Q&A: What does US credit downgrade mean?

S&P believes that a recent deal to raise the US’ debt limit won’t solve the nation’s financial troubles [Reuters]

The United States lost its top-notch AAA credit rating from Standard & Poor’s on Saturday, and the credit-rating agency said the nation’s economic outlook is negative. The following Q&A explains what that means and how S&P thinks the US can improve its rating.

What is Standard & Poor’s?

Standard & Poor’s (S&P) is an independent agency that conducts analysis and provides intelligence on international markets. The data it provides is presented in the form of credit ratings, indices, investment research and risk evaluations and solutions. Investors use these materials to make business decisions. 

What is a credit rating?

A credit rating is a calculated opinion about the ability or willingness of a person, corporation or government to meet its financial obligations in full and on time.

Investors use credit ratings to make decisions, but do not base them on ratings alone. Other factors that they may take into consideration include the current make-up of their investment portfolios, investment strategies and timelines, tolerance for risk and an estimate of an investment’s value compared to other investment opportunities.

How does Standard & Poor’s calculate credit ratings?

S&P combines quantitative measures with qualitative assessments to calculate credit ratings. Within those qualitative assessments are assumptions, or projection estimates, of figures that may not already exist, but are likely to in the future.

What does the drop in the US credit from AAA to AA+ mean?

S&P’s credit ratings are presented in the form of a grade, ranging from D to AAA.

According to S&P, a credit rating of AAA means that the evaluated body has an “extremely strong capacity to meet financial commitments.” The AA rating means that it has a “very strong capacity to meet financial commitments.”

While the difference may seem negligible, it’s not. The demotion means S&P sees a negative outlook for the US economy. If the US government does not employ policies to reverse this trend, its credit rating may fall even lower – which may cause alarm for investors who are currently invested or planning on investing in the US market.

Why was the US credit rating downgraded?

S&P downgraded the US credit rating because of its debt and deficit burden. The nation currently spends more money than it takes in, and is having trouble paying back its loans.

Washington recently agreed to raise the country’s debt limit so it could borrow more funds and not default on credit payments. S&P does not believe that this is an adequate solution to the country’s financial troubles. It says political gridlock is preventing the country from dealing effectively with the issue.

How will the downgraded credit rating affect Americans?

Some experts believe it could result in higher interest rates for home mortgages, credit cards, car loans and other loans to consumers and businesses.

What does the US need to do to repair its S&P credit rating?

The country needs to prove it can meet its financial obligations – not just by borrowing more money, but by maintaining a healthy balance of credit to debt.

S&P has implied that it may take years before the US’ credit rating is restored to AAA standing.

Have other countries experienced credit downgrades?

Japan’s S&P credit rating was downgraded to an AA+ in 2001. Earlier this year, it was downgraded again to a AA-. Other countries, like Canada and Australia, have also been downgraded in the past. None of these downgrades have had lasting detrimental effects on the respective economies.

Standard & Poor’s credit ratings

S&P displays its credit ratings in the form of grades:  AAA – Extremely strong capacity to meet financial commitments. Highest Rating.  AA – Very strong capacity to meet financial commitments.  A – Strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances.  BBB – Adequate capacity to meet financial commitments, but more subjects to adverse economic conditions.  BBB- – Considered lowest investment grade by market participants.  BB+ – Considered highest speculative grade by market participants.  BB – Less vulnerable in the near-term, but faces major ongoing uncertainties to adverse business, financial and economic conditions.  B – More vulnerable to adverse business, financial and economic conditions, but currently has the capacity to meet financial commitments.  CCC – Currently vulnerable and dependent on favorable business, financial and economic conditions to meet financial commitments.  CC – Currently highly vulnerable.  C – Currently highly vulnerable obligations and other defined circumstances.  D – Payment default on financial commitments.  Note: Ratings from AA to CCC may also carry a plus (+) or minus (-). These signs represent the evaluated body’s standing within one of S&P’s rating categories.