Credit Ratings Agencies - A new compensation model

Introduction
The Who's Who of Wall street have been paraded on Capitol Hill recently. The CEO's from the Credit Rating Agencies (CRA) have been among the more recent visitors in their attempts to downplay their role in the recent credit crisis. Much has been written about the role of the agencies in perptetuating the crisis, but this post specifically outlines changes to the compensation strucutre of the agencies that can prevent similar problems in the future by aligning the incentives of the agencies more closely with those of the creditors who purchase the bonds based on, atleast partly, the ratings the agencies provide.

The problem
The misplacement of trust within these agencies is a fundamental incentive problem. Professor Michael Jensen of Harvard Business School and William Meckling of the University of Rochester won the Nobel Prize for their 1976 paper titled, “The Nature of Man”, which highlights this issue in the organizational context of shareholders and managers of a commercial enterprise. In our context, the hypothesis prevails since the 3 major CRA's who control over 70% of the markte are compensated by the issuers of the credit (the “issuer paid” model), rather than the purchasers of credit (“investor paid” model). It is no surprise then that in the issuer paid model, CRA ratings favor issuers of credit and provide overly optimistic ratings to undeserving borrowers at a heavy cost to the credtiors and society at large.

A new compensation paradigm
While several smaller agencies (product or regionally focused) utilize the investor paid model, which better aligns incentives between investors and the CRA. Yet, in both models, payment to the CRA is typically made upfront when the CRA evaluates the fixed income instrument and payments typically range for 3-5 basis points (0.03-0.05 percent) of the typical size of the debt issuance.

However, a more robust compensation model is required to ensure full alignment. The proposed compensation system, will allow CRA’s, be compensated by issuers(i.e. maintain the issuer paid model) but requires the compensation schedules for the CRA be based on the expected repayment schedules of investors given the CRA assigned rating so that the incentives remain aligned over the course of time. The diagram alongside illustrates this point.



Zone 1 Compensation Model: If the fixed income issuance has been rated poorly (low) by the CRA, the CRA’s rating indicates that the borrower is more likely to default on the fixed income obligation or that only a small portion of the debt issued will be recovered by investors. As a result of this “fair warning” or low rating on the loan, the CRA can be expected to be paid upfront since the agency does not indicate meaningful confidence in the repayment of the entire debt. Such a rating would result in a payment immediately upon the completion of the ratings effort by the CRA, as identified in Zone 1 of Figure 1 above.

Zone 3 Compensation Model: Alternatively, if the CRA were to rate the fixed income issuance highly, the CRA’s rating would indicate it is confident of the borrower’s ability to meet the fixed income obligations for all investors over the life of the loan. In this instance, the payment schedule for the CRA would include a nominal upfront payment to cover the costs of the effort expended in undertaking the credit analysis sans profit. This upfront payment would be followed by a stream of payments that mirror the coupon/interest payment received by the investors of the debt as indicated in the figure below.



Based on the payment scheduled described above, if an issuer were to default on payments or return only a portion of the expected cash flows to investors, the CRA would stand to lose its proportional share of fees from that defaulted stream of payments. The total fees paid over the life-cycle of the loan would remain within the range of the compensation received by the CRA today.

Zone 2 Compensation Model: Finally, if a particular issuance has a moderate/mixed credit rating as defined in Zone 2, then the payment schedules and amounts for the CRA would be over some pre-determined portion of the loan-lifecycle that would adjust for the expected default on principal based on the CRA’s assessment. A sample CRA compensation schedule for a bond with a 50% default rate is shown in the figure below.



The exact formulation of the payment at each time interval and duration over which the Credit Rating Agency will be remunerated under these various scenarios needs to be further refined with guidelines and formulae and is presented conceptually in this posting.

It is my expectation that because the compensation of this organization is better aligned with investors, ratings from a CRA using this compensation model will be more highly sought by issuers than those of existing CRA and will allow this agency to charge a premium above the current fees for-profit CRA’s charge (~0.03 -0.05% of the total size of the debt issuance).

While interesting, these changes are unlikely to be adopted by an oligopolistic industry and yet the opportunity for implementing changes of this scale have never been more ripe. In a subsequent post, I'll likely examine how a new player adopting this model can aim to gain market share.

Hopefully an big-hitter from the agencies, tired of their misaligned incentives is in the mood for ground breaking change to adopt such radical changes. Michael Kolchinsky are you listening?