The Role of Credit Rating Agencies in the Subprime Mortgage Crisis

analytical Essay
826 words
826 words

1. Introduction
Midway through 2007 financial markets began to collapse on news of heavy write-downs by major financial institutions. The housing market in the United States (US), which had been experiencing consistent growth since 1975, began to contract in the third quarter of that year while the delinquency rate had been rising since 2006 (Mortgage Bankers Association, 2008). Investors were uncertain how severe the losses would be but it was becoming more likely by the end of the year that a financial crisis was imminent: the amount of subprime and collateralized debt obligation (CDO) losses had surpassed US$120 billion and were expected to increase in 2008 (Gaffen, 2008). As economic conditions turned from bad to worse investors, academics and practitioners began to wonder how such a crisis could have been precipitated in the first place. Blame was placed on mortgage originators, the Federal Reserve and on the investment banks, to name a few. The credit rating agencies (CRAs), seldom in the spotlight, were also heavily criticized for their role in causing the crisis. CRAs certainly do play an important part in financial markets and Thomas Friedman, the Pulitzer Prize winning New York Times columnist, once remarked that there are two superpowers in the world: the US and Moody’s (Lowenstein, 2008). But did the CRAs really deserve blame or were they being held as scapegoats? In the past the agencies generally avoided significant criticism for their rating of corporate debt and government issues, but their role in the burgeoning structured finance market in the early 2000s was characterized by conflict of interest issues, poor risk modeling and ineffective government regulation. As a result low quality ratings proliferated the mar...

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...s Research Paper Series Research Paper No. 07-46, 59-99.
Renault, Olivier and Arnaud de Servigny, 2002, Default Correlation: Empirical Evidence, Staff report, Standard & Poor’s
Rosner, Joshua, 2007, Stopping the Subprime Crisis, The New York Times, Online Edition, July 25.
Rotemberg, Julio, 2008, Subprime Meltdown: American Housing and Global Financial Turmoil, Harvard Business School Case Study 9-708-042.
Securities and Exchange Commission, 2008a, Summary Report of Issues Identified in the Commission Staff’s Examinations of Select Credit Rating Agencies.
Securities and Exchange Commission, 2008b, Proposed Rules for Nationally Recognized Statistical Rating Organizations.
The Economist, 2007, Measuring the Measurers, The Economist, June 2, Finance & Economics section.
Tillman, Vickie, 2007, Don’t Blame the Rating Agencies, The Wall Street Journal, August 31, p. A9.

In this essay, the author

  • Opines that the credit rating agencies should be held partly responsible for one of the most profound market crashes in the century.
  • Explains that ratings for structured finance products may not be accurate or disgorge profits if they turn out to be wrong.
  • Explains the subprime mortgage crisis and how mortgage originators began lending more frequently to borrowers who did not qualify for prime mortgages due to poor credit quality. structured finance products were financially engineered to investors' risk and return preferences.
  • Explains that low interest rates were not the only reason for the appreciation, but it is often noted as one of the most important factors.
  • Cites ashcraft, adam b., schuermann, and covitz, daniel m.
  • Analyzes gaffen, david, hunt, john patrick, and the international monetary fund's global financial stability report.
  • Cites levitt jr., arthur, and lowenstein, roger, as well as lucchetti, aaron and kara scannell. sec tightens rules for rating firms.
  • Analyzes mason, joseph r., and joshua rosner's work on misapplied bond ratings cause mortgage backed securities and collateralized debt obligation market disruptions.
  • Cites partnoy, frank, renault, olivier, and arnaud de servigny.
  • Cites rotemberg, julio, and the securities and exchange commission's summary report of issues identified in the commission staff’s examinations of select credit rating agencies.
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