In 2008, the world faced the worst financial crisis since the Great Depression of the 1930’s (also known as the Great Recession of 2008-2009). This great Recession was the result of the Subprime Mortgage Meltdown in the United States. Billions of dollars worth of securities backed by their mortgages had plummeted in value, which in result strained the balance sheets of Wall Street investment banks. The causes of the financial crisis were extremely complex and responsibility fell to many different parties but some analysts questioned the accuracy of the ratings and the critical role in widening financial crisis played by the “Big Three” rating agencies — Moody's Investors Service, Standard & Poor's (S&P), and Fitch Ratings. One of the main reasons the analysts bore blame on Moody’s was because over the previous years, Moody’s had rated thousands of bonds made up of home loans to people with low incomes and poor credit histories, who were buying houses they could not afford. They blamed Moody’s for having misjudged the risk inherent in these securities. The world’s financial markets relied heavily on Moody’s, and other credit rating agencies, in evaluating the safety of bonds-debt issued by governments, companies, investment banks and public agencies.
Moody’s was founded by John Moody in 1909 and it was composed of 2 business units. The first one is Moody’s Investor Service which provided credit ratings (which earned 93% of total revenue) and the second one is Moody’s KMV which sold software and analytic tools. Moody’s ratings, along with its competitor, enabled buyers to evaluate the risks of various fixed-income investments.
Legally, Moody’s committed no crime whatsoever. However, 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, they were also fully aware of the effect these bundled tranches were making on the lending process. 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 and are not definitive advice or recommendation on the stability or substantiality of a particular financial instrument. Moody’s primary goal was pleasing the investors, which they themselves were often personally involved with. There’s no doubt that some of the ratings may have been padded in order to make the investment packages look more appealing to potential investors. 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 major part.
The main stakeholders that benefited most from Moody's actions were the homebuyers that did not traditionally qualify for a mortgage. Investors also benefited from the poor credit ratings that Moody's assessed because millions of investors relied on them for an independent and objective assessment. Another stakeholder that benefited greatly was Wall Street because the lender packaged thousands of mortgage-backed loans and sold them to investment banks like Lehman Brothers and Merrill Lynch. Lastly, mortgage brokers benefited because they received commissions for selling the riskiest loans that carried high fees. The investors who placed 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. However, these investors 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. The main stakeholders that were hurt by Moody's actions were the good paying homeowners whose homes lost value and therefore couldn't sell or refinance because of all the defaults from subprime homeowners. All in all, everyone eventually ended up being hurt by Moody’s actions and that is why a lot of the blame was placed on Moody’s during the recession of 2008.
McDaniel stated when he was under oath speaking to the House of Representatives on Oversight and Government Reform that there was no conflict of interest and that conflict of interest will arise whether ratings agencies utilize an issuer or investor-pays system. Moody’s 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. The original conflict of interest was that Moody’s was paid by the firms that were organizing and selling the debt to investors. For example, For every $10,000 the security was worth, Moody’s would get about $11. This conflict could have been eliminated by enforcing rating standards and having better transparency with investors. The best way to prevent or reduce conflict of interest is for the SEC to change the relationship between the bond issuers and the rating agencies. I believe 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.
Everyone played a crucial role in the financial crisis of 2008, including Moody’s. First and foremost we have the home-buyers who were told to lie in order to qualify for the loan and since no one would verify their information, it would actually work in their favor. Next, the mortgage companies made loans to people and then bundled them together to sell to investment banks so that the mortgage lender had cash in order to create more loans. Then, the investment banks would 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 wanted to make everyone a homeowner, regardless of credit, income, or down payment in order to “help” the U.S seem like they were the land of homeowners. 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. Even though they legally did nothing wrong, they still committed a huge injustice by not providing their customers with accurate information.
First and foremost, in order to prevent the reoccurrence of something like the subprime mortgage meltdown the government needs to have more regulation. I say regulation as in they need to be part of the process, from the mortgage all the way to the investors. Something else that needs to happen is that the structure of the credit rating industry needs to be evaluated properly and a public policy needs to be made as to how each step should be carried out (so basically a big list of Do’s and Don’t Do’s). These policies will ensure that a person can qualify for a loan and that they have the right amount of credit, down payment and income to properly pay for the loan and this will prevent default. Ultimately, the change would have to start with the government and having more regulation especially more regulation when it comes to rating companies such as Moody’s, Standard & Poor's (S&P), and Fitch Ratings.
Below are some of the steps that should be taken to prevent another subprime meltdown:
Lenders should practice stricter underwriting procedures ensuring that the people they give loans to are actually credit worthy.
Public policy should not push lenders to be so “relaxed” on standards and should enforce some degree of responsibility on the lenders themselves.
Government regulations should require rating agencies to be more transparent to investors and hold banks responsible for subprime lending.
Credit rating agencies should have internal monitoring programs to ensure proper ratings and allow outside sources to periodically review the process of how they rate certain securities.