What Does a Downgrade Mean?

Q. This whole system seems a lot like what consumer credit bureaus do.

A. Yes. The three big credit bureaus analyze your personal financial history — do you pay your bills on time, do you run balances on your cards and how much? By assigning you a credit score, the bureau is making an informed guess about you as a future credit risk. A low score means you pay a higher rate on the new mortgage you're getting. A high score means you get a low rate.

Q. Do rating agencies rate stocks?

A. No. Stocks are different from bonds — they're shares of ownership. They're rated by a different category of Wall Street analysts.

Q. Then why did stocks dive after the news of the U.S. government's downgrade?

A. Apparently because Wall Street saw the downgrade as new evidence of a souring global economy. If even the U.S. government was getting pummeled, could the rest of the economy be far behind? A sell-off began that became self-fulfilling — people sold stocks out of fear they would drop in value, and selling made the value drop.

Q. Are the rating agencies really objective?

A. They have in place elaborate safeguards meant to ensure that they report fully and honestly on what they find. But critics say there's a fundamental flaw in the system: With corporate bonds, the rating agencies are paid by the very company whose bonds they're rating. How, the critics ask, can they really tell the whole truth about the person who's paying the bills?

Q. Is S&P the only rating agency?

A. No, there are two other big ones: Fitch and Moody's. After the debt ceiling deal was reached, both reaffirmed their AAA ratings for the U.S. government. But Fitch also said it will keep its rating under review until the end of August.

Q. How reliable do the ratings turn out to be?

A. Often very reliable. The agencies know what to look for. But there's no shortage of people on Wall Street who say the agencies are too slow to downgrade ratings when problems start to appear. Bonds issued by the energy company Enron remained highly rated until shortly before the company's collapse.

And in the months before the great financial crashes of 2008, the critics say, the rating agencies failed to sound the alarm on bonds that were backed by pooled mortgages, giving top ratings to some of the ones that turned toxic and brought huge institutions to their knees.

At the same time, institutions with low ratings often complain that their rating is not accurate and doesn't reflect the facts. The U.S. government, for instance, says that S&P's explanation of its downgrade contained a math error of $2 trillion and therefore is unfair. (Just like sometimes many of us feel that the consumer credit bureaus have ranked us too low.)

Q. Do countries' credit ratings ever go back up?

A. Yes, but it can take a long time. S&P Managing Director John Chambers told MSNBC that five countries — Australia, Canada, Denmark, Sweden and Finland — had lost their AAA ratings but got them back. The amount of time? Nine to 18 years.

Also of interest: Be ready for the next market downturn. >>

John Burgess is an associate editor at the AARP Bulletin.