April 14 (Bloomberg) -- Standard & Poor’s and Moody’s Investors Service defended their compensation structures amid criticism from regulators that being paid by investment banks to assign credit ratings creates a conflict of interest.

S&P President Deven Sharma, in remarks prepared for a Securities and Exchange Commission roundtable tomorrow, said the “issuer-pays” model ensures that the highest number of bonds get ratings. Without grades, it would be difficult for borrowers to raise money, particularly “new entrants to the capital markets,” he said.

S&P, Moody’s and Fitch Ratings have been faulted by lawmakers for assigning mortgage securities their highest AAA rankings and maintaining the assessments months after home loans began defaulting in 2007, triggering the collapse of the housing and credit markets. Compensation has been a central focus in efforts to revamp the industry.

SEC Chairman Mary Schapiro in February said some ratings companies have “inherent conflicts” because they are paid by underwriters who sell the securities and want the highest possible rankings.

Sharma said a “subscriber-pays” model, in which investors pay companies to rate securities they hold, fails to resolve the issue. Investors want “lower, initial ratings,” because such securities pay higher yields, he said.

“In the subscriber-pays model, it is possible to envision a small number of large investors representing enough of a bloc to attempt to put significant pressure on the ratings process,” he said in remarks that were posted today on the SEC Web site.

Short Sellers Incentives

Moody’s Chief Executive Officer Raymond McDaniel said short-sellers, investors who bet against companies, have incentives to take advantage of ratings companies.

“As subscribers under an investor-pays model, they may be highly motivated to encourage a negative rating action,” McDaniel said in prepared comments. “The more negative and unexpected the action, the better for their financial interests.”

Sharma said fewer bonds will draw ratings if subscribers paid for them and only a limited number of investors would know it when securities are downgraded, increasing “information asymmetry and market inefficiency.”

Sean Egan, whose Egan-Jones Rating Co. charges investors for its assessments, said the pay structure used by McGraw-Hill Cos.’ S&P, Moody’s and Fitch doesn’t work.

“Under the issuer-paid business model, a rating agency which does not come in with the highest rating will, before long, be an unemployed ratings firm,” said Egan, who is also attending the SEC roundtable.

‘Revenue Pool’

SEC Commissioner Elisse Walter in March said creating a “revenue pool” from which S&P, Moody’s, Fitch and other ratings companies would receive compensation is one option to reduce conflicts. Revenue may be collected as fees from debt underwriters or public companies that are selling bonds.

McDaniel said such a system might eliminate any motivations ratings companies have to “produce better quality ratings.”

“If fees are guaranteed” the incentive to “innovate, update and adapt methodologies to changing market conditions” is removed, he said.

The SEC is holding the meeting to discuss further reforms of credit-rating companies. In December, the agency prohibited those who assess debt from discussing compensation with underwriters. The agency also restricted gifts from investment banks to rating-company employees.

The SEC is seeking public comment on a proposal that would force credit-rating companies to disclose the data that goes into rankings. The agency says that change would encourage unsolicited ratings by letting companies grade bonds even if

To contact the reporter on this story: Jesse Westbrook in Washington at jwestbrook1@bloomberg.net.

Last Updated: April 14, 2009 17:33 EDT