Credit Rating Agencies and the Credit Crisis: How the “Issuer Pays” Conflict Contributed and What Regulators Might Do About It

Abstract

All good–or at least interesting–stories have a villain, and as the Credit Crisis started to unfold in 2007, credit rating agencies (“CRAs”) emerged as obvious targets for fingerpointing by regulators, scholars, and commentators alike. In short, many observers have accused the agencies of doing a poor job assessing the risks inherent in securities backed by subprime mortgages. These securities–particularly residential mortgage-backed securities (“RMBS”) and collateralized debt obligations (“CDOs”) backed by subprime mortgages–have been at the center of the Credit Crisis, and many assert that these instruments would not have been as marketable without the CRAs’ perceived seal of approval. Why did the agencies perform so poorly? There are likely many contributing factors, but a popular focal point has been the conflict of interest embedded in the CRAs’ issuer pays business model. Indeed, several features of the structured finance ratings market, including the growth in structured finance products, the concentration of the CRAs’ customer base for these securities, and the ratings process itself, suggest that the conflict may have been exacerbated. This Note explores these characteristics and argues that the current regulatory regime, with its emphasis on disclosure, is likely insufficient to protect against a similar problem in the future.