How much power do credit ratings agencies have?

They've downgraded Greece to junk status and have the UK in their sights. We reveal all about the mysterious world of the credit rating agencies Credit ratings agency Standard & Poor's has taken some flack for turning the eurozone crisis into a drama by 'downgrading' the credit ratings of three countries at a time when the markets were already hugely jittery. Bang! Down goes Greece. Bang, bang! Take that, Portugal and Spain. Any time I mention the ratings agencies, the first question I'm usually asked is: are these the same credit ratings agencies who said that US sub-prime debt was a solid gold investment? The answer is, yes they are. That naturally leads on to a second question: why on earth do we still listen to them? It's a good point. And in many ways - as we'll see shortly - the market doesn't listen to them. But for good or for bad, they still wield a lot of power. That means that what they say matters. And that's something for Britain's politicians to bear in mind, as they jostle for first shot at governing us.

Why the Greek crisis matters

Who are these agencies?

There are many credit rating agencies, but the three best-known are Standard & Poor's (S&P), Moody's, and Fitch. Here's what they do. Companies and governments, like the rest of us, sometimes need to borrow money. One way they do this is by issuing bonds, which are simply IOUs. A typical bond will pay a regular interest payment (the coupon) and then return the original sum borrowed at the end of the term (when the bond 'matures'). In the same way as individuals borrowing on a credit card or from a bank, the more creditworthy you are, the lower the rate of interest you'll have to pay. Here's where the ratings agencies come in. Before you take out a personal loan, a bank will do a credit check on you. The likes of Moody's basically do the same thing, only on a much bigger scale. They look into how creditworthy the borrower is and give their debt a rating. The format of the ratings varies from agency to agency, but broadly speaking, at the top of the scale you have AAA-rated debt (which should mean the issuer is very unlikely to default - ie not repay you), all the way down to 'junk' bonds, where there's a high risk of losing some or all of your money. Clearly, if you get a AAA stamp, then you can borrow money cheaply. But if you're told you're 'junk', then you'll have to pay a pretty big interest rate (ie offer a higher coupon) to get credit.

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How do the agencies decide their ratings? Obviously you would think that a credit ratings agency would know more about credit-worthiness than anyone else. But their reputations are hardly pristine. First there was energy trader Enron - rated AAA until something like four days before it actually went bust. And, far more recently, the ratings agencies simply rubber-stamped parcels of dud sub-prime mortgages with an AAA rating. The various investigations that followed the last financial crisis found that agencies' models made unrealistic assumptions (such as discounting the possibility of house prices ever falling by much). Things were made worse by the fact that the agencies were paid for their ratings by the same investment banks who were putting together these packages of mortgages in the first place. Now the mortgage parcels in question were fiendishly complicated. It's perhaps understandable that investors happily turned over responsibility for grading them to the ratings agencies (although it also highlights the importance of never buying anything you don't understand). To be fair to the agencies, it's easier to understand how they gauge the ratings of different countries. They look at things like tax income, debt levels, economic growth, and whether the government can make all the sums add up. So rating sovereign debt is a pretty transparent business compared to the likes of a collateralised debt obligation (as these parcels of mortgage debt are known). What's more problematic is the timing of ratings changes, as we'll discuss in a moment.

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What happens when you're downgraded? What you have to understand about the bond market, and where it differs (conceptually at least) from the personal loans market, is that the debt is sold on as a matter of course. The people who initially buy these bonds don't have to hold them until they're redeemed. They can sell them in the open market. Obviously, as people get more concerned about how risky a bond is (ie as they start to worry about whether they'll get paid back in the end or not), they start to demand a higher return in exchange for buying the bond. So prices fall, and it'll cost the company or country more to borrow if it wants to renew ('roll over') existing loans, or borrow extra money. So clearly, if a ratings agency changes its mind about a credit rating, or decides that a country's circumstances have changed, this can have a big impact on how much it has to pay to borrow. Who listens to the agencies? But so what? After all, Greek debt was hardly sitting pretty before S&P said it was junk. Greek bond yields had already spiked to beyond the point of no return. S&P was late to the scene. It was like the patsy at the start of a crime caper, who wanders in to find a corpse with a gun lying next to it, and picks up the gun just as the police kick down the door. As Pimco's Bill Gross, manager of the world's biggest bond fund and thus extremely important in this area, put it in a recent research note, investors should simply "dismiss" the ratings agencies and their ratings. He said that the agencies' models might look impressive, but they entirely lacked common sense. Rating agencies and the government That's all very well and for many investors it's correct. But it's not the whole story. You see, the agencies have some level of official government endorsement. Institutional investors, including central banks and pension funds, use the ratings as guides as to what they can and cannot invest in. Certain types of funds, for example, are only allowed to invest in debt of a certain quality. So even though a downgrade might be stating the brutally obvious, it can be the trigger point at which institutions are forced to sell an asset if they haven't already done so. And, of course, the agencies' actions can make a panic worse. Sure, Greece was no surprise. But to follow that hot on the heels with a downgrade (albeit a less dramatic one) for Portugal and then Spain merely added to the whole fear of contagion. At a time when confidence and speed of reaction is a genuinely serious issue, communicating in this way isn't helpful.

Problems would still exist

But let's not kid ourselves here - if ratings agencies didn't exist, Greece and the euro would still have been in dire straits and the markets would still have been panicking. In this case they've added to the noise, but they're hardly the root cause of the problem. Arguably, as Gross says, they are little more than a distraction that smart investors would do well to ignore. Perhaps stripping the agencies of their semi-official status would help to increase competition in the sector and allow investors to make judgements based on the track record of an agency, rather than on how dominant it is. Better yet, it might force investors to do their own due diligence and use their common sense before they pile into Greek debt, imagining that it's German.

The UK general election and your money

So how likely is Britain to be downgraded - and does it matter? But we're stuck with the agencies for now and the next big target everyone's wondering about is our own country. The main agencies rushed out after the hung parliament to state that there was no immediate effect on Britain's AAA-rating. But what with the kicking they've taken over the eurozone recently, they may well be playing it safe to avoid being accused of making a bad situation worse. I suspect that Britain has a short grace period. If we can't then get a government together, which agrees on the specifics of how to cut the deficit and can push it through parliament, then investors in gilts, rather than the ratings agencies, will start to drive up the cost of British borrowing. If the only likely resolution is a second election, then at some point we may well have to start brewing the kettle for the International Monetary Fund team to pop by. The reality is that the ratings agencies, as usual, will be late to the party. By the time they actually downgrade us, you'll already know that all hell is breaking loose.