Wednesday, May 21, 2008

Comments on Moody's CPDO computer glitch

(Bloomberg) -- Moody's Investors Service said it's conducting ``a thorough review'' after the Financial Times reported that a computer error was responsible for Aaa ratings being assigned to complex debt securities that slumped in value.

Banks obtained the highest grades in 2006 and 2007 for constant proportion debt obligations, funds sold in Europe that used borrowed money to speculate on an improvement in credit quality. The subprime crisis caused banks including UBS AG and ABN Amro Holding NV to unwind their CPDOs, triggering losses of as much as 90 percent for investors.

Some senior staff at Moody's were aware in early 2007 that CPDOs rated Aaa the previous year should have been ranked as many as four levels lower, the FT reported today, citing internal Moody's documents. The firm adjusted some assumptions to avoid having to assign lower grades, the paper said.

``If it is true, does that mean other products haven't been rated correctly?'' said Puneet Sharma, Barclays Capital's head of investment-grade credit strategy in London. ``Will they be downgraded? It could lead to turmoil.''

Banks created at least $4 billion of CPDOs, promising annual interest of as much as 2 percentage points above money- market rates combined with the highest credit ratings -- described a ``holy grail'' for investors by Bear Stearns Cos. strategist Victor Consoli in a November conference call.


Moody's and Standard & Poor's stripped CPDOs of their Aaa grades this year as rising defaults in the U.S. housing market increased the cost of credit-default swaps referenced by the funds by as much as 670 percent in the past year.

``The integrity of our ratings and rating methodologies is extremely important to us, and we take seriously the questions raised about European CPDOs,'' New York-based Moody's said in an e-mailed statement. ``We are therefore conducting a thorough review of this matter.''

Moody's has ``adjusted its analytical models on the infrequent occasions that errors have been detected,'' the statement said. ``It would be inconsistent with Moody's analytical standards and company policies to change methodologies in an effort to mask errors.''

Credit rating firms have come under scrutiny from lawmakers and regulators for assigning their top grades to securities tied to loans to people with poor or limited credit.

``As far as CPDOs are concerned there shouldn't be a material impact'' because the securities have already been downgraded, said Andrea Cicione, a credit strategist at BNP Paribas SA in London. ``Of course there could be a reputational impact for Moody's.

Naked Capitalism comments:

Just when the world at large has become inured to the stories of the role of rating agency incompetence and complicity in our credit mess comes a bit of news that catches the attention of even the jaded.

Moody's had a bug in a program used to rate complex debt securities (constant proportional debt obligations, a troubled subsector) in 2006 that led billions to be rated Aaa when they deserved grades as much as four notches lower.

But it gets better:
1. Moody's became aware of the error in early 2007 but did not mark the paper down to its correct level till 2008 when it was downgrading lots of other subprime paper. In other words, it waited until it could cover its tracks.

2. You have thunk that Moody's would have noticed the error right away, since issuing artificially high marks should have led to a readily apparent disparity with Standard & Poor's ratings. So consider this statement from the Financial Times article that is breaking the story (hat tip Steve):
The world’s other major credit agency, Standard and Poor’s, was the first to award triple A status to CPDOs but many investors require ratings from two agencies before they invest so the Moody’s involvement supplied that crucial second rating.

S&P stood by its ratings, saying: “Our model for rating CPDOs was developed independently and, like our other ratings models, was made widely available to the market. We continue to closely monitor the performance of these securities in light of the extreme volatility in CDS prices and may make further adjustments to our assumptions and rating opinions if we think that is appropriate.”

This begs the question that the so-called bug wasn't a bug at all but a feature, that the model was designed (or tweaked) to produce ratings that conformed with S&P. After all, if an issuer got an AAA from S&P and wanted a second rating from Moody's, it would kill Moody's chance of ever rating similar paper for it to issue a markedly lower score.

In other words, while banks have rogue traders, it appears rating agencies have rogue computer models.

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