After the fact, it’s easy to say that you saw the downgrading of the US credit rating coming . . . but how many of us could have predicted it a month ago?
Prior to S&P lowering the nation’s AAA rating and prior to last week’s bitter political debates over the debt-ceiling, John Petersen wrote an article, “The Impact of United States debt crisis on technology” for a computer technology website.
When I first read the article with its triple-A credit rating downgrade prediction, my immediate response to John was, “. . . I understand the risk (and significance) if the US Treasuries were to drop in the AAA credit rating BUT – what do you think the likelihood of that happening is? That kind of financial catastrophe would create a complete collapse in the financial markets.” Wow — what a difference a few weeks makes . . . look where we are now! Naively, I wasn’t willing to believe that our government would jeopardize our country’s financial future. John’s article provides an interesting analysis in regards to the impact that the financial crisis will have on technology — I hadn’t looked at it that way.
I guess the next big question is after the credit rating downgrade that added an exclamation to last week’s turbulent week, is what impact will we see on Wall Street when the markets open Monday? Anyone willing to make a crystal ball forecast?
The impact of United States debt crisis on technology
July 16, 2011
By John Petersen
In addition to working as a software developer for 20 years and authoring several computer technology books, John has a MBA and JD.
If you work in the financial industry, you may already have a sense of what the impact is. If you happen to work for a firm that manages portfolios, such as an asset management company, if you don’t know what the impact is, you ought to. And if you fall into the former category of not knowing, by the end of this post, you will… I speak from experience here as I used to be a senior technologist for a UK based asset management company.
In case you have been living under a rock, you have heard that the United States Government is wrangling through numerous budgetary issues. The most notable of these issues is whether to raise the debt ceiling. The US is always refinancing its debt. US Treasury securities are issued all of the time. Treasuries are one of the chief ways portfolio managers hedge against risk. PM’s will usually purchase US Treasuries of the same duration as the security being purchased. It has always been ASSUMED that treasuries have a AAA credit rating. In other words, there is code out there that hard codes this assumption. Often, the process that hydrates a database simply associates the best credit rating with US securities. Ask anybody in the business and they will tell you that it’s just a fact – US Treasuries have the best credit rating you can have – AAA. Its not even questioned. It’s an assumption like magnetic north, Isaac Newton’s 3 laws of motion, the speed of light, etc.
What happens in our business when a fundamental assumption no longer holds true? Anybody here remember Y2K? In the Y2K issue, 2 digit years would be ambiguous. Imagine this calculation: 9/1/20-9/1/23! If all your system did was support 8 digit dates, this is what you were left with. Of course we know this is really 9/1/2020 – 9/1/1923. Imagine if Social Security #’s were no longer 9 digits? Imagine the havoc that would inflict on our systems???!!! This is the kind of calamity I’m talking about.
Now . . . imagine calculating the average credit rating for a portfolio knowing that a similar type assumption as Y2K exists with the current US Debt situation.
All of the code that ASSUMES that US Treasuries have a AAA credit rating and that code will have to be changed. It will be a big job.
By the way, if you cannot calculate an average credit rating for a portfolio, you cannot manage the portfolio. Portfolios normally have compliance guidelines. For example, you may not be able to purchase instruments that are not deemed to be “socially responsible” That can mean anything – but often, it will include securities for tobacco and liquor companies. Another guideline is that average credit rating has to be maintained. Remember when I said earlier when bonds are purchased, US Treasuries are often also part of the purchase as both a hedge and as a way of making sure the portfolio’s overall average credit rating is at a sufficient level? There are many of other areas such as pre-trade compliance, attribution, quantitative analysis, etc that are also effected. Regardless, I’m sure by now, you get the idea. The center of all of that is the software.
If US Treasuries fall below AAA, what securities can a portfolio manager buy? A AAA rating for US Treasuries has always been magnetic north. It’s always been there. Imagine if there was no magnetic north? A compass would be useless! Get the analogy??? If a portfolio cannot be managed within stated guidelines, the fines and penalties for the portfolio manager will begin to rack up quickly. And at the center of all that is the software.
If the US Treasuries don’t have a AAA rating, the way Fixed Income (bonds) are managed will be completely upended – and front and center in that storm will be the software and systems that drive the business. Of course it won’t matter because the entire system will collapse. What software can/cannot do will be the least of our problems, the software’s inability to manage the crisis notwithstanding.
The reasons why Treasuries Securities have such low rates is because of its AAA rating. Imagine if that is lost? Rates on the Treasury Bonds will increase to compensate for the extra risk. Remember the portfolio compliance issue and average credit rating? Portfolio managers will have to begin to sell out of Treasury Bonds. That will drive the price down. What instrument will take its place? I have no idea at this time. Maybe it will be another government’s security. Imagine if Canadian Bonds were the hedge? One thing is for sure, software is at the center of all of this. Worse yet, if the US Treasuries were to go to BBB: less than investment grade, there will be portfolios that won’t be able to buy into US Treasuries because there may be guidelines that forbid buying junk bonds. Often, a portfolio will have bonds that subsequent to acquisition are downgraded to junk status. In those cases, the bonds have to be sold. Sometimes, there are other portfolios that can pick up the slack – but only if other investment guidelines are met.
The biggest database in the world, in reality, is MS Excel… Think of all the tasks that are managed with Excel? Think of those hardcoded cells, macros, etc??? Think of all that gap-filling code that simply stuffs the credit rating to AAA. You need to do this because if you don’t, the rating will be null and you will have a null propagation problem. Think of a portfolio management tool like Charles River, or any other investment system and how they manage and how it gets its data?
Now, the crisis is not so abstract because if this all happens, it will affect us all because the portfolios I’m talking about might be yours, they may be a fund that is held by your 401K, your pension, etc. Think of the folks that live on credit cards – and they max them out. The US is no different in that it won’t be able to rollover/re-finance its debt. And worse, asset management companies will have an administrative problem because the software will likely not be able to cope with the new reality.
As for the Y2K crisis . . . that will be a walk in the park compared to what we are facing here.
There is an ancient Chinese curse: may you live in interesting times. These are VERY interesting times. It will be interesting to see how firms and more specifically, their technology teams deal with the crisis and the aftermath. Maybe in between Words with Friends and Angry Birds, they will think about and confront the problem with a solution.
15 CommentsAdd a Comment
I hope this puts an end to the John Peterson bashing. The man is brilliant and we should all listen to him. Most brilliant people are a little difficult, and he is no exception. I am proud to call him my friend.
Patty, thanks for posting Petersen’s article. I may not always agree with everything he says but Petersen is spot on here!
A very interesting and insightful analysis.
It was reported back in July that there was a 50/50 chance Standard & Poor’s would not affirm the U.S.’s AAA bond rating. But investors wanted to believe the ratings agency was trying to influence the gridlock in Washington and end the debt ceiling uncertainty.
It turns out, the ratings agency didn’t like the deficit reduction deal that was struck – even if its job is to rate investment instruments based on the likelihood of repayment – which for US treasuries, remains 100%.
I smell politics in S& P’s downgrade and a desire to help install a plutocrat in the White House in 2012 – one who will play by the rules of the most powerful and monied interests in this country. But that’s me…
As John points out, U.S treasuries have always carried no risk, so what will happen Monday if central banks, wealth funds, pension funds etc are forced to liquidate to lower portfolio risk levels? And what can possibly replace them? Canadian bonds, or those of the 16 other countries that retain AAA ratings?
For those of us who “held steady” last week and saw much of the last years’s gains evaporate, what should an investor do now? Sell before the market declines further? It’s a choice between realizing PAINful losses now or possibe GOD-AWFUL pain in the near future.
The new normal is beyond nerve-wracking – especially for retirees and those approaching retirement – not to mention parents about to pay their kids’ tuition bills and small businesses trying to stay afloat by scoring some credit to stay in the black.
Anyone notice the lack of traffic on local roads, the emptier parking lots at local stores? Even in this sheltered community where many have a cushion? it seems people are hunkered down, not spending, staying home, worrying… (And yes, others are simply away on vacation…worrying about their financial futures wherever they are.)
There is plenty of blame to go around for our current predicament, but our leaders have to stop making political calculations, look at history and empirical facts, and come together to move this country forward.
Congress’s decision to stick with their month-long vacations seems downright reckless and irresponsible – given the current mess we’re in.
“On June 8th Fitch, a rating agency, said such a default would trigger a downgrade of America’s credit rating from AAA to junk. The previous week Moody’s Investors Service warned that if August 2nd approached with no progress, it could put America’s rating on review for possible downgrade.”
from The Economist June 9th
From what I can tell, John was not predicting a downgrade. That was common knowledge in the financial community months ago. John was concerned that “mindless” portfolio management software might exacerbate the problem.
S&P decision to knock down the credit rating from AAA to AA+ coming on the heels of a disastrous week on Wall Street has me anxious for what to expect when the market opens tomorrow.
The lowering of the credit rating is certain to raise interest rates and borrowing costs on everything from credit cards to mortgage rates. Up to now, our school district and township have enjoyed AAA credit ratings – what effect will the downgrading of the US credit rating have on local government budgets?
As for the politics (and politicians) that brought us to this point . . . they all seem more interested in playing the ‘blame game’ than looking for solutions to the crisis.
Beware IT guys bearing prognostications of gloom and doom! That whole Y2K fandango left me very jaded about the profession. It may be that many systems have Treasuries hard-coded as AAA, but if the work around was as hard as John suggests maybe we’d have heard about it elsewhere?
The problem today is not that S&P downgraded Treasuries – we know that the rating agencies just codify what the market is already saying. The problem is mounting evidence that the growth assumptions underlying the plans to delever all the world’s developed economies (now the problem is Italy?!) are just too rosy. So equities are crushed and everyone rushes to Treasuries despite the downgrade.
Economics seems to me to be all about confidence – when folks think things are going to get better, they spend and invest (and generate government revenues), and when they think things are going to get worse, they don’t do those things.
So now is totally the time for Obama to dig deep and find the leadership that will convince the US and indeed the whole world that in fact things are going to get better – because he has a plan. A real short term investment (jobs) program and a real long term revenue and spending rebalancing program. If the naysayers squash that in the name of short term political advantage, hopefully the electorate will know who to blame for the ensuing depression.
Time to put up, or shut up.
Government does not create jobs; the private sector does. In 2009, Obama signed into law the American Recovery and Reinvestment Act at a cost of untold billions of dollars. A primary goal of this legislation was to “create or save” American jobs. First, this sets up a phony metric – how does one measure a job “saved” when it’s simple logic that one can’t prove a negative? Second, with nationwide unemployment hovering at 9%, how’s that working out for ya?
Barack Obama is 31 months into his presidency. Presumably, he had some awareness of the issues the American President would need to address. When does he start owning the problem? When does he stop trying to spend his way out of it with our money?
what is really amazing, looking back, is how the American electorate can elect someone to arguably the most difficult executive position in the world, when all his worldly experiences total zero along these lines. Votes “present” in the senate. Experiment failed. We will recover. WIll take time and the right people.
Bye bye barry.
Ask laid-off employees of any government sub-contractor that has lost business whether or not – in the short term – government creates jobs.
It’s clearly crazy for federal stimulus money to pass straight through the states to simply pay for increased compensation for government employees. However, I do think that an investment in productive infrastructure makes sense. If accompanied by the credible long term budget control plan I advocate above, then the private sector gets that boost in confidence that will help grow us out of the slump.
every where i look, there is “infrastructure” being built or improved. So it is good for those guys that are working, for sure. But where is the improvement in the overall economy.
What we have is a clash of 2 competing philosophies. Obama and the democrats philosophy won’t work. But they are unable to”pivot”, as Bill Clinton did, and rethink their strategies. And it has become personal out in the backroads of America, because of this intransigence and arrogance. President Obama’s ability to GOVERN has been tested. So far it is a failure. Just listen to his speech yesterday. Same old politics. Not leadership, no bold new ideas. He is what he is, to use a trite slogan, and he cannot get away from being himself. He will never pivot. It will be the doom of his presidency. This is not leadership. Just think about that commission that was noted here on these boards. Shelved. Just raise taxes, never enough to pay the debt, but to redestribute. Well it is tired. Back to work
I think there is danger in generalizing any group of people, including the IT professionals. I don’t know that John’s point was one of ‘doom & gloom’ but rather an explanation of what the downgrading of the credit rating could mean for technology. Many companies are hardcoded under the assumption there is a AAA credit rating. The US has always had AAA credit rating so why should there be concern or necessity for Plan B — until this week that is! With the unprecedented downgrading of the credit rating, I’m certain there are major software issues facing computer system experts coast to coast. As a result of the credit rating change, in addition to causing major problems for IT departments, I’m guessing that their backs are against the wall to get the changes made ASAP. Although there had been rumblings over the last few months about the possibility of a downgrade, I don’t know how many businesses were actually prepared with a Plan B to make the necessary system changes.
We the People, need to start to get HONEST about the real numbers, and the Facts as to how the USA got itself into this mess…..Please take the time to review and read this website…www.brcfs.com The USA Debt Mess,,,all started with Ronald Reagan, who ran on a Balanced Budget, but obviously was not successful.
While I appreciate the analyses JP offered, the Y2K and the AAA are all just more ways to obfuscate the root of our problems. One problem is clear — we have an economy where every decision is based on numbers — not what’s good for the nation. The phrase in Eisenhower administration — As goes GM, so goes the Nation….well, GM doesn’t go so well, and the government bailed it out. GM and the other two US companies fell victim to “legacy costs” — and in my opinion, the US is falling victim to the same thing. We all want what we have, and no one wants less. I heard an Ohio senator say that we cannot lower the social security age because some people cut hair or drive trucks, and they cannot do that after 65. That’s a “legacy” notion. We have unions that only negotiate raises or freezes, not reductions. We have a government that talks about “spending reductions” when in fact they mean a reduction in the increase. Even locally, our own unions “froze” their salaries ….the teachers for 6 months — but they get their full raises to establish a new base — just a little late. And how many of us have said “a deal’s a deal.” Everyone wants MORE. Talk to the people who are losing their homes because they don’t have any income — their employer isn’t paying their mortgage….and unemployment benefits don’t maintain lifestyle.
Numbers govern everything, and because of technology, numbers don’t require human intervention in the decision process. Buy/sell — short/long — lease/purchase — subcontract — outsource — the WORLD IS FLAT.
Back to work indeed. WHy not take a little more from those who make over $250K? Well, most of what we have already comes from those people. People don’t invest anymore — they hedge. Help?
Social Security and Medicare obligations are increasing at a greater rate than inflation and with an increasingly larger pool of beneficiaries vs the pool of workers whose wage taxes support those beneficiaries. This is a result of a number of things, including simple baby boom demographics and longer longevity due to increasing life expectancy.
So these programs have been growing, and we have funded two wars through borrowing. It is no wonder we have consecutive and growing budget deficits.
We can address this by 1) raising taxes, 2) reforming entitlements; and 3) reducing the defense budget dramatically. The third alternative has happened in the past under many presidents.
The first 2 are more problematic, since the radical right wont look at the first, and the radical left wont look at the second.
Theres your problem lady. But theres no news here.
S&P just pointed out that the ship will sink unless its course is righted, and there is a conflicted captain unwilling or unable to act.