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In the financial world, it’s akin to the gold standard: AAA, three letters meant to denote the safest possible investment.
The U.S. had proudly held to that top-notch debt rating for decades, reflecting its status as the world’s biggest — and safest — economy, one that has never defaulted on its debt obligations.
But on Tuesday, Fitch Ratings cut the U.S. debt by one notch, from AAA to AA+, partly in response to how the federal government handled the debt crisis two months ago. That move mirrored a similar downgrade by S&P in 2011, also following a debt ceiling standoff in Congress.
Fitch cited alarm over the country’s deteriorating finances and expressed major doubts about the government’s ability to tackle the growing debt burden because of the sharp political divisions, exemplified by the brinkmanship over the debt ceiling that brought the government close to a disastrous default.
Treasury Secretary Janet Yellen issued a blistering rebuke of Fitch’s decision, The Dow Jones Industrial Average fell more than 300 points.
That’s hardly a market meltdown, but that doesn’t mean the downgrade is insignificant.
Here’s a look at credit ratings, how they came into being, and why they matter.
What are credit ratings?
At its most basic, credit ratings are meant to denote how safe it is to invest in the debt issued by a country or a company, their creditworthiness.
The ratings are similar to the credit score familiar to anybody who has incurred any kind of debt, like on credit cards.
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And just like your personal score, a credit rating helps determine how much interest a country or company will need to pay when they sell a bond or a security.
The rating system is dominated by three major companies: S&P Global Ratings, Moody’s and Fitch Ratings.
Although there are slight differences, all three issue ratings on a similar sliding scale that start with AAA as the top-rated investment, that goes all the way down alphabetically to D, which typically denotes a default.
How important are credit ratings?
Today, the credit ratings agencies have become deeply ingrained into the global financial system and are a critical part of bond markets worldwide.
Companies that want to sell debt generally need to get two credit ratings from established rating agencies, for example.
Still when it comes to investment decisions, ratings are just one factor. But they can make a difference, especially for developing countries.
Some investment funds, for example, will only buy debt rated above a certain rating.
How reliable are they?
This is where it gets dicey. While ratings remain an important part of the financial system, the agencies that issue them have come under a good deal of criticism.
During the 2008 Global Financial Crisis, a lot of the subprime mortgage bonds that went bust had been highly rated by the ratings agencies, exposing flaws in the system.
Regulations governing credit agencies were tightened in the aftermath of that crisis, but the system of rating debt remains largely the same.
The main thing to know is that credit ratings are subjective. They’re an assessment by an agency — and opinions can differ.
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So what happens if the U.S. loses its AAA rating?
The first time it happened in 2011, the U.S. took it pretty badly.
The markets slumped (although they eventually recovered) and President Obama addressed the downgrade in a news conference, with then-Treasury Secretary Tim Geithner angrily denouncing the S&P decision as flawed
This time, the circumstances are similar, but the reaction so far has been more muted.
A key reason is that the reasons identified by Fitch — the “deterioration” of the country’s finances, the growing debt burden and the “erosion of governance” — are now widely known.
Goldman Sachs, a top investment bank, put it bluntly on Wednesday: “The downgrade contains no new fiscal information,” adding the projections given by Fitch were similar to their own.
And the country’s sharp political divide has been evident for years now without any meaningful consequences in markets.
Most importantly, the dollar remains the world’s top reserve currency. Investors all over the world, from other top central banks to pension funds, hold trillions of U.S. government debt, and that’s unlikely to change simply because of Fitch’s downgrade. The U.S. dollar is still seen as a safe haven.
“The downgrade should have little direct impact on financial markets as it is unlikely there are major holders of Treasury securities who would be forced to sell based on the ratings change,” Goldman Sachs said.
But…there’s still an impact
There’s a reputational hit to the U.S., which explains Yellen’s blistering rebuke of Fitch’s decision.
Losing the AAA rating further removes the U.S. from a small group of countries that still maintain the top-notch rating from all three major agencies. The group of nine are Australia, Denmark, Germany, Luxembourg, Netherlands, Norway, Singapore, Sweden and Switzerland.
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Moreover, the issues identified by the credit agency are still major risks facing the U.S.
Experts have long warned the U.S. faces serious fiscal challenges, including how to pay for Social Security and Medicare, as Fitch noted.
At the moment, investors continue to buy Treasuries because they still consider them to be the safest investments in the world.
But fiscal challenges continue to rise and the country’s leaders remain as sharply divided as ever, as Fitch noted.
Those are real problems — and failure to reverse the country’s surging deficits or bridge its political divisions — can have real critical consequences.