The Financial Ratings Model is Broken, Just in Case You are Wondering

That commie pinko rag the Financial Times discovered that Moody’s improperly rated a complex entity called a constant proportion debt obligations (CDPO) giving them the much desired AAA rating, when it should have been 4 levels lower, Baa.

Moody's was the second rater, in addition to S&P, which also rated them as AAA, though a number of other ratings agencies, Fitch Ratings and DBRS, disputed rating these securities so highly. (There is a graphic at the link that is rather byzantine, which is a sign to run the other way):

The results showed that early CPDOs might lose between 1.5 and 3.5 notches in the Moody’s Metric, an internal measure, which equals up to four ratings notches.

Some Moody’s analysts had concerns. With so many transactions from other banks in the rating pipeline, the code could not be left as it was. The bug was corrected.

At the same time, the documents record that Moody’s staff looked at how they could amend the methodology to help the rating.

Some of the most senior managing directors in Moody’s European structured finance division were involved in meetings to discuss the updating of the methodology for rating CPDO-like transactions in February.

The staff also looked at reducing assumptions about the future volatility of the credit markets so that Moody’s model only anticipated minor moves in credit indices over the next 10 years.

This had the effect of reducing the negative impact on the ratings of correcting the code error.

So, they goofed on a rating, but S&P thought that everything was just ducky, and their reaponse was how do we cover this up.

It's no wonder then that the agencies are vehemently opposed to the idea of guaranteeing the quality of their ratings. Because it's a fundamentally dishonest mindset in a business that appears increasingly dodgy.


As Tanta of calculated risk notes, it's the last two paragraphs of the story (first link)that are scary:

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 implies a sort of mutual back scratching to generate fees that makes all of the ratings suspect.