We’ve given much attention to S&P and the prospect of Moody’s following S&P’s lead with the second cardinal sin behind a debt default, a downgrade. Historically, however, all this began the other way around when S&P followed Moody’s in an act of one-up-man-ship during the last financial meltdown.
Sometime this year, the Kenan Institute for Ethics at Duke University released a case study, Greed, Negligence, or System Failure? Credit Rating Agencies and the Financial Crisis (2011), as part of its ongoing project, Institutions in Crisis. This a well-worth-it read; especially in light of Moody’s recent downgrade threats. The study places Moody’s at the heart of the last financial crisis when in 2004, when Moody’s “unveiled a new credit-rating model for collateralized debt obligations (CDOs)” that began a spiraling-down of its risk standards and set off a market-share war with its rival, Standard & Poors.
In August of 2004, Moody’s Corporation’s Managing Director, Gary Witt, unveiled a new credit-rating model for collateralized debt obligations (CDOs). The new model relaxed many of the standards that Moody’s had used for years to assess the risk of these complex financial instruments. The move sparked a market-share war that pushed long-time competitor Standard & Poors (S&P) to make similar changes. Internally, each ﬁrm would spend the next few years experimenting with their models to ensure that they generated results that pleased their clientele so as not to lose business to competitors.As the subprime mortgage bubble burst and the market for CDOs dried up, however, it became apparent that Moody’s and its competitors had understated the risk the CDOs (many of which derived their value from subprime mortgages) posed to investors. The entire financial industry, which counted on the accuracy of these ratings, was affected.Many financial experts cite conﬂicts of interests as the major contributor to the use of rating standards that undervalued risk. As this case reveals, however, other factors, including competitive pressures, a negative shift in Moody’s corporate culture, and decades of inadequate regulatory oversight, contributed to systemic changes that negatively affected Moody’s and the entire financial industry. This case considers these factors to better understand how the organizational crisis at Moody’s and in the credit ratings sector more generally had such a devastating effect on the global financial system.
The innovation of the ABS and CDO transformed the entire mortgage market and eventually reshaped how Wall Street made money. As discussed above, subprime mortgages were originally only a contract between a prospective homeowner and a mortgage lender. However, as Wall Street gained the ability to package fixed-income assets for investors, the subprime supply market expanded, allowing a range of new investors. As described in Appendix A: The Securitization Food Chain, investment ﬁrms began buying up subprime contracts from lenders by the thousands and securitizing them into sellable bundles. They would then turn these around and sell them to investors. What’s more, thanks to the Gramm-Leach-Bailey Act of 1998, these new derivative markets were extremely deregulated. The markets were allowed to expand with little or no government oversight.