Case 1: Moody’s Credit Ratings and the Subprime Mortgage Meltdown
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
Ethics and ethical reasoning
Organizational ethics and the law
Public policy
Government regulation of business
Shareholder rights
Executive compensation
1
4
5
8
8
14
14
Case Synopsis:
In the mid-2000s, Moody’s, the leading credit rating agency in the world, evaluated thousands of
bonds backed by “subprime” residential mortgages—home loans made to people with low
incomes and poor credit. When housing prices began to decline in 2006, the value of many of
these bonds collapsed, and Moody’s was forced to downgrade them steeply. In late 2008,
several investment banks, commercial banks, and mortgage lenders that had been heavily
involved in the subprime market failed. In the wake of these failures, credit froze up, consumer
confident plunged, and job losses deepened across the global economy. Although the financial
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
financial crisis and Moody’s role in it. It challenges students to consider how businesses,
governments, and society can better assure the integrity of the credit rating industry.
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Case 1: Moody’s Credit Ratings and the Subprime Mortgage Meltdown
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
subprime mortgages and securities backed by them. The segment is available as streaming video
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
interviews with several experts to explain how $200 billion or so in bad housing debt
precipitated a worldwide financial crisis. The segment is available as streaming video from PBS
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.
On December 14, 2008, CBS’s Sixty Minutes ran a story titled “A Second Mortgage Disaster on
the Horizon?” The segment predicted a second wave of mortgage defaults (and collapse of
bonds backed by them) over the following few years, as so-called Alt-A and payment-option
ARM loans reset. This segment may be useful as an epilogue to the case. The transcript and
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
journalistic excellence. In making the award, the judges wrote: “Through terrific storytelling and
economic insight, the reporters demystify the subprime mortgage meltdown using personal
stories to explain such terms as derivatives, tranches, short selling and credit swaps.” The
episode is quoted in the case. The instructor may wish to require that students listen to the
complete podcast before class (it runs approximately one hour). It is available at:
http://www.thislife.org/radio_episode.aspx?episode=355.
For students who wish to read rather than listen, a transcript is available at:
www.thislife.org/extras/radio/355_transcript.pdf.
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Case 1: Moody’s Credit Ratings and the Subprime Mortgage Meltdown
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?
Moody’s misjudged the risk inherent in thousands of complex asset-backed securities,
particularly residential mortgage-backed securities that it rated during the mid-2000s. It stopped
rating RMBSs in mid-2007, and over the following year downgraded more than 5,000 of them,
including 90 percent of those first rated in 2006 and 2007. The downgrades represented an
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
investors and, indeed, the entire financial system at risk. In its own defense, Moody’s would
likely point out that ratings are simply an opinion of the statistical probability of default. It
would no doubt argue that when the ratings were first issued, they were based on the best
information and statistical models available and therefore provided an accurate probability
estimate at that time.
2. Which stakeholders were helped, and which were hurt, by Moody’s actions?
Stakeholders are those people and groups that affect, or are affected by, an organization’s
decisions, policies, and operations. Many stakeholders, both market and nonmarket, were
affected by Moody’s inaccurate ratings.
Initially, many stakeholders benefited from Moody’s high ratings of RMBSs.

Moody’s shareholders benefited greatly from the company’s stellar financial results
during the early 2000s; as shown in Exhibit B, share value rose 354 percent over a 5-year
period, well above the S&P 500 composite index and its comparison group.
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Case 1: Moody’s Credit Ratings and the Subprime Mortgage Meltdown

Institutions, governments, and individuals who invested in RMBSs benefited, since these
securities typically paid interest rates above those paid by other investments with
comparable investment grade ratings during 2004-2007.

Mortgage originators and investment banking firms earned high fees from selling,
packaging, and marketing mortgage loans during the housing bubble of 2003-26—
transactions that were enabled and facilitated by investment-grade ratings on mortgagebacked securities.

However, investors were later badly hurt when mortgage-backed securities dropped
precipitously in value, sometimes becoming entirely worthless. Even investors who did
not hold RMBSs directly were hurt, as the stock and bond markets fell broadly in
response to the financial crisis. The case reports that in 2008, investors lost around $7
trillion in the market value of their assets.
However, all of these groups, and others, suffered tremendous losses when these RMBSs later
collapsed in value. Investment banks, mortgage companies, and commercial banks collapsed.
Moody’s own stock fell in value. Stock and bond investors lost trillions of dollars in assets.
And, taxpayers were forced to assume much of the enormous cost of bailing out many of the
investment banks and commercial banks that failed and homeowners that lost their homes.
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.
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Case 1: Moody’s Credit Ratings and the Subprime Mortgage Meltdown
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.1
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.2
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
judgment have a reasonable expectation that the agent will act in the principal’s interest, not the
agent’s. Failure to disclose a conflict of interest represents deception and may result in injury to
the principal. Many ethicists believe that even the appearance of a conflict of interest should be
avoided, because it undermines trust in the relationship.
Did Moody’s have a conflict of interest?
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?
Moody’s core business was rating the safety and security of bonds issued by companies,
governments, and public agencies, as well as of securities comprised of pools of debt. The U.S.
government had granted Moody’s a quasi-regulatory role in the bond market. Investors relied on
credit ratings to assess the relative risk of various fixed-income securities. In this instance,
Moody’s was the agent that exercised professional judgment on behalf of investors, the
principals. Yet, since the 1970s, Moody’s had charged issuers to rate their bonds. In order to
bring in business and build market share, Moody’s and other rating agencies had an interest in
Michael Davis, “Conflict of Interest,” pp. 131-133 in Patricia H. Werhane and R. Edward Freeman, eds.,
Encyclopedic Dictionary of Business Ethics (Oxford, UK: Blackwell, 1997).
2
John R. Boatright, Ethics and the Conduct of Business, 4th ed. (Upper Saddle River, NJ: Prentice Hall, 2003), p.
140.
1
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Case 1: Moody’s Credit Ratings and the Subprime Mortgage Meltdown
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.
What steps could be taken to eliminate or reduce this conflict?
Moody’s could take a number of steps to eliminate or reduce this conflict.
The company could eliminate the conflict by drawing revenue from a source other than fees
charged to issuers. This would require a complete change in its business model. Possible
options might include:
 Charge pensions, mutual funds, and other institutional investors to subscribe to a rating
service to help them evaluate the safety of fixed-income securities. (In effect, this
would mean a return to the business model Moody’s had used prior to the 1970s.)
 Require the government to fund the bond-ratings services provided by the credit-rating
agencies, as an extension of its regulatory obligation to protect the interests of investors
in publicly-regulated markets.
 Pay rating agencies according to a standard formula from a fund that is paid into by
institutions each time they issue a bond, thus separating the fee paid from any specific
bond or transaction.
TEACHING TIP: COUNTER ARGUMENTS
After each of these options is proposed, ask students to critique them. For example, in the case,
Moody’s CEO Raymond McDaniel makes several arguments against the investor-pays business
model, suggesting that it carries its own conflicts of interest.
As an alternative, the company could attempt to manage the conflict. As explained in the case,
steps the company had already taken included:


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Rate bonds by a committee, not by an individual.
Bar analysts from owning stock in institutions whose bonds they rated.
Separate compensation from revenue based on analyst’s own ratings.
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.
Bar the provision of research or other services to institutions whose bonds the agency
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).
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Case 1: Moody’s Credit Ratings and the Subprime Mortgage Meltdown
TEACHING TIP: “A” STUDENT / “C” STUDENT
Excellent students will recognize that the procedures Moody’s has adopted to manage conflicts
of interest address possible individual conflicts (e.g., an individual analyst owns stock in a
company whose bonds he rates), as opposed to organizational conflicts (e.g., Moody’s is paid by
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?
One way to approach this question is to ask students to make the case for the responsibility of
each of these parties for the financial crisis.
All of these parties acted irresponsibly, and thus shared part of the blame for the financial crisis.
Home buyers: Many people irresponsibly purchased homes that they could not afford, based on
lax lending standards, low initial monthly payments, and an inaccurate assumption that housing
values would continue to rise indefinitely. In many cases, it was in their short-term interest to do
so, because these purchases enabled them to improve the quality of their housing.
Mortgage lenders: Many lenders made loans to borrowers of dubious creditworthiness,
generating large fees. So long as they were able to quickly package and sell these loans, they did
so with little or no risk.
Investment bankers: Large Wall Street investment banks repackaged risky home loans into
complex asset-backed securities and sold them to investors, generating large underwriting fees.
So long as they were able to move them quickly off their books, they did so with little risk.
Government regulators: Regulators contributed to the financial crisis by failing to rein in risky
lending and monitor the market in asset-backed securities, and by pre-empting state regulatory
efforts to curb predatory lending.
Government policymakers contributed by promoting low interest rates and other policies to
encourage home ownership for low-income individuals.
Moody’s and its executives (and, by extension, other leading credit rating agencies) contributed
by providing investment-grade credit ratings to many mortgage-backed securities, enabling them
to be widely marketed to investors.
Investors: Investors, particularly institutional investors, purchased risky assets in search of higher
returns.
In short, all parties bore a share of the responsibility; each was pursuing its own self interest in
an inadequately regulated system. Each party sought to benefit, while passing the risks along to
others.
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Case 1: Moody’s Credit Ratings and the Subprime Mortgage Meltdown
TEACHING TIP: WHO BORE THE GREATEST RESPONSIBILITY?
Students may be asked to debate which party was most responsible. Some will argue that the
credit rating agencies bore the greatest responsibility, because the RMBSs could not have been
sold without investment-grade ratings. Other will argue that the home buyer was ultimately
responsible, because without bad loans the subprime market would not have collapsed.
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
person. For example, someone with auto theft insurance might be less careful to always lock his
or her car, or a person covered by flood insurance might be more likely to buy a house in a flood
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
the lenders. Lenders sold mortgages soon after underwriting them, pushing the risk onto
investors. Investment banks bought the mortgages and chopped up mortgage-backed securities
into slices, with some slices being less risky and other slices being more risky. Investors bought
securities and hedged against the risk of default and prepayment, pushing those risks further
along. All of these businesses accepted profits and tried to leave the next guy vulnerable to risk.
Participants thought they were insulated from the negative consequences of bad decisions.”3
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
that they would not bear any costs of possible later downgrades.
In short, every actor in a complex system acted recklessly, believing that they were insulated
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:
3
Holden Lewis, “Moral Hazard Helps Shape Mortgage Mess,” www.bankrate.com, April 18, 2007.
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Case 1: Moody’s Credit Ratings and the Subprime Mortgage Meltdown
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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.)
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
commercial banks to assume a greater share of the risk of loans that they make or
package and sell to others. In other words, prohibit the complete “hand off” of risk.
Permit greater competition in the credit rating industry by making it easier for new
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
The instructor may wish to ask students to investigate what others have said on this issue. Some
sample ideas follow.
Robert Reich, former Secretary of Labor in the Clinton administration, wrote in his blog on
October 23, 2007:
It’s obvious why credit-rating agencies didn't blow the whistle [on the risk inherent in
RMBSs]. (They didn't blow the whistle on Enron or WorldCom before those entities
collapsed, either.) You see, credit-rating agencies are paid by the same institutions that
package and sell the securities the agencies are rating. If an investment bank doesn’t like
the rating, it doesn’t have to pay for it. And even if it likes the rating, it pays only after
the security is sold. Get it? It’s as if movie studios hired film critics to review their
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,
before the dotcom bubble burst, advised clients to buy stocks their own investment banks
were issuing. The remedy for that was to split the two functions – analysis from
investment banking.
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Case 1: Moody’s Credit Ratings and the Subprime Mortgage Meltdown
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 moviegoers subscribe to publications where reviews appear.4
Representative Jackie Speier (Democrat-California), a member of the House Oversight and
Government Reform Committee, published a newspaper op-ed after the hearing recommending
changes in the rules governing the credit rating agencies. She wrote:
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.
3) Create a Consumer Financial Products Safety Commission. Like the Consumer
Products Safety Commission is empowered to stop dangerous toys and other products
from being sold, a financial productions commission would have the authority to prevent
overly risky financial instruments from reaching market.
4) Provide better transparency of mortgage-backed securities by allowing easier access to
information documenting their likelihood of default.5
Epilogue:
As of the time of writing, the financial crisis was ongoing, and Moody’s role in it continued to be
debated. As an assignment, students may be asked to research events subsequent to the hearings
in October, 2008. In particular, they may be asked to investigate the status of:
4
5

lawsuits brought by union pension funds that lost money in Moody’s-rated securities;

lawsuits brought by Moody’s own shareholders who charged that Moody’s had used
inflated ratings to keep its own revenues and share value high;

Moody’s own internal review of its ethics procedures;

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.
http://robertreich.blogspot.com/2007/10/they-mystery-of-why-credit-rating.html.
Jackie Speier, “Credit Rating Agencies Are No Longer First Rate,” San Francisco Chronicle, December 17, 2008.
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