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.
From the Financial Times:
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, a 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….
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.
The comment from Moody’s is particularly sanctimonious:
……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.
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I don’t think it’s a a questionof designing a model to conform with S&P – both agencies were rating the first transactions at the same time. I think conformity with S&P led them to ignore the error which led to that conformity, and then they panicked when they found it. The real sin, if the FT is right, was in failing to disclose the error and tweaking the methodology to maintain the rating once the error was found. A lot depends on how accurate the FT is in its reading of the internal documents – was this methodology change independent of the error or triggered and informed by its discovery? Were the changes it made justified (at the time) as improvements, or were they fudges? So far, it looks very bad.
It’s also worth noting that Moodys’ official statement is a classic non-denial denial.
I am young and have only spent a bit over 1 year in the financial workforce. Yet I learnt quickly the ethics when dealing with mistakes in large international companies.
The last statement from Moody’s is particularly striking. At my place of work it was unwritten policy to cover up our mistakes and even maintain incorrect analysis to avoid losing face with our clients. Totally contrary to the legal and regulatory requirements we faced. I would have some great stories for the SEC.
Ahh, the old agent-principal problem.
Don’t forget that S&P’s model is based on historical default rates rather than actual analysis of underlying collateral. Remember, the whole “basis” for this was.. drop the standards for AAA so that we can sell more of it and get more exec options! So, instead of rating the loans at what they should be, they’re selling D- loans at AAA basis point rates.
Moody’s should not be lambasted alone for this shlock.
S&P’s model is fatally flawed as well, and deserves equal time being roasted on the spit.
unsympathetic – there is no underlying collateral as such in a CPDO. They’re effectively leveraged bets on spread movements in indices of credit default swaps.
We are looking for expert witnesses in a case against debt rating agencies, investment banks and lenders.
Anonymous stated they would have some great stories for the SEC.
Anonymous and others please send email to:
michaelsblomquist@gmail.com
Have you ever written a line of code in your life?? Just a simple dot in a c++ code is enough to give you a syntax error, but a logic error (lets say in a loop) can give you the wrong results without anyone realising that there was a mistake. If an error like this exist in a monte carlo program lets say, then it is enough to cause problems without anyone realising it.