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Case Study: Moody’s Credit Rating and the Subprime Mortgage Meltdown

Introduction

Credit rating is the process of evaluating and rating debt instruments based on ability to pay back this debt to the lender. Credit rating agencies, including Moody’s, played a huge role in the subprime mortgage crisis that led to the economic recession of 2008. Following this financial crisis, securities lost much of their value leading to the collapse of leading investment banks such as Bear Stearns, Merrill Lynch, and Lehman Brothers. The crisis resulted from complex and interconnected factors such as bad debt management, loans, and structured finance (Brownell 56). The aim of this essay is to provide answers to the five questions posed in the case study “Moody’s Credit Rating and the Subprime Mortgage Meltdown.”

Question 1

Legally, Moody’s operations were within the law. At the beginning of the twenty first century, structured finance products were very popular. They involved combining income-generating assets, mortgage loans, auto loans, and credit card debt into pools before selling them to investors. One example of these products, the Residential Mortgage Backed Security (RMBS), made home loans easily accessible before pooling them and selling them to investment banks. The banks would then create a bond for sale to buyers and receive income from monthly payments made on the home loans. Credit rating agencies such as Moody’s would then rate these mortgage-backed securities. As the U.S. financial markets continued to develop, the Securities Exchange Commission named Moody’s, together with two other companies, as the country’s core rating agencies. These ratings became very important to investors, most of whom depended solely on them when making investment decisions. Before the financial crisis, demand for asset-backed securities was higher than the banks were able to cater for. In combination with the government’s efforts to make home ownership affordable, home loans became very easy to access. In the end, it became obvious that most Americans who had taken these loans would be unable to pay for them. This default in loan repayment marked the beginning of the real-estate bubble burst and the financial crisis. Undeniably, Moody’s conducted its operations within the law and the prevailing market trends. However, the company went wrong by failing to regulate mortgage lenders effectively. Those who traded in securities relied heavily on the company’s ratings to make investment decisions. Unfortunately, most of the recommendations it provided did not reflect the truth regarding prevailing market conditions. This inaccurate information has greatly contributed to the onset of the financial crisis.

Question 2

Firstly, security issuers benefited through huge contributions made by investors. Secondly, Moody’s was also a major beneficiary because it charged fees for providing information on credit ratings. Americans trusted the company since it had been sanctioned by the government as one of the approved rating agencies. The biggest victims of the crisis were investors who relied heavily on Moody’s credit ratings. Lack of further research and consultation before investment led to poor investment decisions and huge losses most of which were felt during the actual crisis.By the time they realized that their securities had been overvalued, the financial crisis was well underway. When the real estate bubble burst, those who had invested heavily in the real estate market also suffered huge losses. Moreover, citizens lost homes because they were no longer able to make monthly repayments on their mortgages. Lastly, the subsequent rise in unemployment rate had a far-reaching impact on American citizens.

Question 3

During a Congressional hearing, Moody’s CEO, Raymond McDaniel Jr., explained that the credit rating process and the securities industry were in a conflict of interest before the financial crisis (Lawrence 480). According to him, it did not matter whether the issue was assessed using issuer- or investor-oriented system. Both credit issuers and investors applied various strategies and procedures to influence the immediate rating provided by companies such as Moody’s (Brownell 80). Issuers branded and modified their securities into structured ones to make them more attractive and profitable to investors. Similarly, investors sought to improve their portfolios and investments by seeking good ratings for the securities they had acquired. The lack of government regulation in this rating process encouraged falsification, inaccuracy, and under/over-valuing of securities by one party with the aim of making profits at the expense of the other. This conflict can only be completely eliminated through strict regulation of daily credit rating processes. Moreover, external precautions have to be taken to ensure that accurate ratings that promote continuity in the financial markets are provided.

Question 4

Neither Moody’s nor the other two government-appointed rating agencies were single handedly responsible for causing the sub-prime meltdown. Nevertheless, they contributed to the onset of the crisis. Their ratings acted as the main link between investors and issuers. Moody’s and its executives had the power to shape expectations on structured and fixed securities. The idea of structured security ended up putting home owners, mortgage providers, and bankers on one end and investors on the other. Moody’s could have brought the two groups together and streamlined the process through a transparent credit rating system. Since the company failed to perform this task, one can state that it played a significant role in the onset of the financial crisis. Other stakeholders such as the government and policymakers were responsible for the worsening of the crisis since they did not take any action to slow down its negative effects on the economy despite receiving warning signs from financial advisors and consultants.

Question 5

The concept of a shadow banking system has been widely understood and explained following this crisis. This refers to complex financial bureaucracies that are legal, but are able to avoid transparency scrutiny that financial organizations perform. Before the crisis, this unmonitored and unregulated system flourished within the sub-prime mortgage sector whose target market was low-income earners with bad credit history. The crisis revealed that failure to regulate these bureaucracies can easily lead to the collapse of the American financial system. The best way to achieve sustained financial recovery while maintaining adherence to the law and ethics is by ensuring that this banking system is fully regulated. Moreover, financial institutions need to establish synergies with public policy stakeholders, credit rating stakeholders, and government regulators in the management of the entire financial system in order to boost its stability(Brownell 124). Fortunately, the Consumer Protection Act of 2010 has greatly enhanced the regulatory framework governing the country’s financial systems.

Conclusion

The subprime meltdown is a clear indication of the need to promote the transparency of credit rating agencies such as Moody’s. It is also evident that efforts to boost home ownership through subprime mortgages only provide a temporary fix to the country’s housing problem. It attempted to provide mortgages to those with limited resources and poor credit ratings only for them to end up accruing huge debts and loan defaults that had ripple effects on investment and subsequently the US economy. Today, credit agencies continue to influence investment, but they are now more regulated in an attempt to prevent another financial crisis while at the same time providing a platform for recovery from the 2008 meltdown.

Works Cited

Brownell, Charles.Subprime Meltdown: From US Liquidity Crisis to Global Recession.Washington, DC: CreateSpace Independent, 2008.Print.

Lawrence, Anne. Moody’s Credit Rating and the Subprime Mortgage Meltdown. New York: North American Case Research Association, 2009. Print.

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