Did a coding error contribute to the credit crunch?

The Financial Times reports that flawed code resulted in Moody's mistakenly giving high ratings to structured financial products

Published May 21, 2008 2:22PM (EDT)

The last refuge of the incompetent credit rating agency: Blame the computer!

Or in this case, a "bug" in the computer programming model that Moody's used to rate the credit-worthiness of a particularly exotic strain of complex derivative financial product -- the "constant proportion debt obligation" (CPDO).

The Financial Times has the scoop:

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.

How the World Works is not even going to attempt defining how a CPDO is supposed to work. Interested readers can wrestle with this Wikipedia explanation or the sidebar on this Financial Times story. Suffice to say that CPDOs were all the rage in 2006 but performed awfully when the credit crunch obliterated the wacky world of structured finance.

And now we learn that if not for a programming error many CPDOs should never have received the blue chip ratings required for institutional investors to be allowed to play with them. Those damn computers! Why does software have to be so hard? If only the models had been better, we could have avoided this whole mess.

Well, maybe. But as the Financial Times observes, another ratings agency, Standard & Poors, also gave stellar ratings to the same CPDOs, and as yet, there's no evidence that bugs were running wild in their machines. Naked Capitalism's Yves Smith suggests this implies that the screwed up models were screwed up on purpose.

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.

But that still doesn't resolve the mystery of how S&P justified its own high ratings for CPDOs. Which, to my mind, makes the whole question of whether the bug was a feature or a mistake moot. One way or another, the ratings agencies were going to give the issuers of these products the ratings that they craved, no matter how the models had to be tweaked.

Felix Salmon provides more detail.

By Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

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