On Friday August 5, 2011, Standards and Poor's lowered the credit rating of United States Bonds from 'AAA' to 'AA+'. To some, this was viewed as a major blow to the U.S. To others, it was viewed as a non-event. However, there are some whose reaction was "what's does this mean, and what does it mean to me?"
S&P, along with several others, are what people in the financial industry call rating agencies. They "rate" the ability of bond issuers to be able to pay their creditors. Remember that a bond is just a loan. Just as a bank might look at your credit score to determine whether or not to loan you money, a bank might look at a companys' or countrys' credit rating in order to determine whether or not to buy its bonds. Each rating agency has its own scoring methodology, but generally they look at a variety of factors to determine how likely it is that an issuer of bonds is going to not meet its obligations.
S&P gives each borrower a letter grade to indicate their credit-worthiness. S&P's top rating is AAA. A AAA rating means that the borrow has an "extremely strong capacity to meet financial commitments." By downgrading the U.S. to AA+, S&P now thinks that the U.S Government only has a "very strong capacity to meet financial commitments." They added a plus to indicate that the U.S. has a higher standing relative to other organizations in the AA category. In other words, a AA+ rating doesn't mean that the U.S. is going to default on its loans anytime soon. The rating is still quite good, although not as good as it could be. Also note that both Moody's and Fitch are maintaining their AAA rating of the United States, so S&P's opinion still is in the minority.
So what does all this financial gooblety-gook mean to you.
If an individual were to take out a loan, their credit score helps to determine whether or not they get the "best" loan interest rate. If you have a sterling credit score, you are likely to get a lender's best rates because odds are that you will be able to repay your loans. If your score is less than perfect, you might be given a higher rate because there is a higher probability that you won't make good on repaying your loan. This higher rate is to compensate the lender for the additional risk of lending to you.
In theory, the S&P credit rating could act in the same manner. There may be some borrows who will demand that the U.S. Government pay a higher rate of interest on their bonds because there is a higher chance (in the opinion of S&P) that the United States will not make good on their obligations. If this were to happen, that would mean that the United States would have to pay more interest in order to borrow. Therefore, either they would have to spend less or take in more revenue through higher taxes in order to cover this higher interest expense (or they could just borrow more, but of course this money has to be paid back at some point). That, of course, affects you right in your wallet or pocketbook.
In addition, many loan rates are tied to the U.S. bond interest rate. If bond rates go up due to a lower credit rating, that could cause mortgage rates, auto loan rates, etc to go up as well. That, of course, also affects you right in your wallet or pocketbook.
A second possibility is that this rating downgrade affects nothing. Bond investors might say "so what". They might figure that even with this downgrade, U.S. Treasuries are still one of the safest investments around. They certainly are safer than the bonds of many other Western countries. In fact, there is a case to be made that the downgrade might actually cause interest rates to fall, which would be counter-intuitive. The case goes something like this:
1. S&P downgrades U.S. bonds because they feel like the Government does not have a long term plan to control the size of the national debt.
2. Investors perceive this as a sign that the economy is on the ropes, so the stock market starts to drop on fears of another recession.
3. Investors start to move globs of money from the risky stock market for the relatively less risky U.S. Treasuries.
4. Because the demand of Treasuries spikes upward, the Government can borrow at even lower interest rates than before.
It seems crazy that this should take place, but I feel like this scenario is likely. Despite the rating downgrade, most people will continue to view bonds as a safe haven for their money when the stock market is going down. That perception is not likely to change anytime soon.
I do feel, however, that even though the rating downgrade might not have an effect on your money directly, it is a message that people are watching the actions of our politicians very closely to see how they are going to handle our mounting debt. Hopefully, it will be a (relatively painless) wake-up call that some structural changes need to be made in order to stem the flow of red ink on our national balance sheet.
Star Money Articles for the Week of May 22
3 days ago