Conal Gregory: Making the grade when it comes to credit risk

The subject is never far away from the headlines and particularly with Greece tottering on the brink of fiscal meltdown. This matters far more than one single country because Greece's currency is the euro. Not only have 16 out of 27 European states adopted the euro, meaning it is used daily by more than 320 million people, but it is intrinsically linked to so many key trading partners.

Greece is not alone. Few know the real debt that the current UK Government has built up. Along with the US, it currently enjoys a top credit rating. Many wonder if it is justified.

If George Osborne was courageous enough to publish the true figure once he can see inside the Treasury in a few months' time, there would almost certainly be a run on sterling. He cannot risk revealing the truly awful truth of the dual legacy left by Gordon Brown and Alistair Darling.

Yet someone has to give an opinion on credit and that's the job of the various credit reference agencies. They offer an opinion on the ability and willingness of an issuer – a country, city, company or fund – to meet its financial obligations in full and on time. Such views will be relied upon by those considering lending and will affect the terms.

The major agencies have a long track record: Moody's was founded in 1900, Fitch in 1913 and Standard & Poor's in 1916. They have enormous power and yet enjoy an almost secret intellectual anonymity.

They claim that their opinions, unlike those of barristers and doctors, are "not intended to be a prognosis or recommendation," to quote Standard & Poor's, but are primarily to provide investors with information on relative credit risk. They disseminate such information without charge.

Nigel Lawson, when Chancellor in 1988, famously dismissed London analysts as a bunch of "teenage scribblers" in reference to their adverse reports as sterling and gilts fell. It was perhaps a shade harsh since he had earlier been a business writer on the Financial Times.

Each agency applies its own methodology to measure credit-worthiness and uses a specific rating scale to signify its opinion. Typically this may extend from AAA, meaning extremely strong capacity to meet

financial commitments, to C, which is where a bankruptcy petition has been filed, or even D for payments in default.

Part of the evaluation is to assess the impact of future events. In stressing that ratings do not signify investment merit, the analogy could be made with a reputation for dependability when purchasing a car – but this is not the sole criterion drivers usually base their buying upon.

In country terms, the cost of borrowing is almost totally dependent on such ratings and can bring governments to their knees. Fitch downgraded Greece to BBB+ from A- in December, held Portugal at AA last September but revised its outlook to negative, and gave only a BB+/BBB+ view to Iceland. "Iceland's economic and sovereign credit profile is no longer consistent with an investment grade foreign currency rating," summarised Fitch.

Its lowest country rating is given to Argentina as it has defaulted on debt payments. This is probably why most businesses pay for goods and services from Argentina in US dollars in New York, avoiding Buenos Aires. Ecuador and Jamaica are rated only slightly better than Argentina.

Just as taxpayers do not want to pay over the odds to finance debt, so savers wish to know the risk they are taking on. Most will rely on professionals – from stockbrokers and fund managers to insurance providers – to assess investments on the basis of reports from credit ratings agencies.

Comparisons between underlying investments, and hence the total savings mix, are vital to proper investment decision-making. This means an enormous burden and responsibility is placed on credit ratings. We

trust them to analyse accurately, using proven mathematical models, and to not participate directly in the capital markets.

Moody's is quoted in its own right on New York, Fitch is owned jointly by Paris-based Fimalac and Hearst Corporation while publishing giant McGraw-Hill owns Standard & Poor's.

They are fiercely secretive of their client list and will not even reveal who pays – if anyone – for all the work put into their analysis and publication of countries. Is this simply altruistic: a kindness for the general good, subsidised by the banks and other financial bodies who use their services? It certainly creates publicity but can have global ramifications.

Certain countries will most certainly not appreciate having the torch of publicity shone on their national finances and leading politicians may try to dissociate themselves from the agencies' reports.

Typically, agencies are paid either from the issuer that requests a rating or from subscribers who receive the published ratings and credit reports.

This might explain the absence of such information on Zimbabwe. It also means that large institutional investors who subscribe will probably be better informed than smaller ones and private savers but that is part of the cost and power wielded by these agencies.

Conal Gregory is the Yorkshire Post's personal finance correspondent.