UPDATE 2-Agencies warn of rating blackout for risky EU states

* Threat comes as EU mulls legal liability for rating errors

* S&P warns move could restrict ratings for some borrowers

* Row simmers as scheme for weak EU states alarms agencies

(Adds missing word in third paragraph)

By John O’Donnell and Julien Toyer

BRUSSELS Mar 31 (Reuters) – Credit rating agencies have
warned the European Commission they could stop rating risky
countries if the EU executive goes ahead with plans to make them
legally liable for flawed downgrades, industry sources said.

The threat, which one expert said could remove stricken
European countries from the investor map, marks an escalation in
a row between the agencies and EU officials whose efforts to
tackle a debt crisis have failed to stem rating downgrades.

Tensions peaked this week between governments and the three
major agencies, whose ranking of countries and companies
determines their borrowing costs, after Standard & Poor’s
downgraded Portugal and demoted Greece’s credit status to below
that of Egypt.

But public criticism of the downgrade by the EU’s executive
[ID:nLDE72T18V] did not deter Moody’s from warning of further
ratings cuts [ID:nLDE72U0JG] or Fitch from flagging the risk to
ordinary bondholders from an EU bailout plan. [ID:nLDE72T1ED]

In a move many see as an attempt to stop a slide in country
ratings, EU policymakers want to make the agencies legally
liable if a downgrade of Ireland or Portugal, for example, turns
out to be flawed.

The agencies, worried that the EU’s proposals could expose
them to claims from thousands of sovereign bondholders, are
fighting the proposal, arguing it could force them to cease
publishing ratings on some countries altogether.

Uncertainty over how a rating decision would be proven
“incorrect” — which is outlined only vaguely in the
Commission’s proposal for an EU law that could come as soon as
next year — has heightened fears of political interference.

In a document seen by Reuters, Standard & Poor’s outlines
its concerns, saying a “new liability standard could end up
restricting ratings for riskier debt issuers”. S&P’s worries are
shared by others including Moody’s, a source told Reuters.

“Rating agencies are not set up to take on that kind of
liability,” an industry source said late on Wednesday.

“Investors have to be allowed to take risks,” he said,
adding that imposing liability could push agencies to “withdraw
from ratings … in various areas”.

SCEPTICAL INVESTORS

The row highlights the widening rift between the EU’s
political leaders and financial markets. Investors have been
frustrated by conflicting messages from Europe’s leaders about
how they would tackle the debt crisis.

Leaders had hoped to draw a line under months of wrangling
and win over sceptical investors when they last week announced a
new scheme from 2013 to help states in financial difficulty.

But it backfired when rating agencies said the plan actually
increased the risk that ordinary bondholders could be forced to
accept losses and that they could have a weaker claim on
repayment of their money.

Investors remain on edge, expecting Standard & Poor’s to
further downgrade Ireland’s credit rating after it announces the
full impact of its banking crisis on Thursday. [ID:nLDE72T20R]

“The track record of rating agencies is very shoddy — they
overrated before the crisis and now they are rating too low,”
said Sony Kapoor, founder of think tank Re-Define.

“But they are at the centre of the financial system —
everyone uses ratings, from the ECB to banks. This is not an
easy problem for Brussels to solve,” he said. “It has to be
handled carefully. If a country is unrated, it falls off the map
for investors.”

A spokeswoman for Michel Barnier, the European Commissioner
in charge of financial reform, said he was listening to industry
views. “It’s a very complex matter that can’t be solved in a few
minutes,” she said.

To read more about sovereign ratings in the euro zone,
double click on [ID:nLDE729162]

(Editing by Luke Baker, Rex Merrifield, Ron Askew)

UPDATE 2-Agencies warn of rating blackout for risky EU states