V. INFLATED CREDIT RATINGS: CASE STUDY OF MOODY's AND STANDARD & POOR's
Moody's Investors Service, Inc. (Moody's) and Standard & Poor's Financial Services LLC (S&P), the two largest credit rating agencies (CRAs) in the United States, issued the AAA ratings that made residential mortgage backed securities (RMBS) and collateralized debt obligations (CDOs) seem like safe investments, helped build an active market for those securities, and then, beginning in July 2007, downgraded the vast majority of those AAA ratings to junk status. |953| The July mass downgrades sent the value of mortgage related securities plummeting, precipitated the collapse of the RMBS and CDO secondary markets, and perhaps more than any other single event triggered the financial crisis.
In the months and years of buildup to the financial crisis, warnings about the massive problems in the mortgage industry were not adequately addressed within the ratings industry. By the time the rating agencies admitted their AAA ratings were inaccurate, it took the form of a massive ratings correction that was unprecedented in U.S. financial markets. The result was an economic earthquake from which the aftershocks continue today.
Between 2004 and 2007, taking in increasing revenue from Wall Street firms, Moody's and S&P issued investment grade credit ratings for the vast majority of the RMBS and CDO securities issued in the United States, deeming them safe investments even though many relied on subprime and other high risk home loans. In late 2006, high risk mortgages began to go delinquent at an alarming rate. Despite signs of a deteriorating mortgage market, Moody's and S&P continued for six months to issue investment grade ratings for numerous subprime RMBS and CDO securities. In July 2007, as mortgage defaults intensified and subprime RMBS and CDO securities began incurring losses, both companies abruptly reversed course and began downgrading at record numbers hundreds and then thousands of their RMBS and CDO ratings, some less than a year old. Investors like banks, pension funds, and insurance companies were suddenly forced to sell off their RMBS and CDO holdings, because they had lost their investment grade status. RMBS and CDO securities held by financial firms lost much of their value, and new securitizations were unable to find investors. The subprime RMBS market initially froze and then collapsed, leaving investors and financial firms around the world holding unmarketable subprime RMBS securities plummeting in value. A few months later, the CDO market collapsed as well.
Traditionally, investments holding AAA ratings have had a less than 1% probability of incurring defaults. But in the financial crisis, the vast majority of RMBS and CDO securities with AAA ratings incurred substantial losses; some failed outright. Investors and financial institutions holding those AAA securities lost significant value. Those widespread losses led, in turn, to a loss of investor confidence in the value of the AAA rating, in the holdings of major U.S. financial institutions, and even in the viability of U.S. financial markets. Inaccurate AAA credit ratings introduced systemic risk into the U.S. financial system and constituted a key cause of the financial crisis.
The Subcommittee's investigation uncovered a host of factors responsible for the inaccurate credit ratings issued by Moody's and S&P. One significant cause was the inherent conflict of interest arising from the system used to pay for credit ratings. Credit rating agencies were paid by the Wall Street firms that sought their ratings and profited from the financial products being rated. The rating companies were dependent upon those Wall Street firms to bring them business and were vulnerable to threats that the firms would take their business elsewhere if they did not get the ratings they wanted. Rating standards weakened as each credit rating agency competed to provide the most favorable rating to win business and greater market share. The result was a race to the bottom.
Additional factors responsible for the inaccurate ratings include rating models that failed to include relevant mortgage performance data, unclear and subjective criteria used to produce ratings, a failure to apply updated rating models to existing rated transactions, and a failure to provide adequate staffing to perform rating and surveillance services, despite record revenues. Compounding these problems were federal regulations that required the purchase of investment grade securities by banks and others, thereby creating pressure on the credit rating agencies to issue investment grade ratings. Still another factor were the Securities and Exchange Commission's (SEC) regulations which required use of credit ratings by Nationally Recognized Statistical Rating Organizations (NRSRO) for various purposes but, until recently, resulted in only three NRSROs, thereby limiting competition. |954|
Evidence gathered by the Subcommittee shows that credit rating agencies were aware of problems in the mortgage market, including an unsustainable rise in housing prices, the high risk nature of the loans being issued, lax lending standards, and rampant mortgage fraud. Instead of using this information to temper their ratings, the firms continued to issue a high volume of investment grade ratings for mortgage backed securities. If the credit rating agencies had issued ratings that accurately exposed the increasing risk in the RMBS and CDO markets and appropriately adjusted existing ratings in those markets, they might have discouraged investors from purchasing high risk RMBS and CDO securities, slowed the pace of securitizations, and as a result reduced their own profits. It was not in the short term economic self interest of either Moody's or S&P to provide accurate credit ratings for high risk RMBS and CDO securities, because doing so would have hurt their own revenues. Instead, the credit rating agencies' profits became increasingly reliant on the fees generated by issuing a large volume of investment grade ratings.
Looking back after the first shock of the crisis, one Moody's managing director offered this critical self analysis:
"[W] hy didn't we envision that credit would tighten after being loose, and housing prices would fall after rising, after all most economic events are cyclical and bubbles inevitably burst. Combined, these errors make us look either incompetent at credit analysis, or like we sold our soul to the devil for revenue, or a little bit of both." |955|
953. S&P issues ratings using the "AAA" designation; Moody's equivalent rating is "Aaa." For ease of reference, this Report will refer to both ratings as "AAA." [Back]
954. See, e.g., 1/2003 "Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Markets," prepared by the SEC, at 5- 6 (explaining how the SEC came to rely on NRSRO credit ratings); 9/3/2009 "Credit Rating Agencies and Their Regulation," report prepared by the Congressional Research Service, Report No. R40613 (revised report issued 4/9/2010) (finding that, prior to the 2006 Credit Rating Agency Reform Act, "[t]he SEC never defined the term NRSRO or specified how a CRA might become one. Its approach has been described as essentially one of ‘ we know- it- when- we- see- it. ' The resulting limited growth in the pool of NRSROs was widely believed to have helped to further entrench the three dominant CRAs: by some accounts, they have about 98% of total ratings and collect 90% of total rating revenue." 9/3/2009 version of the report at 2- 3). [Back]
955. 9/2007 anonymous Moody's Managing Director after a Moody's Town Hall meeting on the financial crisis, at 763, Hearing Exhibit 4/23- 98. [Back]
Back to Contents E. Preventing Regulatory Failures A. Subcommittee Investigation and Findings of Fact
This document has been published on 08Jul11 by the Equipo Nizkor and Derechos Human Rights. In accordance with Title 17 U.S.C. Section 107, this material is distributed without profit to those who have expressed a prior interest in receiving the included information for research and educational purposes.