Guest Comment: How ratings agency downgrades affect us all

The US, Greece, Spain, Italy and many of our banks have all been downgraded by ratings agencies over recent weeks. But what does this actually mean, and how worried should we be? Financial guru Justin Urquhart Stewart (right), from Seven Investment Management, explains...

As the name implies, a credit rating agency exists to rate things. This can be anything from technical types of institutional debt right through to our own personal debt.

However, it is not just the debt itself they can measure, but the lenders and borrowers of that debt.

Most of us will only know a version of them from those rather creepy adverts on television with introductory offers to look at our own debt rating.

But they are generally of greater significance when they are ranking and rating those huge borrowings involving not just corporates and institutions but also countries themselves. This is often referred to as 'sovereign debt'.

The object of these ratings businesses is to evaluate the borrowers, lenders and their products to ensure that there is an independent measurement of them. For example, to determine whether a borrower is likely to repay their debt.

This is so business partners and potential investors have a better idea of what risk they are taking.

In effect, they are supposed to put the financial kite mark on whatever they are testing. This, of course, is not only laudable but also essential, especially in such nervous economic days as these. However, all is not necessarily what it seems.

Ratings concerns

In 2003, the US Securities and Exchange Commission submitted a report to Congress with proposals to launch an enquiry into potential anti-competitive practices and conflicts of interest. In fact, many of these concerns seemed to have been borne out in the subsequent banking crisis.

It appeared that an oligopoly had developed as only three giant agencies were present, to the exclusion of any other significant competition.

It came to light that many of the ratings covering certain products such as credit default swaps [insurance for a lender if their borrower fails to repay debt] and other complicated financial instruments seemed to provide extremely poor guidance as to their quality and risk. As we know now, many were in fact positively toxic.

Since, there has been much criticism over the lack of effective regulation of these bodies and although much has been done to make their work more transparent, there is concern in the air.

So can we trust the current ratings?

Most recently, ratings agencies have come to light again as a result of the nerves over the debt of various countries, most notably Greece, Portugal and some of the other eurozone nations.

The rating of a nation's debt is not just a matter of national pride but, far more importantly, it affects the amount that a nation (and thus its tax payers) has to pay for its debt.

As an example, our UK national debt costs us a staggering £125,000,000 (yes, that's millions) every day. If we lost our top grade that cost would rise. As it is, we probably pay more in interest on our debt than the cost of our entire defence budget.

However, it is not just countries but also the banks and institutions that hold that debt. If they hold large chunks of poor quality debt which is getting weaker, when it is clear the borrower can't pay it back, then those banks will probably write off large sums. That in turn affects their strength.

If that strength is called into question that infects the confidence between the banks and the vital inter-bank lending dries up faster than water in a desert. Thus, before you know it, you have another banking crisis.

So, like them or not, these ratings beasts affect us all. Now what they need to do is persuade us that we can really trust their ratings and that they aren't just being paid to tell us yesterday's news.

Views expressed are not necessarily those of MoneySavingExpert.com. You can follow Justin on Twitter at @ustewart.