S&P downgrades U.S. credit rating

NEW YORK (CNNMoney) -- Credit rating agency Standard & Poor's on Friday downgraded the credit rating of the United States, stripping the world's largest economy of its prized AAA status.

In July, S&P placed the United States' rating on "CreditWatch with negative implications" as the debt ceiling debate devolved into partisan bickering.

To avoid a downgrade, S&P said the United States needed to not only raise the debt ceiling, but also develop a "credible" plan to tackle the nation's long-term debt.

In its report Friday, S&P ruled that the U.S. fell short: "The downgrade reflects our opinion that the ... plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics."

S&P also cited dysfunctional policymaking in Washington as a factor in the downgrade. "The political brinksmanship of recent months highlights what we see as America's governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed." (FAQ: Behind the downgrade)

A Treasury Department spokesman pushed back on the rating change, saying that S&P's analysis was flawed.

A source familiar with the matter said S&P initially miscalculated the growth trajectory of the nation's debt, and then went ahead with its downgrade anyway.

The source also said S&P didn't give enough credit for the debt-ceiling compromise, which paved the way for more than $2 trillion in spending cuts over the next 10 years.

However, one of S&P's explicit criticisms of the compromise was that it didn't address the biggest drivers of the nation's debt -- Social Security and Medicare -- and didn't allow for additional tax revenue. ("What's wrong with the debt ceiling deal?")

John Chambers, Head of Sovereign Ratings for S&P, told CNN that though S&P didn't have a specific target in mind, the total debt reduction package was not sufficient. Chambers also noted that the plan did not take steps in the near term to boost economic growth.

What does S&P's downgrade mean? Share your thoughts

Rating agencies -- S&P, Moody's and Fitch -- analyze risk and give debt a "grade" that reflects the borrower's ability to pay the underlying loans.

The safest bets are stamped AAA. That's where U.S. debt has stood for years. Moody's first assigned the United States a AAA rating in 1917. The country's new S&P rating is AA+ -- still strong, but not the highest.

The downgrade puts the U.S. debt rating on par with that of Belgium, but below countries like the United Kingdom and Australia. (See who's in the Triple-A Club.)

In the days after lawmakers managed to strike a debt-ceiling deal, the two other major rating agencies have both said the deficit reduction actions taken by Congress were a step in the right direction.

On Tuesday, Moody's said the United States will keep its sterling AAA credit rating, but lowered its outlook on U.S. debt to "negative."

Even after a downgrade, the United States will likely still be able to pay its bills for years to come and remains a good credit risk.

A downgrade really just amounts to one agency's opinion. Federal Reserve Chairman Ben Bernanke articulated that view in April when S&P placed the United States on credit watch. "S&P's action didn't really tell us anything," Bernanke said. "Everybody who reads the newspaper knows that the United States has a very serious long-term fiscal problem."

Investors have limited options for making safe investments, and Treasuries are effectively as liquid as cash. And other big countries have been downgraded and were still able to borrow at low rates.

At the same time, some experts warn that a downgrade could gum up the banking system and ripple out onto Main Street. Treasuries are used as collateral in many transactions between financial institutions and grease the skids of lending.

Shortly after the downgrade, the Federal Reserve, FDIC and other bank regulators moved to blunt the affect of the action on the banking system. In a joint release, the agencies said they would continue to treat Treasuries and other securities issued by government-sponsored entities (such as Fannie Mae and Freddie Mac) the same as before they were downgraded. Treasuries are often used as collateral for short-term lending among banks and other financial institutions.

Consumers and investors could feel the impact of a downgrade. Interest rates on bonds could rise, and rates on mortgages and other types of loans along with them. (Your stocks, your cash: Will you feel the downgrade?)

Government-backed agencies like Fannie Mae and Freddie Mac may also be downgraded. It's also possible that some state and local governments could also face a downgrade.

And investment decisions would become complicated for large institutional investors that are required to hold highly-rated securities.