Moody’s Credit Ratings and the Subprime Mortgage Meltdown

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Moody’s Credit Ratings and the Subprime Mortgage Meltdown

Table of Contents

Introduction……………………………………………….3

Background………………………………………………..4-10

Analysis……………………………………………………10-12

Conclusion…………………………………………………12-13

References………………………………………………….14

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. After noticing 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...
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