Credit rating agencies and the subprime crisis

A large section of the debt securities market—many money markets and pension funds—were restricted in their bylaws to holding only the safest securities—i.e.

[1] The pools of debt the agencies gave their highest ratings to included over three trillion dollars of loans to homebuyers with bad credit and undocumented incomes through 2007.

[6][7] This led "to the collapse or disappearance" in 2008–09 of three major investment banks (Bear Stearns, Lehman Brothers, and Merrill Lynch), and the federal government's buying of $700 billion of bad debt from distressed financial institutions.

Demand for the securities was stimulated by the large global pool of fixed income investments which had doubled from $36 trillion in 2000 to $70 trillion by 2006—more than annual global spending—and the low interest rates from competing fixed income securities, made possible by the low interest rate policy of the U.S. Federal Reserve Bank for much of that period.

[9] Earlier traditional and more simple "prime" mortgage securities were issued and guaranteed by Fannie Mae and Freddie Mac—"enterprises" sponsored by the Federal government.

[9] "Participants in the securitization industry realized that they needed to secure favorable credit ratings in order to sell structured products to investors.

"[13] According to the CEO of a servicer of the securitization industry, Jim Callahan of PentAlpha, "The rating agencies were important tools to do that because you know the people that we were selling these bonds to had never really had any history in the mortgage business.

And because traditional mortgage investors were risk-averse (often because of SEC regulations or restrictions in their charters), these less-safe tranches were the most difficult to sell.

[16][17] To sell these "mezzanine" tranches, investment bankers pooled them to form another security—known as a collateralized debt obligation (CDO).

Trust in rating agencies was particularly important for CDOs for another reason—their contents were subject to change, so CDO managers "didn't always have to disclose what the securities contained".

"[28] By the end of 2009, over half of the collateralized debt obligations by value[29] issued at the end of the housing bubble (from 2005–2007) that rating agencies gave their highest "triple-A" rating to, were "impaired"—that is either written-down to "junk" or suffered a "principal loss" (i.e. not only had they not paid interest but investors would not get back some of the principal they invested).

[30][31][32][33][34] The Financial Crisis Inquiry Commission estimates that by April 2010, of all mortgage-backed securities Moody's had rated triple-A in 2006, 73% were downgraded to junk.

[35] Mortgage underwriting standards deteriorated to the point that between 2002 and 2007 an estimated $3.2 trillion in loans were made to homeowners with bad credit and undocumented incomes (e.g., subprime or Alt-A mortgages)[6] and bundled into MBSs and collateralized debt obligations that received high ratings and therefore could be sold to global investors.

One institution, Merrill Lynch, sold more than $30 billion of collateralized debt obligations for 22 cents on the dollar in late July 2008.

[41] The Economist magazine opined that "it is beyond argument that ratings agencies did a horrendous job evaluating mortgage-tied securities before the financial crisis hit.

[44] Plaintiffs have included by collateralized debt obligation investors (the state of Ohio for losses of $457 million,[45][46] California state employees for $1 billion[47]), the bankrupt investment bank Bear Stearns (for losses of $1.12 billion from alleged "fraudulently issuing inflated ratings for securities"[48]), bond insurers.

[54][55] The FCIC commission found that agencies' credit ratings were influenced by "flawed computer models, the pressure from financial firms that paid for the ratings, the relentless drive for market share, the lack of resources to do the job despite record profits, and the absence of meaningful public oversight.

"[56] McLean and Nocera blame credit ratings lapses on "an erosion of standards, a willful suspension of skepticism, a hunger for big fees and market share, and an inability to stand up to" the investment banks issuing the securities.

On top of revenue generated for issuing credit ratings, agencies often earned $300,000–500,000 and as much as $1 million to construct a structured investment vehicle.

Richard Michalek, a former vice president and senior credit officer at Moody's, testified to the FCIC that even when they were not realized, "The threat of losing business to a competitor ... absolutely tilted the balance away from an independent arbiter of risk ...." When asked if the investment banks frequently threatened to withdraw their business if they didn't get their desired rating, former Moody team managing director Gary Witt told the FCIC, “Oh God, are you kidding?

"[51] While Moody's and other credit rating agencies were quite profitable—Moody's operating margins were consistently over 50%, higher than famously successful Exxon Mobil or Microsoft, and its stock rose 340% between the time it was spun off into a public company and February 2007[65]—salaries and bonuses for non-management were low by Wall Street standards and its employees complained of overwork.

"[67] When asked about this by the FCIC, Moody's president Brian Clarkson admitted that investment banks paid more than his agency so retaining employees was "a challenge".

"[70] At least one other investment firm that bet against the agencies' credit ratings with huge success believed "there was a massive amount of gaming going on.

"[71] When asked by the FCIC Commission about "the high turnover" and "revolving door that often left raters dealing with their old colleagues, this time as clients", Moody's officials stated their employees were prohibited from rating deals by a bank or issuer while they were interviewing for a job with that particular institution, but notifying management of any such interview was the responsibility of the employee.

[68] According to the hedge fund managers Michael Lewis talked to who had bet against mortgages securities, there were a number of ways to game[72] or "reverse-engineer" the raters' models.

[36] Rating agencies judged creditworthiness of a pool of loans in part by looking at the averages of credit scores of borrowers who made up the security.

Knowing this blind spot, securities issuers who could no longer find high-FICO-scoring families who wanted to take out a mortgage found other ways to raise the average pool score.

However, in 2013, McClatchy Newspapers found that "little competition has emerged in rating the kinds of complex home-mortgage securities whose implosion led to the 2007 financial crisis".

[78] In the spring of 2013, Moody's and Standard & Poor's settled two "long-running" lawsuits "seeking to hold them responsible for misleading investors about the safety of risky debt vehicles that they had rated".

This maintains a credit rating is an opinion protected as free speech and requires plaintiffs to prove actual malice by the agency[80] However, some wonder if the defense will ultimately prevail.