One factor that undoubtedly influenced the rating agencies was the way they were compensated. For years, the agencies had charged the buyers of the bonds for rating the bonds, a system encouraged by S&P, Moody’s, and Fitch and that led them to be more conservative because their clients were the bond buyers. When John Moody founded his now-famous firm in 1909, he charged bond investors for the research and ratings. Tragically, in the early 1970s, the SEC, seeking to expand market access to ratings, forced Moody’s and the other rating firms to fundamentally change their compensation model in a way that created serious conflicts of interest. Under the new method, the agencies were paid by issuers—bond sellers, not bond buyers. The SEC was influenced by union and government pension plans that did not want to pay the cost of the ratings. Of course, the cost of the ratings was always embedded in relative bond yields, but it was less visible than the direct cost to bond buyers. Under government-mandated “issuer pays” rules, the rating firms were motivated to lower their standards, fearing that issuers who were displeased with their ratings would yank their business and move it to a competitor rating firm.
The change in the compensation system created very different incentives for the rating agencies. Their client was now the seller (issuer) instead of the buyer (investor). This change obviously endangered investors. Of course, the sellers always want the highest rating possible, as a higher rating allows them to borrow at a lower rate.
Critics of the rating agencies who deride free markets and greed have a false focus: the change in the compensation method (from “investor pays” to “issuer pays”), which so eroded the objectivity of the rating firms, was mandated by the SEC and motivated by its favoritism toward union and government pension plans.
from The Financial Crisis and the Free Market Cure: Why Pure Capitalism is the World Economy’s Only Hope by John A. Allison
The neutering of the ratings agencies was one of many faults in the financial system that contributed to the collapse. FDIC insurance created incentives for recklessness; imprudent Fannie Mae underwriting created excessive housing demand; mark to market accounting increased volatility; the Basel II accords decreased capital requirements; and arbitrary and capricious enforcement of banking rules affecting bond holders rights restricted capital availability. The accumulation of these and many other errors in regulation and policy created a very fragile system that could only collapse under what would be an inevitable stress.
“Every snowflake pleads innocent but it is still an avalanche.”
This is not to excuse the recklessness and judgment of the banks themselves. To blame their malfeasance only on what was allowed by regulators is like a robber justifying his action based on the lack of police. Yet it is a myth that the problem was a lack of regulation. The problem was the regulations themselves; the micromanagement of complex systems that the regulators and policy makers truly did not comprehend or understand.