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Credit Rating Agencies Responsibility
- 1. Coburg University of Applied Sciences / Department of Business Administration / Financial Management / Ethics / WS 2017-18 Credit Rating Agencies Responsibility “The Ethical Side Of The Mortgage Crisis” By: Mohamed A. Abouelenin
- 2. Coburg University of Applied Sciences / Department of Business Administration / Financial Management / Ethics / WS 2017-18 Table of Contents 1. Background i. Description and Key Events ii. Agencies Role Explained 2. Applying Ethical Theories i. Main Ethical Theories ii. Applying Normative Ethics 1. Utilitarianism 2. Kantianism 3. Consequentialism 4. Duty Theories 5. Contract theory 6. Conflict of Interest 3. Responsibility through Rating Agencies Eyes i. Who is Responsible? ii. How did they evaded the Responsibility? 4. What was the aftermath? i. Government Regulations ii. Too Big to fail 5. Other Sources
- 3. Coburg University of Applied Sciences / Department of Business Administration / Financial Management / Ethics / WS 2017-18 Description and Key Events Federal Reserve Bank cuts Interest Banks need better return Mortgages to people who can’t afford “Sub-prime mortgage” Demand Shock for Home Ownership “Prices rise” Create bonds from Sub- primes “MBS & CDO” CRAs Rate Securities “False AAA- BBB” Everyone buys BAD DEBTS Supply Shock Home prices falls People defaults Banks default Everyone defaults Government: $700 Billion BAILOUT Source: Time Magazine, USA Today, Credit Crisis 101
- 4. Coburg University of Applied Sciences / Department of Business Administration / Financial Management / Ethics / WS 2017-18 Agencies Role Explained The CRAs’ functions Can be grouped under three general headings: • Providing information and assessment for investors • Enabling issuers to access capital markets • Helping regulators to regulate. The Growing Importance Of CRAs • Providers of creditworthiness opinions of companies and countries. • They become very important players in financial markets due to growth in Financial Markets and Globalization. • Any Error impacts the overall performance of the financial markets. ”Whenever you find yourself on the side of the majority, it is time to pause and reflect.” MarkTwain • References and further reading: German Institute for International and Security Affairs
- 5. Coburg University of Applied Sciences / Department of Business Administration / Financial Management / Ethics / WS 2017-18 Main Ethical Theories Meta Ethics Questions: • Where our ethical principles come from? what they mean? • Are they social inventions? Answers: • Universal truths or God’s will. • Role of reason in ethical judgments. Philosophers today usually divide ethical theories into three general subject areas: • References and further reading: iep.edu Applied Ethics Involves examining specific controversial issues: • Abortion, Infanticide, Animal Rights, Environmental Concerns, Homosexuality, Or Nuclear War. Normative Ethics Questions: • What good habits we should acquire? • What duties we should follow? • What are the consequences of our behavior on others? Answer: • Golden Rule: We should do to others what we would want others to do to us.
- 6. Coburg University of Applied Sciences / Department of Business Administration / Financial Management / Ethics / WS 2017-18 Applying Normative Ethics Theories 1/3 Utilitarianism • Actions are morally right or wrong depends on their effects. More specifically, the only effects of actions that are relevant are the good and bad results that they produce. • In our Case: The effects of rating the Securities with high ratings is more good in its results than rating them bad. Kantianism • Certain types of actions (including murder, theft, and lying) were absolutely prohibited, even in cases where the action would bring about more happiness than the alternative. • In Our Case: The rating agencies should have followed this course of action and refused the pressures from Financial Institutions. • References and further readings: Kantians ethics, Kant’s Moral Philosophy• References and further readings: Utilitarianism, Act and Rule
- 7. Coburg University of Applied Sciences / Department of Business Administration / Financial Management / Ethics / WS 2017-18 Consequentialism • An action is morally right if the consequences of that action are more favorable than unfavorable. • In Our Case: The consequences for the rating agencies was much favorable (Profit) when rating the sub- prime bonds as good (AAA-BBB). Duty Theories • Absolute duties: Universally binding obligations on people which are the result of contracts between people. Such as avoid wronging others. • In Our Case: It is wrong to not care for other people benefits even if it results in some great benefit, such as financial profits. Applying Normative Ethics Theories 2/3 • Reference: ieu.edu/Duty theories
- 8. Coburg University of Applied Sciences / Department of Business Administration / Financial Management / Ethics / WS 2017-18 Applying Normative Ethics Theories 3/3 Contract Theory • “The view that persons' moral and/or political obligations are dependent upon a contract or agreement among them to form the society in which they live.” • In Our Case: The rating agencies’ contracts hold no obligations or any kind of legal liability on them if their ratings were wrong (even deliberately). Conflict of Interest • “A conflict of interest is a set of circumstances that creates a risk that professional judgement or actions regarding a primary interest will be influenced by a secondary interest.” • In Our Case: Stemming from the issuer- pay model, as Banks (Bonds seller) were the entities who paid the rating agencies to rate their bonds. As a result, rating agencies granted their bonds high ratings in exchange of profits. • References and further readings: Conflict of Interest, P.46• References and further readings: Social Contract Theory
- 9. Coburg University of Applied Sciences / Department of Business Administration / Financial Management / Ethics / WS 2017-18 3. Responsibility through Rating Agencies Eyes i. Who? • Infinite reasons led to the Crisis but we will focus on The Rating Agencies’ role. • Rating Agencies CEOs: • Kathleen Corbet “S&P’s CEO” • Raymond McDaniel “Moody’s CEO” • Classical quote “It’s not me, it’s my manager” • Short video about the misconduct: ii. How? • Identified by a US Congressional Report: • “Key enablers of the financial meltdown.” • “Central villains and that the crisis could not have happened without their misconduct.” • Due to: • Deregulation: the reduction or elimination of government power in a particular industry. (NO RULES) • Their legal argument is that they cannot be held accountable because they are merely issuing “opinions”. • They stated that the amount of sub-prime defaults was insignificant. (An Honest Mistake) • References and further readings: • The Guardian: Who to blame for the Great Recession? • TIME: 25 People to Blame for the Financial Crisis • Forbes: The 2008 Meltdown And Where The Blame Falls • References and further readings: • Harvard Law School, The Telegraph
- 10. Coburg University of Applied Sciences / Department of Business Administration / Financial Management / Ethics / WS 2017-18 4. What was the aftermath? 2. Too BIG To Fail Unfortunately, despite of their unethical and unregulated behavior. These major financial institutions became “Too Big to Fail” which will have a more significant effect on the US and Global economy if they failed. 1. Government Regulations • Dodd–Frank Act “Wall Street Reform” and Consumer Protection Act • Credit Rating Agencies new Governance and Compliance requirements (Proposal) • Created the Consumer Financial Protection Bureau • Financial Stability Oversight Council • Systemic Risk Restrictions • Raising deposit insurance limits • References and further readings: • Harvard: The Financial Panic of 2008 and Financial Regulatory Reform
- 11. Coburg University of Applied Sciences / Department of Business Administration / Financial Management / Ethics / WS 2017-18 Other Sources The Big Short Margin Call Too Big To Fail Inside Job Money For Nothing
Editor's Notes
- There were would-be home buyers who overstated their income on mortgage applications; lenders who didn’t care; appraisers who overstated the value of homes; rating agencies who rubber-stamped securities to get business; traders who knowingly sold investors on securities they knew to be a “sack of sh-t.” and that taxpayers spent gazzillions helping many of these banks. Sub-prime mortgage A risky mortgage loan made to someone with a relatively low credit score and insufficient income to get a conventional mortgage. Sub-prime borrowers are more likely to default (or be unable to make payments on) their mortgages. 1Mortgage-backed security (or MBS) A bundle of mortgages that’s sold and traded like a bond. When you bundle a lot of mortgages, even sub-prime ones, it’s unlikely that all of them will default at the same time, so the risk associated with the bundle is thought to be relatively low. The relative risk of these bundles get graded by ratings agencies like Standard and Poor’s and Moody’s. 2Collateralized debt obligation (CDO) A bundle of mortgage-backed securities. Yes, a bundle of bundles of mortgages. There were also “CDO Squared,” which were bundles of bundles of bundles of mortgages. As you would imagine, these got so complicated that nobody really understood what the underlying value of these were. Yet in many cases they were still rated as very safe investments. Oops. 3Synthetic CDO An even more ridiculously complicated kind of CDO made up of insurance payments from a credit default swap on CDOs made up of MBSs. Got that? Unfortunately, neither did most of the people buying and selling them. Credit default swap An insurance policy that pays off if a CDO defaults. This is how The Big Short guys bet against the real estate market.