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 – Standard & 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 there 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?