Friday, June 13, 2008

S&P, Following Moody's, Finds Errors in CPDO Ratings Models

(Bloomberg) -- Standard & Poor's said it found an error in models that assigned top credit ratings to constant proportion debt obligations, three weeks after rival Moody's Investors Service said it misgraded similar debt because of a computer glitch.

S&P, a unit of New York-based McGraw-Hill Cos., fixed the mistake in October, and there was no ``erroneous'' effect on the ratings, Vickie Tillman, an executive vice president at the firm, said yesterday in an e-mailed statement. Moody's said its error caused the company to give ratings as much as four levels above what the CPDOs deserved.

``We regularly conduct surveillance of our ratings, and in the routine course of that surveillance, we discovered one error,'' Tillman said. The mistake was in a trial version of the model and was used for initial ratings and monitoring, she said.

The disclosures come as ratings companies try to fend off criticism from lawmakers and the SEC for giving the highest rankings to everything from subprime mortgages to CPDOs that later plunged in value. The U.S. Securities and Exchange Commission this week proposed tougher rules on the companies to help prevent a repeat of the credit crisis.

``The ratings companies have definitely made mistakes in structured finance,'' said Don Quigley, who oversees $3.5 billion in assets as co-manager of the Julius Baer Total Return Fund in New York. ``Have they been damaged? Yes. Will they rectify it? I don't know how.''

S&P notified the SEC yesterday after the Moody's disclosure prompted the regulator to begin an inquiry into whether other errors occurred. S&P and Moody's awarded AAA ratings to the CPDOs, funds that used borrowed money to bet on credit-default swaps, some of which have since collapsed.

Model Error

Banks created at least $4 billion of the securities starting in 2006, promising investors annual interest of as much as 2 percentage points above money-market rates combined with the highest ratings.

S&P's model error affected five publicly rated transactions totaling $200 million and a private deal, Chris Atkins, a spokesman for S&P' said. S&P's mistake was made in March 2007 and wasn't detected until October, he said, when a surveillance analyst discovered that a percentage used to calculate cash flow was wrong. The ratings on all six transactions were recalculated using the right percentage and the change didn't affect the rating, Atkins said.

Ratings Stripped

Moody's and S&P stripped CPDOs of their top ratings this year as rising defaults in the U.S. housing market caused the cost of credit-default swaps referenced by the funds to soar amid concern the economy might fall into recession.

McGraw-Hill has declined 37 percent in the past year in New York Stock Exchange composite trading. The shares fell 11 cents to $43.08 yesterday. Moody's, down 42 percent over 12 months, gained 84 cents to $39.29.

Moody's said it began an investigation into whether its staff covered up the errors. The company also retained law firm Sullivan & Cromwell.

``I would say it's fairly rare, but I've seen model errors in my time at Moody's,'' Noel Kirnon, an executive vice president for the firm's structured finance group, said during an investor conference June 5.

The discovery of errors typically leads to reviews of the firm's ratings on securities through new assessment of committees that assigned the initial ratings, Kirnon said.

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