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S&P Downgrade Signals Significant Change is Needed

Polls in CPA Letter Daily offer an insight to the readers’ opinions about topics taking place in today’s world.

Last week’s poll question, with nearly 1,300 responses: Do you believe S&P's downgrade of the U.S. credit rating will affect your organization or your client's company?

  • Yes, very much – 9.47%
  • Yes, but not too much – 29.89%
  • Not at all – 50.08%
  • Unsure – 10.56%

It’s no surprise that a majority of respondents don’t feel the S&P downgrade of the U.S. credit rating will affect their organization or client’s company. In fact, little effect has been felt from the downgrade overall, other than the stock market’s trip to a theme park a couple weeks ago to ride the roller-coasters. To understand what, if any, the downgrade will have on the CPA profession and the U.S. overall, I sat down with a couple economists and picked their brain. See what they had to say after the jump.

Meet the Economists:

  • Genna R. Miller, Ph.D., Visiting Instructor, Economics Department, Duke University
  • Mark Vitner, Managing Director & Senior Economist, Wells Fargo Securities, LLC

Q: A slight majority (50.08%) of our poll respondents don’t feel the downgrade will affect them or their clients. What affect, if any, could the downgrade have on the CPA profession?

GM: In terms of the CPA profession, there may have been some fear that the negative outlook on U.S. sovereign debt, as well as possible increases in interest rates, may have caused a further downturn in the economy. Such a downturn in the economy may have been expected to reduce the demand for accounting services, as clients’ incomes declined. However, as there have only, at this point in time, been minimal impacts on the economy and the accounting profession, this does not appear to be the case. It may be the case that the income elasticity of demand for accounting services may actually be quite inelastic. The income elasticity of demand tells us the percentage change in quantity demanded for accounting services divided by the percentage change in clients’ incomes. Thus, if there is a relatively inelastic income elasticity of demand, then clients who have had accounting services in the past may continue to do so, despite any declines in their own income. On the flip side, some financial planners may have experienced an increase in business as some clients may have needed to re-assess portfolio values from a tax perspective or may have needed to comply with disclosure policies with respect to increased risk.

MV: I think most firms understand that the downgrade does not affect many private businesses. The downgrade and the problems with the federal budget deficit that precipitated it are primarily a problem for state and local governments and government contractors. Businesses and governments that receive a large part of their funding from the federal government will be most impacted by the downgrade and renewed emphasis on deficit reduction.

 

Q: Other than the market’s trip to the theme park last week to ride the roller-coasters, there doesn’t seem to have been a lasting effect to the downgrade? What are we missing?

MV: I am afraid that the recent volatility in the financial markets is likely to persist for a while. For as long as I can remember, the risk-free rate and interest rate on Treasury bills, notes and bonds have been synonymous. Now that Treasury securities are not as risk-free as previously thought, assets will need to be re-priced. This was the source of much of the recent volatility in the financial market. Since the downgrade, assets with more certain cash flows have risen relative to assets with less certain cash flows.

GM: The downgrade itself was actually quite a small change in credit worthiness, in that it was one notch below AAA, decreased to AA+ and not a massive decrease to junk bond status. AA+ is still a very high rating, and even many blue chip companies have AA+ ratings. Thus, the securities are still very attractive, especially considering that there is such a highly liquid global market for U.S. Treasurys. In addition, as long-term debt is still relatively safe, CPA professionals may continue to use U.S. Treasury rates in calculating ‘risk-free interest rates’ when needed. Also, federal regulators have explained that the downgrade will not affect how banking rules treat Treasury bonds (as risk-free assets).

 

Q: How will this downgrade affect other agencies, states and municipalities?

GM: Many states and government agencies are facing similar issues to those experienced with respect to sovereign debt, in that Freddie Mac and Fannie Mae have been downgraded along with the securities of several states. However, these investments are still relatively safer investments than other securities, though this does make it more difficult for these entities to acquire debt/loans which may further the need to cut spending and/or raise revenues and taxes.  States which have historically been highly dependent on federal spending and grants may also experience some belt-tightening.

MV: Government agencies and state and local governments are going to have to get accustomed to less support from the federal government. The nation is going to have to find a way to live within its means or the S&P downgrade will be followed by similar moves from other rating agencies.

 

Q: What are the implications for investors and consumers?

MV: Investors and consumers are going to have to think more closely about the relationship between risks and return. With governments tightening their budgets and households still deleveraging, overall economic growth will likely remain relatively sluggish for the next few years. This means businesses will need to pay close attention to managing risks and controlling costs. The price of making a mistake is amplified in a slower growing economy because it will take much longer to earn back any losses.

GM: There is the possibility of higher interest rates for mortgages, student loans, commercial/business loans and so forth. However, it may be safe to maintain holdings of long-term debt despite the downgrade. There is, of course, more impact of short-run changes for those who require immediate liquidity, such as retirees. In terms of future movements of markets, and the choices of consumers and investors, we may note John Maynard Keynes’s description of economic activity (especially investment spending) being partially driven by “animal spirits,” in terms of economic decisions being made based on spontaneous waves of optimism and pessimism about the state of the economy.

, AICPA Staff.

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