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[CPDO rating error] FT Alphaville exclusive: Moody’s error gave top ratings to debt products

Moody’s awarded incorrect triple A ratings to billions of dollars worth of a type of complex debt product due to a bug in its computer models, an Financial Times investigation has discovered.

Internal Moody’s documents seen by the FT show that some senior staff within the credit agency knew early in 2007 that products rated the previous year had received top-notch triple A ratings and that, after a computer coding error was corrected, their ratings should have been up to four notches lower.

News of the coding error comes as ratings agencies are under pressure from regulators and governments, who see failings in the rating of complex structured debt as an integral part of the financial crisis. While coding errors do occur there is no record of one being so significant.

Moody’s said it was “conducting a thorough review” of the rating of the constant proportion debt obligations - derivative instruments conceived at the height of the credit bubble that appeared to promise investors very high returns with little risk. Moody’s is also reviewing what disclosure of the error was made.

The products were designed for institutional investors. In the recent credit market turmoil, those who still hold the products will have suffered some paper losses while others who have bailed out have lost up to 60 per cent of their investment.

On discovering the error early in 2007, Moody’s corrected the coding glitch and instituted methodology changes. One document seen by the FT says “the impact of our code issue after those improvements in the model is then reduced”. The products remained triple A until January this year when, amid general market declines, they were downgraded several notches.

In a statement to the FT, Moody’s said: “Moody’s regularly changes its analytical models and enhances its methodologies for a variety of reasons, including to reflect changing credit conditions and outlooks. In addition, Moody’s has adjusted its analytical models on the infrequent occasions that errors have been detected.

“However, it would be inconsistent with Moody’s analytical standards and company policies to change methodologies in an effort to mask errors. The integrity of our ratings and rating methodologies is extremely important to us, and we take seriously the questions raised about European CPDOs. We are therefore conducting a thorough review of this matter.”

Credit ratings are hugely important within the financial system because many investors - such as pension funds, insurance companies and banks - use them as a yardstick either to restrict the kinds of products they buy, or to decide how much capital they need to hold against them.

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.”

Related links
CPDOs expose ratings flaw at Moodys - FT

Article Series - CPDO rating error

  1. FT Alphaville exclusive: Moody’s error gave top ratings to debt products
  2. Moody's statement to the FT
  3. A CPDO rating explainer
  4. CPDOs' triple A failure
  5. Buffett doesn't blink
  6. US senator Schumer's letter to Cox
  7. Moody's Confirms External Review of European CPDO Rating Process (Statement)
  8. Moody's on ratings watch negative
  9. Moody's CEO makes statement
  10. Moody's hopes to put CPDO errors behind it
  11. Cox responds to Schumer
  12. S&P admits modelling flaw
  13. Moody's ousts structured finance head, admits breaches to code of conduct

This entry was posted by Sam Jones on Wednesday, May 21st, 2008 at 8:10 and is filed under M&A, Capital markets, Private equity, Hedge funds, People. Tagged with , , , . You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.

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Comments

  1. May 23   20:41 Posted by Relevant Rading From The Past Week « The Capitalist Resistance [report]

    […] FT Alphaville exclusive: Moody’s error gave top ratings to debt products […]

  2. May 23   17:57 Posted by Integrity Research» Blog Archive » A bug in the Moody’s black box? [report]

    […] New York - Earlier this week, the FT reported the disturbing news that “Moody’s awarded incorrect triple A ratings to billions of dollars worth of a type of complex debt product due to a bug in its computer models”. Even worse, investors and clients were not informed when the error was discovered, and the code was corrected simultaneously with a methodological change. To say that this is an embarrassment is an understatement. Moody’s shares have fallen by nearly a quarter since the news broke, and certain legislators, smelling blood in the water, have begun to circle around this case. Ironically enough, S&P has placed Moody’s on ratings watch negative, and it’s possible to foresee a likelihood of lawsuits and regulatory action. […]

  3. May 21   14:17 Posted by Alternative Investment Forum » Blog Archive » THE FINTAG NEWSLETTER @ 21 May 2008 [report]

    […] ftalphaville Moody’s awarded incorrect triple A ratings to billions of dollars worth of a type of complex debt product due to a bug in its computer models, an Financial Times investigation has discovered.Internal Moody’s documents seen by the FT show that some senior staff within the credit agency knew early in 2007 that products rated the previous year had received top-notch triple A ratings and that, after a computer coding error was corrected, their ratings should have been up to four notches lower. […]

  4. May 21   13:08 Posted by DOC [report]

    All grist to the argument that CRA models should be subject to external validation.

  5. May 21   11:38 Posted by grumpy [report]

    Makes a great story but there is probably no such thing as correct coding of these models anyway. They are very complex, assumption laden guesswork that looks impressive when presented to the naive as a neet printout.

  6. May 21   10:51 Posted by Monkey [report]

    Easy mistake to make - like buying halal chicken when you were supposed to get kosher. As long as you dont tell them they will be none the wi …. oh cr*p!

    Whilst it is the rating agencies job to rate things correctly some of the blame lies with the buyers for not bothering to do thier own due diligence. I think the lazy age of ratings reliance may be over.

  7. May 21   10:09 Posted by Moody’s tries to save itself « Mostly Economics [report]

    […] The article is only for subsribers but alphaville blog provides some ideas of what was going on. I found this pretty shocking: […]

  8. May 21   9:43 Posted by Ando [report]

    Hope you’re sending Sam to the Global ABS in Cannes in a couple of weeks. Am sure he’ll come back with some interesting stuff.

  9. May 21   9:35 Posted by G Cox [report]

    Mortgage Banker Dec 2006. S&P Chief Economist.
    Never mind glitches in their models, S&P should have down rated most the extreme leveraged triple A mortgage linked securities when their Chief Economist David Wyss (one of the most experienced economists in the world) warned of the possibility of a 20 % decline in national house prices with worse minus 30% results in the sub-prime focused markets, because their models could not have been stress tested in such an environment since it has never happened before. See last sentence especially. What the hell were British banks doing holding this stuff with forecasts like this extant from a large ratings agency’s chief adviser at end 2006 and why wasn’t this reproduced in the FT???.

    ‘A: For most of this year, we’ve been shocked because the housing market was stronger than we anticipated. Now, sort of all of a sudden in the third quarter, we’re back down to where we thought we were going to be. But as usual, it happened later than we expected and, when it happened, it occurred quicker than we expected.

    So we still think we’re on target for roughly a 25 percent overall drop in housing starts. We do anticipate a bit of a decline in home prices–about 7 percent on the national level, meaning that the median home price will decline 7 percent, not just slow down.

    But obviously, we’re worried about some areas more than others. The areas we worry about most are, first of all, places where the economy is weak. We’re seeing that now in places like Michigan, for example, where the auto industry is laying workers off and home prices are dropping. Secondly, [we worry about] areas that are extremely overpriced. If you look at the overpriced markets, it’s basically the coasts. [On] the West Coast, California has the four highest-priced markets in the country–San Diego, Los Angeles, San Francisco, San Jose.

    All of them [have] average price-to-income ratios that are more than double the national average. A lot of the other problems are in the Northeast. But the areas we worry about most are areas that both have high prices relative to incomes and where there’s a high percentage of investment properties and second homes.

    Q: Can you talk about the worst-case scenario or the perfect storm for home prices, and what it would take to get there? Also, what is the most likely scenario for house prices in 2007?

    A: The most likely scenario for home prices is they edge down a little bit in terms of the median home price–although a lot of that reflects better sales of lower-priced homes and continued problems in the middle with the trade-up homes. You can see that already in the price numbers.

    The “perfect storm” scenario is, obviously, mortgage rates go up more than we expect, maybe because the foreign inflow of funds dries up because foreigners have been buying a lot of these mortgage-backed bonds. That pushes more people out of the market, [and] home prices have to drop more sharply.

    In this kind of scenario, we could be talking about a 20 percent decline in home prices nationally, but that probably means 30 percent on the coasts and 10 percent in the rest of the country.’

  10. May 21   9:07 Posted by hedgehog [report]

    am surprised anyone is surprised

  11. May 21   8:21 Posted by Norman Desmond Ploom [report]

    How ridiculous. ….and S&P still insists it was right to rate them AAA. Either way their credibility is plummeting, yet I am guessing they are still the ones stamping ratings on repos for ECB and the dear ol’ B of E

  12. May 21   8:18 Posted by OJ@home [report]

    it is so believeable. you almost have to feel sorry for them. easy mistake to make. very difficult to corrct afterwards. but perhaps even more interestingly:

    S&P weren’t saying any different so presumably their model was correctly wrong.

  13. May 21   2:51 Posted by wdm [report]

    their story doesn’t add up

  14. May 21   0:26 Posted by bsb [report]

    WELL DONE SAM

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