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Case 1: Moody’s Credit Ratings and

the Subprime Mortgage Meltdown

Eric Hensen, Darcie Gordon, Amber ProvaznikORGL 4223 The Individual, The Organization and Society

Fall 2012, Block 1

Case Summary

Moody’s is the oldest credit rating agency in the world, founded in 1909. Moody’s core

business model was in the area of rating bonds for businesses, specifically the likelihood of

their return. This allowed investors to evaluate the risk of their chosen endeavors. However,

eventually Moody’s business model changed. They began rating more than just corporate

bonds, moving into residential mortgage-backed securities.. These securities were bundled

together in a mixture of high risk and low risk mortgages, allowing them to charge higher

fees and higher interest points than that of traditional corporate bonds. This lead to an

increased amount of money in the early 2000’s for investors to dump into retirements,

hedge funds and pension plans. As a result, the demand for these securities increased as

mortgage lenders were pressured into granting loans to under qualified home-buyers. The

push for an America latent with proud homeowners was another contributing factor.

Eventually, it became apparent that homeowners were faltering on their loans and the real

estate market plummeted. Moody’s then began rating the securities at subprime levels and

investors were losing value in their holdings. Moody’s stock dropped and after much public

criticism, the House of Representatives got involved. A hearing with Moody’s revealed a

huge disparity in the responsibility of this financial crisis.

Discussion Question 1

What did Moody’s do wrong, if

anything?

Answer

Moody’s failed in regulating the pressure put on mortgage lenders. Although

Moody’s was only responsible for rating the loans and the associated risks,

Moody’s was fully aware of the effect these bundled tranches were making on

the lending process. Moody’s took advantage of a lucrative process without

forwardly thinking of the consequences. Their primary goal was pleasing the

investors, which they themselves were often personally involved with as well.

There’s no doubt that some of the ratings may have been padded somewhat in

order to make the investment packages look more appealing to potential

investors, even though the packages were made up of high risk, under qualified

home-buyers. Moody’s may not be solely to blame for this financial crisis and

the crash of the real estate market but they certainly played a part. There

weren’t any indications of efforts made to alter the outcome of what was

obviously a short-term success.

Discussion Question 2

Which stakeholders were

helped, and which were

hurt, by Moody’s actions?

Answer

The stakeholders that benefited most from Moody's actions were the

homebuyers that did not traditionally qualify for a mortgage. Also, investors

benefited from the poor credit ratings that Moody's assessed because millions

of investors relied on them for an independent and objective assessment. Wall

Street benefited greatly because the lender packaged thousands of mortgage-

backed loans and sold them to investment banks like Lehman Brothers and

Merrill Lynch. Finally, mortgage brokers benefited because they received

commissions for selling the riskiest loans that carried high fees.

The stakeholders that were hurt by Moody's actions were the good paying

homeowners whose homes lost value, therefore couldn't sell or refinance

because of all the defaults from subprime homeowners.

Discussion Question 3

Did Moody’s have a conflict of

interest? If so, what was the

conflict, and who or what were the

principal and the agent? What

steps could be taken to eliminate

or reduce this conflict?

Answer

Moody's had a conflict of interest contrary to what Mr. McDonald stated when he

was under oath speaking to the House of Representatives on Oversight and

Government Reform. Their business model put investors interests first. Moody's

was in competition with other credit rating agencies like S&P and Fitch, so to get

lenders to use their services, Moody’s had to lower ratings. Also, Moody's was

asked to rate the creditworthiness of various tranches of the mortgage-backed

securities. Investors had no clue how to assess the safety or security of products

because most products were grouped and sold in shares to investors. Moody’s

needed to rate these products and give a professional opinion of the risk.

As difficult as it may be, the best way to prevent or reduce conflict of interest is

for the SEC (Securities and Exchange Commission) to change the relationship

between the bond issuers and the rating agencies. Issuers should not have a

strong incentive to shop for the best rating. Additionally, the House of

Representatives Committee on Oversight and Government Reform needs to

aggressively audit the credit rating companies, investors, and lenders to make it

as transparent as possible.

Discussion Question 4

What share of the responsibility

did Moody’s and its executives

bear for the financial crisis,

compared with that of home

buyers, mortgage lenders,

investment bankers, government

regulations, policymakers, and

investors?

Answer

Everyone including Moody's played a large roll in the financial crisis. The home-

buyers were told to lie in order to qualify for the loan since no one would verify their

information. The mortgage companies made loans to people and then bundled

them together to sell to investment banks so that the mortgage lender had cash for

more loans.  The investment banks would then create a special kind of bond so the

people who bought the bonds would receive a portion of the mortgage holders

monthly payments.  The policymakers and government regulators had big agendas

for making everyone a homeowner, regardless of credit, income, or down

payment. The agenda was to make it look like they were helping America become

the land of homeowners. Moody’s found out how lucrative rating structure loans

could be and began rating them even though that was not the business they had

begun or been doing. They only saw the money and realized that the bigger

structured loans they rated, the more money they made. Moody’s always gave

good ratings because they wanted people to continue to use their services in order

to continue making money. They all played a part in this game, therefore are all

equally responsible for the financial crisis.  It wasn't just one person who was doing

wrong.  It came apart one block at a time.

Discussion Question 5

What steps can be taken to prevent a

recurrence of something like the

subprime mortgage meltdown? In your

answer, please address the role of

management policies and practices,

government regulation, public policy,

and the structure of the credit ratings

industry.

Answer

In order to prevent another sub prime mortgage meltdown, the government

needs to have more regulation. It needs to be part of the process starting

with the mortgage and carrying through to the investors. The structure of

the credit rating industry should be evaluated and public policy made as to

what will and will not be done and how each step will be carried out. Public

policy will have to be in every part of the process to ensure that each step

is transparent enough to see when something is fishy or unbelievable. The

management polices and practices will have to revert to those of the pre-

"housing for everyone fad".  The policies will have to ensure the person can

qualify for the loan, and possesses the necessary credit, down payment

and income to prevent default on the loan. Rating companies like Moody's

need to tightly regulate and revert back to the company that cannot

change for the ratings they are giving. Then, it would be of no benefit to lie

about the ratings because they would have nothing to gain. It will take

everyone doing something to ensure no more sub prime meltdowns.

References

Lawrence, A.T., Weber, J. 2011. The Meaning of

Corporate Social Responsibility. Business & society:

stakeholders, ethics, public policy (13th ed.) (pp. 50).

New York: McGraw-Hill/Irwin.