A credit rating is an assessment of the creditworthiness of an obligor as an entity or in relation to specific securities or money market instruments. SEC first used the term “Nationally Recognized Statistical Rating Organization” in 1975 to describe those rating agencies whose ratings could be relied upon to determine capital charges for different types of debt securities (securities) broker-dealers held. Since then, SEC has used the NRSRO designation in a number of regulations, and the term has been embedded in numerous federal and state laws and regulations, investment guidelines, and private contracts. As will be discussed, SEC has issued a series of proposals regarding the removal of references to credit ratings in its regulations in accordance with the Dodd-Frank Act. NRSRO credit ratings are intended to measure the likelihood of default for an issue or issuer, although some also measure variables such as the expected value of dollar losses given a default. The NRSROs describe ratings as being intended only to reflect credit risk, not other valuation factors such as liquidity or price risk. To determine an appropriate rating, analysts at rating agencies use publicly available information and market and economic data, and may hold discussions and obtain nonpublic information from the issuer. Issuers seek credit ratings for reasons such as improving the marketability or pricing of their securities or satisfying investors, lenders, or counterparties. Institutional investors, such as mutual funds, pension funds, and insurance companies, are among the largest owners of debt securities in the United States and are substantial users of credit ratings. Institutional investors may use credit ratings as one of several inputs to their internal credit assessments and investment analyses, or to identify pricing discrepancies for their trading operations. Broker-dealers also use ratings to recommend and sell securities to their clients or determine acceptable counterparties, and collateral levels for outstanding credit exposures. CRARA established SEC oversight of credit rating agencies registered as NRSROs. Specifically, CRARA added section 15E to the Securities Exchange Act of 1934 to provide SEC with examination authority and establish a registration program for credit rating agencies seeking NRSRO designation. SEC adopted final rules for a formal registration and oversight program for NRSROs in June 2007. SEC amended several of these rules in February and December 2009 with the goal of further increasing transparency of NRSRO rating methodologies, strengthening the disclosures of ratings performance, prohibiting NRSROs from engaging in certain practices, and enhancing NRSRO record keeping. Since the implementation of CRARA, SEC has registered 10 credit rating agencies as NRSROs. One of these credit rating agencies has recently withdrawn from registration as an NRSRO.pays compensation model and three operate primarily under the subscriber-pays compensation model, in which users pay a subscription fee to the NRSRO for access to its ratings. Despite the growth in the number of NRSROs and the availability of credit ratings from NRSROs operating under a subscriber-pays model, the market remains highly concentrated. In 2011, SEC reported that the three largest NRSROs (Standard & Poor’s, Moody’s Investment Services, and Fitch Ratings) issued approximately 97 percent of all outstanding ratings. Furthermore, NRSROs operating under the issuer-pays model issued approximately 99 percent of the total currently outstanding NRSRO credit ratings. Economists note that the credit rating industry has exhibited a high level of concentration throughout much of its history. SEC and others have noted that the regulatory use of ratings, economies of scale, high fixed costs, and network effects (the value or utility of products or services increasing with the number of users) as factors that have created barriers to entry and led to concentration in the credit rating industry. In our 2010 report, we identified five proposed models—random selection, investor-owned credit rating agency, stand-alone, designation, user-pays—and summarized key features of these proposed models. When we conducted our 2010 study, the level of development for each model varied and none had been implemented. Our current study identified two additional proposed models—the alternative user-pays model and the issuer and investor-pays model—and found that little additional work had been completed on the previously identified models that would provide further details about how each would function. According to some of the authors of these models, there is little incentive to continue developing these models, as the issue of alternative compensation models for NRSROs and their possible implementation appears unlikely to receive much, if any, attention from regulators or legislators. For example, these authors told us that SEC had not reached out to them to further discuss these models as part of the 939F study. However, SEC did solicit public comments about the models through a public notice in conducting its 939F study. Furthermore, SEC staff said that they held follow-up discussions with the authors of some of the models after the 2009 SEC roundtable. While these models generally are intended to address the conflict of interest in the issuer-pays model, some comment letters to SEC for its section 939F study described a number of perceived disadvantages of these models. None of the models has been implemented as of January 2012. As of January 2012, we have identified seven proposed alternative compensation models. The following summarizes the key features of each of these proposed models. A ratings clearinghouse randomly would select NRSROs to rate a new issuance in this proposed model. The clearinghouse could be a nonprofit, a governmental agency such as SEC, or a private-public partnership that would design the criteria by which new entrants could qualify as a credit rating agency. All issuers or sponsors that wanted ratings for their issuances would request them from the clearinghouse, which would use a random number generator to assign an NRSRO registered in the relevant asset class to produce the rating. The clearinghouse would notify the NRSRO of the opportunity to rate the issuance and provide basic information on the type of issuance but not the issuer’s name. Not until the NRSRO agreed to complete the rating would the clearinghouse identify the issuer and details of the issuance. If the selected NRSRO agreed to rate the issuance, the issuer would pay a fee to the clearinghouse. The issuer also would pay to cover clearinghouse costs on top of those required to rate the security. Upon completion of the initial and maintenance ratings, the clearinghouse would distribute the fees to the NRSRO. The clearinghouse would set the ratings fees for the NRSRO depending on the type of security issued, but the letter rating would be free of charge to the public. The proposed model incorporates a peer comparison review to create an incentive for NRSROs to produce quality ratings. As part of this review, the clearinghouse would evaluate the performance of all NRSROs on the basis of two empirical tests. For instance, if the default percentage of debt instruments rated by a given NRSRO differed from the default percentage of its peers by a set parameter, then the NRSRO would be subject to sanctions such as losing a percentage of business or rating fees. A second test would compare annual yields of identically rated debt securities from different asset classes. Securities in different asset classes that are rated similarly should have the same yield. An NRSRO would be subject to sanctions if the yields of identically rated securities differed by a certain threshold. According to the author of this proposed model, by eliminating the linkage between the NRSRO and the issuer, this model would eliminate the conflict of interest stemming from the issuer-pays model. Furthermore, the author stated that the peer comparison review coupled with economic sanctions for poor performance would motivate the NRSROs to continually adjust their models and produce quality ratings. Under this model, sophisticated investors—referred to as “highly sophisticated institutional purchasers” in the model—would create and operate an NRSRO that would produce ratings. Issuers would have to obtain two ratings—one from the investor-owned NRSRO and the second from their choice of NRSRO. More specifically, an NRSRO could not publicly release a rating for which an issuer or sponsor paid unless the NRSRO received written notification that the issuer had paid an investor- owned NRSRO to publicly release its rating. The investor-owned NRSRO would publish its rating on or before the date on which the solicited NRSRO published its rating. Institutional investors would have to qualify as highly sophisticated institutional purchasers before forming or joining an investor-owned agency. To qualify, an institutional investor would have to demonstrate that it was large and sophisticated, managed billions of dollars in assets, and could be relied upon to represent the buy-side interest in accurately rating debt market instruments. The investor-purchasers would hold majority voting and operational control over the agency, which could be for-profit or not-for-profit. Market forces would set the agency fees, which likely would be comparable to fees currently charged by dominant NRSROs. The letter rating and the underlying research would be free to the public. Proponents of this model believe that it would improve the rating process by changing incentive structures. They said that investor-owned agencies would introduce new competition to the industry and balance the investors’ interests against issuers’ interests. NRSROs would only be permitted to produce credit ratings in this proposed model. They could interact with and advise organizations being rated, but could not charge fees for advice. Instead of receiving issuer fees, the NRSROs would be compensated through transaction fees for original issuance and secondary market transactions. The issuer or secondary-market seller would pay part of the fee, and the investor purchasing the security (in the primary or secondary market) would pay the other part. The NRSRO would be compensated over the life of the security based on these transaction fees. The letter rating would be free to the public.