January 11, 2012

Researchers Find Issuer-Pay Model Leads to Higher Bond Ratings

 On the political front and in the media, much is being made about whether the issuer-paid credit rating model encourages a conflict of interest between the issuers and the rating agencies. Many commentators and policy makers claim that charging bond issuers for ratings introduces conflicts of interest into the rating process. A new study by accounting professors at Michigan State University, Texas Christian University and Fordham University shows that theissuer-pay model does, indeed, lead to higher bond ratings, and that this increase derives from inherent conflicts of interest.

Since the issuer-pay model became effective at Moody and Standard & Poor (S&P) in the mid-1970s, the researchers – John Jiang (MSU), Mary Stanford (TCU), and Yuan Xie (Fordham) – compared historical rating data dating from 1971 to 1978 on one bond.

“We found that, when Moody changed from the investor-pay to the issuer-pay model, Moody’s rating was higher than S&P’s rating for the same bond,” said Dr. Stanford, professor of accounting at the Neeley School of Business at TCU. “After S&P adopted the issuer-pay model in July 1974, S&P’s ratings increased to match Moody’s ratings for the same bond.”

Because the researchers used Moody’s ratings for the same bond as a benchmark, they concluded that the increase in S&P’s ratings was not due to general changes affecting bond ratings.

Most importantly, S&P’s ratings increased only for bonds with greater potential conflicts of interest under the new revenue model, i.e., for firms that were likely to pay higher fees or have greater incentives to attain a higher rating.

“For our sample, the average increase in S&P’s rating was approximately 20 percent of a rating category, which results in a reduction in yield spread of roughly 10 basis points,” Dr. Stanford said. “This translates into interest saving of $51,000 per year in 1974, or over $222,000 in 2010 adjusting for inflation. These results are consistent with bond issuers gaining bargaining power when they pay for ratings.”

The study by Drs. Jiang, Stanford and Xieis consistent with two contemporary studies that compare different rating agencies and utilize recent data on ratings for mortgage-backed securities (Xia 2010, He, Qian, and Strahan 2011).

“Because we used Moody’s ratings for the same bond as a benchmark to compare with S&P’s rating, and because we compared the two agencies’ ratings before and after S&P adopted the issuer-pay model, our research design presents a clean test of whether and how much the switch to the issuer-pay fee model influenced credit ratings in the past,” Dr. Stanford said.

Does it matter who pays for bond ratings? These professors say it does. “Our findings suggest that the issuer-pay model leads to higher ratings for firms that likely receive the greatest benefit,” Dr. Stanford said. 

According to a Thomson Reuters article on September 2, 2011, Senator Al Frankin (D-MN) called the issuer-pay model “fundamentally flawed,” and, joined by Senator Roger Wicker (R-MS), called for it to be replaced with an independent self-regulatory organization (SRO).


Elaine Cole
PR Manager
Neeley School of Business at TCU