When rating agencies judge the world

It is on his say-so and the committee he oversees that financial markets have been rocked over the last 18 months. They now await his judgment upon the US debt deal on which will turn borrowing costs all around the world.

Behind all too many of market moves in government debt of late has been a report from one of the major credit rating agencies. S&P is the biggest and arguably the most influential,fast followed by Moody’s Investor Service and then their smaller rival,Fitch Ratings. In national capitals,they are alternately vilified by politicians or held out as just arbiters for denouncing government profligacy.

Yet there is an overwhelming irony in their new-found prominence. These are the same firms that many blame as prime instigators of the 2007-2008 credit crisis for freely giving out top ratings to ultimately worthless structured mortgage products,allowing the credit bubble to form. Now they sit in judgment of the countries that had to ruin their public balance sheets to prevent financial collapse by saving the banks shattered by those bad instruments once blessed by the agencies.

“The ratings agencies failed the world economy in spades in the past,” said Lord Peter Levene,chairman of the Lloyd’s of London insurance market and a former senior adviser to the British finance ministry. “Their track record has not exactly been stellar.”

Today they have Washington in their thrall. S&P and Moody’s both have threatened to cut the top-notch credit rating of the US’ sovereign debt for the first time in its history,a move that could have deep ramifications for financial markets,pushing up the cost of credit world wide for many years. They cite the $14.3-trillion US debt,almost equal to the size of US annual economic output and growing. They warn this is unsustainable and failure to break political gridlock to agree on a credible medium-term plan to reduce the debt pile — at least by $4 trillion — will trigger a downgrade.

In Europe,the agencies already have downgraded three euro zone countries for similar debt problems.

For many people their power and relevance is a mystery. Few understand why these companies have the authority to rock the global economy. Put simply,their role is little different from a credit bureau that hands out scores to individual and households. A bad credit rating denotes higher risk and lenders will push up the interest rate charged borrowers to protect themselves against chances they will not be repaid.

The credit score for the US has outsized import. Its $14.7-trillion economy is the largest in the world and its track record of debt repayment is stellar,hence its Triple A rating from Standard & Poors,Moody’s and Fitch.

US government debt since World War Two has become the gold standard,the global benchmark off which all other credits worldwide — government and corporate — is judged. Lower the US credit score and interest rates not only in the US but worldwide will climb.

The ripple effects could be dramatic,from lower corporate profits to weakened consumer spending,as everything from mortgage rates,credit cards and car loans are costlier. At worst it could be enough to tip a shaky US recovery back into recession and seriously dent world growth.

The credit rating agencies have a secondary source of power of no less magnitude. They are embedded in the regulatory structures that dictate operations of banks and many pension and mutual funds,giving them a central role in the world financial system.

Much of this stems from the unwieldy acronym NRSRO. A “national recognised statistical rating organisation” is an entity that,in the view of the US Securities and Exchange Commission,is qualified to rate companies and their various financial obligations.

Governments and financial institutions around the world have required that any credit investment be officially rated by such an organisation. In other words,an NRSRO has to say a bond is investment worthy before many banks,mutual funds and national treasuries can buy it. As sovereign nations face downgrade and even default,it further weakens banks whose capital reserves are filled with once risk-free sovereign debt.

For years Moody’s,S&P and Fitch were the only recognised credit rating organisations. After a series of reforms,there are now 10. Most people haven’t heard of the other seven,though,and their ratings carry far less perceived weight.