Moody's Credit Ratings & the Subprime Mortgage Meltdown
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University of Malaya - Business Ethics & Corporate Governance
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Moody's Credit Ratings & the Subprime Mortgage Meltdown
- 1. Case Study: Moody’s Credit Ratings & the Subprime Mortgage Meltdown Prepared by: TEN LI WEI CGA150007 TAN WAN TENG CGA150015 ANANTHAN VIJAYAKUMAR CGA150029 WONG GHAI YAN CGA150056 CSGB6102: Business Ethics & Corporate Governance Sem2 2015/2016 Tuesday 6.30 – 9.30pm (Group 1)
- 2. Who is Moody’s? Case Background Discussion Conclusion CONTENTS
- 4. Moody’s Corporation Founded on 1909 by John Moody Moody's Investors Service (MIS) Credit ratings Rate 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
- 5. 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
- 6. FEATURES OF RESIDENTIAL MORTGAGE-BACKED SECURITY (RMBS) HOW IT WORKS? WHY IT GAINS POPULAR? DEVELOPMENT OF SUBPRIME MORTGAGE THE MARKET COLLAPSE HOW MOODY’S REACTED? THE VICTIMS
- 7. 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. RMBS popular 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 complex Lack of transparency Hard for investor to judge its risk =
- 8. RMBS: How it works? From Rating Agencies https://www.moodys.com/researchdocume ntcontentpage.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 level Engage rating agencies (Moody’s)
- 9. 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?
- 10. 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 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
- 11. 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.
- 12. 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”
- 13. 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…
- 14. 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
- 15. 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
- 16. 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 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
- 17. 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%
- 18. What caused Moody’s inaccurate rating? Primary interest The 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
- 19. 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
- 20. 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?
- 21. 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 them It 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
- 22. CONCLUSION
- 23. 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
- 24. References 1. 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.html 3. http://www.slideshare.net/echijc/case-study-moodys 4. 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=0 6. http://www.theguardian.com/business/2011/aug/22/ratings-agencies-conflict-of-interest 7. 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-role 9. http://www.statepress.com/article/2015/04/dodd-frank-why-the-bills-regulations-only-create- bigger-banks
- 25. Additional References U.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.
Notes de l'éditeur
- Moody's is an essential component of the global capital markets, providing credit ratings, research, tools and analysis that contribute to transparent and integrated financial markets. Moody's Corporation (NYSE: MCO) is the parent company of Moody's Investors Service, which provides credit ratings and research covering debt instruments and securities, and Moody's Analytics, which offers leading-edge software, advisory services and research for credit and economic analysis and financial risk management.
- Previously, investors subscribed to publications from each of the ratings agencies. issuers paid no fees for performance of research and analyses that were a normal part of development of published credit ratings As an industry, credit ratings agencies began to recognize that objective credit ratings significantly increased in value to issuers in terms of facilitating market and capital access by increasing a securities issuer's value in the market place, and decreasing the costs of obtaining capital. Expansion and complexity in the capital markets coupled with an increasing demand for statistical and analytical services led to the industry wide decision to charge issuers of securities fees for ratings services. In 1975, financial institutions (commercial banks and securities broker-dealers), sought to soften the capital and liquidity requirements passed down by the Securities and Exchange Commission (SEC). As a result, nationally-recognized statistical ratings organizations (NRSRO) were created. Financial institutions could satisfy their capital requirements by investing in securities that received ratings by one or more of the NRSROs. This allowance is the result of registration requirements coupled with greater regulation and oversight of the credit ratings industry by the SEC. The increased demand for ratings services by investors and securities issuers combined with increased regulatory oversight has led to growth and expansion in the credit ratings industry. In 1975, the Securities and Exchange Commission (SEC) issued new rules that solidified the centrality of the rating agencies. To make capital requirements sensitive to the riskiness of broker-dealers' bond portfolios, SEC decided to use the ratings on those bonds as the indicators of risk.
- There are few forces that led to the popularity of the residential mortgage backed securities among the investors. Early 2000s, US economic growth and thus increase the inflow of global capital. Meanwhile the IT related stock bubble bursting. The investors were divert to the relatively safer investment which was assets backed securities. Rating agencies were given high rating to those assets backed securities. The good sign of economic led to the good opportunity in speculations in property too.
- Back to the our case – the development of subprime mortgage. Due to the popularity and high demand of RMBS, lead to the shortage of RMBS supply. The investment banks were pressing those lenders to generate more mortgages. The lenders at that time act consistently with government policy that approaching to the minorities. Lenders were actually weaken their lending standard to qualify these borrowers even with poor credit records. Thus they called the loan as subprime mortgage. In general, the borrower characteristics included low repayment capability, not understand the loan terms (adjustable rate) and optimistic on the future property value. What is the main cause of Subprime mortgage? Many pointed that it was due to the poor government housing policy, providing financial aid to the new home buyer and absorbing the cost.
- Unfortunately, in year 2006, the interest rate began to rise and housing bubble led to the prices drop. Those weak borrower under subprime mortgage unable to sell or refinance their properties. At last, most of them just dropped the key in mail and walk away. The industry called the incident as Jingle mail. The action was then leading mortgage delinquencies and directly devaluate the housing related securities.
- In july 2007, Moody’s stopped rating RMBS and began the so called Express Train Downgrades whereby moody’s adjusted their rating for existing RMBS only shortly before market collapse. All the mortgage-backed securities Moody’s had rated triple A in 2006, 73% were downgraded to junk. Public started to blame moody’s cause of the rating as the complex securities could not have been sold without the rating from Nationally-recognized statistical ratings organizations.
- Moody’s took advantage of a profitable process without forwardly thinking of the consequences. - Their primary goal was pleasing the investors, which they themselves were often personally involved with as well. There’s no doubt that some of the ratings may have been padded somewhat in order to make the investment packages look more appealing to potential investors, even though the packages were made up of high risk, under qualified home-buyers. 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 part. There weren’t any indications of efforts made to alter the outcome of what was obviously a short-term success.