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FRM Part I · FRM Exam Part I · Anatomy of the Great Financial Crisis of 2007-2009

A key conflict of interest identified in the rating of structured finance products before the crisis was the 'issuer-pays' model. Which statement best describes how this model, combined with ratings shopping, weakened rating quality?

Under issuer-pays, arrangers could shop among agencies and hire the one offering the most favorable rating. Agencies competing for lucrative structuring fees faced pressure to loosen standards, which weakened rating quality for structured products.

  1. AInvestors paid for ratings, so agencies set conservative ratings to avoid litigation
  2. BArrangers could choose the agency offering the most favorable rating for a deal, creating pressure on agencies to loosen standards to win businessCorrect
  3. CRegulators selected the agency for each deal, which reduced competition and innovation
  4. DAgencies were paid only if the security later defaulted, encouraging overly pessimistic ratings

Explanation

Under issuer-pays, the arranger who pays the fee can compare agency feedback and award the mandate to whichever gives the best rating. This incentivized agencies to be lenient to secure fee-generating business. The other options reverse the actual incentives.

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