Thoughts About a Governance Downgrade

4 minute
Gavilan and stethoscope

Current Funding Environment

On Monday, August 7, Moody’s took rating action on 27 banks, including downgrading 10 and adjusting outlooks on others. Identified headwinds include the ongoing impact of adverse deposit flows but also escalating concerns about exposure to slowing sectors, such as commercial property and construction, as well as the banking sector’s ability to manage the myriad of complexities contained in the “interest rate risk” bucket. The troubling scenario is that (1) regional bank credit capacity becomes less available and less useful, (2) this credit retrenchment has a compounding effect that takes the U.S. economy closer to or into recession, and (3) the regional bank challenges infect larger banks, resulting in a deeper-faster dislocation. Look for an addendum to the “know your counterparty” discussion that our Treasury Operations team started on March 16, 2023, and understand that none of the direct or contingent credit pillars that support the healthcare funding platform are stable right now.

 1 Year5 Year10 Year30 Year
 Aug. 11—UST5.36%4.31%4.17%4.27%
v. July 28-0.03%0.11%0.20%0.24%
Aug. 11–-MMD*3.26%2.77%2.70%3.69%
v. July 280.09%0.13%0.13%0.18%
Aug. 11—MMD/UST60.8%64.3%64.7%86.4%
v. July 282.01%0.94%0.01%-0.68%
*Note: MMD assumes 5.00% coupon

SIFMA reset this week at 3.00%, which is approximately 56.6% of daily SOFR* and represents a -98 basis point adjustment versus the July 26, 2023, reset.

*Daily SOFR quoted as of 8/10/2023 – 5.30%

Make or Break Transitional Moments

On Tuesday, August 1, Fitch Ratings downgraded the United States’ long-term rating from “AAA” to “AA+.” This happened despite Fitch’s observation that some “exceptional strengths support [U.S.] ratings.” In some respects, the rating adjustment wasn’t particularly impactful—and it drew sharp criticism, with clusters ranging from “they used the wrong information” to “everything is great, so ‘party on, Garth” to “we’re the biggest, baddest thing on the planet, so of course we should be AAA.” The question is whether Fitch’s action has a downstream impact on benchmark rates or do markets just shrug it off and move on to the next thing.

When you cut through all the chatter and spin, what stands out is that this was a governance downgrade. Of course, there are the glaring leverage indicators that can’t be dismissed (the contrast versus medians noted in the Fitch report is stunning):

  1. General government (GG) deficit rising to 6.3% of GDP in 2023 from 3.7% in 2022, with an expectation of 6.6% in 2024 and 6.9% in 2025 (we have vaulted to a whole new level of deficit).
  2. An interest-to-revenue ratio that is expected to increase to 10% by 2025, versus 1% for the “AAA” median and 2.8% for the “AA” median.
  3. A debt-to-GDP ratio of 112.9%, which is anticipated to reach 118.4% by 2025 and compares to the “AAA” median of 39.3% of GDP and the “AA” median of 44.7% of GDP.

These leverage pressure points are offset by those “exceptional strengths” that seem to have taken the U.S. out of the median game: the unmatched scale/vibrancy/resiliency of the U.S. economy paired with the dollars’ position as the world’s reserve currency. But what isn’t offset and what sits at the core of this rating action is what Fitch’s report describes as an “erosion in governance”:

“The repeated debt-limit political standoffs and the last-minute resolutions have eroded confidence in fiscal management. In addition, the government lacks a medium-term fiscal framework, unlike most peers, and has a complex budgeting process. These factors, along with several economic shocks as well as tax cuts and new spending initiatives, have contributed to successive debt increases over the last decade. Additionally, there has been only limited progress in tackling medium-term challenges relating to rising social security and Medicare costs due to an aging population.”

The main thread is that crises, spending increases, and tax cuts have combined to degrade our resiliency resources; we face material structural spending pressures over the medium term (not long term anymore); and we have a dysfunctional governance process, such that the probability is more debt (resiliency erosion) rather than finding fiscal equilibrium. The other side of the message seems to be that if we were to confront these same economic pressures armed with a functional governance process, Fitch’s rating would probably still be “AAA.” James Clear (author of Atomic Habits) argues that “you don’t rise to the level of your goals, you fall to the level of your systems.” Applying Clear’s lens, Fitch is saying that we aren’t exhibiting “AAA” systems even as the threats are escalating and the threat horizon is getting shorter fast.

Healthcare confronts a different manifestation of the same pressures confronting the U.S. (strained resiliency resources and a structural revenue versus expense dislocation), and the lesson for leaders is that governance and planning systems matter. Fitch—as well as S&P and Moody’s—frequently references the concept of “rating through the cycle”; but what gets you through a cycle of strained performance is good governance (great is better) supported by equally good decision-support and then management execution. Ken Kaufman’s most recent blog—Hospital Strategy and Planning in Times of Financial Challenge—offers a reminder that the path out of the current mess is leadership grounded in comprehensive strategic and financial planning.

The only addition I might offer to Ken’s comments is two points of clarification:

  1. This planning must establish the kind of “medium-term fiscal framework” that might have given Fitch comfort about the credit position of the U.S. If you don’t offer this medium-term framework to the agencies, they will either assume there isn’t one or they will create their own version and apply it to your organization. One way or another, the framework or lack thereof will be a rating factor.
  2. This planning must address the entire enterprise. Most strategic and financial planning is grounded in a dynamic view of operations and operational finance (aka, income statement and cash flows). This makes sense, but it’s not enough. Navigating the current cycle and positioning for the next requires planning that might be led by operations and strategy but that also lays out the playbook for an active and responsive balance sheet. The imperative is one unified view of strategy-operations-balance sheet that emerges from a coordinated and integrated planning process.
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