Moody’s Credit Ratings and the Subprime Mortgage Meltdown

In the early-2000s, Moody’s, one of the leading credit rating agencies in the world, evaluated thousands of bonds backed by so-called “subprime” residential mortgages—home loans made to those with both low incomes and poor credit scores. When housing prices began to fall in 2006, the value of these bonds disintegrated, and Moody’s was compelled to downgrade them significantly.In late 2008, several commercial banks, investment banks, and mortgage lenders that had been profoundly involved in the subprime market failed. In the wake of these implosions, credit stagnated, consumer confidence plummeted, and job losses increased across the globe. Although the financial crisis had many roots, some analysts felt that Moody’s and other credit rating agencies had played a large role by underscoring the inherent risks in mortgage-backed securities.

The actions taken by Moody’s and other credit rating agencies broke no financial laws, posing the question, is what is legal necessarily ethical?This case study will draw historical information, including documents released by Moody’s in connection with a Congressional hearing in October 2008, to search for the causes of the financial crisis and Moody’s role in it. It will then ultimately explain how corporations, governments, and society can improve the integrity and efficiency of the credit rating industry to decrease the risk of financial crises in the future. Moody’s had been founded in 1909 by John Moody, who got his start as an errand boy at a Wall Street bank.

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After oticing the growing popularity of corporate bonds, Moody realized that investors longed for a source of trustworthy information about their issuers’ creditworthiness. By 1918, Moody and his first were rating every bond issued in the United States. By 2008, Moody’s had become the undisputed “aristocrat of the ratings business”. (Lawrence, p. 455) The company was made up of two business units. The largest was Moody’s Investors Service, which provided credit ratings. It earned 93% of the company’s revenue, while Moody’s KMV, which sold software and analytic tools, made up the other 7%.

In 2007, Moody’s reported revenue of $2. 3 billion and employed 3,600 people in offices in 29 countries around the world. (Lawrence, p. 455) Moody’s main business was rating the safety of bonds—debt issued by companies, governments, and public agencies. Moody’s would rate bonds according to a scale from Aaa, known as “triple A”, with a very low chance of default, to C, already in default, with roughly 19 steps in between.

Moody’s ratings and those of other credit rating agencies allowed buyers to evaluate the risks of various fixed-income investments. (Lawrence.P.

455) Over the year, Moody’s saw its business model shift in a different direction. Moody’s had charged investors for its ratings through the sales of publications and advisory services for decades. A Moody’s vice president was quoted saying in 1957, “We obviously cannot ask payment from the issuer for rating a bond. To do so would attach a price to the process and we could not escape the charge, which would undoubtedly come, that our ratings were for sale. ” (Lawrence, p. 455) In 1975, however, the Securities and Exchange Commission (SEC) altered the rules.The SEC selected three companies—Moody’s, Standard & Poor’s, and Fitch—as Nationally Recognized Statistical Rating Organizations, or NRSROs. The government officially sanctioned these three rating agencies and gave them a trusted regulatory role.

It was at this time that Moody’s and the other NRSROs began charging bond issuers for their product ratings. (Lawrence, p. 456) The new SEC rules altered the relationship between the bond issuers and the three ratings agencies. Ratings strongly influenced the market value of the bond, creating a large incentive to ship for the best possible ratings.Rating agencies also had a strong motivation to compete for market share by catering to their clients. In 2000, Moody’s became an independent, publicly owned firm after being released by its parent company, Dun & Bradstreet. This placed even more pressure on Moody’s managers to increase revenues and improve their shareholder’s returns. (Lawrence, p.

456) From this point on, we begin to see the credit rating agencies drastically underestimate the risks of mortgage-backed securities in a selfish attempt to further their own bottom lines.The birth of structured finance came from new techniques of quantitative analysis used by Wall Street investment banks, and suddenly, Moody’s was not just evaluating corporate, municipal, state and federal government bonds. Structured finance consisted of combining income-producing assets—everything from conventional corporate bonds to credit card debt, home mortgages, franchise payments, and auto loans—into pools and selling shares in the pool to investors. (Lawrence, p.

456) A structured finance product that became popular in the early 2000s was the residential mortgage-backed security (RMBS).An RMBS started with a lender—a bank like Washington Mutual or a mortgage company like Countrywide Financial—that made home loans to individual borrowers. The lender would then bundle several thousand of these loans and sell them to a Wall Street investment bank such as Lehman Brothers or Merril Lynch. The Wall Street firm would then create a special kind of bond, based on a pool of underlying mortgage loans. Buyers of this bond would receive a share of the income flowing from the homeowner’s monthly payments. (Lawrence, p.

56) In an attempt to make RMBS more desirable to investors, the investment banks typically divided them into separated “tranches”, with varying degrees of risk. If any homeowners defaulted on their loans, the lowest tranches would absorb the losses first, and so on, up to the highest tranches. It was here that credit rating agencies such as Moody’s were asked to rate the creditworthiness of various tranches of the mortgage-backed securities.

Moody’s charged more for rating structured financial products, considering their higher complexity.Credit ratings were extremely important to investors in mortgage-backed securities because these products were so difficult to understand. Investors had nearly no way to judge the safety of these structured financial products, so they trusted the credit agencies’ judgment. (Lawrence, p. 457) Moody’s began to increase their revenue significantly since they began rating structured financial products.

Revenue from structured finance grew as a proportion of Moody’s overall revenue throughout 1999 to 2007, peaking at 43% in 2006, contributing to the company’s impressive profitability.Operating margins during this period ranged from 48% to 62%, an extremely high level. Moody’s had the highest profit margin of any company in the S&P 500 for five years in a row, beating out companies like Microsoft and Exxon. (Lawrence, p. 458) The enormous financial results rewarded Moody’s shareholders with an impressive return in the early 2000s. Moody’s top executives were also well compensated, with the chairman and CEO Raymond McDaniel earning a total of $7. 4 million in 2007. (Lawrence, p.

59) In the 2000s, the total global volume of financial assets—money available worldwide to purchase stocks and bonds, as well as more complex structured financial products created by Wall Street—grew by leaps and bounds. Global financial assets grew from $94 trillion in 2000 to $196 trillion in 2007. (Lawrence, p. 459) Until the credit crisis, private bonds were one of the fastest-growing asset classes, growing 10% a year between 2000 and 2007, when their global value stood at $51 trillion. Several factors contributed to the growth of a large increase in the total global volume of financial assets.

Big pension plans, private hedge funds, individuals saving for retirement, and foreign governments all sought safe investments with good returns. Emerging economies, including China, India, United Arab Emirates, and Saudi Arabia, built up substantial reserves selling oil and manufactured goods to the United States and other developed nations. At the same time that the volume of financial assets was increasing, many classes of assets were becoming less attractive to investors. (Lawrence, p.

459) In the early 2000s, the stock market was struggling after the high-tech bubble and collapses of Enron and WorldCom.Low interest rates, driven down by the U. S. Federal Reserve, fell to historic lows reaching 1% in 2004. This caused RMBS’s, which paid well above the federal funds rate, to be increasingly attractive when compared to rates of return on U. S. Treasuries. The growing demand for asset-backed securities put significant pressure on investment banks to create more of them.

Investment banks began to put pressure on mortgage originators to produce more loans. This then led to lenders lowering their standards they used to qualify borrowers.Typically, when a person applies for a home loan, they would need to have good credit, money for a down payment, and proof of income and assets. However, in the rush to make loans, lenders began overlooking these requirements, resulting in borrowers with poor credit, low-paying jobs, few assets, and no money to put down. These borrows—and the loans made to them—were known as subprime.

(Lawrence, p. 460) The weakened standards by lenders appeared to be mirrored by public policy towards homeownership by both the Clinton and Bush administrations.The government had helped first-time buyers with down payments and closing costs and allowed borrowers to qualify for federally insured mortgages with no money down. They also encouraged Freddie Mac and Fannie Mae, two government-sponsored mortgage lenders, to buy RMBSs that included loans to low-income borrowers. (Lawrence, p. 460) The industry also began to write more nontraditional mortgages. Instead of traditional fixed-rate loans, under which a borrower made a stable payment every month for many years, the industry developed products with lower monthly payments to allow less qualified buyers to get into the market.

From 2003 to 2005, the subprime and low-documentation share of mortgage originations tripled from 11% to 33%. These loans were very popular in states where housing prices were going up the fastest, such as Nevada, California, Arizona, and Florida. (Lawrence, p. 461) Some banks and mortgage companies became very aggressive in pushing loans on poorly qualified borrowers. A report from The New York Times examined the practices of Washington Mutual, where employees were under extreme pressure to generate loan volume.The report cited that Washington Mutual pressured their sales agents to generate loans while completely disregarding borrowers’ incomes and assets. The bank had set up a system that enabled real estate agents to collect fees of more than $10,000 for bringing borrowers, making agents more beholden to Washington Mutual then they were to their own clients.

Washington Mutual gave mortgage brokers large commissions for selling the riskiest loans, which carried higher fees, increasing profits and the compensation of the bank’s executives.They also pressured appraisers to give inflated property values that made loans appear less risky, causing Wall Street to bundle them more easily for sales to investors. (Lawrence, p. 461) Due to these practices, the quality of mortgage loans disintegrated. In 2005, the Office of the Comptroller of the Currency (OCC), considered new regulations that would have limited risky mortgages and required better explanations to borrowers and warning to buyers of RMBSs. However, mortgage lenders and investment banks lobbied against these rule changes, and federal regulators backed off.

Officials in North Carolina, Iowa, Michigan, Georgia, and other states attempted to rein in lenders, but were overruled by federal officials who argued that federal regulation preempted state regulation. The OCC brought merely one enforcement action related to subprime lending between 2000 and 2006. (Lawrence, p 462) In 2006, the market for residential mortgage-backed securities began to unravel. Interest rates began to rise, and housing prices began to drop. As loans began to reset, homeowners found that they were unable to make the new, higher payments—or to refinance or sell their property.Increasing numbers of homeowners realized they owed more than their home was worth.

As people began to walk away from their homes, mortgages became worthless—and the value of securities based on them fell. In July 2008, Ben Bernanke, chairman of the Federal Reserve, testified in the Senate that he anticipated as much as $100 bullion in losses in the market for subprime-backed securities. By the following summer, Moody’s had downgraded more than 5,000 mortgage-backed securities, with a value in the hundreds of billions of dollars, including 90% of all asset-backed securities it had rates in 2006 and 2007. United States Senate Permanent Subcommittee on Investigations) As Moody’s began downgrading bonds, many institutional investors—whose holdings of mortgage-backed securities were suddenly worth much less—became irate. As criticism began to pour in, downgrades continued, and Moody’s own stock dropped in value, the company’s executives began a reevaluation process of Moody’s own practices. (The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States) On September 10, 2007, McDaniel convened a town hall meeting with his managing directors.He was quoted as saying, “Looking at the subprime crisis speci? cally . .

. We had historically low [interest] rates. We had very easy credit conditions for a number of years. We had of? cial and market-based support for adjustable-rate mortgages. It created what I think is an overdone condition for the U. S. housing [market].

This was a condition that was supported by U. S. public policy in favor of home ownership. And as I once said, once housing prices started to fall, we got into a condition in which people can’t re? nance, can’t sell, can’t afford their current mortgage.

While McDaniel was dodging any personal responsibility that Moody’s should have for the mortgage meltdown, some of his fellow employees were more forthright. One was quoted as saying, “…these errors make us look either incompetent at credit analysis, or like we sold our soul to the devil for revenue, or a little bit of both. ” The failure of Moody’s to accurately rate the inherent risks are due to the conflicts of interest that are in the issuer-pay business model and rating shopping by issuers of structured securities.Moody’s desire to expand their market share made them willing participants in this mortgage-backed securities scandal. It is also far too simple for major banks to pressure lenders or credit agencies to get what they want. The business model prevented analysts from doing their job by putting investors first, and instead put their own company’s bottom line ahead of everything. The credit rating agencies need increased scrutiny and internal controls so that the market can be assured that their ratings are adequate, elimination of the NRSRO designations, and decreasing the conflicts that are created by the issuer-pays model.While Moody’s may not have been practicing any illegal activities, they ultimately failed at delivering their customers accurate information and committed a grave injustice by continuing to intentionally underestimate the risk of mortgage-backed securities for their own profits.

The Financial Crisis Inquiry Commission’s investigations have revealed a “shadow” banking system, where the operations of financial entities are legal solely because the markets and the forces of capitalism have moved faster than the government can pass laws.This allows them to escape conviction and legal action from participating in economically destructive activities. The financial crisis that followed the unethical practices by Moody’s and others led to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Bill Summary & Status – 111th Congress (2009–2010) – H.

R. 4173) which addresses the vulnerabilities of the financial services industry by strengthening regulatory authority, specifically in the areas that were most abused prior to the financial systems’ collapse.The “revolving door” between government officials and corporations may always pose problems for regulators, and lobbyists may succeed in influencing regulators to back off. These concerns mean that regulators must be well paid in order to ensure that they will not give in to bribery or any other unethical action and that there must be a wider separation between government officials and people on Wall Street. The 2008 crisis started when thousands of US homeowners stopped paying interest on their mortgages.The crisis spread because thousands of bankers and fund-managers had ignorantly backed those mortgages, and eventually lost a lot of money. The did this partly because of their own lack of familiarity with RMBSs and also because of the failure of Moody’s and other credit ratings agencies to warn them of the risks involved. Up to 2008, a large proportion of mortgage-based debts were rated AAA, when in reality they were junk.

Just days before the bubble burst, Moody’s still rated these failing investments as safe.The problem of conflicts of interest within the credit rating industry must be adequately dealt with, but an even larger problem may be that rating creditworthiness is difficult to begin with. Moody’s will never be able to predict the unpredictable, or anything that cannot be included within a statistic.

In order for investments to be healthy, Moody’s must rate what it can accurately judge and dismiss the rest as a warning sign to investors that they should beware to place their finances into a bubble that will eventually burst on bring down the entire global economy with it.References Lawrence, A. Weber, J.

(2011) Business and Society, Stakeholders, Ethics, Public Policy, 13th Edition. New York: McGraw-Hill/Irwin The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States. Washington, DC: U. S. Government Printing Office. January 2011. pp.

xxv; 221–222, 226. Becker, Bo; Milbourn, Todd (2011). “How did increased competition affect credit ratings? “. Journal of Financial Economics 101 (3): 493–514.Ratings in structured finance: what went wrong and what can be done to address shortcomings? “. CGFS Papers (Committee on the Global Financial System) United States Senate Permanent Subcommittee on Investigations (13 April 2011).

“Wall Street and the Financial Crisis: Anatomy of a Financial Collapse”. Majority and Minority Staff Report. Committee on Homeland Security and Governmental Affairs. pp.

6, 57. Financial Crisis Inquiry Commission, Testimony of Raymond W. McDaniel, 7



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