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Sample Essay on Moody's Credit Ratings and the Subprime Mortgage Meltdown

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Sample Essay on Moody's Credit Ratings and the Subprime Mortgage Meltdown

2.0 Introduction

Investment opportunities rely on various factors to ensure they achieve a positive credit worthiness reputation. However, this factor is also fueled and influenced by other distinctive dynamics, including ethics, professionalism, and managerial systems. For example, an investment opportunity should ensure proper planning, creation, and execution procedures are developed. These procedures mainly rely on management (Kevin, 2013). A case analysis of Moody’s Corporation affirms the company faced various accusations aligned to company’s failure in managing credit systems. For example, Moody’s Corporation was accused of understating risks in relation to the complex financial products that led to a financial meltdown in 2008. Thus, the management at the company was accused of being greedy and careless coupled with negligence and ignorance. Moody’s Corporation case analysis will therefore be applied in evaluating and discussing various issues aligned to management within the company. The case analysis provides opportunities in order to assess various managerial instruments applicable in formulating solutions and recommendations to deal with the management issues. Management issues across Moody’s Corporation can be attributed to conflict of interests, competitive pressures, lack of regulations, and shifts in incorporating culture across the company (Lawrence & James, 2011).

3.0 Background

Moody’s Corporation unveiled a new credit rating model as collateral to debt obligations in 2004. Before Moody’s Corporation presented the new model, it had been utilizing complex standards in assessing financial risks in relation to corporation’s financial instruments. The complex standards were applied in evaluating candidates’ credit worthiness before awarding them with a subprime mortgage (Lawrence & James, 2011). The new model, however, sparked accusations and controversies across the mortgage industries and market. Due to the continued war of market share, Moody’s Corporation long-term competitor also adopted a similar model. This was aimed at keeping up with the rivalry and competitive pressure. Thus, Standard & Poors Corporation also unveiled a new model for collateralized debt obligations. However, both companies had to spend years experimenting with the new model. The experiments were aimed at ensuring the models presented positive results to please the clients and win a competitive advantage across the mortgage market (Kevin, 2013).

The subprime mortgage market was however facing constraints, leading to decreased financial results. As a result, Moody’s Corporation was accused of understating the risks associated with the new model. The financial industry comprising company clients and investors was adversely affected by the inaccurate ratings derived from the new model. Financial experts cited conflict of interest as a major contributor towards the undervalued risks. However, other managerial issues also led to negative changes after changing the company systems and culture. The government is often required to respond towards serious and threatening financial crisis adequately and promptly, especially during great financial depression periods. For example, the government provided banks and financial organizations with financial assistance from the Federal Reserve after the stock market crashed in 1929. However, this hindered the government’s efforts to respond promptly to an incoming recession. Using Federal Reserve burdened large banks in the country attempting to undertake fiscal responsibilities during recession. As a result, many banks both large and small either closed or collapsed, leading to deeper economic crisis during the worst financial depression recorded in the United States (Kevin, 2013).

These adverse results were also attributed by management issues across the banks and the government. This is because both parties failed to manage the financial markets sufficiently in order to survive financial crisis. Thus, Moody’s Corporation also failed to undertake proper and adequate management to ensure the new model was a positive and effective in adopting systematic changes within the company and industry. According to financial experts, the subprime mortgage crisis was an indicator that the globe would face financial crisis. Thus, firms, such as Lehman Brothers, Bear Stearns, and Moody’s Corporation should have adopted new models and management systems able to foretell financial crisis (TGH, 2011).

4.0 Analysis

In relation to Moody’s Corporation, the following management issues attributed towards the subprime mortgage and financial crisis. Subprime mortgages are awarded to persons without a positive reputation in relation to credit worthiness and history. Moody’s Corporation had undertaken operations and functions aligned towards subprime mortgage lending for several years. However, it was utilizing complex systems to evaluate the financial risks and defaults associated with subprime mortgages (Lawrence & James, 2011). As a result, the company was very selective in choosing candidates qualifying for a subprime mortgage. This is because owners of the company were fully aware they were liable in covering unpaid debts when a candidate failed to update his/her mortgage payments constituting to a default (Kevin, 2013).

The number of candidates qualifying for subprime mortgages within Moody’s Corporation had therefore been low for several years. This is because the company was cautious in providing subprime mortgages to persons without either a credit history or a positive reputation in debt payment. However, changes in managerial systems in 1970s translated to increasing number of subprime mortgages. This was witnessed until 2008 when the financial crisis was recorded in the country, affecting several other corporations. Moody’s Corporation, as a mortgage lender was obliged to acquire financial defaults. Although the company was cautious, it recorded long-term growth rate patterns (Kevin, 2013).

More so, foreclosures rates were low while the housing prices were increasing. Consequently, the returns on subprime investments were constantly rewarding. Derivatives are financial instruments obtaining values from expected future assets underlying in a company. Two parties, therefore, agree on the value of the asset, which ought to be higher than its current recording. In Moody’s Corporation, derivatives played a key role in ensuring investors at the company were constantly earning profits from underlying assets. Although the investors were benefiting, they were also contributing towards various financial dangers the company faced during the 2008 financial crisis. More so, the investors suffered immense losses due to the financial crisis. Thus, Moody’s Corporation was wrong for mixing derivatives with financial instruments directly linked to subprime mortgages. Moody’s Corporation was obliged to take innovation of the Asset Backed Security (ABS), mainly the Collateralized Debt Obligation (CDO). This strategy was to enable the creation of a subprime housing asset within the company. However, the company gathered fixed income assets in order to ensure it would record consistent investment rewards at the expense of investors and global financial systems (Kevin, 2013).

Although the adverse effects and financial crisis were foretold since 2003, Moody’s Corporation neglected to amend the model to avoid the crisis. This was based on the company’s improving financial operations and functions. Foremost, Moody’s Corporation was recording an increasing demand of the subprime mortgages. Consequently, the company continued to grow and develop, recording consistent investment returns. As a result, the investors continued to record increasing returns. However, the company continued to neglect being keen in lending mortgages to candidates who did not qualify (Lawrence & James, 2011). This is because Moody’s Corporation believed that if a bank purchased a debt obligation, it was also liable in covering for mortgages clients had defaulted. More so, investors were also allowed to hold some risks. However, they were not allowed to hold a risk exceeding the amount of money they had invested in the company. Thus, the company continued to lend the mortgages, believing and assuming that the investment banks would take financial risks associated with defaulted payment. Thus, the new model was profitable for a short period of time (Kevin, 2013).

However, in 2006 the company began noticing issues with the new model. First, housing prices and the number of sales recorded began to either stand still or decline. The company was also alarmed when the interest rates began to rise. As a result, a large number of investors began to withdraw from the subprime market. The investors sold back their investments to investment banks, leaving mortgage lenders, including Moody’s Corporation with increasing debts. This crisis was coupled with a declining supply of capital. Eventually, the company was accused of being careless and negligent towards safeguarding the mortgage market (Kevin, 2013).

Moody’s Corporation was also legally wrong in relation to mortgage ratings. Residential mortgage backed securities were based on mere opinions rather than definitive recommendations and advice from experts. Moody’s Corporation Chief Executive Officer and the chairperson affirmed to a Financial Crisis Inquiry Commission that the company failed to observe trends in relation to the declining mortgage backed securities and qualities. They acknowledged that as a managerial team at Moody’s Corporation, they began to observe the declines as early as 2003. This was four years prior to the financial crisis. However, they asserted that it was beyond their managerial duty or role to ensure the financial instruments were either substantial or stable. Thus, the management team at Moody’s Corporation was neither ethical nor professional. The team opted to ignore the warning signs that led to the 2008 financial crisis, leading to huge financial losses recorded by various parties aligned to Moody’s Corporation (Kevin, 2013).

Mortgage lenders and security issuers were immediate beneficiaries from Moody’s Corporation’s actions. Financial institutions involved in providing the securities also profited immensely as they played leading roles in making distributions across the mortgage markets. Moody’s Corporation was also a beneficiary. It received fees in relation to investment rates from the financial instruments and derivatives. However, these benefits were short lived after an employee within Moody’s Corporation affirmed competitive pressures led to the lapse of mortgage rating systems. As a result, investors recorded immense losses. Thus, investors were adversely affected by the company’s actions and failure to acknowledge the warning signs. Although the investors believed the securities were unbiased and financially sound, the declines across the mortgage market led to their investments earning fewer values than they had calculated, anticipated, desired, or systematically determined. Thus, Moody’s Corporation investors and clients suffered for a long period of time from the company’s actions (Kevin, 2013).

These revelations, therefore, affirm that Moody’s Corporation had a conflict of interest. The conflict of interest was however unavoidable as it involved rating agencies utilizing issuers and/or investor-pays systems. Both parties had interests in ensuring the determined values from the credit ratings were achieved. First, issuers were hoping to distribute higher credit rating values and securities in order to appear attractive, legit, and financially substantial among investors. Conversely, institutional investors were attempting to improve investment portfolios while seeking enhanced ratings for their possessions in form of securities. Both parties, including issuers and investors therefore undertook their roles without distinctions, leading to conflict of interests (Kevin, 2013).

However, the conflict of interest would have been avoided. For example, the government should have implemented regulations in relation to legal ramifications to ensure inaccuracies were decisively mitigated or eliminated. The financial damages accounted from adopting the new model at Moody’s Corporation should have been analyzed by qualified and experienced economists. This would have ensured delayed payment schedules among investment ranging and rating agencies were avoided. More so, the results would have been utilized to avoid a recurrence of the financial crisis and the huge adverse financial magnitudes experienced in the company as well as across the mortgage market (Kevin, 2013).

Moody’s Corporation was however neither innocent nor entirely to blame for contributing towards the financial crisis. This is because credit rating systematic agencies played a major role towards the financial crisis. First, they failed to provide financial advice towards their clients and investors. They should have advised Moody’s Corporation by providing the company with accurate and reliable information with regards to their misgivings towards the newly adopted model. Homebuyers, mortgage lenders, investment bankers, government regulators, investors, and policy makers often rely on credit rating agencies distributed within the financial and mortgage markets. The credit rating agencies are tasked and mandated to provide trusted, reliable, accurate, and valued resources, ratings, and information affecting financial instruments within the market. Thus, credit rating agencies are mainly to blame for the financial crisis. However, the management team at Moody’s Corporation is entirely to blame for failing to observe early warning signs, leading to the crisis. The team opted to assume the signs four years prior to the crisis rather than adopting measures aimed at either preventing or mitigating the adverse financial effects witnessed across the market (TGH, 2011).

5.0 Conclusion

            Moody’s Corporation was a major company aligned towards recording rewards, profits, and investment in relation to subprime mortgages across the United States. However, it also played a leading role flourishing the 2008 global financial crisis. This is because Moody’s Corporation adopted a flawed and erroneous system in building financial structures. The assets and financial instruments were therefore neither calculated accurately nor determined using reliably financial ratings and systems. Although this further fueled the financial crisis to flourish, Moody’s Corporation neither violated nor failed to abide by the legally formulated laws. Instead, it failed to adopt ethical and practical managerial decisions aimed at promoting and enhancing moral and professional obligations.

For example, it should have protected investors and clients by adopting accountable and credible quality corporation operations, functions, and system models. The company’s guiding principle should have exceeded making profits. Thus, the guiding principle should have been adopted to promote and achieve social, economical, and financial obligations. Moody’s Corporation should have therefore adopted managerial systems focused on promoting ethical and responsible corporate citizenship.

6.0 Recommendations

Managerial transparency is crucial across industrial markets. This principle should be coupled with government and self-imposed regulations. These factors play vital roles in preventing managerial and financial crisis or misgivings. The Financial Crisis Inquiry Commission provided findings from investigating the 2008 financial crisis revealing the following facts. First, the findings revealed members of the public lack proper, substantial, accurate, and reliable information in relation to mortgage markets and banking systems. Thus, legally established companies and financial entities undertake operations and functions without being regulated, scrutinized, and criticized to ensure they undertake their mandates effectively and efficiently (TGH, 2011).

More so, banking institutions were neither monitored nor regulated to ensure activities aligned towards mortgage lending were unbiased against borrowers. Borrowers with a negative credit reputation were often regarded as unsuitable candidates for a subprime mortgage. However, when lending companies began to record increasing sales and housing prices, they also awarded persons with poor credit histories with subprime mortgages. After a period of time, most of the candidates defaulted on their mortgage payments. This created an unsatisfactory debt income ration. Financial experts affirmed that this also attributed towards the financial crisis as it adversely affected global financial systems. Thus, lenders should have continued to provide mortgages to candidates with prove that they can meet and fulfill the payments. Candidates with flawed credit histories should have been denied an opportunity to acquire a mortgage. They defaulted on their mortgage payments leading to deeper financial crisis within the company as well as across the market (Kevin, 2013).

Consequently, investment companies should have acquired securities based on mortgage values as determined by borrowers. Borrowers’ ability to repay the mortgage played a vital role among investors evaluating and managing the number of securities they would purchase. Thus, credit rating agencies should have managed the systems and standards. They should have monitored and regulated the systems and standards to control the competitive pressures. More so, this would have facilitated growth of market shares to enhance credit ratings and promulgate securities. Consequently, profits from mortgage backed assets and securities would have been regulated ensuring that their values increase and improve. Lastly, government regulations and limits across the public sector would have ensured financial market undertake their roles and duties ethically and professionally. Thus, the managerial teams from the government and the company would have played their roles in regulating and controlling factors that led to the crisis witnessed across subprime mortgage market (TGH, 2011).

7.0 References

Kevin, S. (2013). Greed, Negligence, or System Failure? Credit Rating Agencies and the Financial Crisis, Duke University Case Studies in Ethics.

Lawrence, A. T., & James, W. (2011). Business and Society: Stakeholders, Ethics, Public Policy, New York, McGraw-Hill Irwin.

The Ground-Hog (TGH). (2011). Case Study Shows Moody’s Credit Rating Agency at the Heart of the Financial Crisis Starting in 2004, Ground-Hog Financial Reports.

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