Nationally Recognized Statistical Rating Organizations (NRSROs), or creditrating agencies, provide investors with independent assessments of a debt issuer’s ability to make scheduled interest and principal payments. NRSROs assess corporate bonds, government bonds, municipal bonds, and debt obligations backed by collateral, such as mortgage-backed securities (MBSs). Broadly speaking, all NRSROs use the same approach for evaluating a debt instrument—feed quantitative data and qualitative judgments into a statistical model, then use the resulting default probability to award a letter grade on a continuum from “extremely unlikely” to “almost certain.” Moody’s, Standard & Poor’s, and Fitch dominate the creditratings business, accounting for nearly 95% of the market. The reputations of the Big Three—each has been in business over 100 years—make their ratings highly coveted. But the Great Recession of 2007-09 tarnished those reputations. The pre-recession housing boom and strong demand for highly rated debt boosted the value of outstanding mortgage-backed securities to over $11 trillion by 2008, or 35% of U.S. bond market debt. This trend made the business of rating MBSs very lucrative, perhaps leading NRSROs to overlook potential flaws in their default-risk models. From 2000 to 2007, MBSs accounted for nearly half of Moody’s rating revenues; in 2006 alone, Moody’s awarded a “AAA” rating to an average of 30 MBSs every day. But when home prices across the U.S. started to tumble in 2007, the flaws in the models of default risk became apparent as home mortgage defaults soared. Ultimately, Moody’s had to downgrade 83% of the $869 billion in MBSs rated AAA in 2006. The fallout from widespread MBS “ratings inflation” brought down two of the nation’s largest investment banks—Bear Stearns and Lehman Brothers—and contributed to the worst recession since the Great Depression. In the post-game analysis, many blamed fraud for the ratings inflation, as suggested by an internal December 2006 Standard & Poor’s email that proclaimed “Let’s hope we are all wealthy and retired by the time this house of cards falters.”* Others pointed to a flawed system whereby the issuer of the debt instrument, not the investor, pays the NRSRO. But these explanations cannot tell the whole story— several large financial institutions that paid for ratings of complex MBSs were undone by their own holdings when those ratings turned out to be inflated. Moreover, ratings inflation did not extend to the traditional bread-andbutter of the business—corporate bonds—despite the fact issuers also pay for those ratings.

1. What ethical issues could arise because companies or governments issuing debt—not investors— pay NRSROs to rate those instruments?

2. Why do you think NRSROs inflated ratings for new complex MBSs but not traditional corporate bonds in the run-up to the Great Recession?