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Understanding The Credit Rating Of The U.S.

Wednesday, August 03, 2011

Posted by Mike Beene - Now that the debt ceiling debate is behind us, where does the United States stand with its creditors? We hear a lot about the credit rating, but what does that mean in terms of the country? Can we make some sense of this all and understand why it matters?

Before we discuss what the credit rating agencies want from the U.S. and whether the debt ceiling raise will satisfy them, let’s look at a little history. For over a century the debt of the U.S. has been rated AAA, confirming the long-held belief that bonds backed by the U.S. are the safest in the world. People, corporations and governments from all over the world loan the U.S. money at very low rates, and the dollar remains the world’s reserve currency because treasury instruments such as bills and bonds are considered safe havens. The two largest rating companies, Standard and Poor’s and Moody’s, are paid by entities that wish to borrow money (governments, cities, school districts, corporations, etc.) to give an opinion on how likely it is that an borrower will default on its obligations. 

Earlier this year, S&P revised the outlook on the U.S. from stable to negative. Although the outlook of negative is based upon S&P’s stated concern that the U.S. will not be able to agree on medium and long-term budget issues by 2013, the rating remains AAA. This means that S&P believes the U.S. has an extremely strong capacity to meet its financial commitments at this time, but there is a one-in-three chance of a downgrade in the next two years if the situation deteriorates. Three weeks ago, both S&P and Moody’s warned the U.S. about a potential downgrade of the credit rating. The floating rumor is that the U.S. needs to quickly put forth a solid plan to reduce its debt by $4 trillion or face a rating downgrade that could come at any time.

While no one knows what a downgrade would really bring, most experts believe that the market for U.S. bonds would act in a similar fashion to downgrades in other governments and corporations, the wild card being the reserve currency nature of the dollar. History and economics says a ratings downgrade will result in higher interest rates. If the U.S. government is paying more to borrow, then banks will pay more to borrow and ultimately businesses and individuals will pay more as well. As a result, we can anticipate at least two problems for our economy: First, a small movement up in interest rates would cost the U.S. government a lot. One estimate is 7/10 of a point in interest rate increase would cost the government $100 billion more a year in interest payment, making it harder to get out of debt. The other damaging result is how much more in interest payments already strapped businesses and individuals will face if they can get credit. Think of how interest rate movement makes a mortgage go up or down. A percentage point can make a big difference in your payment, and this is no different. Money spent on interest expense is money taken away from investment, new opportunity, expansion and staffing.

This is not what our economy needs at this time, or at any time. We must take the difficult steps necessary to get our house in order or we will become just a historical footnote: We do have a spending problem and perhaps we should thank the rating agencies for the wakeup call. Dealing with entitlements may be painful, but if we don’t they’ll never achieve what their original purpose was. We need our economic engine running full steam ahead if we are going to be financially able to offer the opportunities to the next generation that we were given and to financially support those in our society that need our assistance.

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