The make-or-break power of ratings agencies

Back in 1996, the American commentator Thomas Friedman quipped that there were two superpowers in the world: the United States and Moody's. The US, he observed, could destroy you by dropping bombs and Moody's could destroy you by downgrading your bonds. Much has changed in the intervening years, but America's arsenal can still wreak havoc on the world and Moody's, Fitch and Standard and Poor's (S&P), the three giant credit-ratings agencies, can still rattle markets with nothing more than a change of heart.

Just ask the Greeks. The other week, S&P slashed Greece's ratings to junk, indicating a high risk of default and prompting investors to demand eye-popping premiums to hold the country's debt. Lisbon was next: S&P lowered Portugal's ratings by two notches. Though Lisbon maintained its investment-grade status, indicating a relatively high level of creditworthiness, the move sparked fears of contagion.

Spain's ratings soon faced the axe, with S&P slicing them by a notch, though keeping them above Portugal's, shortly before the London market closed on 28 April. The FTSE 100, which had been on its way to end in the black, swiftly veered to a loss and the euro struck a fresh low against the US dollar. In Britain, with the election campaign in full swing, would-be chancellors sought to present themselves as prospective guardians of the UK's AAA standing, the highest available.

European leaders waded in, taking aim at the agencies. The EU's internal markets commissioner, Michel Barnier, said: "The power of these agencies is quite considerable, not only for companies but also for states," and the French President, Nicolas Sarkozy, and German Chancellor, Angela Merkel, called for a review of the sector. It also emerged on Friday that the US Securities and Exchange Commission (SEC) has told Moody's that it may face action for allegedly misleading regulators in a 2007 application to remain an officially recognised ratings firm.

The agencies aren't new to controversy. While now they're being criticised for downgrading government debt, in the past they've been attacked for their failure to recognise the subprime bubble by affixing favourable ratings on mortgage-related securities. In 2007, Pimco's Bill Gross chided the agencies, saying: "Many of these good-looking girls are not high-class assets worth 100 cents on the dollar. You were wooed, Mr Moody's and Mr Poor's, by the make-up, those 6-inch hooker heels and a 'tramp stamp'."

Last week, as southern Europe's debt woes shook markets, he revisited his view, saying that "a tramp stamp and hooker heels" did not begin to describe what he termed "the sordid, nonsensical role that the rating services performed in perpetrating and perpetuating the sub-prime craze". At the time of the Enron collapse, it emerged that the major agencies had maintained an investment-grade rating on the energy giant's debt until five days before it filed for bankruptcy, while Lehman Brothers' debt was rated investment grade on the day it sunk.

The agencies weren't responsible for Lehman's investment decisions, nor did they pile all this debt on Greece's balance sheet. But how is it that despite being criticised in the recent past, a piece of research from one of their ilk triggers such worry in both dealing rooms and the corridors of power? The answer, many argue, is that the agencies are often backed up by the same governments they can unsettle by shuffling their ratings. In the US, New York University professor Lawrence White traces the rise of the agencies from John Moody's ratings of railroad bonds at the turn of the last century. His firm was joined by Poor's publishing company in 1916, and then the Fitch publishing company in 1924, the precursors of today's giants, with the three selling their views in thick ratings manuals.

The mid-1930s were a key marker. The US Office of the Comptroller of the Currency prohibited banks from putting money in "speculative investment securities" as determined by "recognised ratings manuals". This effectively endowed ratings with the force of law, according to Professor White. Other regulators followed suit and in the 1970s the SEC came up with a new category of nationally recognised statistical rating organisations, or NRSROs. From then on, NRSRO ratings were used to work out the capital requirements of broker-dealers, thereby entrenching the role of the agencies in the financial system.

These and other moves – in Europe today, for instance, ratings play a role within the Basel II framework of calculating capital requirements for banks – put the agencies on a "pedestal", according to Professor White. The key to curbing their influence is less, not more regulation, he says, arguing for the elimination of regulatory reliance on ratings.

The political imperative seems to be moving in the opposite direction, however. In Europe, the push is towards more rules, as opposed to removing the agencies from the regulatory system. "That is a broader debate, which we should probably have but like a lot of things, is not being pursued at the moment," says Patrick Buckingham, a regulatory partner at the law firm Herbert Smith.

S&P says that if regulators and other authorities are to continue referencing ratings in their rules or criteria, "they should use other measures, too", otherwise "there is a risk of encouraging undue investor reliance on credit ratings". A Moody's spokesperson said the agency had "long supported the removal of ratings from regulation".