Credit downgrades: What do they mean and why are they so important?

As we noted earlier today, 15 major, world-wide banks and financial institutions found their credit rating downgrades by Moody's yesterday.  These are major institutions, including Morgan Stanley, Bank of America and Citigroup.  This will cost these banks millions in added interest rates.

Now, here's an important question that we've gotten today: what the heck are credit ratings, and what do they mean?

Let's start here.  There are three major credit agencies:  Moody's, Standard & Poors and Fitch.  All three provide ratings on private and public entities.  They use slightly difference scales but all essentially have the same meaning - the higher the rating, the more credit worthy your agency/country is.

Credit ratings are essentially gauges of the risk that an investor would take by making an investment.  They serve as independent verification of that risk.  Agencies with a lower credit rating are charged higher interest when borrowing, and the reverse is true as well - better rating = less interest.

These ratings are not foolproof, of course.  In the past, agencies have been criticized for being too slow to make ratings chances (Enron is a prime example) and for contributing to the housing bust of the late 2000s; many agencies gave multiple high ratings to mortgage securities that then went bust.

For the most recent downgrades of the 15 banks, the downgrades were a result of these banks having "risk management" problems (such as JPMorgan, which just announced a $2 billion trading loss and found its credit rating cut three levels) or lacked sufficent capital to buffer against the economy.
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