Moody's and Subprime Crisis

Moody’s main business model

It rates commercial and government entities based on their credit worthiness. It also performs rankings on such entities using a standardized ratings scale. It has a 40% market share worldwide in the ratings business.

Background

During the 2003 to 2006, mortgages based credit securities became an important source for profits. Profits soared as the Moody’s began to rate such securities to feed the growing appetite of investors who sought higher returns.

After the bursting of the Internet bubble in 2000 and the events on September 11, the US economy seemed to be bad shape. The Federal Reserve sought to lower interest rates in order to simulate enterprises and make it easier for people to borrow money to invest in businesses. Hence, during the early 2000s, interests rate fell to about 1% and this soon began to create a massive liquidity bubble

The cheap money was soon used by entities such as hedge funds, banks, insurance companies and mutual funds to buy assets. Similarly, central banks across the world followed suited and soon a massive bubble began to form globally. During this time, the spread between the junk bonds and treasury bonds began to narrow, fuelling a boom in leverage buy outs led by a host of private equity firms.

Mortagages and Securitization

Investment bankers securitized mortgages and loan them as packages to investors. Ratings firms such as Moody’s played a part by rating them using their models to make it easier to sell them.

With the growing appetite of investors (i.e. hedge funds) who were willing to purchase such mortgage backed securities, mortgage lenders soon began chasing customers who had a poor credit histories and more likely to default by offering loans with variable rates. During this period, interest rates were low so customers were able to afford the interest on the loan. Some of the mortgage lenders were even more aggressive and introduced deferred payment schemes which offered low initial monthly payments and pushed interest further away into the future. Such aggressive practices allowed high risk customers who were likely to default to borrow money for acquiring new homes.

Subprime mortgage lenders then packaged such these loans and securitized them to generate revenue. However, one of the problems for Moody was how to rate such mortgage backed securities…

Moody’s devised several complex financial models to help rate such securities. However, this proved to be a Herculean task as many of these financial models use past historical data and assumed historical volatilities would be the same. Moreover, such complex models are difficult to understand and could never be 100% accurate as it’s often difficult to take in all the information especially in a dynamic marketplace. Lastly, financial models fail to take in account that much of the markets movements are driven by psychology (i.e. fear and greed) which can never be truly reflected in financial models. Hence, due to the mispricing of risk in these financial models, many of the mortgage backed securities were awarded dubious ratings.

Hedge funds, hungry for returns especially in the competitive world of money management, had scooped loads of such securities using leverage in order to juice their profits. Many of these funds had relied on ratings firms such as Moody’s to rate such bonds and tended to buy those of higher investment grade (especially in the sub prime market) for safety. Using leverage on such risky investment products only made the situation. Unbeknown to the rating firms, subprime mortgage lenders had adopted aggressive practices to boost securitization revenue.

In my next article, I will touch more on Moody’s and look at its financials.

Cheers,

Manpreet