praxeologist on Nostr: Initially, credit rating agencies followed an “investor pays” model, where ...
Initially, credit rating agencies followed an “investor pays” model, where investors paid for ratings information. However, in the early 1970s, this model shifted to an “issuer pays” system, where the entity issuing the bonds also pays the rating firm to rate the bonds. This shift opened the door to potential conflicts of interest, as agencies might feel inclined to favor the issuers who pay for their ratings
Several factors contributed to the shift from “investor pays” to “issuer pays.”
First, before the early 1970s, rating agencies sold thick manuals containing their credit assessments to investors under the "investor pays" model. However, as high-speed photocopy machines became widespread, investors could easily make copies of these ratings from colleagues or friends without buying the manuals themselves. This potential for “free-riding” made the "investor pays" model less profitable, pushing rating agencies to reconsider their revenue structure
Second, the unexpected collapse of the Penn-Central Railroad—a major U.S. corporation—was a wake-up call for bond issuers and investors alike. Issuers realized that they needed ways to assure investors of their creditworthiness to attract capital more reliably. This incident made issuers more willing to pay rating agencies directly to vouch for their stability, providing an additional incentive for agencies to switch to the "issuer pays" model.
Third, in the 1970s, regulators began requiring banks and other financial institutions to hold only "investment grade" securities, as rated by recognized agencies. This meant that issuers needed ratings not only to attract investors but to meet regulatory standards for financial institutions. Recognizing this, rating agencies saw an opportunity to charge issuers for their essential "blessing," as issuers now needed favorable ratings to access a wider, regulated investor base.
Fourth, the credit rating industry functions like other “two-sided markets,” where payments can come from either side (e.g., advertisers and readers in newspapers). In this case, both investors and issuers could potentially pay for the information provided by rating agencies. Shifts in economic or technological conditions sometimes cause one side of a market to become the main source of revenue.
Key factors in the subprime mortgage debacle included the over-optimistic ratings assigned to mortgage-backed securities and the complex structure of these securities. The rating agencies had little experience with mortgage-backed securities, and they faced pressure from issuers to give high ratings. These high ratings facilitated the widespread sale of mortgage-backed securities, which helped fuel a housing market bubble. Additionally, as “members of a tight, protected oligopoly,” rating agencies grew complacent and “less worried about the problems of protecting their long-run reputations,” which contributed to a lack of accountability in their assessments
My takeaways from "Markets: The Credit Rating Agencies" by Lawrence J. White
Source: https://www.aeaweb.org/articles?id=10.1257/jep.24.2.211
#grownostr #FinancialHistory #CreditRatingAgencies #regulations
Several factors contributed to the shift from “investor pays” to “issuer pays.”
First, before the early 1970s, rating agencies sold thick manuals containing their credit assessments to investors under the "investor pays" model. However, as high-speed photocopy machines became widespread, investors could easily make copies of these ratings from colleagues or friends without buying the manuals themselves. This potential for “free-riding” made the "investor pays" model less profitable, pushing rating agencies to reconsider their revenue structure
Second, the unexpected collapse of the Penn-Central Railroad—a major U.S. corporation—was a wake-up call for bond issuers and investors alike. Issuers realized that they needed ways to assure investors of their creditworthiness to attract capital more reliably. This incident made issuers more willing to pay rating agencies directly to vouch for their stability, providing an additional incentive for agencies to switch to the "issuer pays" model.
Third, in the 1970s, regulators began requiring banks and other financial institutions to hold only "investment grade" securities, as rated by recognized agencies. This meant that issuers needed ratings not only to attract investors but to meet regulatory standards for financial institutions. Recognizing this, rating agencies saw an opportunity to charge issuers for their essential "blessing," as issuers now needed favorable ratings to access a wider, regulated investor base.
Fourth, the credit rating industry functions like other “two-sided markets,” where payments can come from either side (e.g., advertisers and readers in newspapers). In this case, both investors and issuers could potentially pay for the information provided by rating agencies. Shifts in economic or technological conditions sometimes cause one side of a market to become the main source of revenue.
Key factors in the subprime mortgage debacle included the over-optimistic ratings assigned to mortgage-backed securities and the complex structure of these securities. The rating agencies had little experience with mortgage-backed securities, and they faced pressure from issuers to give high ratings. These high ratings facilitated the widespread sale of mortgage-backed securities, which helped fuel a housing market bubble. Additionally, as “members of a tight, protected oligopoly,” rating agencies grew complacent and “less worried about the problems of protecting their long-run reputations,” which contributed to a lack of accountability in their assessments
My takeaways from "Markets: The Credit Rating Agencies" by Lawrence J. White
Source: https://www.aeaweb.org/articles?id=10.1257/jep.24.2.211
#grownostr #FinancialHistory #CreditRatingAgencies #regulations