Lib Dem shadow home secretary Chris Huhne has an article in today’s Times noting that how much it costs the Treasury to borrow money depends on three ratings agencies … and asks the crucial question: are they fit to wield this power?

Chris’s credential for writing an article outside his brief? Well, he founded the sovereign group at Fitch Ratings, and was group managing director. Here’s an excerpt:

Last week Moody’s — one of the big three international ratings agencies — warned that the UK’s top bond rating would be under threat if Britain failed to sort out its public finances in the next three years. For the first time in decades, British Chancellors have to worry about the bond market. … the bond market is vast, global and powerful, as it sets the tone for all the other markets, including shares. Within the bond market, there is no more crucial part than the market for government bonds because they are traditionally regarded as the safest. Hence their UK name: gilt-edged securities, or gilts. If sovereign debt becomes riskier, it affects everyone else’s debt, too. Even share prices often fall. …

The ratings agencies do not claim to pinpoint when a borrower will default, but to assess the likely chance that they may. The notations — from the top AAA down to C — reflect the probability of default. There is a long history of corporate and bank borrowing against which defaults can be assessed. The difficulty arises in those areas — including government bonds — where there are not so many issuers and the history is patchy. Analysts then have to use their judgment, and we know that they can get things horribly wrong, as they did during the credit crunch. …

In each upturn, there is usually some new instrument — in this crisis, securitised lending, but in the Eighties crisis it was multi-bank syndicated lending — which people think is far less risky than anything that went before. We do not discover the error until the next crisis. During the boom, the risk of the innovation is systematically under-priced, helping bankers and brokers to make the most dangerous case in markets: “This time it is different.”

Rating agencies ought to be immune, but sadly most people who work for them are human. This might account for why they are so vigorously rattling their chains today: hell hath no fury like an agency analyst caught out being a softie.

The agencies also have financial interests. … [Fees from the banks, companies and governments they rate] do undermine judgment, because the boss’s pay packet depends on growth and success. Throughout the last upturn, structured finance was the go-go sector of the bond market, coining billions for bankers and agencies. No one wanted to kill the golden goose.

What is the solution? … The best option would be to insist that the agencies publish every year exactly how much they receive — or do not receive — from each bond issuer. Academics could then check whether there was a relationship between fees, ratings and rating changes. Agencies that wanted to keep their reputations would happily bite the hand that feeds them.

The key is surely transparency in these mysterious but important institutions. Greater openness is the path to honesty in the use of power.

You can read Chris’s article in full here.