Ratings agencies are likely to find themselves under increasing attack after Standard & Poor’s last night warned that plans to corral French and German banks and insurance companies into contributing to the second Greek bailout could push the country into default.

The S&P warning threatens to derail proposals, carefully crafted by French banks which are the biggest foreign holders of Greek debt, under which banks and insurance companies would roll up to €30 billion of their debt maturing between now and 2014 into new Greek bonds. The participation of private lenders reduces the amount that the European Union and the International Monetary Fund have to tip into the second bailout for Greece — estimated at up to €120 billion — and is seen as crucial for winning over taxpayer support for a second rescue for the debt-strapped country.

Ratings agencies — which have previously been condemned for playing a major role in the US financial crisis because they failed to spot major problems with the creditworthiness of mortgage debt — are increasingly being accused of fuelling the European debt crisis. Critics argue that when ratings agencies slash the credit ratings of debt-laden countries, investors become more wary about buying their bonds, which pushes up their borrowing costs. As a result, their financial plight worsens.

Last month, Michel Barnier, the European Commissioner for Financial Services, complained about the “brutal downgrades” that ratings agencies had inflicted on countries such as Greece that were undergoing austerity programs. He threatened to tighten up the regulations on ratings agencies, for instance by prohibiting all ratings of countries that are in the process of undergoing an international adjustment program.

At a roundtable discussion in Paris overnight, the ratings agencies hit back. S&P’s chief European economist, Jean-Michel Six, complained that countries were increasingly refusing to co-operate with ratings agencies. According to the French newspaper, Le Monde, he pointed out that sovereign debt risk is a very long-standing risk. Until the middle of the 19th century, states were considered the worst borrowers, and even the 20th century had been punctuated with resounding defaults. He argued that in a $41 trillion market, investors were more than ever in need of an “opinion” before making their decisions.

S&P’s Alexandra Dimitrijevic joined in the defence of ratings agencies, according to Le Monde.

“Breaking the thermometer in the crisis period, at the height of the illness, is not the solution,” she argued, adding that “sovereign debt ratings work”.

History shows that countries with a Triple C rating have a default rate of 40% in the year following the downgrade, and more than 70% within five years. Last month, S&P downgraded Greece to Triple C, putting the country deep into junk bond territory.

S&P’s latest warning that the French banks’ plan for rolling over Greek debt could trigger a default is a set-back for French president, Nicolas Sarkozy. Last week, he was confident that the plan for voluntary private sector participation would allow Greece to avoid default.

“If it wasn’t voluntary,” he said, “it would be viewed as a default, with a huge risk of an amplification of the crisis.”

Under the French plan, lenders would agree to reinvest 70% of their loans into new 30-year Greek bonds, which would pay an interest rate of between 5.5% and 8%, depending on Greek economic growth. A second proposal would see lenders rolling at least 90% of loans that mature before mid-2014 into new five-year bonds, which would pay a coupon of 5.5%.

But both plans, which have received the blessing of German banks, were conditional on ratings agencies not downgrading Greece’s debts.

S&P, however, has taken the view that the debt rollover would be a “distressed” transaction, which would leave lenders worse off, and therefore would probably lead to Greece being declared in “selective default”.

The S&P warning has likely rung the death-knell for the French plan, and has made the task of coming up with a second bailout for Greece by mid-September all the more difficult.

*This article was first published on Business Spectator