Leeds School of Business



S&P Downgrade Prompts $1 Trillion Stock Loss; August 24, 2011 Background Note: On Friday, August 5, 2011 shortly after 8:00pm (EST) S&P officials publically announced that they had downgraded U.S. Government debt from AAA to AA+. In doing so, S&P said the downgrade "reflects our opinion that the fiscal consolidation plan that Congress and the administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics." It also blamed the weakened "effectiveness, stability, and predictability" of U.S. policy making and political institutions at a time when challenges are mounting.Shareholders in U.S.-listed companies can thank Standard & Poor’s for making them $1 trillion poorer after the rating firm earlier this month lowered the grade on Treasury securities for the first time to AA+ from AAA. Now, some of the most experienced investors say the stock market losses make no sense. While the benchmark index for U.S. equities dropped as much as 6.7 percent, or $1.03 trillion, since the Aug. 5 downgrade, 10-year Treasuries rallied the most in 28 months and the government was able to finance its quarterly debt obligations at the lowest interest rates ever. The S&P 500 fell to 12.2 times earnings the first day after the downgrade, the lowest since March 2009, while Treasuries have returned 2 percent since. “One of the most perverse things I’ve seen in 25 years of doing this is that S&P downgrades the United States government, and investors’ reaction is to run towards the securities that they downgrade, selling businesses without asking at what price,” Kevin Rendino, a money manager at BlackRock Inc., which oversees $3.65 trillion in New York, said in an Aug. 23 telephone interview. “Equity prices have swung well too far.” For Rendino and Liz Ann Sonders of Charles Schwab Corp., selling that may have been justified turned indiscriminate following the reduction, creating bargains in equities. The Chicago Board Options Exchange Volatility Index jumped 50 percent to 48, the highest level in 29 months and the biggest jump in more than four years, the first trading day after the action was announced. Edward Sweeney, a spokesman for S&P, declined to comment on whether the rating company’s decision influenced investors’ decisions to sell stocks. The downgrade, which conflicted with Moody’s Investors Service and Fitch Ratings, turned investors’ focus from the 10th straight quarter in which S&P 500 companies topped analyst earnings forecasts. As of Aug. 8, per-share profits had increased 18 percent among companies in the index, with 76 percent topping the average analyst projection, according to data compiled by Bloomberg. Sales rose 13 percent. The new rating from S&P, which cited “uncertainty” in the policymaking process, is the second-highest and puts the U.S. on the same level as Belgium and New Zealand, above Japan and China. Congressional Republicans warned in November, when outstanding U.S. debt totaled $13.7 trillion, that they would oppose raising the ceiling. Lawmakers agreed on Aug. 2 to boost the limit and adopt a plan to enforce $2.4 trillion in spending reductions over the next 10 years. “It did a lot of damage to confidence, which had been shaky anyway,” Sonders, New York-based chief investment strategist at Charles Schwab, said in an Aug. 23 phone interview. Her firm has $1.65 trillion in client assets. “We had started to get a sense of a little bit of a lift for the economy in the second half of the year, and you just kind of wiped it out because of the lack of confidence in our political leaders. S&P reflected that with the downgrade, but what it ended up causing was a real confidence crisis, more than an economic crisis.” Demand for Treasuries surged since the downgrade, helping send the yield on the 10-year note, the benchmark for home mortgages and car loans, to a record low 1.97 percent on Aug. 18. The bonds have returned 3.1 percent this month, poised for the biggest return since December 2008, according to Bank of America Merrill Lynch index data through Aug. 23. The Treasury sold $35 billion of two-year notes on Aug. 23 at a record low yield of 0.22 percent as investors continued to seek the world’s safest securities as refuge from financial market turmoil and a slowing economy. It was the first of that maturity to be sold after the downgrade. S&P, a New York-based unit of McGraw-Hill Cos., erred when it lowered the ranking and the U.S. merits a “quadruple A,” Warren Buffett, the chief executive officer of Omaha, Nebraska- based Berkshire Hathaway Inc. said in an Aug. 6 interview. Berkshire Hathaway made its biggest bets on the stock market on Aug. 8, the day the downgrade sent the S&P 500 to its worst plunge in more than two years, Buffett said in a television interview with Charlie Rose broadcast Aug. 15 on PBS. Under S&P’s definitions, debt rated AA is barely different from AAA securities and shows that a borrower’s ability to “meet its financial commitment on the obligation is very strong.” Stocks were falling before S&P took action as record interest rates in Spain and Portugal spurred the European Central Bank to resume bond purchases and Congress debated the U.S. debt ceiling, said Warren Koontz of Loomis Sayles & Co. in Boston. The S&P 500 slumped 4.8 percent on Aug. 4, its biggest retreat since 2009, and had lost 11 percent since July 22 as reports showed the world’s largest economy grew 0.4 percent in the first quarter and 1.3 percent in the second. “The downgrade wasn’t good, but more important for the selloff was the concern about Washington gridlock over the debt ceiling and the slowdown in Europe,” Koontz, who helps manage about $160 billion as head of U.S. large-cap value stocks at Loomis Sayles, said in an Aug. 23 telephone interview. “If we hadn’t been in an economic soft patch and if we hadn’t had the debt-ceiling ruckus, then we might not have had the downgrade, so I don’t think the timing was a surprise.” S&P said on Aug. 22 that it will replace President Deven Sharma with Citibank NA Chief Operating Officer Douglas Peterson at the end of the year as the ratings company faces regulatory scrutiny. The U.S. Senate Banking Committee is looking into the downgrade decision, a committee aide briefed on the matter said Aug. 8. The Securities and Exchange Commission is also scrutinizing the method S&P used and whether the firm protected the confidential decision, a person with direct knowledge of the matter said Aug. 15. “The fact that S&P’s president is stepping down is interesting timing,” Quincy Krosby, a market strategist for Newark, New Jersey-based Prudential Financial Inc., said in an Aug. 23 telephone interview. Her firm manages $883 billion. “It begs the question whether S&P thought that everything was fine with this downgrade, its timing and its consequences.” “There’s no connection between the downgrade of the U.S. and Mr. Sharma’s departure,” S&P’s Sweeney said in a phone interview. Peterson became head of Citigroup’s Japan operations in May 2004, a role he kept until January 2010. In November 2004, he became the first foreigner to testify before a Japanese parliamentary committee after regulators found Citigroup’s local private bank failed to conduct proper money-laundering checks. “My mandate is to fix problems,” Peterson said during 90 minutes of questioning by lawmakers from governing and opposition parties in the upper house. The probe forced Citigroup to close the private bank and send then-Chief Executive Officer Chuck Prince to Tokyo, where he apologized to regulators and bowed in a gesture of remorse. The S&P 500’s 6.7 percent drop on Aug. 8 was the biggest daily decline since December 2008, the height of the financial crisis spurred by Lehman Brothers Holdings Inc.’s bankruptcy. The index has lost 12 percent since July 22, as the debate about extending the debt-ceiling spurred concern the U.S. government would default. It alternated between gains of losses of more than 4.4 percent in the four days after the downgrade, the first time that’s ever happened. Shares of financial firms and banks led declines since the downgrade, losing 5.5 percent as a group. Energy companies and technology stocks have lost more than 3.2 percent. The S&P 500 Aerospace & Defense Index, made up of companies from Northrop Grumman Corp. (NOC) to Lockheed Martin Corp. (LMT) that depend on U.S. government spending for revenue, has declined 3.2 percent in the same period. Addendum: Financial Market Reaction to DowngradeImpact of Downgrade on Stock MarketFriday, August 5, 2011: DJIA Close at 11,444.61 (Note: Downgrade announced after the market closed)Monday, August 8, 2011: DJIA closes down at 10,809.85. This is a decline of 634.76 points from Friday’s close, or about 5.5%Impact of Downgrade on U.S. DollarImpact of Downgrade on 10-Year T-Bonds ................
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