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What Does a Downgrade Mean?

The impact on stocks, bonds, interest and governments

En español | Q. We all know now that Standard & Poor's downgraded the U.S. government's credit rating on Aug. 5. Just what is Standard and Poor's and how does it do its work?

A. Standard & Poor's, usually called S&P, is a large rating agency entrusted with the job of giving investors honest, unbiased views of the creditworthiness of big borrowers. The borrower might be a company or a government, but the basic question is the same: Will the debt be repaid?

See also: What to do when the stock market slumps.

Q. How does the agency come up with an answer?

A. Suppose a power company decides to issue bonds to finance construction of a new generating plant. Bonds are essentially just IOUs — the company is borrowing money not from a bank but from the people who buy the bonds. It's promising to pay them a certain interest rate for a period of time and repay them in full at the end.

As preparations for the new bond issue proceed, analysts from a rating agency get busy. They look at the company's revenues and expenses, at its record in paying past debts. Much of their work involves raw numbers, but they also make judgment calls — are the company's managers up to the job, is there strong demand for the electricity that the plant will generate? When they're done, they issue a rating for those bonds.

Q. So how important is that rating?

A. Very important, because it will play a big part in determining what interest rate the company will pay to people who buy its bonds. A high rating means that the rating agency believes the power company is very likely to pay its debts. That means low risk, and a generally low interest rate.

If the credit rating is low, the power company will generally have to pay a high rate of interest, to compensate for the higher risk that investors may not get their money back at all.

A low rating is bad for business, of course — if the interest rate is too high, the company may not be able to borrow and build the plant.

As the project progresses, the rating agency may change the rating if it feels that circumstances have changed.

Q. How does this work with governments?

A. Pretty much the same. To raise money for general spending or specific projects, governments issue bonds that promise interest payments to the people or other governments who buy them. Credit rating analysts look at the issuer's tax revenues and its expenditures. They look at its economy and system of political decision-making and come up with a rating that can influence interest rates.

That's why the S&P decision to downgrade the U.S. rating from AAA to AA+ caused such a stir. It could mean the U.S. government will have to begin paying higher interest rates, a burden that is ultimately shouldered by American taxpayers.

Q. So when will the higher interest rates begin?

A. It's hard to say — and there's always the chance that the downgrade will have no real impact on interest rates. People who buy U.S. government bonds could decide that, whatever S&P may say, they still have full confidence in the bonds and are willing to continue accepting the low interest rates.

Next: Is S&P the only rating agency? >>

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.