Call tech support, quick! Apparently, the subprime crisis is just a big computer glitch.
Improper computer model coding caused Moody’s Investors Service to give triple-A ratings to billions of dollars of derivative financial products in error, according to the Financial Times. Big institutional investors lost as much as 60 percent when they bailed on those investments after they tanked.
The U.K. daily reviewed internal documents from the credit rating agency in the course of its investigation. It says that some Moody’s senior staff members were aware of the problem early last year.
The products retained their triple-A ratings, however, until January, and they were only later downgraded several notches during general market declines.
The erroneous ratings were for constant proportion debt obligations (CPDOs), derivative financial products designed for institutional investors. Such big investors depend in large part on credit ratings to determine which products to buy and how much capital to hold against them.
CPDOs are highly leveraged bets on the performance of corporate debt in the U.S. and Europe intended to pay out a high fixed return over 10 years. Early products were based on credit derivatives that covered the 125 most actively traded companies in each region.
Standard and Poor’s was the first major rating agency to give CPDOs triple-A status. Because most institutional investors review ratings from two agencies before investing, the Moody’s ratings became critical to those investment decisions.
S&P stands by its ratings.
“Our model for rating CPDOs was developed independently and, like our other ratings models, was made widely available to the market,” the agency said, adding that it “may make further adjustments to our assumptions and rating opinions if we think that is appropriate.”
Regulators say that incorrect ratings of complex structured debt products lie at the heart of the current financial crisis. While other coding errors have occurred, this one is the most significant thus far.
Demand for the structured credit products — which originated in late 2006 — was so overwhelming that Moody’s executives say the agency’s analysts were “overwhelmed” with the volume of work.
The incorrectly rated CPDOs offered assurances of low-risk and high returns. Some promised to pay as much as 200 basis points above the “risk-free” rate at which banks lend to each other — even though comparable European prime mortgage-backed products were typically paying less than 20 basis points.
Moody’s announced it is “conducting a thorough review” of the ratings.
“It would be inconsistent with Moody’s analytical standards and company policies to change methodologies in an effort to mask errors,” the agency said in a statement to the FT.
“The integrity of our ratings and rating methodologies is extremely important to us, and we take seriously the questions raised about European CPDOs.”
“Moody’s regularly changes its analytical models and enhances its methodologies for a variety of reasons, including to reflect changing credit conditions and outlooks,” the agency said.
“In addition, Moody’s has adjusted its analytical models on the infrequent occasions that errors have been detected.”
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