Moody’s Colossal Bug

by Stubborn Mule on 22 May 2008 · 6 comments

A Financial Times story has been doing the email rounds in the markets over the last couple of days that points to a colossal stuff-up on the part of the financial ratings agency Moody’s. It seems that a programming error in the model they used to rate “Constant Proportion Debt Obligations” (CPDOs) meant that they assigned a rating of AAA to billions of dollars of securities which they should have rated A+, a whole four notches lower! To make matters worse, FT claims that when Moody’s found the error, they tweaked their rating methodology so that they wouldn’t have to lower the ratings. Shortly afterwards, of course, the credit bubble burst and the price of CPDOs collapsed. Whoops!

ABN Amro devised the first CPDO in late 2006. They called it “Surf” and it was a fairly complex “structured credit” product built using the relatively new iTraxx credit default swap index. Surf was leveraged to generate a high return (around 2% over LIBOR bank rates) and yet ABN managed to convince the rating agencies that it really wasn’t very risky and they were award AAA ratings by Moody’s and Standard & Poor’s. This seemed too good to be true and shortly afterwards countless other investment banks jumped on the bandwagon with their own variations. Of course, when anything seems to good to be true, it probably is. A colleague of mine at the time began calling CPDOs “weapons of mass destruction”. The return offered by CPDOs was so much higher than other AAA securities that something had to be wrong. Even so, investors in these products would rightly be feeling aggrieved about Moody’s shenanigans. Mind you, it still leaves me wondering how Standard & Poor’s ever came up with their AAA rating.

By the way, Surf won ABN Risk Magazine’s deal of the year and IFR’s innovation of the year.

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{ 3 comments… read them below or add one }

1 Craig May 24, 2008 at 8:41 pm

Humm. This all seems highly suspicious and convenient Mule. But I’m affriad I’m not buying their “programming error” line. Could it be that the “error” was in developing the “model” in the first place? You see the devil is always in the detail. Perhaps the hidden message was that the acronym CPDO really stood for Colossal Potential Downgrade Option…

2 stubbornmule May 24, 2008 at 9:05 pm

@Craig I thought I was cynical! Still, just because you are cynical, doesn’t mean you are wrong.

3 derek May 30, 2008 at 4:24 pm

The screenwriter William Goldman (Butch Cassidy, THe Princess Bride) famously said the three rules of Hollywood were: 1) Nobody 2) Knows 3) Anything. I begin to think the same thing is true of the financial speculation industry.

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