The FT has an explosive story today about the market in CPDOs, and the way that Moody’s, in particular, rated them. The problem is that CPDOs are so ridiculously complex that this scandal – and it is a scandal – will probably not get the traction it deserves, just because it’s very difficult to understand. But in a nutshell, this is what happened:
ABN Amro issued a few securities, which Moody’s rated triple-A. But when Moody’s went back to double-check its calculations, it found a bug in the computer code used to generate that rating. When the bug was fixed, it turned out that the securities in question should have been rated four notches lower. But what happened? Moody’s never rerated the securities in question, and indeed it continued to give triple-A ratings to new, almost identical, securities. It did this because it was making money hand over fist by rating them because by sheerest coincidence, at exactly the same time as it fixed that computer-code bug, Moody’s also made two changes to its ratings methodology elsewhere – changes which resulted in this class of securities retaining their triple-A rating.
Sam Jones, who helped report the story, also takes advantage of his presence over at Alphaville to add some color: in this entry he exposes an internal Moody’s document which says that only two of three proposed ratings changes were made because the third “did not help the rating.” That’s a smoking gun, if you ask me: there’s simply no way that whether or not a proposed change helps the rating should ever be a factor in the decision to adopt that change.
Interestingly, the official Moody’s statement stops short of denying that they did that:
It would be inconsistent with Moody’s analytical standards and company policies to change methodologies in an effort to mask errors… We are therefore conducting a thorough review of this matter.
Jones also, wonderfully, gets full reign to explain all the nitty-gritty in a blog entry: this is where the internet really comes into its own. You couldn’t print all this kind of stuff in a newspaper, it would be far too technical and boring. But online you can put everything up.
At Moody’s the CPDO model – as with most structured product models – came in two parts: the dll and the CDOROM. The dll was the proprietary part: the secret mathematical model developed to spit out the rating. The CDOROM meanwhile, contained a whole series of methodological assumptions about the market which the dll took in as data.
The “error” in Moody’s code, which a Financial Times investigation revealed on Wednesday, was in the dll.
When Moody’s discovered the error they corrected it and found that this meant that standard “ABN-like” first generation CPDOs would lose up to four notches of their ratings. CPDOs rated after the correction, however, still achieved triple A.
In part, it seems this was because Moody’s made two simultaneous changes to their rating methodologies in the CDOROM. These reduced the impact of the coding issue, say documents seen by the FT.
The changes reflected different methodological assumptions about the market. Most notably, the first change put a “volatility cap” onto Moody’s predictions for how the CDS markets would behave. This had the effect of discounting any scenarios spat out by the model which predicting large movements in price: in effect, the model was adjusted so it couldn’t predict the credit crisis.
A lot of people have been waiting for this story to emerge for a while: the long-form journalism practiced by the likes of Jesse Eisinger and Roger Lowenstein is all well and good, but this kind of investigative piece is where financial journalism really makes a difference in the markets. Gold stars, then, to Sam Jones and Paul Davies at the FT, as well of course to the redoubtable Gillian Tett. A fine job.