Case Study:
Moody’s Credit Ratings & the Subprime Mortgage Meltdown
Prepared by:TEN LI WEI CGA150007TAN WAN TENG CGA150015ANANTHAN VIJAYAKUMAR CGA150029WONG GHAI YAN CGA150056
CSGB6102: Business Ethics & Corporate GovernanceSem2 2015/2016
Tuesday 6.30 – 9.30pm (Group 1)
Who is Moody’s?
Case Background
Discussion
Conclusion
CONTENTS
WHO IS MOODY’S?
Moody’s CorporationFounded on 1909 by John Moody
Moody's Investors Service (MIS)
Credit ratingsRate debt/ securities based
on the debtor's repay ability
Research Debt
Instruments & securities
Moody's Analytics
Software & Analytic Tools
for credit and economic analysis, financial risk
management.
Who is Moody’s?
Moody’s Core Business
Moody’s Business – Government Relation
New rules: SEC decided to use the ratings on those bonds as the indicators of risk.
Nationally-recognized statistical ratings organizations (NRSRO)
Paid no fees for the research and analysis by publication of credit ratings.
Subscribed publications & Advisory from
$$$
Before 1975,
In 1975,
Securities & Exchange
Commission (SEC)
Investors
Require all bond issuer/bank to use NRSRO’s rating for certain regulatory purposes
Impacts on Credit Rating Agencies- Relationship with banks: Bank pay for rating, “shopping” for best rating- Higher pressure, Market Competition
FEATURES OF RESIDENTIAL MORTGAGE-BACKED SECURITY (RMBS)HOW IT WORKS?
WHY IT GAINS POPULAR?DEVELOPMENT OF SUBPRIME MORTGAGE
THE MARKET COLLAPSEHOW MOODY’S REACTED?
THE VICTIMS
CASE BACKGROUND
Features of RMBS
A type of mortgage-backed debt obligation whose cash flows come from residential debt.
Comprised of a pool of mortgage loans created by banks and can be purchased by investors.
RMBSpopular in early 2000s
Residential Mortgage-backed Security (RMBS) - a tradable financial asset. One of the famous structured finance rated by Moody’s
Home Loan
Home Loan
Home Loan
Tranches from
Low risk to
High risk
Very complexLack of transparency
Hard for investor to judge its risk=
Monthly Repayment Direction
RMBS: How it works?Investment / Loan Direction
From Rating Agencies
https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_79004
Individual Borrowers
Mortgage loan to buy house
Lenders
Bundle loans and sell to Investment bank
Global Investors
Make decision based on agency’s ratings on creditworthiness
Investment Bank
Funded loans with securities by risk levelEngage rating agencies (Moody’s)
Popularity Forces
early 2000s
Global investor Dot-com stock
bubble bursting
Increase of Investors demand
- higher rate of return & safe
Robust economic growth in US, increase inflow of global capital
Banks increased risk. Higher debt to equity ratios
Optimistic "AAA“ credit ratings on asset backed
securities
Speculation in real estate.
Mortgage brokers Incentive structures
RMBS: Why it gains popular?
Global demand of
RMSB increase
Stress lender to produce more loans
Policy encouraged minorities to own a
home
Weaken standard to
qualify borrowers by
adjustable rate loans
Subprime mortgage
a loan offered to borrowers with poor credit records
RMBS: Development of Subprime Mortgage
No income, no job, no assets
Low repayment capability
Didn’t understand loan’s terms
Believed able to sell/ refinance in future - worth more
What is main cause of Subprime Mortgage? poor government housing policy:
• Designed to expand home ownership• Help 1st time buyer with down payment & etc• Reduction in mortgage underwriting standard• Lead to poor housing finance system
Consistent with
RMBS: The Market Collapse
• In 2006, interest rate rise, housing prices drop - housing bubble.
• 80% of subprime mortgages were adjustable-rate mortgages - reset at higher interest rates - causing higher monthly payments.
• Difficult for weak borrowers to make repayment or to refinance their loans as housing declining value.
• “Jingle mail” incident – dropped the key in mail & walk away.
• Leading to mortgage *delinquencies and foreclosures.
• Leading to the devaluation of housing-related securities.
By early 2008, 27% borrowers no longer paying loans.
Subprime mortgage crisis coincided with the US recession of December 2007 – June 2009.
*Delinquent is the failure to accomplish what is required by law or duty, such as the failure to make a required payment.
How Moody’s reacted?
Adjusted their ratings for existing RMBS only shortly before market collapse.
Validated RMSB Underestimated risks Failed to figure out the loss ahead of the fact Led people into dangerous risk
Blame on Moody’s
In July 2007, Moody’s stopped rating new RMBS and began
“Express Train Downgrades”
Subprime mortgage crisis: The victims
Homeowners • Their homes lost value• Couldn’t sell or refinance their property due to high interest rate
Investors who hold RMBS directly• They relied on the quality of Moody’s ratings, received the information with
full belief that the ratings attributed to them were analytically sound and unbiased.
• Discovered that their investments were far less value than before.
Investors who didn’t hold RMBS directly • Stock and bond markets fell broadly in response to the financial crisis
After RMBS collapsed in value…
SHOULD MOODY’S BE BLAMED?WHO SHOULD BE RESPONSIBLE FOR THIS CRISIS?
WHY NOBODY TAKES IT SERIOUSLY BEFORE? WHAT CAUSED MOODY’S INACCURATE RATING?
INTRODUCTION OF DODD-FRANK
DISCUSSION
Should Moody’s be blamed?A CRA’s roles:
Provide rating based on the creditworthiness of debt securities Assess the credit risk of the securities Provides investors with unbiased review and opinion
Legally, didn’t commit a crime• Not to serve as the “gate-keeper” of
the securities market • Ratings are just their opinions, not an
recommendation on the stability of a particular financial products
Unethical - took advantages on profitable process• Inaccurate rating - Make the
investment packages look more attractive to investors
• Underestimate credit risk, Misleading information
Who should be responsible for this crisis?
Home Buyers
Lenders Investment bankers
Government Moody’s Investors
- All were irresponsible in their own duties- Each was pursuing its own self-interest in this ineffectively regulated system - Each party searched for benefit and passing the risks along to others
Who has the greatest responsibility? Moody’s/ NRSRO – Key Enabler, RMBS could not be sold without their ratings
Government regulators/policymakers – poor housing policy: reduction in mortgage underwriting standard, underestimate important role played by banks and NRSRO
Why nobody takes it seriously before?They are shortsighted, greedy and self-centered.
Homebuyers Supposedly they did
not qualified for a mortgage
Lenders Received sales
commissions for selling high rating of loans
Investors RMSBs typically paid
high interest rates than other investments
Moody’s Employees Top executives (CEO,
Chairman) and Managers earned good compensation
Investment Banks Earned high fees from selling,
packaging and marketing high rating of structured finance
Moody’s Shareholders In 5 years, Moody’s had
highest profit margin of any company (Microsoft, Exxon)
Enjoy total return which is rose 354%
What caused Moody’s inaccurate rating?
Primary interestThe principal goals of the profession, such as the professional duties of rating
Secondary interest Not only financial gain but also such motives as the desire to increase market
share and the wish to do favors for clients
“A conflict of interest is a set of circumstances that creates a risk that professional judgement/actions regarding a primary interest will be
disproportionately influenced by a secondary interest”Bernard Lo and Marilyn J. Field, Committee on Conflict of Interest in Medical Research, Education, and Practice; Institute of Medicine
How was conflicts of interest existed?
Investment bankers
Moody’s Investors
Pay $$$
The products were grouped and complicated, I didn’t know how to judge the safety / security of products
Need professional opinion on risk of products
Need “nice” ratings and tell investors how worthful to invest my products
Increase market share, keep my business, more revenue
professionally
unprofessionally
X choose Moody’s
Choose Moody’s
• Give clients the ratings they want, prevent clients take the business to other ratings agencies.
• Higher rating of debt = higher earning to bankers → increase Moody’s revenue
Might X invest
Might Invest
Introduction of Dodd-Frank
Main causes of Financial Crisis (2008)
• Government housing policies forced a reduction in mortgage underwriting standards
• Conflict of Interest in CRAs
To promote the US financial stability by improving accountability and transparency in the financial system
To protect consumers from abusive financial services practices
Categorized into 16 titles Requires that regulators create 243 rules, conduct 67
studies, and issue 22 periodic reports Signed into federal law by President Barack Obama on
July 21, 2010
Dodd-Frank Act
Aims:
Did it solved the problems?
The Failure of Dodd-Frank Act
Dodd-Frank does nothing about government housing polices to fix a broken housing-finance system. The law comes out with unnecessary regulations on financial firms and unrelated matters to the crisis.
The regulations is very complex to be defined: Favor large banks that can afford lawyers to analyse themIt tighten the regulation on banks/bond issuers of complex securities Created a set of rules that hurt businesses like smaller banks and CRAs
Why?
Necessary to recognize the root causes: how, why it happened in order to prevent issues reoccur
CONCLUSION
Conclusion
• Effective regulation to solve the root causes
• Enforcement efforts to improve accuracy and transparency of provided to investors
• Relationship with bond issuers• Government and agencies should realize
the costs beforehand
• Each involved party shared part of the blame for financial crisis
• Began with inappropriate government regulation and bad monetary policies
New economics regulation is needed to
correct the market failure
Conflicts of Interest by credit rating
agencies
Market failure of RMSBs couldn’t be blamed on Moody’s
only
References1. https://prezi.com/zhmg9n9fphrr/moodys-credit-ratings-and-the-subprime-mortgage-meltdown/2. http://thecrisisofconscience.blogspot.my/2012/02/case-study-of-moodys-corp-and-subprime.html3. http://www.slideshare.net/echijc/case-study-moodys4. https://groundupct.wordpress.com/2011/08/08/case-study-shows-moodys-credit-rating-agency-at-the-heart-of-the-financial-crisis-starting-in-2004/5. http://www.nytimes.com/2008/04/27/magazine/27Credit-t.html?_r=06. http://www.theguardian.com/business/2011/aug/22/ratings-agencies-conflict-of-interest7. http://www.investopedia.com/articles/bonds/09/history-credit-rating-agencies.asp#ixzz46zAhSa7G 8. http://mercatus.org/publication/brief-history-credit-rating-agencies-how-financial-regulation-entrenched-industrys-role9. http://www.statepress.com/article/2015/04/dodd-frank-why-the-bills-regulations-only-create-bigger-banks
Additional ReferencesU.S. Securities and Exchange Commission (SEC) actions
On 11 June 2008, the SEC proposed far-reaching rules designed to address perceived conflicts of interest between rating agencies and issuers of structured securities.
1. The proposal would, among other things, • Prohibit a credit rating agency from issuing a rating on a structured product
unless information on assets underlying the product was available, • Prohibit credit rating agencies from structuring the same products that they rate,
and require the public disclosure of the information a credit rating agency uses to determine a rating on a structured product, including information on the underlying assets.
2. The last proposed requirement is designed to facilitate "unsolicited" ratings of structured securities by rating agencies not compensated by issuers.
On 3 December 2008, the SEC approved measures to strengthen oversight of credit rating agencies, following a ten-month investigation that found "significant weaknesses in ratings practices," including conflicts of interest.
