BY JIM RANDLE – Worries about government borrowing are a key reason for the recent downgrade of U.S. debt, the economic crisis in Europe, and the wild swings from gains to losses and back again on global financial markets.
A bond is an agreement between a borrower and a lender. In government bonds, the lender provides money used to build bridges, schools, or pay for other things governments need, and the government promises to repay the money in a specific period of time.
Finance Professor Gerry Hanweck of George Mason University says these bonds, which are written agreements by borrowers to pay someone in the future, are often sold. The buyer of the debt pays the original investor in the hope of making a larger amount of money in the future. “They are registered on exchanges, and traded electronically in huge markets. One of the biggest markets in the world,” he said.
That gain would come in part from interest, a fee that borrowers pay to lenders. Think of it as rent. If you rent an apartment, you get to use that living space for a specific period of time, say one year, in return for an agreed amount of money. Bonds work pretty much the same way. A government gets to use money for a period of years, if it agrees to return the original loan money and an additional fee, or interest.
It is very important for lenders to determine just how likely the borrower is to repay the loan and the interest and do it on time, in full, as agreed. The recent one-level downgrade of the U.S. credit rating by Standard & Poor’s showed the agency’s opinion that Washington became slightly less likely to pay its bills.
A group that urges Washington to manage its money better, the Center for A Responsible Federal Budget, says the ugly spectacle of partisan bickering in Washington damaged the country’s once top-level credit. “(S&P) has lost confidence in the American political system to make hard choices when push comes to shove,” he said.
Mark Goldwein is the group’s policy director and he says this downgrade could be the first in a series unless Washington shows it can better manage both its budget and politics.
A credit rating downgrade means the agency thinks there is greater risk of default, or non-payment. Credit rating downgrades usually mean investors demand higher and higher interest rates to make loans. The higher rates are called a “risk premium.” Goldwein says each downgrade can raise the interest rate, which raises the borrowing costs, which makes the financial situation worse, perhaps leading to additional downgrades in a downward cycle.
But that is not what has happened to Washington. Instead of interest rates on U.S. bonds going sharply higher, they have actually fallen.
That is because many investors still consider the United States to be the safest place in the world to put their money. Finance Professor Walter Schreiber of La Salle University says low interest rates are a measure of that confidence. “I think you can tell from the rates that they are demanding, that people are very confident that the united states will pay them back,” he said.
The current economic tensions mean there is a surge in the number of investors seeking out U.S. bonds as a safe place to keep their money until the economy improves. With more and more investors seeking bonds, Washington can offer lower and lower interest rates to borrow the money.
Those same economic worries also affect the prices on the stock market. But stocks are different than bonds. Bonds are loans, with a promise to repay a specific amount of money at an agreed date. Stocks are shares of a company. Stockholders are buying a part ownership in the company, with no promise that their investment will be repaid. Stockholders make their investments in the hope that the value of the company will grow, and they can sell their stock at a higher price in the future, and make a profit.