Issuer-Pays Model

The Issuer-Pays Model is a business arrangement where the company or government entity issuing a financial security (the “issuer”) pays a fee to a credit rating agency (CRA) to receive a credit rating. Think of it like a movie studio paying a critic to review its latest blockbuster. This model is the standard practice in the credit rating industry, used by the big three agencies—Moody's, Standard & Poor's, and Fitch Ratings. The issuer, wanting to borrow money by selling bonds, pays for a rating to signal its creditworthiness to the market. A good rating can lower borrowing costs and attract a wider pool of investors. While it sounds straightforward, the issuer-pays model has a notorious built-in flaw: a fundamental conflict of interest. The agency's revenue comes directly from the companies it is supposed to be evaluating with impartial rigor. This creates a powerful incentive for the agency to issue favorable ratings to keep its clients happy and ensure a steady stream of business. This dynamic played a central role in the 2008 Financial Crisis, where complex, risky securities were awarded top-tier ratings, misleading investors into thinking they were safe investments.

The core problem with the issuer-pays model is that the supposed “umpire” is paid by one of the teams. This can lead to several dangerous outcomes for investors who rely on these ratings.

Because issuers pay for the service, they can “shop around” for the best rating. If one agency provides a preliminary rating that the issuer doesn't like, they can simply approach another agency in the hopes of getting a better one. This competitive pressure among CRAs can lead to a “race to the bottom,” where standards are loosened to attract and retain business. The result is rating inflation, where securities are given a higher grade than their underlying risk actually warrants.

This conflict of interest was on full display leading up to 2008. Investment banks created incredibly complex products called Collateralized Debt Obligations (CDOs), which were bundles of mortgages, including many risky subprime loans. They then paid the credit rating agencies to rate these CDOs. To win the lucrative business, the agencies gave many of these risky bundles pristine AAA ratings—the highest possible grade. Investors, including pension funds and individuals, trusted these ratings and bought what they thought were ultra-safe assets. When the housing market collapsed, these “safe” investments turned out to be toxic, triggering a global financial meltdown. The agencies made millions in fees, while investors lost trillions.

If the model is so problematic, why is it still the industry standard? There are two main reasons.

• The Free-Rider Problem: A credit rating has qualities of a “public good.” Once a rating is published, it's difficult to prevent people who didn't pay for it from using it. If the model were switched to an investor-pays model, where investors subscribe to receive ratings, a free-rider problem would emerge. Many would simply wait for a paying subscriber to leak the information. This makes the investor-pays model far less profitable and difficult to sustain for the CRAs.
• Issuer Convenience: From the issuer's perspective, paying for a rating is a simple, effective way to broadcast their creditworthiness to the entire market at once. It's a marketing expense that, with a good rating, pays for itself through lower interest rates on their debt.

For a value investor, the lesson of the issuer-pays model is simple and profound: Do your own homework. A credit rating should be seen as, at best, a starting point for your own investigation, and at worst, a biased piece of marketing material. A true value investor, in the spirit of Warren Buffett, never outsources their thinking. Instead of blindly trusting a rating that was paid for by the company you're analyzing, you must become your own analyst. This means:

• Dig into the financials: Read the company's financial statements, especially the annual 10-K report. Understand its revenue, profits, cash flow, and debt levels.
• Assess the debt: Don't just look at the rating; look at the debt itself. What are the interest rates? When is it due? Can the company's cash flow comfortably cover its obligations?
• Understand the business: Is this a durable, profitable business with a competitive advantage? Or is it a weak company using debt to stay afloat?

A credit rating tells you the opinion of a paid consultant. Your own research tells you the reality. By relying on your own analysis to determine a company's true intrinsic value, you can invest with a genuine margin of safety, protecting yourself from the conflicts of interest baked into the system.