Ratings agencies such as Moody’s and Standard & Poor’s rate securities to give investors an independent grading of the risks involved in financial transactions. During 2007 both Moody’s and S&P reported large increase in profits due to the increased volume of securities being issued and the consequent need for their services. Moody’s reported a 20 percent rise in net profits during the first quarter of 2007, while the parent company of S&P (McGraw-Hill) indicated its financial services business (including S&P) recorded a 38 percent increase in operating profits. Both companies cited the growth in issuances as the driver of their profits.

Shortly after these earnings announcements in 2007, financial markets tightened in response to the collapse of the “subprime” mortgage market. Subprime home mortgages were bundled together by issuing lenders and sold to investors in what are called mortgage-backed securities, which are rated by agencies like Moody’s and S&P. In fact, both companies have come under fire for not accurately rating the risks associated with the subprime securities.

Required

(a) What will the tightening of credit markets do the business volume of the ratings agencies?

(b) Where on the financial statements will Moody’s and S&P reflect the drop in issuing activity?

(c) Assume that the two companies are held responsible for their inaccurate ratings on the mortgage-backed securities. What possible entries might appear on future income statements if the companies’ reputation and business are hurt due to subprime collapse?