Moody’s Credit Ratings and the Subprime Mortgage Meltdown Essay

Since mid 1990s, the subprime mortgage market has grown rapidly experiencing a phenomenal 23% compound annual growth rate to 2006. The total subprime loan originations increased from $65 billion in 1995 to $613 billion in 2006. The subprime sector has become a significant sub-sector of the total residential market accounting for 21% of all residential mortgage originations in 2006. Similarly, by year-end 2006, total outstanding balance of subprime loans grew to $1.2 trillion, approximately 12.6% of all outstanding mortgage debt.

People started to buy houses that they couldn’t afford and then they were left behind leaving. The economy is falling and so are the communities. Insects, graffiti, dirty pools are left behind since people are evicted and people don’t have were to go.

The world’s financial system was almost brought down in 2008 by the collapse of Lehman Brothers that was a major international investment bank at that time. The government sponsored these banks’ bailouts that were funded by tax money in order to restore the industry. Before the crisis, banks were lending irresponsible mortgages to subprime borrowers who had poor credit histories. These mortgages were purchased by banks and packaged into low-risk securities known as collateralized debt obligations (CDOs). CDOs were divided into tranches by its default risk. The ratings of those risks were determined by rating agencies such as Moody’s and Standard & Poor’s. However, those agencies were paid by banks and created an environment in which agencies were being generous to ratings since banks were their major clients.

In October 1981, Congress passed a tax break that allows thrifts to sell their money-losing mortgage loans and reinvest the proceeds for higher returns. Mortgages were pooled by dollar amount and interest rate and then traded. Salomon Brother’s wanted to make mortgages look like bonds. Ranieri had the loans transferred into bonds by getting a stamp of the U.S. government agency Ginnie Mae, Frannie Mae, or Freddie Mac. The stamp was proof of the U.S. government guarantee that made trading mortgage bonds possible. Ranieri’s mortgage department made 215 million over 3 years. After 6 years, Ranieri’s mortgage department was making more money than any other Salomon businesses combined. They formed this group of traders, all characterized as Italian, loud, and fat.

The incumbent credit raters had received severe criticism following the collapse in creditworthiness and prices of mortgage-and asset-backed securities during the financial crisis in 2008 and 2009. The three large rating agencies were accused of facilitating a vast bubble in these securities by issuing overly

Moody’s did not necessarily commit any crime. However, their rating of mortgage-backed securities is what caused the interest of investors to decrease and the demand for more securities to increase.

The worst of the mortgages were packaged and tranche into bonds and got rated AAA by these credit rating agencies. By erroneously rating these bundles of mortgage-backed security payments too highly, the credit rating agencies substantially contributed to the creation of toxic financial assets. The problem was each agency were competing for the banks revenue, to keep the banks business the agencies would always rate their bonds the highest possible grade of AAA.

These brokers have neither the credit skills nor the interest to conduct proper payment due of potential homebuyers. Their interest is only in selling the houses as fast as they can. The MBS instruments allowed all financial institutions to transfer the risks to other investors. The dissociation of ownership of assets from risks encouraged poor credit assessment and was fundamental increasing the risks.

Before the 1970s the banking was not a business that you went into to make money. That was until Louis Ranieri came around. Louis Ranieri had one idea that changed the housing market forever. His plan was to have a mortgage back security. A mortgage back security is an assist based security backed by a mortgage. For example, if you use your mortgage to start a business, your business is backed by that mortgage. The average mortgage loan has a fixed rate loan and takes thirty years to pay off, but then he thought to bundle them all together. They thought these would still be less risky because who would not pay their mortgage. They were doing hundreds of million dollars in mortgage bonds a year, but that all changed when they ran out of mortgages to put into the bonds. If there were no bonds then there was nothing left to make money, and the banking world was going to back to the way it was. Rather than letting that happen, the banks made a loan called a subprime loan.

As home prices continued to rise, lenders thought the borrowers would just default on the mortgage and then the lenders would just be able to sell the house for more cash. While prices and risks were rising, investors were notified by credit rating agencies that mortgage backed securities were safe investments by giving them AAA rating (Naude 3). These investors were told one thing and market investments were not showing high returns. Lenders started to create more and more investments because investors wanted to buy more securities, but in order to create more investments, lenders needed more mortgages (Erkens, Hung, & Matos 392). A way to create more mortgages was to widen their customer market. Lenders created less strict rules and regulations

As was previously stated, Moody’s committed no crime or infraction, yet one cannot overlook a somewhat lax stance in regards to it’s’ ratings on residential mortgage backed securities. 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, not definitive advice or recommendation on the stability or substantiality of a particular financial instrument.

In the movie the big short, Lewis Ranieri, who is a banker of the Wall Street, created an idea that companies packed thousands of mortgage all bundled together to sell, which is the AAA credit-rating bond, and can obtain high yields with low risk because everyone should pay for their mortgage. The concept of Lewis Ranieri is called mortgage-backed securities (MBS). However, the demand of buying MBS is more than MBS supply. Therefore, when the risk of MBS is high, Collateralized Debt Obligation (CDO) is a way to change subprime loans to high- rating bonds and it can be sold again. Although CDO is full of subprime loans, it still can get AAA rating because

Traditionally banks funded their loans from deposits. But the us government found that they could not keep pace with the demand for residential mortgages with this type of funding. Portfolios of mortgages were created and cash flows (principal amount and interest payments) were packaged as securities and sold to investors. Securitization allowed the banks to increase their lending faster than their deposits were growing. The US government created Government National Mortgage Association which protected the mortgage backed securities investors against defaults by borrowers. As the securitization market developed investors became comfortable with the situations where there was no guarantee against defaults by borrowers.

The collapse of the subprime mortgage market causing a global financial crisis (GFC) in 2007, has given the concept of securitisation a bad name. Securitisation is the process of conversion of receivables and cash flow generated from a collection or pool of financial assets into the marketable securities. Any asset that generates a cash flow can be securitised, which are then sold to capital market investors. Asset securitisation is the process whereby interests in loans and receivables are packaged and sold in the form of an asset-backed security (ABS). An ABS is the bond or notes backed by some financial assets. These assets consist of receivables such as residential and commercial mortgage loans, automobile loans, and credit card financing. Mortgage-backed securities (MBS) are bonds that are backed by pools of mortgage loans. Examples include mortgage papers, house papers, and land and property papers. Thus in-turn, reflective of the underlying assets in the security are these two terms. Additionally, securitisation is a method of financing assets, to serve as the main source of payment to investors, it usually depends on cash flow generated from principle and interest repayments.

Then, in the 1990s, bonds were created consisting of subprime mortgages, which were higher risk mortgages with high interest rates, made to borrowers with lower credit levels. Essentially, banks were handing out mortgages like candy to consumers who were never going to be able to make the payments, but Wall Street kept buying and packaging the mortgages into bonds. Since these bonds were inherently riskier, one wonders why investors were still willing to buy. Investors, who look at ratings by agencies such as Moodys and Standard & Poors, had no reason to believe these bonds were risky investments. The agencies, whom were being paid by Wall Street, were assigning high ratings to these risky bonds.