Moody's Awards False AAA Ratings on CPDOs Due to Computer Error

Armen Hareyan's picture

According to the Financial Times, who conducted an independent investigation, Moody's awarded incorrect Triple A ratings to billions of dollars worth of CPDOs. Apparently, the Financial Times discovered a computer glitch in Moody's models that would have awarded ratings up to four notches lower than the original AAA rating.

Moody's is now investigating the "computer bug" after reading FT's report. Isn't it great when one of the largest ratings agencies outsources its computer modeling to a bunch of financial reporters? It should give comfort to all of those investors out there who purchase securities solely based on AAA ratings granted by the rating agencies. How reliable are those models anyway? Apparently, betting on Naomi Campbell to show up on time and not throw a phone is a safer bet.

Sure we can blame the AAA rating on a computer bug, but intuitively, it's amazing that investors ever thought that CPDOs were "safe" investments. CPDOs, Constant Payment Debt Obligations, were structured products that were supposed to yield a nice steady income of Libor + 200 (a fabulous return at the time in 2006).

The yield was generated by selling credit default swaps, or insurance, on the main investment-grade indices in the US and Europe, and collecting a premium. Anyone with even a cursory knowledge of derivatives can tell you that a structure that is designed to sell volatility and then sell some more when volatility goes higher, has a fairly decent shot of losing boatloads of money.

Selling volatility is always a high risk proposition, particularly when you do it when premiums are at record lows, right before they spike to record highs. This is not a case of "hindsight is 20/20," as several astute investors and commentators criticized the structure when it was initially introduced.

The bigger question here obviously is not about the computer bugs found in these particular structures. The question is: How much more reputational damage can the ratings agencies suffer before investors start to call Warren Buffett instead?

Source: By Mock The Market Blog - http://mockthemarket.blogspot.com/

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