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Originally published April 18, 2011 at 9:01 PM | Page modified April 19, 2011 at 1:38 PM

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Why S&P downgraded U.S. debt outlook

S&P maintained the coveted AAA rating on U.S. government debt but switched its outlook from stable to negative, a sign that the ratings agency has doubts about prospects for taking effective action to curb deficits and debt.

McClatchy Newspapers

WASHINGTON — A surprise warning about U.S. debt by credit-rating agency Standard & Poor's sent stocks plunging Monday and crystallized the threat that mounting federal budget deficits and national debt pose to the U.S. financial system and the American way of life.

S&P maintained the coveted AAA rating on U.S. government debt but switched its outlook from stable to negative, a sign that the ratings agency has doubts about prospects for taking effective action to curb deficits and debt.

"The negative outlook on our rating on the U.S. sovereign signals that we believe there is at least a 1-in-3 likelihood that we could lower our long-term rating on the U.S. within two years," S&P analysts noted. "The outlook reflects our view of the increased risk that the political negotiations over when and how to address both the medium- and long-term fiscal challenges will persist until at least after national elections in 2012."

The surprise action, which sparked a sharp drop in stocks and was considered belated by many financial analysts, raises the prospect that the United States could be deemed less creditworthy, which would increase the cost of borrowing for government, business and taxpayers alike.

A deeper look at what this is all about:

Q: What is Standard & Poor's, and why does its opinion matter?

A: S&P is a nationally recognized organization that rates debt, in this case U.S. Treasury bonds, in terms of the risk of default they pose to investors in them. U.S. government securities long have enjoyed the top AAA rating but now are viewed as at risk for a downgrade of creditworthiness.

Q: Why would a downgrade affect borrowing costs?

A: The ratings issued by S&P and its main competitors — Moody's Investors Service and Fitch Ratings — are used by investors to calculate what sort of return they should demand in exchange for the default risk they assume when investing in a given security. A lower rating means a higher chance of default. The issuer, in this case the U.S. government, would have to pay a higher interest rate to market its lower-rated bonds. Because the government must borrow to pay off existing debt, the cost of that would snowball into an even more costly fix for our fiscal problems.

Q: How would that affect me?

A: Mortgage interest rates often are pegged to prevailing rates for U.S. government securities, as are other borrowing rates. If your 401(k) retirement plan invests in bonds, you might receive returns from rising bond rates. This was reflected in the marketplace Monday as the interest rate on bonds crept up and stocks lost value. But rising borrowing rates choke off economic growth. If there's no political compromise on taming future deficits, that would be bad for the U.S. economy. And if there is a compromise, it is likely to entail austerity measures that slow economic growth.

Q: But lawmakers will reach agreement eventually, won't they?


A: The two political parties are far apart. Their differences are rooted in deep philosophical disputes over the role of government in society. It's quite possible there will be no significant deal on resolving federal finances until after the 2012 elections, and then only if one side gains significant strength. S&P analysts noted ongoing fiscal austerity efforts in France and Great Britain and questioned the lack of similar government financial discipline in the United States.

Q: Was the S&P action totally a surprise?

A: No. In February, PIMCO, the world's largest bond investment fund, announced it was selling off its U.S. government debt because it didn't believe the return on investment properly reflected the risks of holding U.S. debt. PIMCO this month began betting against U.S. debt. In a sense, big players in the bond market were ahead of the ratings agencies, which they depend on for guidance.

S&P "should have made this move a long time ago," said Steven Ricchiuto, chief economist for Mizuho Securities USA in New York. "Let's be honest. Ireland, Portugal, the (debt) issues of Spain are nothing more than a warm-up for what's in play here. ... If something doesn't happen, it's going to be 'how many warnings do you have to send somebody before they pay attention.' "

Q: How big are our deficits and debt?

A: The nation's debt Monday totaled $9.67 trillion, while the debt the federal government owes itself is about $4.6 trillion. The total public debt was $14.3 trillion. The deficit — the shortfall between what government collects in revenues and what it spends in a given year — is projected to come in around $1.6 trillion for the current fiscal year, which ends Sept. 30.

Q: What are the prospects for a budget deal?

A: The first real indication may come next month, when the U.S. is expected to reach its current $14.3 trillion debt limit. Congress must increase the legal limit on how much the U.S. can borrow. If it doesn't, the U.S. won't be able to pay creditors. That would sow financial chaos worldwide, as U.S. bonds are regarded globally as one of the world's safest investments.

Q: Why does this matter to the broader debt debate?

A: Republicans, pushed by tea-party activists, oppose a "clean" bill that does nothing more than increase the debt ceiling. They hope to extract from Democrats and the Obama administration deeper spending cuts and progress on a long-term, deficit-reduction plan. Most Democrats oppose the GOP approach.

McClatchy Washington bureau reporters David Lightman and Steven Thomma contributed to this report.

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