The Issuer-Pays model is the dominant business model for credit rating agencies (CRAs) globally. In this arrangement, the company or government entity (the “issuer”) that is issuing a bond or other debt security pays the CRA to have that security rated. Think of it like a movie studio paying a critic to review its upcoming blockbuster. This model is used by the “Big Three” CRAs: S&P Global Ratings, Moody's, and Fitch Ratings. While it ensures that ratings are produced and widely distributed, it also creates a glaring, inherent conflict of interest. The agency, which is supposed to be an impartial judge of creditworthiness, is on the payroll of the very entity it is evaluating. This can create pressure—subtle or overt—for the agency to provide a more favorable rating than might be warranted to maintain a good business relationship and secure future contracts.
Imagine you want to know the best steakhouse in town. You find a review that gives “Bob's Bistro” a perfect five-star rating. Sounds great, right? But then you discover that Bob paid the critic handsomely for that review. Suddenly, the rating doesn't seem so trustworthy. This is the core dilemma of the issuer-pays system. This conflict of interest isn't just a theoretical problem; it played a starring role in the 2008 Financial Crisis. During the housing boom, investment banks created complex securities like mortgage-backed securities (MBS) and collateralized debt obligations (CDOs). They then paid the CRAs to rate these products. To win lucrative business, agencies were incentivized to slap their highest AAA ratings on these securities, which were packed with risky subprime mortgages. Investors, from pension funds to individuals, trusted these ratings and bought the securities, believing they were as safe as government bonds. When the housing market collapsed, these “safest of the safe” assets became toxic, triggering a global financial meltdown. The agencies made millions rating the products, while investors lost trillions.
If the model is so flawed, why is it still the industry standard? There are two main arguments in its defense.
Credit ratings are a bit like a lighthouse. Once the light is on, every ship at sea can use it for free. Similarly, once a rating is published, the information is widely available. If CRAs used a subscriber-pays model (where investors pay for access to ratings), they would face a “free-rider” problem. Many would wait for a large institution to pay for the rating and then use the information once it inevitably leaks. The issuer-pays model solves this by having the entity with the most at stake—the one trying to borrow money—foot the bill. This ensures the rating gets produced and distributed for the benefit of the entire market.
Proponents argue that issuers are more willing to share sensitive, non-public information with a CRA they have hired. This deeper access, in theory, allows the agency to conduct a more thorough and accurate analysis than it could by only using publicly available data. Under a subscriber-pays model, issuers would have little incentive to cooperate, potentially leading to less informed ratings.
For a value investor, understanding the issuer-pays model is crucial. It means you should treat credit ratings with a healthy dose of skepticism. They are not gospel. Warren Buffett famously quipped that you can't outsource your thinking, and that is especially true when it comes to relying on ratings from conflicted agencies. Here’s how to approach it: