What Does the U.S. Credit Rating Downgrade Really Mean?

In August 2011, the United States’ credit rating was downgraded by the credit rating agency Standard & Poor’s (S&P) from AAA to AA+, or down one level. Because this is the first time in American history that the U.S. credit rating has been downgraded, the long-term economic impact remains uncertain. Here is a brief explanation of the S&P downgrade decision, some background on credit ratings, and possible implications of the downgrade.
Reasons for the downgrade in the U.S. credit rating

Standard & Poor’s believed that the rising level of government debt and lack of effective policymaking weakened U.S. creditworthiness to a level no longer commensurate with an AAA sovereign credit rating. S&P pointed to a debt trajectory where U.S. net general government debt of $11.4 trillion (74% of GDP) this year (2011) is projected to increase to $14.5 trillion (79% of GDP) by 2015.

In addition, S&P was troubled by the U.S. political climate, observing that the stability, predictability, and effectiveness of the nation’s policymaking has weakened, as demonstrated in the recent debate around the debt ceiling. S&P criticized the nation’s lawmakers for failing to cut spending and raise revenue to reduce record budget deficits.
How governments like the U.S. get a credit rating

A sovereign credit rating is the credit rating of a sovereign entity, namely a national government. The credit rating is an evaluation of the likelihood of default and credit-worthiness of an issuer of debt, like the U.S. government. Credit ratings are determined by credit ratings agencies, the most influential being Standard & Poor’s (S&P), Moody’s, and Fitch Ratings. These agencies determine credit ratings for both sovereign entities, like national governments, and private corporations.

Credit ratings are based on qualitative and quantitative information for a government, the judgment and experience of the rating agency’s analysts, and their evaluation of public and private information, including a nation’s history and long-term economic prospects. S&P also publishes a more detailed explanation of credit ratings. The following chart shows the various sovereign credit ratings given by each of the major credit rating agencies.

Credit ratings should not be confused with credit scores. Credit scores are based on mathematical formulas that assign numerical values to information in a person’s credit report regarding financial history, current assets and outstanding liabilities. Banks and other financial services companies use the credit score to estimate the probability that the individual will pay back a loan or credit card.

A credit score does not take into account future prospects or changed circumstances. In short, a sovereign credit rating is a forward-looking estimate of a national government’s probability of default while a credit score is an estimate of an individual’s potential for default based on past performance.

S&P gives 18 sovereign entities its top ranking, including Australia, Hong Kong, and the United Kingdom. New Zealand is the only country other than the U.S. that has an AA+ rating from S&P and an Aaa grade from Moody’s. Belgium has an equivalent AA+ grade from S&P, Moody’s and Fitch.