Credit Rating Agencies Business Model

Rating agencies have been very profitable, especially in recent times. In 2007, revenue from the top 3 rating agencies was $4.9 billion with bond issuance at $4.7 trillion (Deb &

Murphy, page 2). While their revenues were down sharply to the $3.7 billion on issuance of

$3.9 trillion following the crisis, they are nevertheless, substantial. The rating fees are probably lower, because rating agencies earn ancillary fees for other services. According to Frank Partnoy, S&P is paid 3 to 4 basis points of the size of the issue size for a corporate bond rating. Fees for rating structured finance bonds, are higher. They could be 10 bp for a typical CMBS transaction, or higher for more complex transactions (How and Why Credit Rating…2006).

It is important to understand the business model for the rating agencies and who pays for ratings, because, the choice of business model leads to the potential for conflict of interest.

At least in theory, one might expect a rating agency to potentially be influenced in their rating assessment, by who pays for the rating. The two primary models are the subscriber/investor-pay model and the alternative, issuer-pay model. Originally, investors paid for credit ratings. In the early years, credit ratings were just a source of research. This

changed, for several reasons, to the issuer-pay model, which is prevalent today, although there are still several rating agencies that use the subscription-model.

Another reason why the business model is important, is its legal impications. Under the issuer-pay model, the rating agency does not have a business or contractual relationship with the investor, who may use the rating in their investment process. This fact helps the rating agencies protect themselves from investor legal challenges.

When investors paid for ratings (investor/subscriber-pay model), they would receive the research in printed form. The payments were essentially a subscription service (e.g.

Moody‘s Bond Record). As technology to enable cheap copying and re-distribution, the rating agencies recognized the risk to their subscription-based business. This risk was known as the "free-rider" (Credit Rating Agencies… 2009: 2). The rating agencies were concerned that the ratings could simply be used by the market place without getting paid.

The major rating agencies still generate some fees from subscriptions of their analysis and sales of their analytic products, but the bulk of their revenues comes from issuers.

Based on different CRA‘s website information, despite the fear of losing revenue due to free use of their research, there are several rating agencies who use the subscriber pay model, such as Egan-Jones, and Real Point. There are also non-NRSRO rating agencies such as Creditsights and Rapid Ratings that use the subscription model.

Aside from the issue of illegal re-distribution of their product, a primary reason for the move to the issuer-pay model was the recognition by the rating agencies that the government had essentially created an oligopoly structure with strong barriers to entry by requiring ratings from NRSROs. The rating agencies realized that they were indispensable to the issuers, and, therefore, they had much more pricing power with issuers than with investors. With only 3 NRSROs the market became a victim of oligopoly pricing.

Actually, it was even worse. In most traditional oligopolies, market share is divided among the producers. In the market for credit ratings it is easily possible for several rating agencies to have market share in excess of 50%, because many issuers use ratings from more than one rating agency.

The big 3 rating agencies are issuer-pay (Credit Rating Agencies… 2009). Typically the issuer pays for the initial rating as well as a fee for surveillance of the rating. The rating agencies that use the issuer-pay model, claim that investors benefit, because the ratings are made available for "free" to everyone. Critics claim that this arrangement makes the rating agencies beholden to the issuers. There is truth to both sides of this argument, and it will be discussed later in this report. Many of the new regulations have been designed to control the possible conflict of interest that can arise from the issuer-pay business model.

While the fee schedules for corporate bonds are made public, the actual fee charged can be negotiated based on size and frequency of issuance. Fees for structured finance transactions are not published at all. These fees are more heavily negotiated. Based on discussions with market participants, it can be reported that fees can range from $500,000 to $1,000,000 per deal. Because of the potential for conflict of interest, fee discussions today are kept away from the analysts and are done by a separate group at the rating agency (Appendix 2).

Most of the ratings on sovereign bonds are done for free. The situation is that for big countries like USA, Germany, France, etc. receives no fee. It is interesting, that despite this, there is so much criticism of the rating agency sovereign ratings. There is obviously, no conflict of interest in this case, from the threat of an issuer to take its business to another agency. Instead, the pressure is political pressure. The country involved could try to disallow the rating agency from operating in its country, and even try to prosecute its analysts (Ambrose, E.-P. 2012; Reuters 2011). In contrast, for smaller countries like Estonia, South Africa they do get paid. When they are not paid, the rated is designated as

―unsolicited‖ and must be listed this way. When they are paid, like for Estonia, the rating is listed as ―solicited‖ (Standard & Poor‘s homepage, Sovereigns Rating List).

The claim in this case by investors is that the rating agencies were improperly downgrading Italian debt, and their negative reports were affecting Italian stock prices. This has been an ongoing complaint by European investors and regulators. They claim that the rating agencies, because they are US companies, are biased towards the US, and against the Europeans. One of the solutions that has been proposed is to create a European rating

agency. However, this effort has recently failed (Dearth of Investors… 2012; Conservative MEPs… 2013).