The fee structure of credit ratings gets a lot of undeserved blame for the poor quality of credit evaluation churned out by Stand & Poor’s, Moody’s and Fitch during the housing bubble. The idea is that the change from an “investor pays” model of ratings to an “issuer pays” model corrupted the ratings, allowing investment banks to bribe the agencies to provide favourable ratings.
We don’t think this story really holds up. (See our explanation here.) But even if it did, the solution many folks are proposing—going back to the “investor pays” model—simply won’t work.
To understand why a return to the investor pays model is unfeasible, it helps to recall the history of ratings. When John Moody produced the first publicly available bond ratings in 1909, he was basically publishing a book that contained the ratings. And when Poor’s Publishing Company joined him in 1916, that’s what it did too: published a book. Standard Statistic joined up in 1922, and two years later Fitch Publishing Company. As almost all the names reveal, these guys were publishers.
When investors were paying for ratings, what they were paying for were the published products of the ratings advisors. These were books, manuals, and periodicals that people paid to receive individually or by subscription. The “investor pays” model was basically the same model followed by book publishers and magazine publishers.
That model just won’t work these days. In fact, there’s good reason to think that one of the reasons the market switched from investor pays to issuer pays was cheap copying technology. These days, the investors in bonds have too many ways of easily discovering the ratings without paying for them. There might be some incremental value to receiving the information first, before it proliferates through the internet. But bond investors aren’t usually in the business of making speedy buys.
Perhaps large institutional investors—banks and pension funds—in bonds would pay something to receive ratings. But over time the minimal value of paying for bond ratings rather than just getting them for free would be sure to crush this business. There might be a market for deeper analysis of the businesses issuing bonds, but even this is questionable. Just look at the difficulty investment banks have turning a profit from stock analysis.
There’s a lot of reform that needs to happen when it comes to the way the ratings agencies operate. But trying to force an investor pays model on the market shouldn’t be part of that effort.
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