S&P Drops U.S Rating to AA, Fannie & Freddie Follow: 5 Easy-to-Understand Effects of a Downgrade

Aug. 8, 2011 — -- So it's happened -- right or wrong: a downgrade of Uncle Sam's credit for the first time in history.

Standard & Poor's announced Monday that it was also downgrading the credit of Fannie Mae and Freddie Mac one notch, to AA+ from AAA, its very highest rating. The two agencies guarantee or own more than half the $5 trillion in home loans in the U.S.

The announcement followed S&P's downgrade of the government's debt on Friday evening, but the U.S. stock markets -- already spooked by Friday's news --reacted negatively anyhow.

For more on Standard & Poor's downgrade on U.S. long term debt, click here.

"The downgrades of Fannie Mae and Freddie Mac reflect their direct reliance on the U.S. government," said Standard & Poor's in a statement.

The downgrading of Fannie and Freddie "was inevitable," said Robert Litan, a former Clinton administration budget official who is now vice president for research and policy at the Kauffman Group. "If the U.S. government is downgraded it follows logically they would have to be downgraded too."

What's next, asked Litan?

"The states and locality ratings will be next because of the interest rates benchmarked against U.S. treasuries so there is a linkage between that debt," he said. "In an environment of budget austerity this is not good for states and localities. This will trigger another closer look at state and local finances. Some states that were in in trouble already and some in the bubble."

Lots of people will be wondering what this means for the real economy and the stock market. Here's a quick primer based on ABC News' extensive reporting on the possibility of a downgrade -- five easy to understand effects:

1. The interest rates the government pays to finance the growing national debt will almost certainly rise as a result of the downgrade. That increases the amount of money Uncle Sam has to spend each year on "debt service." General market discussions have turned on an increase in rates that would up the annual tally by about $10 in the short-term and go up to $75 billion in additional costs in the coming years.

2. The interest rates YOU and YOUR EMPLOYER pay will go up. Basic credit facilities -- like mortgages, student loans and credit cards -- are all at least loosely tied to the rates the government pays. A half a percent increase in mortgage rates could increase the total cost of the average traditional mortgage by $19K (on a $172K home). Businesses would have to spend more money to finance expansions. Costs for borrowed money goes up, effectively raising the price of anything you're not paying for with cash.

3. Needless to say, increasing costs for consumers and businesses tends to slow their economic activity. Some estimates put a downgrade like this as likely to shave 1 percent off GDP. This slowing certainly increases the risks that the U.S. will have a second dip into recession. It also means less tax revenue, so the potential for additional debt increases.

4. As the economy slows, expect the stock market to react. After all, investors buy shares to get a piece of growing profits. A slowing economy means profits grow less rapidly or go down. The relative value of a share of anything will go down. Some experts predict a downgrade could force stocks to sell-off by 6 percent to 10 percent in short order. That's another 1,100 points on the Dow.

5. A slowdown in economic activity also means less demand for workers. The non-partisan group Third Way has published estimates that a simple 0.5 percent increase in interest rates could erase more than 640,000 jobs.