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[CPDO rating error] A CPDO rating explainer

Constant proportion debt obligations are, in themselves, complex products, but their mathematical complexity somewhat pales in comparison to the rating agency models which were developed to judge their default risk.

A rating model, in simple terms, is a simulation: data observed from the market (based on “methodological assumptions”) is fed into the model at one end and out the other end, a random outcome is produced. The “outcome” reflects whether the bond will, or will not, pay all of its coupons and return its principal. In what’s known as a monte carlo simulation, that process is repeated again, and again, and again - usually a million times - to give a whole range of likely “outcomes”. A rating is then awarded based on the number of those million outcomes which result in the bond defaulting. In the case of triple A, the simulation must show that of the million different outcomes, only a minuscule proportion are defaults.

The complexity with CPDOs comes in several parts: with an ordinary structured product, a model is built which statistically assesses the quality of the underlying collateral. For example, with a subprime CDO, a rating agency would look at past default rates and conservatively apply them across the collateral pool to obtain a figure for potential losses. Using past data, it’s fairly simple to extrapolate how that collateral will behave. In simple terms, the ratings for structured products like CDOs are based on fundamentals.

CPDOs, however, don’t make money from fixed-income collateral pools but from trading on credit default swap markets. A CPDO is essentially a dynamic and levered market bet.

The trouble with putting a rating onto such a product is that you have to make assumptions about how the market will move. Bankers, hedge funds and investors may have been doing that for a long time, but rating agencies haven’t been. For CPDOs, the rating agencies needed to develop a model which would accurately simulate the way CDS indices would move over the next 10 years.

At Moody’s the CPDO model - as with most structured product models - came in two parts: the dll and the CDOROM. The dll was the “black box” proprietary part: the secret mathematical model developed to spit out the rating.
The “error” in Moody’s code, which a Financial Times investigation revealed on Wednesday, was in the dll.

When Moody’s discovered the error they corrected it and found that this meant that standard “ABN-like” first generation CPDOs would lose up to four notches of their ratings. CPDOs rated after the correction, however, still achieved triple A.

In part, it seems this was because Moody’s made two simultaneous changes to their rating methodologies. These reduced the impact of the coding issue, say documents seen by the FT.

The changes reflected different methodological assumptions about the market. Most notably, the first change put a “volatility cap” onto Moody’s predictions for how the CDS markets would behave. This had the effect of discounting any scenarios spat out by the model which predicting large movements in price: in effect, the model was adjusted so it couldn’t predict the credit crisis.

More detail on that, in CPDOs triple A failure.

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 11:39 and is filed under Capital markets. 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   17:57 Posted by Integrity Research» Blog Archive » A bug in the Moody’s black box? [report]

    […] One way for Moody’s to regain its credibility would be to release all of its model code to investors. As reported by the FT, “at Moody’s the CPDO model - as with most structured product models - came in two parts: the dll and the CDOROM. The dll was the ‘black box’ proprietary part: the secret mathematical model developed to spit out the rating. The ‘error’ in Moody’s code was in the dll.” Releasing the code behind this secret model would encourage smart analysts at investment research firms to go through it themselves and look for errors. If no errors are found, then the credibility of a Moody’s rating will only be strengthened by this transparency. Furthermore, the knowledge that any mistakes will be visible to the public will cause the firm to take its own quality-control process more seriously; in addition, the fact that the full code is available will give an incentive to investment managers to do more extensive due diligence before they rely on a rating. The overall effect will be greater transparency and efficiency for the market as a whole, and greater trust in the Moody’s franchise. […]

  2. May 22   10:46 Posted by Credit Crunch... Blame the programmers! - Hong Kong [report]

    […] 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. Behooves me to think that the math / financial geeks could not have spotted what seemed like obviously dodgy products and are busy hiding behind the "these were too exotic for ordinary humans to rate" nonsense. FT Alphaville ? Blog Archive ? A CPDO rating explainer FT Alphaville ? Blog Archive ? Moody’s linkfest __________________ Join the GeoExpat Network on LinkedIn.Com or FaceBook.Com New: Hong Kong Jobs - Employers Section & Candidates Section […]

  3. May 21   16:30 Posted by Fitz [report]

    Fabulous job in unravelling another bit of “magic” behind the credit mess.

  4. May 21   14:15 Posted by raider [report]

    - In our 1st statistics lesson we’ve been taught:
    Garbage in, garbage out. It doesn’t matter how often you perform the MC-simulations….

    - In our 1st economics lesson we’ve been taught:
    It’s all about assumptions. Once you’ve made the wrong ones you’re doomed….

    - In our 1st business lesson we’ve been taught:
    It’s all about incentives, stupid. Make’em big enough and they’ll do whatever you need the to do….

    If it weren’t real money it would have been fun to laugh at Moody’s doing all three rookie mistakes….

  5. May 21   12:44 Posted by Ando [report]

    How was Moody’s remunerated for this sort of thing? Did ABN pay Moody’s to have the product rated, or to have it AAA rated by whatever means possible?

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