Monday, July 25, 2011

What does the U.S. debt ceiling mean for CFOs?

As the U.S. government continues to wrangle of the issue of government overspending and limitation of the imposed debt ceiling, CFOs would be right in asking what does it mean for their organizations. 

The current state of the situation is this: the U.S. Congress has set a debt limit of USD 14.3 trillion.  The U.S. Government for years spent more than it took in tax revenues.  It has done this by issuing debt.  Should an agreement not be reached prior to 2 August, the U.S. Treasury department will have to make some tough choices.  The U.S. Treasury department is legally required to pay certain obligations and Timothy Geithner has stated that a default on U.S. debt is a very real possibility.

What does this mean?  The U.S. generally makes interest payments to its creditors.  Under the scenario where the debt limit is not raised, the U.S. would not make these payments, thereby being in default.  If this happens, the U.S. will have to offer its debt at higher interest rates since buyers will view the U.S. as a riskier investment.  In fact, Moody's, a major credit rating agency, warned that it would lower the credit rating of the U.S. Government if measures were not taken. 

Specific to CFOs, Treasury bills, also known as "T-bills”, are issued by the U.S. Treasury department as one of many ways to raise needed funds to cover the gap described above.  Should the U.S. credit rating be downgraded, T-bills might not be seen as a risk free investment. 

Therefore, as a risk assessment measure, CFOs should be aware of places and processes within their organization where they are currently using the T-bill rate as a risk free rate.  Three potential impact areas are loan covenants, securities/debt structures, and capital budgeting. 

The first action is to review your covenants for loans and debt instruments.  Covenants are specific requirements that protect the lender or buyer of the debt instrument from the seller from increasing their risk profile.  Typical covenants include minimum standards for working capital ratios, liquidity ratios and financial leverage ratios.  While it would be rare for a covenant to be tied to a movement in the T-bill rate, there may be an underlying measure that relies on the T-bill as a comparative element.  For example, if the covenants were written in such a way that compared the rate of a bond to Moody’s risk free rating of Aaa and Moody’s downgraded the U.S. from Aaa to Aa, it may require the issuer of the bond to increase a provision. 

Another area might the capital structure of the company.  60% of corporate treasurers currently hold some amount of U.S. treasury bonds in their corporate portfolios.  As we move closer to 2 August (the default date), finance execs might want to revisit their corporate investment portfolios and shift assets from U.S. treasury bonds to other assets.  While plenty of investments exist in the same asset class as U.S. treasury bonds (such as government bills from Germany), finance execs do not want to be caught off-guard.    

If your capital budgeting process relies on a risk free rate, and you use the short term T-bill rate as your measure of a risk free investment, then what happens in the next few months may be extra important to you.  As stewards of your shareholder’s assets, selecting investments that earn a return for your shareholders is part of your job description.  Further, selecting the right investments requires that you understand what risk is acceptable; the risk free rate you choose as a comparative would be part of that decision.  The Capital Asset Pricing Model (CAPM) is a common tool to determine the appropriate rate of return of an asset.  If you use this model in capital budgeting for investment projects, you may need to determine a new risk-free rate of interest. 

There are several areas within Finance that may be affected by what happens with the U.S. debt ceiling.  Regardless of what Washington does, finance leaders shouldn't be caught off guard.  Is a proactive review in order for your organization?  

1 comment:

  1. It's never worth taking risks, especially when dealing with government contract cost proposals VA.