This post is from new staff writer Sarah Gilbert. We’d planned for her to make her debut later, but Gilbert offered to write about the current economic situation, so she’s stepping up the plate a little early. This is a rare GRS foray into current events. Do you like it? Hate it? Not care either way? Let us know. (I’ll do a formal introduction for Gilbert later; for now, a mini-bio is at the end of this post.)

It’s tough for a girl who’s worked in junk bonds to get too excited about the downgrade of U.S. Government debt from AAA to AA+. When I was an investment banker at First Union (now Wachovia) in the 1990s, in fact, I would routinely shake my head at people who called it "junk." We called such debt — BB+ and below — "high yield." The yield, or interest rate, could be higher on companies that were deemed riskier investments; so the mostly institutional investors who bought the bonds could count on making a lot more money.

In the time-honored risk/reward ratio, the more the risk, the better the reward; we young investment bankers almost felt we were cheating sometimes, charging LIBOR — the base rate banks use to reflect market rates — plus two or three basis points for debt we privately felt was far safer than any equity.

Note: For a refresher on bonds, check out these articles from the GRS archives: What is a Bond?, The Basics of Bonds, and How Bonds Work.

Cause and effect?
As much as I may shake my head, the markets have had a big reaction. The Dow Jones Industrial Average was off over 630 points, or 5.55%, on Monday in response to the news. Even though the market had a recovery Tuesday, the average of top stocks is still down 1,000 points (about 10%) what it was just 10 days ago. The debt ratings don’t have an immediate effect on any one company’s prospects, of course; it would make far more sense to see such a reaction to the credit ratings of the companies which make up the Dow; but the DJIA is seen as a barometer of investor sentiment. The people are very worried.

I was staying in a hostel in San Diego when the downgrade occurred, and on Sunday I overheard two men huddling in the common eating area and predicting dire things for us all. They were worried: another example of that poor investor sentiment, perhaps, or just generally bad mood all around. “Why can’t our government get its act together?” everyone seems to be asking.

It’s instructive to think about how, exactly, debt ratings work, and what they should mean to you. If, as many pundits are saying, a downgrade from AAA to AA+ doesn’t really mean anything, why is everyone so upset? Why the damage control from Washington?

How debt ratings work
At their most basic, debt ratings are an estimate of how likely the indebted will pay back what is owed according to the terms of the initial lending agreement.

For government bonds, that lending agreement is described in the treasury auction, or the launch of the T-bills in question. Take a standard measure of global lending sentiment, the 10-year treasury note. It pays interest twice a year, and then the principal is paid back at the end of the 10-year period.

If ratings agencies (which are, as most of us remember from the banking crisis, private companies operating independently and, largely, secretly) believe that a government has a 100% chance of paying both the interest and principal on time, the rating would be AAA or its equivalent. For such a "risk-free" investment, the yield, or interest rate, is comparatively low. The most recent such rate was 2.306%. Greece’s debt, as a comparison, pays out over 15% for a ten-year bond.

Many experts believe that government debt ratings issued by S&P are almost meaningless for a number of reasons; chiefly because the bonds are purchased by large "institutional investors"; in other words, banks and insurance companies whose business it is to figure out how likely a corporation or government is to pay back debt. They’ve already done the math; for U.S. treasuries, the math is probably done once a week or so.

What’s at stake?
In finance (as in fiction), the biggest question to ask is always this: "What’s at stake?" Debt ratings are the best guess at answering that question. (There’s nothing so quantitative for novels, sadly.) The worst-case scenario is always that a debtor won’t be able to pay interest, and in the end, won’t be able to pay principal either.

Take your average "junk" status company, with a BB+ rating or below. (Those were the majority of my clients when I was an investment banker.) The probability of default is somewhere between 5% and 8% of all borrowers. But even in the worst-case scenario (think Greece or the average underwater American homeowner), instead of going belly-up and declaring bankruptcy, borrowers typically restructure their debts — asking lenders to agree to more relaxed repayment schedules or lower interest rates in return for not losing everything.

It’s instructive to note that, in the case of a liquidation, debt holders get paid before equity holders. Take a company like Ford, which is rated BB-. If Ford were to declare bankruptcy and sell everything, after salaries and taxes were paid, the debt holders would be paid the principal they were owed, and then, last, the stockholders, who would probably get nothing.

Countries really don’t have the option of shutting down and selling all they own — especially not the U.S. And everyone seems to agree "the U.S. will not default on its debt!" — so the debt rating issued by S&P is more of a scolding than anything. And, just as in corporate stock, what’s good for the debt holders may not be good for the equity holders (who are, as I see it, the American public in this case); the austerity measures being taken by Congress will not help the American people or expand the economy. But it will make it easier to repay the debt.

You know what Shakespeare wrote: "neither a borrower nor a lender be"? It’s hard to see, in the modern economy, how this can be true; it’s the owners who end up losing every time.

About the author

Sarah Gilbert was once an investment banker. After graduating from Wharton with an MBA in 2000, she bit on the dot-com hook and flopped around for years in management at various startups. She began blogging professionally in 2004, and worked for AOL for several years, launching and managing BloggingStocks and WalletPop. Now she’s an award-winning writer, about everything from food to finance to life as a military wife.

We’re excited to have her join the staff at Get Rich Slowly.