Most homeowners purchase their houses by borrowing the funds in what is called a mortgage loan. Banks and other financial institutions that make the mortgage loans often package the loans for resale to investors, pooling many mortgage loans together into a "mortgagebacked bond." Investors purchase the bonds and earn interest to compensate for the risk of default by the homeowner on the mortgage loan. In the years leading up to 2007 a very active segment of the mortgage loan market was made up of "subprime" mortgages, loans made to individuals with less-than-stellar credit histories. The subprime mortgages were also pooled together and sold as bonds to investors.
The subprime bonds were graded by Moody's and Standard & Poor's, along with other ratings agencies. However, many of the subprime mortgage-backed bonds were highly rated by the agencies even as the housing market began to struggle and defaults by homeowners increased. Often, investors purchased the bonds in part based on the ratings provided by the agencies. Those investors began to lose money in 2007 as the underlying home mortgages defaulted when homeowners could not afford the payments.
REQUIRED:
a. What is a ratings agency, and how does it grade debt securities?
b. How does a rating affect the interest rate on a bond issue, and how does that interest rate affect the price of a bond issue?
c. What risks would a ratings agency look for when reviewing a bond issue composed of loans to borrowers with "subprime" credit?