The credit rating agency Moody's announced yesterday that "following a comprehensive review of its ratings process for European constant-proportion debt obligations (CPDO), it has initiated employee disciplinary proceedings and accelerated measures to strengthen its rating and monitoring processes."
The disciplinary action was taken in the wake of a computer error in its models used to assess the risk in CPDO's that led to about $1 billion worth of the securities to be incorrectly rated.
Moody's says that its investigation showed that "its personnel did not make changes to the methodology for rating European CPDOs to mask any model error."
However, Moody's personnel did violate the Moody's Code of Professional Conduct, which says that " a committee may consider only credit factors relevant to the credit assessment and may not consider the potential impact on Moody's, or on an issuer, an investor or other market participant."
In essence, once the computer error was discovered, it wasn't immediately disclosed as required - people kept quiet as a means to try to mitigate the possible consequences (reputation, financial, etc.) to Moody's and maybe themselves.
There is a very interesting story today in the Financial Times of London (which broke the original story in May), about how financial instruments like CPDOs "are so fiendishly complex that they can only be valued with the help of a computer - or in some cases, several computers running a programme over the course of several days."
The story goes on, "In some ways, this shift has been a boon for the agencies such as Moody's. It has meant that most asset managers have been unable to work out the value of instruments such as CPDOs by themselves - forcing them to rely on the ratings agencies' models for guidance. Indeed, even among the investment banks there has been a growing tendency to use rating agency models, at least for preliminary product design."
However, the story notes:
"In other ways, this increased trend towards complexity - and model usage - has also turned into a rating agency curse. For as investment banks have competed furiously with each other to push more products out into the market, groups such as Moody's have faced pressure to produce more and more ratings - placing their own models under growing levels of stress."
Finally, the Times story goes on to say that, "the CPDO incident may now leave investors, issuers and regulators asking new questions about the reliability of all the other complex computer models being used to rate other financial instruments. And that, in turn, leaves the financial world in a subtle trap. Nobody can see any alternative to using models, given how complex products have become; however, trust in these models is far from high."
