Default, Downgrade, Lions, And Tigers And Bears; Oh My!

Report from the Land of Oz

The last post, “Default: Won’t Happen. Downgrade: Fear Not; Our Best Generals Are In the Field!” talked about the difficulty of adjusting to the reality of uncertainty. Embedded in the discussion was the misplaced comfort associated with a good, working fiction.

To illustrate, In Congressional hearings Standard & Poor's President Deven Sharma was questioned about contacts his agency had with Geithner and others in the administration before it issued its initial downgrade warning in April. Sharma pointed out that consulting with those issuing a bond is standard. Of course congress was told the same thing in connection with bank- issued mortgage-backed securities and asset-backed securities issued during the credit bubble. Then congress members, especially Democrats, flipped out about it being proof of conflict of interest, thus contributing to the very convenient fiction of the great Wall Street conspiracy.

Sharma told the panel that officials at the agency had allowed Treasury officials to review a draft of the S&P press release warning before it was issued. He said that was done to make sure that there were no inaccuracies in the press release. He pointed out that this was standard S&P practice and did not involve any special favors for the U.S. government. Think the same congress members will flip out again? Where are Barney Frank and Henry Waxman and their rants about conflict of interest? No, they’re far too despondent watching their pet fiction turned on its head. But, at least we have a new fiction to embrace. It is so much more comfortable to believe there’s something sinister at work. It’s a good working fiction.

Jules Kroll, chairman and chief executive of Kroll Bond Rating Agency questions whether private enterprise should be in the business of rating sovereign debt. Mr. Kroll's firm was launched last year to challenge S&P, Moody's and Fitch. Talking his book, me thinks. But his statement struck a cord with many Americans. What’s behind the sympathy his comment evokes. Well, if the government has a good working fiction, damn freedom of speech; don't rock the boat. But, it’s hard to keep a fiction working once someone notices. To keep the AAA fiction going, it may be more important to address the media rather than rating agencies. We also need to control opposition parties. Worse yet, we may have to address the reality of our debt. No, no, what a bad idea; after all what’s fiction for if not to escape reality.

The conspiracy theorists’ conflict of interest argument favors the belief that the US should have been downgraded before. Egan Jones, who is paid by bond holders rather than big issues like the US, downgraded the US about a month ago. Europeans’ can’t understand the absence of a downgrade. It’s a fiction that the experts always know. But, that’s a more comfortable fiction than accepting the fact that in some instances no one knows.

Since The Hedged Economist never believed the popular fiction of a risk-free return, AAA verses other prime ratings like AA isn’t as big a concern, certainly not lions and tigers and bears from a financial management perspective. As stated in the posting entitled, “The US Will Lose It’s AAA Rating,” it will be a disappointment, but not a surprise.

As noted in a previous posting, this blog noticed that people tend to be more interested in postings on policy than postings on an individual’s financial management. The downgrade or default issue is a perfect illustration of why both are important. It also illustrates why the focus of this blog bounces between them. The series on investing was an exception in that it focused exclusively on financial management. It was a necessary detour.

Without the series “On Investing” some of these comments about policy could lead to financial folly. For example, adequate liquidity, a diversified portfolio that includes real estate, stocks (domestic and international), bonds including Treasuries (risk and all), non-publicly traded firms, commodity exposure, and tax deferred, long- term investments are all necessary in order to rationally respond to uncertainty. That’s true whether the uncertainty was recognized by all or hidden by a good working fiction. But, it is a comfortable fiction to believe that one would be OK without an investment plan if only those evil (fill in the blank) weren’t messing up.

In this instance, having addressed the folly of a risk-free rate of return, the issue of others realizing US Treasuries aren’t risk free can be addressed without panicked adjustment in investments and without the waste of time involved in a search for blame. One has to admit the idea of a risk-free rate of return was truly a beautiful fiction. It allowed a massive financial edifice that spit out certainties at an amazing pace. Never mind that they were fiction.

With that noted, it’s time to look at what an individual investor should do. Most have heard all sorts of advice. Newsletters from brokerage and mutual funds, talking heads on TV and radio on both financial channels and “mainstream” media, newspapers and magazines, you name it, have all chimed in. Not surprisingly, individuals who have well-designed portfolios should do very little if anything. But, it’s a comfortable fiction for those without a well-designed portfolio to think there are emergency steps that they can take to overcome the problem.

Of all the nonsense floating around, the piece that most appealed to The Hedged Economist was one that basically said no one knows what this means because no one could possibly know. The piece took a lot of words and had some excellent analysis. It mapped out a tree. For example, going out one branch: Default or downgrade? If downgrade, was it a downgrade with debt ceiling agreement or without? If with an agreement, was the agreement big or small? If big, did cuts come early or down the road? If early, did the Fed loosen via QE3-like steps or not? In each step there were different consumer and international responses. Hopefully that conveys the approach.

What really made the analysis useful was that it didn’t try to predict the results of any branch. Rather it just pointed out the risks / uncertainties each path created. It made no effort to pretend is could remove uncertainty; it just identified the uncertainties associated with each branch. How refreshing is that after legions of politicians, government officials, and assorted pundits have made fools of themselves assuring anyone who’d listen that they could protect us from the inevitability of uncertainty? Uncertainty is no fiction. Neither is it lions and tigers and bears.

As this posting was being wrapped up, there was a rush to microphones in Washington by crowds who wanted to report that they singlehandedly cut the Gordian knot. Well, there’s a fiction we’ll all love. We can each believe our hero saved the day in the nick of time. Tomorrow morning we’ll see.

The Hedged Economist? Look for someone skipping down the yellow brick road saying “risk and uncertainty and reality; oh my!”