WASHINGTON - Standard & Poor's is defending the practice of municipal bond and other issuers paying for their own ratings, arguing in a white paper released ahead of tomorrow's Securities and Exchange Commission roundtable on rating agencies that "issuer-pays" is the most effective business model for fostering high-quality ratings and a transparent ratings process.
Meanwhile, California Treasurer Bill Lockyer chastised the SEC in a recent letter for not including at the roundtable muni bond issuers who could discuss the "double standard" of rating muni bonds on a more rigorous scale than corporate debt, even though their default rate is much lower. He urged the SEC to discuss this issue at some point in the future.
The 11-page Standard & Poor's white paper, which was released Friday, comes as the issuer-pays model used by the three major rating agencies has come under fire, largely because the agencies, in an effort to get more business, gave unduly high ratings to structured subprime mortgage securities even though their underlying credit quality was poor. At a confirmation hearing in January, SEC chairman Mary Schapiro said that the issuer-pays model is "at the heart of the conflict problem."
But in examining three different business models - issuer-pays, subscriber-pays, and a system with a government-owned rating agency - Standard & Poor's said that conflicts with every business model can be managed with regulatory oversight and robust internal controls.
Briefly acknowledging the problems tied to its ratings for structured products, Standard & Poor's said that some had "clearly" not performed well but argued that rating agencies have made important changes to strengthen their analytical independence.
Standard & Poor's also pointed to potential conflicts with the subscriber-pays model and any would-be government-run rating agency. For instance, in a subscriber-pays model, the firm said that "it is possible to envision a small number of large investors representing enough of a 'bloc' to attempt to wield significant influence over the ratings process," adding that in certain types of structured securities, a small group of investors often purchases the entire offering.
Standard & Poor's said that a "government utility model" would not necessarily have any less conflicts for several reasons, including because it would have "a natural interest" in protecting or stimulating the growth of issuer companies that are important to the economy.
Though the white paper clearly favors the issuer-pays system, Standard & Poor's cautioned that the market would be harmed if the government sanctioned only one type of business model.
"If, for example, the industry moved exclusively to a subscriber-fee model, how would investors around the world gain access to full coverage they currently receive from ratings firms employing the issuer-fee model?" the white paper said. "Only the large players able to pay for research would have access to it."
On the issue of the government mandating one model, Standard & Poor's is in agreement with at least some of the other participants in Wednesday's SEC roundtable. Alex Pollock, a resident fellow at the American Enterprise Institute who is slated to speak on a panel about barriers to entering the rating agency industry, said that the government should not decide between issuer-pays and subcriber-pays models.
"My idea is not to restrict [a rating agency's] issuer-paid model, but to encourage meaningful competition between the two models," Pollock said. "Let investors and other users of ratings decide which they prefer."
Turning to transparency, Standard & Poor's noted that the issuer-pays model historically has "fostered the greatest levels of transparency" by enabling agencies that employ it to make ratings widely available to the public for free and in real time.
Because distribution of ratings in a subscriber-pays model is "necessarily limited to subscribers," exclusive use of this model is likely to result in a big decline in the overall volume of information available to the market, the white paper said.
While a government-run agency would create maximum transparency in that ratings would be available to the market free of charge, this would require all governments to be equally transparent about criteria and assumptions, the rating agency said.
Meanwhile, Standard & Poor's noted that until the 1970s, virtually all rating firms used the subscriber-pays model. But in the wake of several notable defaults - including Penn Central Railroad's unexpected default on its commercial paper - investors began to demand more transparent ratings, which Standard & Poor's said could only be met through the adoption of the issuer-pays model.