This morning's Financial Times of London (subscription may be required) has two interesting stories (here and here) about a software coding error that is causing some turmoil both within the rating company Moody's and the financial markets. Look for this story to have some long legs.
According to an investigation conducted by the FT:
"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... "
The debt product goes by the name Constant Proportion Debt Obligations or more commonly CPDOs.
The FT goes on: "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."
"... While coding errors do occur there is no record of one being so significant."
When Moody's gave their AAA rating on CPDOs last year, many analysts thought the rating was too good to be true. Seems it was.
What makes this story even more interesting is the implication that Moody's wasn't exactly forthcoming in acknowledging its software error after it was found and may have even tried to hide it. The FT article states that:
"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."
Moody's responded to the FT article this way: "Moody’s regularly changes its analytical models and enhances its methodologies for a variety of reasons, including to reflect changing credit conditions and outlooks. In addition, Moody’s has adjusted its analytical models on the infrequent occasions that errors have been detected."
“However, it would be inconsistent with Moody’s analytical standards and company policies to change methodologies in an effort to mask errors. The integrity of our ratings and rating methodologies is extremely important to us, and we take seriously the questions raised about European CPDOs. We are therefore conducting a thorough review of this matter.”
In other words, Moody's really, really, really hopes that the decisions to change the rating methodology and the fixes to the coding problem were taken independently, but if they weren't, its reputation is likely going to take a very, very big hit, on top of its rather undistinguished showing in the sub-prime and credit debacle. Earlier this month, Moody's President and COO "decided" to retire, which was seen by financial observers as an admission that the company performed poorly last year in assessing risk.
This fall-out from this small coding error should be be entertaining to watch. Reminds me a little in terms of both cause and impact of the AT&T switch software problem of 1990.
