On May 20th the Financial Times reported Moody’s error gave top ratings to debt products.

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.

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 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.”

Yves Smith at Naked Capitalism had this cynical comment: “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.

What Yves is referring to is the practice of “shopping around” debt to whoever is willing to rate it the highest. Back in March, bond insurer MBIA even went so far as to ask Fitch to stop issuing credit ratings on its insurance units. See Amazing Action In Ambac, MBIA for more on Fitch.

Cover Up Probe On Moody’s

Bloomberg is reporting Moody’s Plunges for Second Day After Cover-Up Probe.

Moody’s Corp., owner of the second- largest credit-rating company, fell for a second day after starting a probe into whether executives covered up a computer error that gave top rankings to securities that didn’t deserve them.

Moody’s extended its two-day drop to as much as 24 percent after lawmakers and prosecutors stepped up scrutiny of the company’s credit-rating unit. Connecticut Attorney General Richard Blumenthal said yesterday he is investigating New York- based Moody’s for potential fraud in connection with a possible “cover-up” of inaccurate ratings. U.S. Senator Charles Schumer urged regulators to examine the matter and fine the company if it delayed disclosing the mistake to investors.

The calls escalate criticism of the ratings company, which has been under siege since July, when top-rated debt began tumbling as defaults on subprime mortgages soared to records. The company yesterday said it is conducting “a thorough review” of whether a computer glitch caused it to assign Aaa rankings to about $4 billion of European securities that later fell in value.

Buffett also joined the commentary, urging Moody’s to fire employees if the investigation finds they did “things they shouldn’t have done.”

“This is the smoking gun for how these rating agencies operate,” said Martin Weiss, chairman of the Weiss Group Inc., a research firm, in Jupiter, Florida. “It’s a warning signal not only regarding the rating agencies but regarding the accuracy and fairness of credit ratings in general.”

Blumenthal said his office was aware of possible errors before they were reported this week by the FT.

“We have been aware of allegations that, in effect, there was a cover-up of these ratings inaccuracies and defects in the models applied to these complex structured securities,” Blumenthal, who is conducting a broad investigation into ratings companies, said in an interview yesterday. “The question is whether the defects were purposeful” and whether Moody’s subsequently sought to hide the errors, he said.

‘Shirking Responsibility’

Schumer, a New York Democrat, said in a letter to SEC Chairman Christopher Cox yesterday that the “revelations” are “indicative of a culture of shirking responsibility that must end.”

California Treasurer Bill Lockyer called for more regulation, saying that Moody’s kept its ratings artificially high by covering up its mistake.

“It’s time to reexamine the rating agencies’ freedom from any meaningful regulation,” said Lockyer’s spokesman Tom Dresslar. “They like to say that all they do is offer opinions. It’s kind of like a judge saying all he does is offer opinions. These guys wield vast control over our capital markets and our entire economy.”

Missing The Boat

Schumer, Cox, Dresslar, Lockyer, etc are all missing the boat. The problem is emphatically NOT lack of regulation. The problem is misguided regulation by the SEC that created government sponsorship of Moody’s, Fitch, and the S&P.; The solution is to strip Moody’s, Fitch, and the S&P; of their clearly unwarranted government sponsorship.

I have been talking about these problems for years. If you have not yet done so, please read Time To Break Up The Credit Rating Cartel.

The potential for fraud, conflict of interest, ratings shopping, and other problems all came about because a SEC ruling created a monopoly for the big 3 rating agencies. Further compounding the problem, that SEC sponsorship turned upside down the model of who had to pay to receive a debt rating.

Previously debt buyers would go to the ratings companies to know what they were buying. The new model was issuers of debt had to pay to get it rated or they couldn’t sell it. Of course this led to shopping around to see who would give the debt the highest rating.

Government sponsorship of the big 3 created this mess. If Moody’s, Fitch, and the S&P; were paid on the accuracy of their ratings instead of by monopoly mandate, they would quickly sink into oblivion because of the clear incompetence they have displayed.

No one can possibly trust any rating from any of these companies. It is a farce that MBIA and Ambac carry AAA ratings. It is a farce that tons of stuff rated AAA by these companies ever carried those ratings.

We do not need more regulation to fix this mess, we need to eliminate the regulation that created this mess and return to a model whereby rating agencies are sought out because of the accuracy of their rating instead of by government mandate.

Mike “Mish” Shedlock
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