Q. How do the rating agencies earn their living? Who pays them?
A. The original business model for the rating agencies, established when John Moody published the first publicly available ratings in 1909, was an “investor pays” model. Moody, and subsequently other rating agencies, sold thick “rating manuals” to bond investors. In the early 1970s the Big Three changed to an “issuer pays” business model, which means that an issuer of bonds pays fees to the rating agency that rates its bonds. This model continues today. The three smaller U.S. agencies, however, maintain an “investor pays” model.
Q. Why the change to the “issuer pays” business model?
A. There is no definitive answer. Here are some leading candidates: First, the early 1970s was the era when high-speed photocopying machines became commonplace, and the rating agencies may well have feared that widespread copying by bond investors of their ratings manuals would reduce their revenues. Next, the rating agencies may have belatedly realized that the issuers needed ratings in order to sell their bonds to regulated financial institutions, for the reasons mentioned above, therefore the issuers should be willing to pay for a rating (and photocopying wouldn’t interfere with fees charged to issuers). Finally, the unexpected bankruptcy of the Penn-Central Railroad rattled the bond markets and may have made bond issuers willing to pay credit rating agencies to vouch for their creditworthiness (although that bankruptcy should also have increased bond investors’ willingness to pay to discover who was more creditworthy).
Q. Doesn’t the “issuer pays” business model create a conflict of interest?
A. It certainly creates the potential for conflict of interest. If the credit rating agency is being paid by the bond issuer—and the bond issuer has the ability to “shop around” for another rating by a different rating agency—then the issuers may well have leverage with the rating agencies, and the latter may shade their ratings in favor of issuers in order to keep the engagement.
The rating agencies used to argue that they took special efforts to make sure that this potential didn’t become an actuality. They have now acknowledged that the problem is greater than they had earlier admitted and that additional steps, including greater transparency, are required to deal with the problem.
The rating agencies also argue that even an “investor pays” business model can involve some conflicts, since investors would prefer lower ratings (and thus higher yields) for newly issued bonds, as would anyone who has sold short any other security of the issuing entity. With respect to subsequent downgrades, investors who already own the bonds would disfavor them, while short sellers would welcome them. Nevertheless, the potential conflicts seem substantially less severe than for the “issuer pays” model.
Finally, the rating agencies point out that the “issuer pays” model has the advantage of rapid dissemination of ratings to the market, whereas an “investor pays” model would require some lag in general dissemination. But if the former ratings are less accurate than the latter would be, then the advantages of speedy dissemination are clearly muted.
Q. Was the “issuer pays” model even more of a potential problem in the rating of the mortgage-related securities?
A. Yes it was. Unlike the rating of a corporate bond or a government bond, where the existing structure of the entity that is to be rated is largely a given (although judgments about future prospects can clearly be more subjective), the underlying mortgage (and other) collateral and the payment structures of the mortgage-related securities were largely malleable. Thus the rating agencies worked closely with the packagers/issuers to determine collateral requirements and payment structures, which—at a minimum—heightened the appearance problems of the “issuer pays” model.