978-1259315411 Chapter 7 Case

TEACHING NOTE FOR:

MOODY’S CREDIT RATINGS AND

THE SUBPRIME MORTGAGE MELTDOWN

This case illustrates the following themes and concepts discussed in the chapters listed:

Theme/Concept Chapter

Stakeholder analysis 1

Ethics and ethical reasoning 4

Organizational ethics and the law 5

Public policy 7

Government regulation of business 7

Shareholder rights 13

Executive compensation 13

Case Synopsis:

In the mid-2000s, Moody’s, the leading credit rating agency in the world, evaluated thousands of

crisis had many causes, some analysts believed that Moody’s and other credit rating agencies had

played a key role by underestimating the risks inherent in mortgage-backed securities. The case

draws on publicly available data, including internal documents released by Moody’s in

connection with a Congressional hearing in October 2008, to explore the multiple causes of the

TEACHING TIP: VIDEOS AND PODCASTS

Several videos and podcasts are available that may be used with this case. They include the

following:

On August 30, 2007, the NewsHour with Jim Lehrer (the PBS news program) ran a report by

economics correspondent Paul Solman, entitled “Risky Subprime Market Sends Ripples through

Financial World.” In the segment, Solman interviews an economics professor, who explains

from PBS at:

http://www.pbs.org/newshour/bb/business/july-dec07/subprime_08-30.html

On March 21, 2008, the NewsHour with Jim Lehrer ran another report by Solman, entitled

“Examining the Roots of U.S. Economic Woes.” Solman uses some clever dime-store props and

at:

http://www.pbs.org/newshour/bb/business/jan-june08/domino_03-21.html

The instructor may wish to show some or all of these two PBS segments in class.

streaming video are available at:

http://www.cbsnews.com/stories/2008/12/12/60minutes/main4666112.shtml

In April 2008, Public Radio International’s radio show “This American Life” aired an episode

entitled “The Giant Pool of Money.” This show later won a DuPont-Columbia award for

Summary of Discussion Questions

1. What did Moody’s do wrong, if anything?

2. Which stakeholders were helped, and which were hurt, by Moody’s actions?

3. Did Moody’s have a conflict of interest? If so, what was the conflict, and who or what

were the principal and the agent? What steps could be taken to eliminate or reduce this

conflict?

4. What share of the responsibility did Moody’s and its executives bear for the financial

crisis, compared with that of home buyers, mortgage lenders, investment bankers,

government regulators, policymakers, and investors?

5. What steps can be taken to prevent a recurrence of something like the subprime

mortgage meltdown? In your answer, please address the role of management policies

and practices, government regulation, public policy, and the structure of the credit

ratings industry.

Discussion Questions and Answers

1. What did Moody’s do wrong, if anything?

acknowledgment by Moody’s that its original ratings were inaccurate. Arguably, Moody’s failed

to consider the risk inherent in the loans underlying these complex asset-based securities, putting

estimate at that time.

2. Which stakeholders were helped, and which were hurt, by Moody’s actions?

comparable investment grade ratings during 2004-2007.

TEACHING TIP: “A” STUDENT / “C” STUDENT

Excellent students will recognize that many of the parties that benefited in the short run from

Moody’s ratings—including home buyers, mortgage originators, investment banks, and

investors—took huge losses later when securities backed by bad loans collapsed and were

downgraded.

3. Did Moody’s have a conflict of interest? If so, what was the conflict, and who or what

was the principal and the agent? What steps could be taken to eliminate or reduce this

conflict?

THEORETICAL LINK: CONFLICT OF INTEREST

The term conflict of interest has been defined by the Encyclopedic Dictionary of Business Ethics

as follows:

[A] conflict of interest occurs if and only if a person P is in a relationship with one or

more others requiring P to exercise judgment in their behalf, and P has a (special) interest

tending to interfere with the proper exercise of judgment in that relationship.

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Another definition has been offered by John Boatright:

[A] conflict of interest is a conflict that occurs when a personal interest interferes with a

person’s acting so as to promote the interest of another, when the person has an

obligation to act in that other person’s interest.

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In ethics theory, the person or organization exercising judgment is normally referred to as the

agent, and the person or organization on whose behalf judgment is exercised is referred to as the

principal.

Conflicts of interest are normally considered unethical for several reasons. Persons and

organizations that have contracted with an agent for a service that requires an exercise of

Yes. As the case explains, Moody’s was paid by the same institutions that issued the bonds it

rated.

If so, what is the conflict, and who or what is the principal and the agent?

bring in business and build market share, Moody’s and other rating agencies had an interest in

serving the issuers. Arguably, Moody’s main goal was to satisfy the bond issuer—who naturally

would seek the highest possible rating. This could well conflict with the interest of the investor,

who naturally would seek an accurate rating.

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John R. Boatright, Ethics and the Conduct of Business, 4th ed. (Upper Saddle River, NJ: Prentice Hall, 2003), p.

140.

Moody’s could take a number of steps to eliminate or reduce this conflict.

options might include:

in publicly-regulated markets.

 Pay rating agencies according to a standard formula from a fund that is paid into by

TEACHING TIP: COUNTER ARGUMENTS

As an alternative, the company could attempt to manage the conflict. As explained in the case,

steps the company had already taken included:

 Rate bonds by a committee, not by an individual.

Students may suggest other methods of managing the conflict, such as:

 Compartmentalize conflicting roles within the agency, e.g., separate the marketing and

business development function from the ratings function.

rates.

 Base compensation of analysts (and the executives who manage them) on the long-term

accuracy of the ratings (or, penalize originators of ratings that later prove inaccurate).

TEACHING TIP: “A” STUDENT / “C” STUDENT

the institutions whose bonds it rates).

4. What share of the responsibility does Moody’s and its executives bear for the financial

crisis, compared with that of home buyers, mortgage lenders, investment bankers,

government regulators, policymakers, and investors?

efforts to curb predatory lending.

returns.

TEACHING TIP: WHO BORE THE GREATEST RESPONSIBILITY?

THEORETICAL LINK: MORAL HAZARD

One concept that the instructor may find useful is “moral hazard.”

The term “moral hazard” refers to the likelihood that someone who is protected from risk will

behave differently from one who is exposed to risk. The term first arose in the insurance

industry, where an insured person might be expected to take greater risks than an uninsured

plain.

Holden Lewis, writing for bankrate.com, offered a clear explanation of the relevance of this

concept to the subprime mortgage meltdown:

“…each link in the mortgage chain collected profits while believing it was passing on risk to the

next link in the chain. Brokers weren’t lending their own money, so they were pushing risks onto

Lewis did not mention credit rating agencies in his account, but arguably they also passed along

risk, giving subprime mortgage-backed securities investment grade ratings, with the assumption

from negative consequences of their actions.

5. What steps can be taken to prevent a recurrence of something like the subprime

mortgage meltdown? In your answer, please address the role of management policies

and practices, government regulation, public policy, and the structure of the credit

ratings industry.

Students may make a number of recommendations, including the following:

 Change the business model of the credit rating industry so that revenue flows not from

issuer fees but from a government funds, a “blind” trust, or investor subscriptions (see

above.)

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 Change credit rating firm executive compensation and employee incentives 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 ratings.

 Implement government regulations that set higher minimum underwriting standards for

personal and commercial loans.

 Enforce standards of personal responsibility and accountability by restricting the use of

no down-payment and no-recourse loans.

 Implement government policies that require mortgage lenders, investment banks, and

entrants to qualify as NRSROs.

 Give the SEC or other government agency greater resources and authority to regulate

highly complex asset-backed securities.

 Temporarily withdraw the NRSRO designation from credit rating agencies with poor results.

TEACHING TIP: OTHER PERSPECTIVES

sample ideas follow.

Robert Reich, former Secretary of Labor in the Clinton administration, wrote in his blog on

October 23, 2007:

movies, and paid them only if the reviews were positive enough to get lots of people to

see a movie…

The whole thing rested on a conflict of interest analogous to that of stock analysts who,

investment banking.

The remedy here is to do much the same: bar issuers from paying credit-rating agencies

for rating their securities. If investors want to examine securities’ ratings, they or the

pension or mutual funds they invest through can subscribe to the service – just as movie-

goers subscribe to publications where reviews appear.

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http://robertreich.blogspot.com/2007/10/they-mystery-of-why-credit-rating.html.

Here are four ideas:

1) Pay rating agencies from a fund that is paid into by bond sellers, similar to the method

the Food and Drug Administration uses to fund drug research. This arm’s-length

transaction would return the rating agencies to answering to investors.

2) Prohibit rating agencies from providing consulting services to the institutions they rate.

information documenting their likelihood of default.

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Epilogue:

As of the time of writing, the financial crisis was ongoing, and Moody’s role in it continued to be

 the SEC’s proposed rules governing the big three credit rating agencies;

 negotiations with various state attorneys general over fees charged for reviewing

mortgage-backed securities.

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