Case 1: Moodys Credit Ratings and the Subprime Mortgage Meltdown

TEACHING NOTE FOR: MOODYS CREDIT RATINGS AND THE SUBPRIME MORTGAGE MELTDOWN This case illustrates the following themes and concepts discussed in the chapters listed: Theme/Concep Stakeholder analysis Ethics and ethical reasoning !rgani"ational ethics and the law $ublic policy &o'ernment regulation of business Shareholder rights E(ecuti'e compensation C!#e S$nop#%#: )n the mid*+,,,s- Moodys- the leading credit rating agency in the world- e'aluated thousands of bonds backed by .subprime/ residential mortgages0home loans made to people with low incomes and poor credit1 2hen housing prices began to decline in +,,3- the 'alue of many of these bonds collapsed- and Moodys was forced to downgrade them steeply1 )n late +,,%se'eral in'estment banks- commercial banks- and mortgage lenders that had been hea'ily in'ol'ed in the subprime market failed1 )n the wake of these failures- credit fro"e up- consumer confident plunged- and 4ob losses deepened across the global economy1 5lthough the financial crisis had many causes- some analysts belie'ed that Moodys and other credit rating agencies had played a key role by underestimating the risks inherent in mortgage*backed securities1 The case draws on publicly a'ailable data- including internal documents released by Moodys in connection with a Congressional hearing in !ctober +,,%- to e(plore the multiple causes of the financial crisis and Moodys role in it1 )t challenges students to consider how businessesgo'ernments- and society can better assure the integrity of the credit rating industry1 Ch!p e" 1 # % % 1 1

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Case 1: Moodys Credit Ratings and the Subprime Mortgage Meltdown

TEACHING TIP: &IDEOS AND PODCASTS Se'eral 'ideos and podcasts are a'ailable that may be used with this case1 They include the following: !n 5ugust 6,- +,,7- the 8ews9our with :im ;ehrer <the $=S news program> ran a report by economics correspondent $aul Solman- entitled .Risky Subprime Market Sends Ripples through ?inancial 2orld1/ )n the segment- Solman inter'iews an economics professor- who e(plains subprime mortgages and securities backed by them1 The segment is a'ailable as streaming 'ideo from $=S at: http:@@www1pbs1org@newshour@bb@business@4uly*dec,7@subprimeA,%*6,1html !n March +1- +,,%- the 8ews9our with :im ;ehrer ran another report by Solman- entitled .E(amining the Roots of B1S1 Economic 2oes1/ Solman uses some cle'er dime*store props and inter'iews with se'eral e(perts to e(plain how C+,, billion or so in bad housing debt precipitated a worldwide financial crisis1 The segment is a'ailable as streaming 'ideo from $=S at: http:@@www1pbs1org@newshour@bb@business@4an*4une,%@dominoA,6*+11html The instructor may wish to show some or all of these two $=S segments in class1 !n December 1 - +,,%- C=Ss Si(ty Minutes ran a story titled .5 Second Mortgage Disaster on the 9ori"onE/ The segment predicted a second wa'e of mortgage defaults <and collapse of bonds backed by them> o'er the following few years- as so*called 5lt*5 and payment*option 5RM loans reset1 This segment may be useful as an epilogue to the case1 The transcript and streaming 'ideo are a'ailable at: http:@@www1cbsnews1com@stories@+,,%@1+@1+@3,minutes@main 33311+1shtml )n 5pril +,,%- $ublic Radio )nternationals radio show .This 5merican ;ife/ aired an episode entitled .The &iant $ool of Money1/ This show later won a Du$ont*Columbia award for 4ournalistic e(cellence1 )n making the award- the 4udges wrote: .Through terrific storytelling and economic insight- the reporters demystify the subprime mortgage meltdown using personal stories to e(plain such terms as deri'ati'es- tranches- short selling and credit swaps1/ The episode is Fuoted in the case1 The instructor may wish to reFuire that students listen to the complete podcast before class <it runs appro(imately one hour>1 )t is a'ailable at: http:@@www1thislife1org@radioAepisode1asp(EepisodeG6##1 ?or students who wish to read rather than listen- a transcript is a'ailable at: www1thislife1org@e(tras@radio@6##Atranscript1pdf1

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Case 1: Moodys Credit Ratings and the Subprime Mortgage Meltdown

D%#c'##%on ('e# %on#: )* Wh! +%+ Moo+$# +o ,"on-. %/ !n$ h%n-0

1* Wh%ch # !2eho3+e"# ,e"e he3pe+. !n+ ,h%ch ,e"e h'" . 4$ Moo+$# !c %on#0

5* D%+ Moo+$# h!6e ! con/3%c o/ %n e"e# 0 I/ #o. ,h! ,!# he con/3%c . !n+ ,ho o" ,h! ,e"e he p"%nc%p!3 !n+ he !-en 0 Wh! # ep# co'3+ 4e !2en o e3%m%n! e o" "e+'ce h%# con/3%c 0 7* Wh! #h!"e o/ he "e#pon#%4%3% $ +%+ Moo+$# !n+ % # e8ec' %6e# 4e!" /o" he /%n!nc%!3 c"%#%#. comp!"e+ ,% h h! o/ home 4'$e"#. mo" -!-e 3en+e"#. %n6e# men 4!n2e"#. -o6e"nmen "e-'3! o"#. po3%c$m!2e"#. !n+ %n6e# o"#0 9* Wh! # ep# c!n 4e !2en o p"e6en ! "ec'""ence o/ #ome h%n- 3%2e he #'4p"%me mo" -!-e me3 +o,n0 In $o'" !n#,e". p3e!#e !++"e## he "o3e o/ m!n!-emen po3%c%e# !n+ p"!c %ce#. -o6e"nmen "e-'3! %on. p'43%c po3%c$. !n+ he # "'c '"e o/ he c"e+% "! %n-# %n+'# "$* D%#c'##%on ('e# %on# !n+ An#,e"#: )* Wh! +%+ Moo+$# +o ,"on-. %/ !n$ h%n-0 Moodys mis4udged the risk inherent in thousands of comple( asset*backed securitiesparticularly residential mortgage*backed securities that it rated during the mid*+,,,s1 )t stopped rating RM=Ss in mid*+,,7- and o'er the following year downgraded more than #-,,, of themincluding H, percent of those first rated in +,,3 and +,,71 The downgrades represented an acknowledgment by Moodys that its original ratings were inaccurate1 5rguably- Moodys failed to consider the risk inherent in the loans underlying these comple( asset*based securities- putting in'estors and- indeed- the entire financial system at risk1 )n its own defense- Moodys would likely point out that ratings are simply an opinion of the statistical probability of default1 )t would no doubt argue that when the ratings were first issued- they were based on the best information and statistical models a'ailable and therefore pro'ided an accurate probability estimate at that time1 1* Wh%ch # !2eho3+e"# ,e"e he3pe+. !n+ ,h%ch ,e"e h'" . 4$ Moo+$# !c %on#0 Stakeholders are those people and groups that affect- or are affected by- an organi"ations decisions- policies- and operations1 Many stakeholders- both market and nonmarket- were affected by Moodys inaccurate ratings1 )nitially- many stakeholders benefited from Moodys high ratings of RM=Ss1

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Case 1: Moodys Credit Ratings and the Subprime Mortgage Meltdown

Moodys shareholders benefited greatly from the companys stellar financial results during the early +,,,sI as shown in E(hibit =- share 'alue rose 6# percent o'er a #*year period- well abo'e the SJ$ #,, composite inde( and its comparison group1 )nstitutions- go'ernments- and indi'iduals who in'ested in RM=Ss benefited- since these securities typically paid interest rates abo'e those paid by other in'estments with comparable in'estment grade ratings during +,, *+,,71 Mortgage originators and in'estment banking firms earned high fees from sellingpackaging- and marketing mortgage loans during the housing bubble of +,,6*+30 transactions that were enabled and facilitated by in'estment*grade ratings on mortgage* backed securities1 9owe'er- in'estors were later badly hurt when mortgage*backed securities dropped precipitously in 'alue- sometimes becoming entirely worthless1 E'en in'estors who did not hold RM=Ss directly were hurt- as the stock and bond markets fell broadly in response to the financial crisis1 The case reports that in +,,%- in'estors lost around C7 trillion in the market 'alue of their assets1

9owe'er- all of these groups- and others- suffered tremendous losses when these RM=Ss later collapsed in 'alue1 )n'estment banks- mortgage companies- and commercial banks collapsed1 Moodys own stock fell in 'alue1 Stock and bond in'estors lost trillions of dollars in assets1 5nd- ta(payers were forced to assume much of the enormous cost of bailing out many of the in'estment banks and commercial banks that failed and homeowners that lost their homes1 TEACHING TIP: :A; STUDENT / :C; STUDENT E(cellent students will recogni"e that many of the parties that benefited in the short run from Moodys ratings0including home buyers- mortgage originators- in'estment banks- and in'estors0took huge losses later when securities backed by bad loans collapsed and were downgraded1

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Case 1: Moodys Credit Ratings and the Subprime Mortgage Meltdown

5* D%+ Moo+$# h!6e ! con/3%c o/ %n e"e# 0 I/ #o. ,h! ,!# he con/3%c . !n+ ,ho o" ,h! ,!# he p"%nc%p!3 !n+ he !-en 0 Wh! # ep# co'3+ 4e !2en o e3%m%n! e o" "e+'ce h%# con/3%c 0 THEORETICAL LIN<: CONFLICT OF INTEREST The term conflict of interest has been defined by the Encyclopedic Dictionary of =usiness Ethics as follows: K5L conflict of interest occurs if and only if a person $ is in a relationship with one or more others reFuiring $ to e(ercise 4udgment in their behalf- and $ has a <special> interest tending to interfere with the proper e(ercise of 4udgment in that relationship1) 5nother definition has been offered by :ohn =oatright: K5L conflict of interest is a conflict that occurs when a personal interest interferes with a persons acting so as to promote the interest of another- when the person has an obligation to act in that other persons interest11 )n ethics theory- the person or organi"ation e(ercising 4udgment is normally referred to as the agent- and the person or organi"ation on whose behalf 4udgment is e(ercised is referred to as the principal1 Conflicts of interest are normally considered unethical for se'eral reasons1 $ersons and organi"ations that ha'e contracted with an agent for a ser'ice that reFuires an e(ercise of 4udgment ha'e a reasonable e(pectation that the agent will act in the principals interestnot the agents1 ?ailure to disclose a conflict of interest represents deception and may result in in4ury to the principal1 Many ethicists belie'e that e'en the appearance of a conflict of interest should be a'oided- because it undermines trust in the relationship1 Did Moodys ha'e a conflict of interestE Mes1 5s the case e(plains- Moodys was paid by the same institutions that issued the bonds it rated1 )f so- what is the conflict- and who or what is the principal and the agentE Moodys core business was rating the safety and security of bonds issued by companiesgo'ernments- and public agencies- as well as of securities comprised of pools of debt1 The B1S1
1

Michael Da'is- .Conflict of )nterest-/ pp1 161*166 in $atricia 91 2erhane and R1 Edward ?reeman- eds1Encyclopedic Dictionary of Business Ethics <!(ford- BN: =lackwell- 1HH7>1 2 :ohn R1 =oatright- Ethics and the Conduct of Business, 4th ed. <Bpper Saddle Ri'er- 8:: $rentice 9all- +,,6>- p1 1 ,1 Case 1*#

Case 1: Moodys Credit Ratings and the Subprime Mortgage Meltdown

go'ernment had granted Moodys a Fuasi*regulatory role in the bond market1 )n'estors relied on credit ratings to assess the relati'e risk of 'arious fi(ed*income securities1 )n this instanceMoodys was the agent that e(ercised professional 4udgment on behalf of in'estors- the principals1 Met- since the 1H7,s- Moodys had charged issuers to rate their bonds1 )n order to bring in business and build market share- Moodys and other rating agencies had an interest in ser'ing the issuers1 5rguably- Moodys main goal was to satisfy the bond issuer0who naturally would seek the highest possible rating1 This could well conflict with the interest of the in'estorwho naturally would seek an accurate rating1 2hat steps could be taken to eliminate or reduce this conflictE Moodys could take a number of steps to eliminate or reduce this conflict1 The company could eliminate the conflict by drawing re'enue from a source other than fees charged to issuers1 This would reFuire a complete change in its business model1 $ossible options might include: Charge pensions- mutual funds- and other institutional in'estors to subscribe to a rating ser'ice to help them e'aluate the safety of fi(ed*income securities1 <)n effect- this would mean a return to the business model Moodys had used prior to the 1H7,s1> ReFuire the go'ernment to fund the bond*ratings ser'ices pro'ided by the credit*rating agencies- as an e(tension of its regulatory obligation to protect the interests of in'estors in publicly*regulated markets1 $ay rating agencies according to a standard formula from a fund that is paid into by institutions each time they issue a bond- thus separating the fee paid from any specific bond or transaction1 TEACHING TIP: COUNTER ARGUMENTS 5fter each of these options is proposed- ask students to critiFue them1 ?or e(ample- in the caseMoodys CE! Raymond McDaniel makes se'eral arguments against the in'estor*pays business model- suggesting that it carries its own conflicts of interest1 5s an alternati'e- the company could attempt to manage the conflict1 5s e(plained in the casesteps the company had already taken included: Rate bonds by a committee- not by an indi'idual1 =ar analysts from owning stock in institutions whose bonds they rated1 Separate compensation from re'enue based on analysts own ratings1

Students may suggest other methods of managing the conflict- such as: Compartmentali"e conflicting roles within the agency- e1g1- separate the marketing and business de'elopment function from the ratings function1

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Case 1: Moodys Credit Ratings and the Subprime Mortgage Meltdown

=ar the pro'ision of research or other ser'ices to institutions whose bonds the agency rates1 =ase compensation of analysts <and the e(ecuti'es who manage them> on the long*term accuracy of the ratings <or- penali"e originators of ratings that later pro'e inaccurate>1 TEACHING TIP: :A; STUDENT / :C; STUDENT

E(cellent students will recogni"e that the procedures Moodys has adopted to manage conflicts of interest address possible indi'idual conflicts <e1g1- an indi'idual analyst owns stock in a company whose bonds he rates>- as opposed to organi"ational conflicts <e1g1- Moodys is paid by the institutions whose bonds it rates>1 7* Wh! #h!"e o/ he "e#pon#%4%3% $ +oe# Moo+$# !n+ % # e8ec' %6e# 4e!" /o" he /%n!nc%!3 c"%#%#. comp!"e+ ,% h h! o/ home 4'$e"#. mo" -!-e 3en+e"#. %n6e# men 4!n2e"#. -o6e"nmen "e-'3! o"#. po3%c$m!2e"#. !n+ %n6e# o"#0 !ne way to approach this Fuestion is to ask students to make the case for the responsibility of each of these parties for the financial crisis1 5ll of these parties acted irresponsibly- and thus shared part of the blame for the financial crisis1 9ome buyers: Many people irresponsibly purchased homes that they could not afford- based on la( lending standards- low initial monthly payments- and an inaccurate assumption that housing 'alues would continue to rise indefinitely1 )n many cases- it was in their short*term interest to do so- because these purchases enabled them to impro'e the Fuality of their housing1 Mortgage lenders: Many lenders made loans to borrowers of dubious creditworthinessgenerating large fees1 So long as they were able to Fuickly package and sell these loans- they did so with little or no risk1 )n'estment bankers: ;arge 2all Street in'estment banks repackaged risky home loans into comple( asset*backed securities and sold them to in'estors- generating large underwriting fees1 So long as they were able to mo'e them Fuickly off their books- they did so with little risk1 &o'ernment regulators: Regulators contributed to the financial crisis by failing to rein in risky lending and monitor the market in asset*backed securities- and by pre*empting state regulatory efforts to curb predatory lending1 &o'ernment policymakers contributed by promoting low interest rates and other policies to encourage home ownership for low*income indi'iduals1 Moodys and its e(ecuti'es <and- by e(tension- other leading credit rating agencies> contributed by pro'iding in'estment*grade credit ratings to many mortgage*backed securities- enabling them to be widely marketed to in'estors1 )n'estors: )n'estors- particularly institutional in'estors- purchased risky assets in search of higher returns1
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Case 1: Moodys Credit Ratings and the Subprime Mortgage Meltdown

)n short- all parties bore a share of the responsibilityI each was pursuing its own self interest in an inadeFuately regulated system1 Each party sought to benefit- while passing the risks along to others1

TEACHING TIP: WHO BORE THE GREATEST RESPONSIBILITY0 Students may be asked to debate which party was most responsible1 Some will argue that the credit rating agencies bore the greatest responsibility- because the RM=Ss could not ha'e been sold without in'estment*grade ratings1 !ther will argue that the home buyer was ultimately responsible- because without bad loans the subprime market would not ha'e collapsed1 THEORETICAL LIN<: MORAL HA=ARD !ne concept that the instructor may find useful is .moral ha"ard1/ The term .moral ha"ard/ refers to the likelihood that someone who is protected from risk will beha'e differently from one who is e(posed to risk1 The term first arose in the insurance industry- where an insured person might be e(pected to take greater risks than an uninsured person1 ?or e(ample- someone with auto theft insurance might be less careful to always lock his or her car- or a person co'ered by flood insurance might be more likely to buy a house in a flood plain1 9olden ;ewis- writing for bankrate1com- offered a clear e(planation of the rele'ance of this concept to the subprime mortgage meltdown: .Oeach link in the mortgage chain collected profits while belie'ing it was p!##%n- on "%#2 to the ne(t link in the chain1 =rokers werenPt lending their own money- so they were pushing risks onto the lenders1 ;enders sold mortgages soon after underwriting them- pushing the risk onto in'estors1 )n'estment banks bought the mortgages and chopped up mortgage* backed securities into slices- with some slices being less risky and other slices being more risky1 )n'estors bought securities and hedged against the risk of default and prepaymentpushing those risks further along1 5ll of these businesses accepted profits and tried to lea'e the ne(t guy 'ulnerable to risk1 $articipants thought they were insulated from the negati'e conseFuences of bad decisions1/5 ;ewis did not mention credit rating agencies in his account- but arguably they also passed along risk- gi'ing subprime mortgage*backed securities in'estment grade ratings- with the assumption that they would not bear any costs of possible later downgrades1 )n short- e'ery actor in a comple( system acted recklessly- belie'ing that they were insulated from negati'e conseFuences of their actions1

9olden ;ewis- .Moral 9a"ard 9elps Shape Mortgage Mess-/ www1bankrate1com- 5pril 1%- +,,71 Case 1*%

Case 1: Moodys Credit Ratings and the Subprime Mortgage Meltdown

9* Wh! # ep# c!n 4e !2en o p"e6en ! "ec'""ence o/ #ome h%n- 3%2e he #'4p"%me mo" -!-e me3 +o,n0 In $o'" !n#,e". p3e!#e !++"e## he "o3e o/ m!n!-emen po3%c%e# !n+ p"!c %ce#. -o6e"nmen "e-'3! %on. p'43%c po3%c$. !n+ he # "'c '"e o/ he c"e+% "! %n-# %n+'# "$* Students may make a number of recommendations- including the following:

Change the business model of the credit rating industry so that re'enue flows not from issuer fees but from a go'ernment funds- a .blind/ trust- or in'estor subscriptions <see abo'e1> Change credit rating firm e(ecuti'e compensation and employee incenti'es so that managers and analysts are rewarded based on performance of their ratings- with a portion of compensation deferred and dependent on the long*term performance of ratings1 )mplement go'ernment regulations that set higher minimum underwriting standards for personal and commercial loans1 Enforce standards of personal responsibility and accountability by restricting the use of no down*payment and no*recourse loans1 )mplement go'ernment policies that reFuire mortgage lenders- in'estment banks- and commercial banks to assume a greater share of the risk of loans that they make or package and sell to others1 )n other words- prohibit the complete .hand off/ of risk1 $ermit greater competition in the credit rating industry by making it easier for new entrants to Fualify as 8RSR!s1 &i'e the SEC or other go'ernment agency greater resources and authority to regulate highly comple( asset*backed securities1
Temporarily withdraw the 8RSR! designation from credit rating agencies with poor results1

TEACHING TIP: OTHER PERSPECTI&ES The instructor may wish to ask students to in'estigate what others ha'e said on this issue1 Some sample ideas follow1 Robert Reich- former Secretary of ;abor in the Clinton administration- wrote in his blog on !ctober +6- +,,7: )ts ob'ious why credit*rating agencies didnPt blow the whistle Kon the risk inherent in RM=SsL1 <They didnPt blow the whistle on Enron or 2orldCom before those entities collapsed- either1> Mou see- credit*rating agencies are paid by the same institutions that package and sell the securities the agencies are rating1 )f an in'estment bank doesnt like the rating- it doesnt ha'e to pay for it1 5nd e'en if it likes the rating- it pays only after the security is sold1 &et itE )ts as if mo'ie studios hired film critics to re'iew their mo'ies- and paid them only if the re'iews were positi'e enough to get lots of people to see a mo'ieO The whole thing rested on a conflict of interest analogous to that of stock analysts whobefore the dotcom bubble burst- ad'ised clients to buy stocks their own in'estment banks were issuing1 The remedy for that was to split the two functions Q analysis from
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Case 1: Moodys Credit Ratings and the Subprime Mortgage Meltdown

in'estment banking1

The remedy here is to do much the same: bar issuers from paying credit*rating agencies for rating their securities1 )f in'estors want to e(amine securities ratings- they or the pension or mutual funds they in'est through can subscribe to the ser'ice Q 4ust as mo'ie* goers subscribe to publications where re'iews appear1 Representati'e :ackie Speier <Democrat*California>- a member of the 9ouse !'ersight and &o'ernment Reform Committee- published a newspaper op*ed after the hearing recommending changes in the rules go'erning the credit rating agencies1 She wrote: 9ere are four ideas: 1> $ay rating agencies from a fund that is paid into by bond sellers- similar to the method the ?ood and Drug 5dministration uses to fund drug research1 This armPs*length transaction would return the rating agencies to answering to in'estors1 +> $rohibit rating agencies from pro'iding consulting ser'ices to the institutions they rate1 6> Create a Consumer ?inancial $roducts Safety Commission1 ;ike the Consumer $roducts Safety Commission is empowered to stop dangerous toys and other products from being sold- a financial productions commission would ha'e the authority to pre'ent o'erly risky financial instruments from reaching market1 > $ro'ide better transparency of mortgage*backed securities by allowing easier access to information documenting their likelihood of default1# Ep%3o-'e: 5s of the time of writing- the financial crisis was ongoing- and Moodys role in it continued to be debated1 5s an assignment- students may be asked to research e'ents subseFuent to the hearings in !ctober- +,,%1 )n particular- they may be asked to in'estigate the status of: lawsuits brought by union pension funds that lost money in Moodys*rated securitiesI lawsuits brought by Moodys own shareholders who charged that Moodys had used inflated ratings to keep its own re'enues and share 'alue highI

http://robertreich.blogspot.com/200 /!0/they"mystery"of"#hy"credit"rating.html. :ackie Speier- .Credit Rating 5gencies 5re 8o ;onger ?irst Rate-/ $an %rancisco Chronicle, December 17+,,%1 Case 1*1,

Case 1: Moodys Credit Ratings and the Subprime Mortgage Meltdown

Moodys own internal re'iew of its ethics proceduresI the SECs proposed rules go'erning the big three credit rating agenciesI negotiations with 'arious state attorneys general o'er fees charged for re'iewing mortgage*backed securities1

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