Issuer vs. Investor-pay Model

In CDO land, it’s long been considered a conflict of interest for issuers to pay rating agencies to have their own bonds rated (i.e., the “issuer-pay” model).

Indeed, both parties have the same initial goal: to close the deal and get paid. If the deal doesn’t close, neither party gets paid. (If the deal closes, but you’re not the rating agency used due to too stringent criteria, you similarly won’t get paid.)

This “mis-alignment” of interest is thought to encourage rating agencies towards leniency on certain rating considerations that may otherwise hinder deals from being done.

Excerpt from (now Chief Credit Officer at S&P) Mark Adelson’s Sept. 2007 speech before the House’s Committee on Financial Services, on the role of credit rating agencies in the structured finance market:

…rating agencies that had tougher standards become invisible, and, once more, they don’t make any money, because the way you make money rating a deal is you rate the deal and charge the issuer. So it puts pressure on the rating agencies to loosen their standards…

The “quick fix” solution - an “investor-pay” model - proposes that rating agencies are compensated by the investor and hence align their compensation structure with the party whose interests they’re trying to serve: after all, they are an “investor’s service.”

Firstly, we’re not convinced that an investor pay model removes this conflict-of-interest. Secondly, importantly, we show that investors may already be paying these rating agency fees.

Example:
A CDO’s flow-of-funds details how funded note issuance proceeds are used to purchase collateral and account for the deal’s closing expenses. When issuance proceeds prove insufficient, one solution is to issue a loan that covers the remaining expenses. Payments to this loan will be made through the deal’s priority of payments “waterfall” senior to any noteholder’s.

Under the issuer-pay model, some investors pay rating agency fees over time.

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In the above table, the loan covers the $800K owed to rating agencies. On each distribution date, this loan will be partially amortized though a payment of both interest and principal. This payment represents proceeds that would have otherwise made their way to investors. In low default scenarios, this effects equity noteholder’s excess spread. In higher default scenarios, this effects rated noteholder’s ultimate receipt of interest and/or principal.

Under the investor-pay model, all investors pay rating agency fees upfront.

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In the above table, investors purchase the deal’s notes at an additional 20 bps. This additional cost covers rating agency fees. The loan will be smaller and will therefore represent less of a burden to investors on each future distribution date.

At the end of the day, issuer-pay vs. investor-pay may just be the difference between having some investors pay fees over a few years and having all investors paying agency fees right now.

Keep watching this page for updates on where we’re going with this…