Getting Rid of Issuer-Pay Will Not Improve Credit Ratings

Abstract

Critics of credit rating agencies’ issuer-pay revenue practice say that it allows debt issuers and arrangers to shop among agencies for the highest rating. They allege that such “rating shopping” incents rating agencies to win business by rating debt higher than warranted by actual credit risk. To eliminate inflated ratings, issuer-pay critics suggest barring debt issuers from selecting and paying rating agencies.

Issuer-pay critics assume that ratings would be accurate if only the issuer-pay incentive for inflated ratings was extinguished. But we document a historical test of this assumption, an instance when issuer-pay and rating shopping were irrelevant concerns and ratings were still inappropriately high. With issuance effectively zero in 2007-09, S&P had no commercial incentive to maintain inflated ratings on subprime mortgage-backed securities and collateralized debt obligations backed by subprime mortgage-backed securities.

Yet, S&P’s ratings were severely inflated when compared to market prices and the credit analyses of market observers. Because 2007-09 conditions still produced inflated subprime ratings, getting rid of issuer pay will also not be sufficient to improve rating agency accuracy. But if issuer-pay critics succeed in abolishing the revenue practice, it would only be the latest in a long history of ineffectual and counter-productive rating agency regulations.