Layman’s Terms: What Is the S&P Downgrade?

Well, I was going to rattle off my thoughts on the S&P downgrade like everybody else but first I thought I’d make a post explaining what that even means to help give some context for anyone who doesn’t follow world financial news or even national financial news all the time.

So, basically, there are three organizations known as the Big 3 credit ratings agencies –┬áStandard & Poor’s (S&P), Moody’s, and Fitch. There are investors all over the world, from rich billionaires to folks managing the retirement portfolios of middle-class Americans, and they like to make more money by loaning the money they have to various groups of people, from governments to homebuyers, who pay it back with interest. Except sometimes, of course, people can’t pay the money back when it’s due – maybe a country got into too much debt and is about to collapse, or maybe a million people bought homes they couldn’t afford and then lost their jobs and then stopped making house payments and now the group that originally loaned the money to the homebuyers from the investors can’t pay the investors back. That’s oversimplified, of course, but the main point is that when you loan money there’s a good chance you’ll get more money back but always a small chance you won’t get any of it back. In general, the more investors are wary of a certain borrower, the higher the interest rate they will require to loan them money. If the interest rate for, say, bonds issued by a certain country is low enough that there aren’t enough investors willing to get in on it, then the rate goes up until enough investors get attracted by it so the country can borrow as much money as they need for that time period, and that’s partly why interest rates all over the world go up and down all the time.

This is all well and good, but it gets rather complicated. for your average portfolio manager (let’s name him Max). If Jane Smith has $25 coming out of her check every two weeks to save for her retirement, Max tries to decide where best to invest the money. But┬áthere are thousands of places where he could put that money, from stock markets to government bonds all over the world, and he doesn’t have time to keep up with the ever-changing details of every country’s financial situation – right now the 5% interest rate on Italy bonds is a way better return than every stock market in the world, but the reason it’s so high is there are increasing fears that the government there might default – so Max probably doesn’t want to put Jane’s money there. But that’s just one example, and Max doesn’t have time to keep up with the ever-changing risks associated with the thousands of available options. So how does he decide where to put Jane’s money?

That’s where the rating agencies come in. They have a bunch of people trying to keep track of these things, and they assign letter ratings to borrowers all over the world. The ratings are similar to the grades you got in high school or college, but a little fancier – besides A-, A, and A+, you can get double-A versions of all three, which is even better, or a triple AAA, which is best of all. Triple-A is basically supposed to mean that there is absolutely no chance that the money won’t get paid back, and the other fancy A’s are various levels of tiny percentages that the money won’t get paid back.

Investors use these ratings to help decide where to put money. Depending on the details of the investment and the level of risk the investor is allowed to take, they may put money in a lower A rating that gets a higher interest rate. Some investment funds, however, are required to only hold AAA investments.

Now for recent history. Like most countries, the United States has debt. The government borrows money because people want it to spend money on a lot of things but people don’t want to pay for it all in taxes, and there are enough investors in the world willing to make up the difference as long as the government keeps paying them back with interest. And it always has. The amount of revenue that goes to paying interest on the United States debt has been growing, but it’s still fairly low. As such, the United States has always had a AAA rating with all three agencies – a privilege currently shared by only a dozen or so countries including Australia, Canada, France, Germany, Sweden, and the UK.

But the debt has been growing enormously in recent years – from about $4 trillion in 2000 to over $14 trillion now, and we’re projected to need to borrow over $1 trillion every year for the foreseeable future. Some people were starting to wonder if the United States will soon get to a point where it can’t afford to pay the interest on its debt, and in January 2011 both S&P’s and Moody’s warned that the US could lose its AAA rating if its debt kept growing at such a rate – even though so many investors seem to trust and want the debt (for now) that the interest rates on it this year have been at historic lows.

This is exactly what the new Tea Party wing of the Republican Party has been yelling about, and with the new influence from winning a bunch of last November’s Congressional elections, they started trying to get the government to start cutting some spending. The fury came to a peak with last week’s debt ceiling crisis, as the government finally agreed to increase the amount of borrowed money in exchange for “cutting” a couple trillion dollars out of the next ten years’ projected spending (even though nothing really changed).

Well, apparently, S&P didn’t think it was good enough, and yesterday, August 5, 2011, for the first time in history, they downgraded United States from AAA to AA+. (Here is text of their official press release.) The other two agencies still have US at the highest rating, although for now it’s uncertain how long that will remain, or what will happen to all the investment funds required to hold AAA debt – some of them may stop investing in US treasury bonds, some may not stop because the other agencies still consider it AAA, and some may just change their rules to be allowed to hold AA+ debt as well.

There are a lot more details in the news about what has happened in the last 24 hours, and the economic and political commentariat are spewing out heated opinions at thousands of kilobytes of text per second. Some say that it doesn’t change anything because the information out there about the state of U.S. debt is already pretty well known to anyone who cares about it, and we stil have plenty of willing investors for now. Some say S&P doesn’t even matter anymore because they lost all credibility when they had bad mortgages (see above) rated AAA when the crisis hit three years ago. Other think it matters a lot and are angrily passing the blame around. I will cover some of all of that later, but this post is a basic explanation of what it means when people say that S&P downgraded U.S. debt. Ultimately, there’s a lot we don’t know and it’s always good to remember the uncertainty.

(If you understand these things more than I do and want to correct something I wrote above, please let me know. And if you understand these things less than I do and want me to clarify something I wrote above, please let me know. Thanks.)