Senators Al Franken (D-MN) and Roger Wicker (R-MS) have renewed the call for the SEC to regulate how credit-rating agencies generate revenue. Eight of the nine registered credit-rating agencies employ what is known as the “issuer-pays” model in which ratings agencies receive “their principal revenue stream from issuers whose products they rate.” This model has been blamed for inflating the value of financial products, particularly mortgage-backed securities, and thus misleading investors and contributing to the 2007-2009 financial crisis. The senators want to prevent future manipulation by empowering the SEC to better regulate these credit-rating agencies’ revenue generating systems.
Senator Franken originally called for the abolition of the issuer-pays model in 2010. He and other legislators argued that the issuer-pays compensation model should be replaced with an alternative model. In addition, he wanted to task the SEC with creating an independent board to oversee the credit rating of financial products. This proposal, known as the “Franken Amendment,” ultimately failed to find its way into the Dodd-Frank Act, and was replaced with a provision in the bill calling for the creation of a task force to study the issue.
The task force produced a study that analyzed the potential advantages and disadvantages of replacing the current credit-rating system. On May 14th, the SEC hosted a roundtable discussion to “evaluate ways to improve” the credit-rating system. Commissioner Luis A. Aguilar noted the importance of a robust credit-rating system to investors, but emphasized the issuer-pays model’s contributions to the financial crisis.
Recently, there has been renewed interest in holding the credit-rating agencies accountable for their alleged contributions to the financial crisis. In February of this year, the DOJ brought fraud charges against Standard and Poor’s Rating Service—alleging that S&P sought to generate more business by rewarding customers with unreasonably high credit ratings for their financial products.
Many critics claim that the issuer-pays model tends to create incentives for the credit-rating agencies to inflate prices in order to maintain their market share because failure to issue favorable ratings could cause customers to choose another rating-agency. Thus, the issuer-pays model can lead to a “race to the bottom” in which the accuracy of credit-rating services is sacrificed in order to maintain profitability and market share.
A 2011 study compared the issuer-pays model to the “investor-pays” model (also known as the “subscriber-pays model”), in which investors pay for access to the credit ratings of various firms and financial products. Investors’ desire for accurate information creates an incentive for those firms employing the investor-pays model to ensure that their ratings are as accurate as possible. In contrast, the study found that the issuer-pays model often leads to inflated credit ratings, especially for those issuers in need of short-term debt.
However, the investor-pays model may not be the solution to problems now facing the credit-rating industry. First, the investor-pays model is not often employed. Of the nine registered credit-rating agencies, only Egan-Jones uses the investor-pays model; the remaining eight adhere to the issuer-pays model.
Second, those in the industry are quick to note that abolition of the issuer-pays model would be a prelude to the end of the credit-rating industry altogether. In an interview with the Financial Times, the CEO of Fitch Ratings, Paul Taylor, quipped that a move to the investor-pays model would be great, but noted that “[t]he reality is that you wouldn’t have a ratings industry if that was the case.” The issuer-pays model enables the agencies to not only produce credit-ratings, but to publish ratings to everyone in the market simultaneously. Critics of the investor-pays model doubt that it could sustain this system because of the ability of large investors to conduct the ratings themselves, and the inability of smaller investors to adequately fund the system.
Moreover, critics of the investor-pays model point out intrinsic conflicts of interest in that compensation structure as well. Leaders of the credit agencies argue that large investors would pressure the agencies not to downgrade the assets in their portfolios. This could lead to the same inflationary tendencies that are alleged to be inherent in the issuer-pays model as firms seek to maintain their share of the credit-rating market.
Regulators in Washington are struggling to come up with a workable alternative that provides adequate credit ratings while preventing future financial crises. The ultimate question facing the SEC is whether the issuer-pays system can be salvaged through regulatory means or if it will have to craft an alternative model that satisfies the market’s need for information and investors’ need for protection.