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Impact of the U.S. Downgrade on the Cost of Capital

Impact of the U.S. Downgrade on the Cost of Capital. Paul T. Hunt, Jr. Director of Regulatory Finance and Economics Southern California Edison Company*. Society of Utility and Regulatory Financial Analysts 44 th Financial Forum April 26, 2012.

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Impact of the U.S. Downgrade on the Cost of Capital

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  1. Impact of the U.S.Downgrade on theCost of Capital Paul T. Hunt, Jr.Director of Regulatory Finance and EconomicsSouthern California Edison Company* Society of Utility and Regulatory Financial Analysts44th Financial ForumApril 26, 2012 * All opinions expressed herein are those of the author and do not necessarily represent the positions, strategies or opinions of Southern California Edison, its parent company Edison International, or any of their affiliates.

  2. Recent Rating Agency Actions

  3. Historical Relationship, Thirty-Year Treasury and Aaa Corporates 67 basis point spread

  4. Why Did We Not See An Effect on Treasury Bond Rates? • The difference in the probability of default between AAA and AA+ is virtually zero. • However, the transition rates out of AA+ are higher than for AAA (S&P data) • The interest rate difference between AAA and AA+ is surely very small • Central banks are engaged in substantial monetary policy activity • S&P was severely criticized by some parties; action seen as political • European downgrades are more significant • European banks are less well capitalized

  5. A Downgrade Is Not A Default • A downgrade can trigger other adverse events • In corporate space, a downgrade can trigger collateral calls and accelerations • A default would likely cause a noticeable change in U.S. Treasury bill and bond rates • The United States defaulted on Treasury bills in late April and early May, 1979 • Zivney and Marcus* estimated that this event caused a permanent increase in interest rates of 60 basis points (including some effect on interest rates on non-Treasury securities) *Zivney, T. L., and Marcus, R. D., “The Day the United States Defaulted on Treasury Bills, The Financial Review, August 1989, pp. 475-489.

  6. Historical Data, Stock Market Volatility

  7. Evidence for Increased Market Risk Premium

  8. Conclusions • S&P downgrade of United States does not appear to have resulted in any noticeable adverse effect on Treasury rates (risk-free rates) to date • Downgrade may be an indicator of a broader increase in risk • Suggests that we should be looking at the market risk premium for an impact • There is some evidence from bond yield spreads that the market risk premium has increased

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