Pattye Benson

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.