US control. This will be a call of the oft-maligned rating agencies. But, even if they do not downgrade, the market may…especially since it is the market that typically acts prior to the rating agencies.
So far, the market (primarily via the credit default swap arena) is telling us that the US is still a slightly better credit risk than the strong German economy. But, that may be more a case of Germany’s commitment to the much expanded pan-European, EFSF, bailout fund (so far a backstop primarily for Greece, with more candidates on the horizon) than a comment on any stability in US finances.
But, the more salient point for insurers is how would a US downgrade specifically impact your portfolio?
Of course, we are unable to answer that for every insurer, but we can discuss how a generic insurer’s policy and portfolio might be impacted, even if the downgrade is simply to AA+. Here is a start to the discussion:
1 – Say goodbye to 100% limits on US Treasury investments or those with the ‘full faith and credit’ of the US government. Most policies view UST’s as ‘credit risk free’, so why not allow what is in essence ‘no limit’? When they stop being such, we would expect insurers will want to place similar limits as those placed on other AA+ credits and/or other sovereign exposure. For most insurers, we would expect that this will cause little or no change in current UST exposure, since they already are a very low percentage of the portfolio (there are not many reasons to hold low yielding securities).
However, many insurers hold significant amounts of mortgage related securities that are guaranteed by GNMA, a ‘full faith and credit’ issuer. And, a UST downgrade will most certainly cause a downgrade in GNMA debt. We would expect that policies would be revised to reconsider GNMA securities and be subject to tighter per pool or diversification limits.
And, we would also expect that FNMA/FHLMC securities would suffer a similar downgrade, causing a parallel reappraisal of policy limits.
2 – Should the US be downgraded by the rating agencies, next up on the hit list (after US agencies) will be financials. Please remember that the rating agencies are generally dubious about the Dodd-Frank ‘reforms’ when it comes to ‘too big to fail’. They suspect that should a large bank get in financial trouble, the US government will be forced to ‘save’ them ‘for the sake of the US and global economies.’ In other words, implicit in large bank ratings is some kind of implicit backing of the US government. Thus, a downgraded US government will mean downward rating pressures for the large banks. Perhaps atleast the ‘weakest’ of the group may be downgraded, which could cause problems for contracts that require a minimum credit rating level. Thus, forward looking insurers will want to reassess their financial sector exposure both from a policy and portfolio holdings perspective.
3 – Other corporate bonds will undoubtedly receive scrutiny as well, since it is difficult for a corporate to be rated higher than its sovereign rating. I think we only have one or two AAA corporate issuers remaining in the US. But, will Microsoft still be standing at AAA if Uncle Sam takes a hit? We shall see. More importantly, the rating agencies may very well consider the distance between a given corporate today and the supposed ‘risk free’ UST, and then reconsider the corporate rating to maintain that distance from a downgraded UST.
And, related to this are portfolio ‘average credit rating’ minimums found in policies. How will this recalculation, assuming the UST and its agencies are downgraded, impact portfolio compliance? Will it mean a sale of bonds at the lower end of the investment grade spectrum just to maintain that ‘average credit rating?
4 – Many municipal debt issuances are either defeased with US Treasury debt or have some link to support of the US government. Those issuances would also be subject to downward rating pressure and would have to be reconsidered in limit of both policy limits and portfolio holdlings.
5 – Some structured securities also use US Treasuries as a way to guarantee ultimate payment of some long dated tranches. Downgrading of those tranches will undoubtedly occur, but this type of asset is usually quite a small part of insurer portfolios, if at all.
Quite frankly, these are just some initial thoughts about how a downgraded UST market would impact policies of insurers. I am certain that the portfolio impacts (changing valuations, spreads, etc) will be much more important and are much more interconnected than noted here.
What are your thoughts on what might happen should the US be downgraded? If you have not started thinking about this, now would be a good time to think about it atleast as a possibility.
With that in mind, we are hosting a discussion of this topic on our new Insurer Investment Forum Online discussion group on LinkedIn. If you have a LinkedIn account (it is free), please click here to join the discussion. If not, you can always join LinkedIn, or add your comment on the link below.
Thank you and I look forward to your thoughts on this burgeoning issue.