Friday, February 3, 2012

Case Study of Moody's Corp and Subprime Mortgage Meltdown

According to the Bureau of Labor Statistics, American unemployment has decreased to an encouraging 8.3 percent.
Not fantastic progress, but respectable. Before we get lost in the euphoria of this recovery, let's not forget the reasons why we need one.

In 2010, I wrote a case study on Moody's Corporation and the general role of ratings agencies in the mortgage meltdown, and while I am not singling out any particular entity or corporation as the sole cause of the crisis, I think that a thorough analysis of these institutions and other components of the "shadow" banking industry, is absolutely necessary.

Case Study of Moody’s Corporation and the Subprime Mortgage Meltdown

To lay at the feet of Moody’s Corporation or any of the other major credit ratings agencies the primary responsibility for the 2008 global financial crisis would be a simplistic and ultimately erroneous determination.   However, one cannot deny their active facilitation of a systemically flawed financial structure that was buttressed upon illusory assets and ineffective, and perhaps even unwilling, regulation.   The nature of the activities that permitted the financial crisis to flourish and finally implode beggars the question that perennially arises in the discussion of matters both societal and economic;     Is what is legal necessarily ethical?.  In the case of Moody’s Corporation, there was no clear violation of any regulation or law that the enterprise was bound to abide by, nonetheless, was there a moral and professional obligation held by the company that transcended mere legality? If so, how culpable is the company for its actions, if truly responsible at all? This author hopes to discuss these inquiries and others throughout the subsequent analysis.
  1. What did Moody’s do wrong, if anything?
Legally, as was previously stated, Moody’s committed no crime or infraction, yet one cannot overlook a somewhat lax stance in regards to its’ ratings on residential mortgage backed securities.   Chairman and Chief Executive Officer of Moody’s, Raymond McDaniel, testified before the Financial Crisis Inquiry Commission that while Moody’s did observe a trend in the declining quality of mortgage-backed securities as early as 2003, that it is not the role of Moody’s nor any other credit rating agency to serve as the “gate-keeper” of the securities market and that their ratings are merely opinions, not definitive advice or recommendation on the stability or substantiality of a particular financial instrument.[1]
  1. What stakeholders were helped, and which were hurt, by Moody’s actions?
Clearly, the immediate beneficiaries of Moody’s ratings were the securities issuers,  those institutions which provided these securities profited immensely from their continued distribution throughout the market, as did Moody’s who received sizeable fees to rate said instruments.[2]  One Moody’s employee indirectly described the competitive pressures which led to the lapses in the ratings systems,
“He described RMBS(residential mortgage backed securities) as the worst team to work on at Moody’s. It’s difficult to maintain market share in a market that has become commoditized and where Moody’s expected loss analysis means higher costs for issuers. “[3]
The investors, placing great confidence in the quality of Moody’s credit ratings, received these securities with the full belief that the ratings attributed to them were analytically sound and unbiased in any way. These investors however would be the most severely affected by the eventual downturn of the market, discovering that their investments were in reality of far less value than had originally been determined.
  1. 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?
The current credit ratings agency business model, in the opinion of this author, is by nature one in which the conflict of interest is unavoidable.  Moody’s CEO Raymond McDaniel states however that conflict of interest will arise whether rating’s agencies utilize an issuer or investor-pays system.[4] Each party has an interest in influencing the determinations of the credit ratings agencies; issuers are seeking to distribute securities and higher credit ratings allow these securities to appear more attractive to investors, on the other hand, institutional investors will always attempt to improve their investment portfolios and understandably would seek better ratings for securities in their possession.  Additionally, the distinctions between issuers and investors have grown nebulous as parties in the present-day global financial system now actively participate in both roles.   While this author believes that stronger government regulation with legal ramifications for purposeful inaccuracy is the only way to decisively mitigate or even eliminate the damage which this business model can cause, some economists have suggested delayed payment schedules for ratings agencies and investment quality ranging, rather than grading, in order to prevent a reoccurrence of this magnitude.[5]  
  1. What share of the responsibility did Moody’s and its executives bear for the financial crisis, compared with the home buyers, mortgage lenders, investment bankers, government regulators, policymakers, and investors ?
To quantify the exact contribution of Moody’s to the crisis is an undertaking well outside the realm of this case study, yet the conduct of Moody’s as well as the other credit ratings agencies was undeniably symptomatic of a fatally defective paradigm in regards to the structured finance market.  The credit ratings agencies, despite the contention that they are not financial advisers, are remiss to believe that institutional investors do not look to their determinations as trusted and valued resources.  While they may legally be capable of denying their culpability within the crisis, the agencies ultimately failed in their responsibility to provide their customers with accurate information and committed a true injustice by continuing to provide such information despite internal misgivings.[6]
  1. 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.
Industry transparency and regulation, both governmental and self- imposed, are the areas that must be addressed if the mortgage crisis is to be prevented from reemerging.  The Financial Crisis Inquiry Commission’s investigations have revealed to the general public the existence of a little understood “shadow” banking system.  This refers to the operations of financial entities that are legal, yet so under regulated, that they escape the scrutiny and criticism to which their commercial banking counterparts are subject. [7]  The combination of this practically unmonitored and unregulated banking sector with a mortgage lending environment that was delving deeply into what would come to be known as the subprime market, representing those borrowers with poor credit histories and normally unsatisfactory debt to income ratios, were primary components in  the creation of the financial crisis.  Considering these factors, one can carefully follow the chain of events which would eventually upset the global financial system:
1) Lenders originated mortgages to customers with doubtful ability to repay the loans
2) Investment banks purchased securities based on the mortgages, whose value was dependent on the perceived ability of borrowers to repay their debts, these securities became numerous and highly popular with investors and were vigorously provided to the market
3) Credit rating agencies who rated such securities gradually relaxed their standards as the competition to maintain market share grew fierce and issuers desired better credit ratings to more easily promulgate their securities
4) Lastly, investors, reliant on credit ratings agencies and the apparently limitless profitability of mortgage backed securities, assumed greater and greater quantities of these securities, with little to no government regulation of any portion of this process, the private sector had no controls other than those imposed by the financial market. 
The market, unbridled and allowed to exercise itself to its utmost capacity, proved to do what it has done unfailingly and cyclically throughout the economic history of the United States, it fell into crisis.  While this occurrence has effectively ended the investment banking system as we have known it[8], it has only further proven that government regulation of banking institutions, credit ratings agencies, and investors is indispensible.  The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 directly addresses the vulnerabilities of the financial services industry and strengthens regulatory authority, specifically in the areas that exacerbated the near collapse of the financial system.[9] Thought the efficacy of this law has yet to be seen, this author believes that is only through concise and enforceable legislation that an industry can be regulated in order to protect the consumer and ensure quality and accountability in corporate operations.  This most recent disruption of the financial system simply reinforces the well documented guiding principle of corporations that are left to their own devices; that profitability is the primary concern, even at the expense of responsible and ethical corporate citizenship.

[1] Financial Crisis Inquiry Commission, Testimony of Raymond W. McDaniel, Chairman and CEO of Moody’s Corporation, June 2,2010, 1-2
[2] United States Senate Permanent Subcommittee on Investigations, Committee on Homeland Security and Governmental Affairs, Exhibits, Hearing on Wall Street and the Financial Crisis: The Role of Credit Rating Agencies,  April 23, 2010, Exhibit #1d
[3] Ibid, Exhibit #1b
[4] Financial Crisis Inquiry Commission, Testimony of Raymond W. McDaniel, 7
[5] Martin Mayer, “Credit Ratings Agencies in the Crosshairs” The Brookings Institution, August 2010,

[6] United States Senate Permanent Subcommittee on Investigations, Committee on Homeland Security and Governmental Affairs, Exhibits, Hearing on Wall Street and the Financial Crisis: The Role of Credit Rating Agencies, 10-11
[7] Financial Crisis Inquiry Commission, Shadow Banking and the Financial Crisis, May 4, 2010, 7
[8] Ibid, 40
[9] Dodd-Frank Wall Street Reform and Consumer Protection Act, 2010, Public Law 111-203, 111th Congress, 2nd Session, January 5, 2010


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