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Jonathan Miller

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Credit Downgrade for Dummies

Posted: 08/06/11 02:50 PM ET

In my column a few weeks ago, Debt Ceiling for Dummies, I discussed how a Congressional failure to raise the national debt ceiling could lead to financial calamity. The ceiling, of course, was raised; but the fiscally timid and wildly unpopular Congressional deal prompted the credit rating agency Standard & Poor's to downgrade the nation's credit Friday night.

Such as with the debt ceiling debate, much of the financial jargon used to explain credit downgrade is confusing, esoteric and sometimes downright yawn-inducing. So, drawing on my more than a decade's experience working with these issues as Kentucky's elected State Treasurer and then its CFO, and now as the lead correspondent at The Recovering Politician, I offer the following straightforward, plain-English summary to, hopefully, help better explain the real-life impact of credit downgrade:

Who are the credit rating agencies and what did they just do?

There are three primary national credit rating agencies:  Fitch, Moody's Investors Service ("Moody's"), and Standard and Poor's ("S&P"). These agencies rate the creditworthiness of governments, companies and individual securities, allowing investors to better understand the risk of their investments. The higher the rating, the more creditworthy -- or, alternatively, the less risky -- the investment.

Our federal government is one of the many entities these agencies rate. The U.S. borrows money -- by issuing bonds and Treasury bills to governments, corporations and individual investors -- in order to operate all of its essential functions. The outstanding current federal debt currently exceeds $14.5 trillion.

Since the credit rating agencies were established, U.S. Treasuries have always enjoyed a triple A rating, the very highest: indicating to global financial markets that they are among the safest investment instruments in the world. Friday night, however -- for the first time in the nation's history -- S&P downgraded the rating of the nation's long-term debt to AA+, one notch below AAA, meaning that the U.S. has been removed from its list of risk-free borrowers.

Earlier in the week, Moody's and Fitch both declined to downgrade the country's credit rating. Moody's, however, changed its "outlook" on U.S. debt to "negative," meaning that there is a risk of a future downgrade. Fitch stated it would determine whether to lower its own outlook by the end of the month. Both have urged Congress to make more progress in debt reduction in order to avoid a potential full downgrade.

Why should we listen to the credit agencies -- aren't they part of the problem?

There is broad consensus that credit rating agency action -- or often times, inaction -- was a significant contributor to the 2008 financial collapse. This April, a U.S. Senate investigations panel declared that Moody's and S&P triggered the financial crisis when they were forced to downgrade their ratings on the very complex and controversial mortgage-backed securities that were at the heart of the collapse that almost brought our entire financial system to its knees. Had the ratings agencies been exercising more diligence, many experts argue, they would have alerted investors of the riskiness of these controversial financial instruments long before they became a problem.

However, while the credit ratings agencies do not enter the discussion with entirely clean hands, their decisions are extraordinary significant. Their role is written into the statutes and regulations that govern the financial system. Think of it this way: Even though progressives may decry the partisanship on the U.S. Supreme Court, and thoroughly detest some of its recent 5-4 decisions, we must abide by them.

What is the impact of this credit downgrade?

Thanks to those awful free credit report commercials, most of us understand that having a low credit rating is a bad thing: Low credit scores for individuals could mean the denial of credit for the purchase of cars, homes and other items.

For the nation, a credit downgrade informs investors that U.S. Treasuries are a riskier proposition. This means that in order for the nation to borrow funds to pay for essential services, Treasury might have to provide investors with a higher interest rate to compensate for the additional risk they would be taking.

Once those interest rates begin to climb, the U.S. would have to spend billions more on interest payments, further increasing the national debt. Moreover, many individual states may experience their own credit rating downgrades, depleting their already-bleak coffers further by higher interest payments, potentially requiring state tax hikes and/or cuts in education, health care and law enforcement.

These interest rate hikes would not be limited to our governments' borrowing. They would translate to higher interest rates on our credit cards and mortgages, directly reducing the incomes of regular Americans.

Finally, many institutions that by law or policy invest only in risk-free, triple-A rated bonds -- such as many pension funds and investment trusts -- would be forced to dump their U.S. holdings. This would shift financial transactions away from the U.S., potentially resulting in the dollar losing its status as the world's reserve currency, a major blow to American global financial leadership.

But wait: Only one of the three agencies downgraded U.S. credit? Is that significant?

Yes, the split verdict among the credit agencies provides a measure of hope for the economy. U.S. debt is still deemed risk-free by two out of the three credit rating agencies; and most of the time, interest rate hikes and/or the mandatory dumping of riskier holdings by some investors are triggered only when a majority (i.e., two) of the credit rating agencies issue a downgrade. That's why many analysts suggest that the impact of the S&P decision could be modest. Moreover, the Federal Reserve immediately issued a statement that the creditworthiness of U.S. securities has not changed.

However, with Moody's lowering its outlook to negative, and Fitch considering the same, a potential downgrade by a second agency -- or even all three -- is certainly a real possibility in the short-term. Moreover, Friday night's first-in-history U.S. credit downgrade alone will undoubtedly rattle many investors, shaking their confidence, causing some to demand higher interest rates and others to flee U.S. Treasuries.

In short, we have not reached financial Armageddon. But unless Congress immediately begins to address our financial debt in a meaningful, bipartisan way -- including both tax and entitlement reform -- our economy will suffer a devastating blow.

What can I do?

The credit agencies have given Congress clear marching orders: Come together in a bipartisan way and start making the tough choices necessary to restore fiscal sanity.

It is up to the rest of us to enforce them.

We are at the brink of economic disaster because the loudest voices that our elected representatives are hearing come from the extremes of our political system, particularly Tea Partiers who are unwilling to accept the real-life economic impact of their ideology and who threaten to punish those representatives who are willing to forge bipartisan compromise for the good of the nation.

If the rest of us make ourselves heard -- and polls continue show that a clear majority of Americans support bipartisan compromise -- Congress will listen. So please contact your congressmen today, using all of the technologies our new media and social networks offer. Share your message with your friends and neighbors, at church or synagogue, when you drop your kids off at school or when you attend the next sporting event.

And if you are looking to participate in bipartisan, grassroots activism, join us at No Labels, a new national movement of Democrats, Republicans and Independents, all of whom agree that we must put aside our labels on occasion to work in the country's best interests. Our message is simple: In order to solve the debt crisis, everything needs to be on the table, and everyone needs to be at the table. Click here to identify 12 things you can do today stand with No Labels in demanding a bipartisan solution to the debt crisis.

While the Tea Party has been the most significant recent contributor to our nation's hyper-partisan paralysis, the debt crisis is a bipartisan problem that requires a bipartisan solution. It's up to all of us to pitch in to fix it.

 

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