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Old 08-10-2011, 06:59 PM
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Default S&P Downgrade and Cash Flow Testing

Has anybody thought about how the S&P downgrade of U.S. Treasuries might affect your company's cash flow testing models this fall? For example, I believe our models use the S&P quality ratings to look up asset default rates for a "haircut" to the investment returns. I haven't really looked at the assumptions in the models, but it sounds like we might consider the haircut for U.S Treasuries to now be greater than 0, when it has always been 0 in the past. Perhaps there are other consequences we should consider as well.

Does anybody have any thoughts on this?
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Old 08-10-2011, 08:47 PM
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In prior CFT work, we've used the middle of the 3 ratings. Unless there is a downgrade from Fitch or Moody's, the S&P action is a non-event for us.
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Old 08-10-2011, 09:18 PM
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I suspect, without having considered this thoroughly, that enough company will continue to view treasuries as risk-free (whatever the justification) that it will be considered standard industry practice and difficult for auditors to push back (not even sure whether there's any intention by the accounting firms to view them as other than risk-free).
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Old 08-11-2011, 10:33 AM
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Quote:
Originally Posted by urysohn View Post
I suspect, without having considered this thoroughly, that enough company will continue to view treasuries as risk-free (whatever the justification) that it will be considered standard industry practice and difficult for auditors to push back (not even sure whether there's any intention by the accounting firms to view them as other than risk-free).
Some people have treasuries hard-coded in their models as being risk-free assets, totally unlinked to any ratings.
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Old 08-11-2011, 10:36 AM
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Quote:
Originally Posted by urysohn View Post
I suspect, without having considered this thoroughly, that enough company will continue to view treasuries as risk-free (whatever the justification) that it will be considered standard industry practice and difficult for auditors to push back (not even sure whether there's any intention by the accounting firms to view them as other than risk-free).
(also, without having considered this thoroughly)
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Old 08-11-2011, 11:10 AM
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Our base assumption will probably be risk-free. We will probably run a sensitivity with them not being risk-free.
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Old 08-11-2011, 11:15 AM
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Quote:
Originally Posted by limabeanactuary View Post
Some people have treasuries hard-coded in their models as being risk-free assets, totally unlinked to any ratings.
If if the model currently links them to a rating, this is certainly a big enough item to warrant reviewing and changing that assumption.
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Old 08-11-2011, 11:30 AM
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Some people have treasuries hard-coded in their models as being risk-free assets, totally unlinked to any ratings.
Yes, I've always had US treasuries (and other govmt backed securities) coded as a rating of "G", and those have zero haircut.

I'm currently of two thoughts on this:

1. The market consistent modeling method would be to use CDS rates for the haircut on treasuries.

2. My other thought is that the base economic scenarios that I use are in terms of treasury yields. For the NY7 at least, the level/down scenarios are inconsistent with a treasury DEFAULT (lower interest rates are not inconsistent with the downgrade because a true default would be years away). So, I might look at results on a scenario basis, and sensitivity test some of the up scenarios with an additional treasury haircut. Or just measure expected Govt exposure in those years.

In short, in a best estimate + PAD projection, I wouldn't necessarily include the possibility of a treasury default (nonpayment of principle or interest). I think that probability is way lower than the 20-35% reserve testing sufficiency. I might consider it more in a principles based capital setting. (Of course, there are many events included in the model which are less than 20-35% chance of happening, but because of the assumed independence of those events and the quantity, modeling an expected value on those is reasonable. I don't think it is reasonable for treasuries - hence the next paragraph.)

Finally, I think a US treasury default would change so many other model assumptions/scenarios that modeling that cost as a haircut doesn't make sense. It would best be modeled as a 0/1 binary variable where if it does happen the knock-on effects are also modeled. The haircut method is a reasonable assumption for assets which are part of a well diversified portfolio where correlation between asset defaults is minimal. The correlation between a treasury default and corporate bond defaults would be huge (I believe).

Note: This should not be considered an actuarial opinion. I'm just spittballing here... I am looking forward to the Val Act to hear other thoughts.

Last edited by A Student; 08-11-2011 at 11:36 AM..
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