Subject: File No. 4-579
From: Harry Long

April 15, 2009

Ratings Agencies, Public Policy, and the Structure of Incentives
by Harry Long

The recent debate over whether issuers or investors should pay ratings agencies totally misses the point. Both models create incentives for potential distortions of ratings behavior.

As many have pointed out, when issuers pay, there is a clear incentive to make the initial rating higher than it otherwise might be. No one would debate that.

However, the investor pays model creates incentives for distortions of ratings behavior which could be just as damaging. For instance, in an investor pays model, the initial ratings may be lower, on average. However, the ratings agencies would be incentivized not to downgrade debt. Doing so would create losses for bond investors. These same investors could steer business to ratings agencies which are more amenable to not downgrading debt.

Perhaps even more disturbing, as large institutions such as PIMCO or CALPERS would probably be paying among the highest fees in an investor pays model, there could be distortions in debt markets tied to their holdings, which may become statistically less likely to be downgraded. In such a scenario, the strategy of smaller players might be to imitate their portfolios, not because they are evil or dumb, but out of a rational urge to safeguard capital. The dangerous herd instinct of our capital markets would be further intensified and the very bubbles regulators are trying to stop could develop.

Bottom line, each model incentivizes distortions in behavior. This realization has led some to point out the salutary effect of competition. I would counter that it is precisely the urge to increase market share that has the effect of incentivizing raters to scrape the bottom of the barrel when rating debt. In a stable market share situation, with rational actors, there is no incentive to engage in ratings "grade inflation." The prospect of renewed competition incentivizes new competitors and established players such as S&P (MHP), Moody's (MCO), and Fitch to engage in product differentiation through ratings inflation. Certainly, new entrants cannot compete effectively on heritage, brand name, quality of databases, or the experience of personnel. In a situation in which firms essentially choose their regulator, the normal prescription of increased competition does not apply. It exacerbates the problem, and allows firms to pick the most lax ratings agency possible, from a wider menu of options--which is precisely what rational actors will do.

To be clear, all of the ratings agencies have made mistakes. I am merely trying to highlight the structure of incentives in the oft-proposed investor-pays model. I also own shares in MCO and MHP, so I am not a disinterested party. While we have had a healthy public debate about the issuer-pays model, I do not feel that the media, the ratings agencies, or regulators have given sufficient thought to the very real shortcomings of alternatives. All policy should be measured against the alternatives. Are we prepared to substitute one set of well-understood incentives, for another with wholly unexperienced effects? Are we prepared to exacerbate the incentive for ratings inflation with renewed competition that will only increase it?