Slashdot Mirror
Coding Flaws Caused Moody's Debt Rating Errors
An anonymous reader writes "The Financial Times has the story that billions in incorrect AAA ratings given out by Moody's were the result of a coding error in its computer models. '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.'"
In any case, it sounds like they found a new scapegoat and they're going to take it for a test ride.
this is probably more a feature than a bug --- those instruments are rated by multiple agencies, each of which use their own risk evaluation methodologies and software. i find it highly unlikely that s&p would make mistakes, independently, that would cause it to give the same junk paper the same AAA rating that moody's gave.
As an industry, we really need to start growing up and using the tools the mathematicians have provided us, just as other engineers do in other disciplines, to show our programs actually work as advertised.
The competent have nothing to fear from formal verification and anyone who is not capable of doing such verification should not be writing software anyway.
Simon
The Financial Times has the story that billions in incorrect AAA ratings given out by Moody's were the result of a coding error in its computer models.
So one of the top financial services companies in the world, staffed with MBA's and finance professionals, and none of them noticed a coding error that changed debt ratings by that big of a margin? That strains credibility to the breaking point. And on the other side of the table, none of the financial institutions buying collateralized debt instruments ever looked at those ratings and thought they were a little optimistic? Come on. The entire sub-prime mortgage mess was a computer glitch.
Guess that means cocaine use is alive and well on Wall Street. Because you have to be really, really high to field a whopper like that.
That's our life, the big wheel of shit. - The Fat Man, Blue Tango Salvage
According to one of the Financial Times reporters on the story, interviewed on my local NPR station, the rating was unchanged AFTER Moody's supposedly found and corrected the error, because they "changed their methodology" between the original flawed rating, and the discovery of the flaw.
This guy didn't sound especially convinced, and no one's mentioned any kind of due diligence requirement on the rating agency to actually make sure that their ratings are correct. Apparently whatever gets spit out of the formula is accepted as official, and in this case, they had a lot of incentive to fail to get around to any due dilligence.
It looks like the problem is that these investment vehicles are really hard to understand the intrinsics of, let alone model properly. The FT's awesome finance blog, FT Alphaville goes into a lot more depth on the whole issue - they "explain" the investment thingies themselves, the CPDOs, as well as the failures themselves.
"I'm not sure I buy it really. It just seems like corporate blame deflection."
If anything, the story paints a completely different, much worse picture:
1) Coding bug found to be cause, internally at Moody's
2) Internal docs show adjustment of model factors, ruling out high volatility as part of the model, in order that ratings after the bug fix don't deviate much from those before the bug was found.
That's my understanding of the story, anyway - IANAFinancier. But to me this paints Moody's in a much, much worse light than if they had *just* had a bug in the initial model which they then fixed - after all, that would have resulted in a re-rating...
(Again, I don't quite understand what's going on here, but that was my initial take on the situation)
They won't go after some low-profile wonk. The French bank with billions of losses from a couple of months ago is trying the same thing. It's not plausible.
This is very quickly how the scam works:
The way bond agencies survive is by acquiring new business. Let's say a utility issues a bond for a new water project. They shop the issuance around. Highest rating gets the business. The higher rating means (roughly) less "insurance" they have to carry and the more they can use free cash to do other things.
The bond agencies are as "financialized" as a low-end broker sweat shop. No one seemed to care when the money was flowing. It's easy to take shots after the fact.
Few people follow the Fed's TAF's and its junk-filled balance sheet. It's worse than the credit agencies situation. Who knows if that will ever blow up like the credit markets.
http://www.maxineudall.com/2010/02/should-economists-be-sued-for-malpractice.html
This is B.S. They were double dipping because they provided ratings and at the same time consulted about how to get better ratings... and getting paid for both. They are simply crooks looking for excuses.
This is how the author makes his living - everyone has to support themselves somehow, you know. If he gave his insights away for free, he wouldn't have nearly as much time to devote to his specialty as he does.
I wrote a diary on k5 a few years back which referenced Shadow Stats, which linked to an interview that links to a fuller interview of John Williams, the guy behind the Shadow Stats site.
My impression is that while Mr. Williams is quite right about the government mangling the statistics, he's wrong about the long-term implications (inflation forevermore). I like Mish of the Global Economic Analysis blog's take: he's been saying for some time that the end-game of current economic developments is massive deflation, as all the loans in the economy go bad one at a time, in a sort of cascading system failure. We're now seeing the deflation prediction come to pass - while Gas & food are skyrocketing, other assets (housing, etc) and prices are dropping fast, as homeowners and businesses struggle to find buyers at any price. This is what you'd expect if the amount of money available in the economy (read: available for the everyday working Joe to spend - the trust fund manager who made $1billion last year doesn't count) was decreasing.
For the record, I don't subscribe to Mr. Williams' newsletter - much too poor for that right now.
Learn the rules so you know how to break them properly.
www.teslabox.com
Calculated Risk believes this is a case where S&P decided not to believe their own models and tweaked them to match the results derived by Moody's, which spit out the wrong results in the first place. Call it bug-compatibility, but it's also clear that there were plenty of financial incentives at the time for the rating agencies to deliver results in step with their peers lest they lose out on lucrative "second opinion" business.
Dog is my co-pilot.
I'm no MBA but I would imagine that the rating of any composite
security should be the lowest rating of the most risky component.
Nor are you a statistician (which I'm not either, BTW, but I slept in a Holiday Inn Express last night...). Not dissing you, BTW.
The risk of a portfolio is dependent on the individual components' correlation with each other, as well as their individual risk. You can make a fairly safe portfolio out of relatively risky investments, IF the individual investments are not correlated in their behavior. If you have stocks and bonds in your portfolio, for example, this reduces portfolio risk because prices of stocks and bonds tend to not track each other tightly. Something that trashes the stock market overall may not impact the bond market as much, thus the variability in the overall portfolio is reduced.
This assumption of lack of correlation is what is causing the house of cards to tumble. Risk packagers assumed that there would be no fundamental common fall to the subprime housing market, and priced risk accordingly, which caused interest rates to be too low for the associated risk, which caused over-purchase of the loans. Everyone could have been completely honest, and we would still have this problem.
From my limited understanding of the problem, there are several fun things going on in this situation, any one of which are troublesome:
1) the real estate bubble as a whole, where we lost sight of what a piece of property can really be worth. Regardless of how pretty the house is, the price has to be something that can be paid for out of the income stream of the owner. This was enabled by
2) the mispricing of loans by the industry, in part due the flawed risk assessment, and in part by the complete breakdown of law and morality in the mortgage brokering business, well described elsewhere. These two factors made it cheaper for marginal borrowers to get into property that they couldn't afford, and in that deal (this is subtle) the ultimate lendors endangered themselves because they made loans at an interest rate which did not properly compensate them for the risk they took on. This was enabled by
3) the growth of the securitization of the mortgages into portfolio securities. This was and is I think a good idea, as it allows flow of capital into housing loans from sources that wouldn't otherwise easily be able to supply it. However, apparently the risk modeling that was used to price these was flawed, well before the aforementioned bug surfaced. That meant that these loans were mispriced, as I mentioned before. Since the price was too low, people overpurchased the product. Several somebodies, somewhere, didn't factor in the risk of the bubble in the prices mentioned in one, and what a price collapse would do. That fundamental risk, and the resultant mispricing of the loans is what is bringing the house of cards down. That risk makes this bug trivial in comparison. IMCLTHO
I was taught to respect my elders. The trouble is, it's getting harder and harder to find some.
Sure, a coding error may have resulted in some incorrect ratings, but I suspect that a good chunk of the ratings mis-hits on mortgage deals was also due to their not fully understanding the risks involved, in a very material way.
These structured products are broken into what are known as tranches.
Even if you know you're holding a pile of dog crap mortgages, you know that most will be able to make first months payment. Each successive monthly payment pool is likely to have more defaults, and thus uncertainty grows. If you take 1000 loans, and group the payments together, you can theoretically predict the risk of each band of payments. If you buy the first band, aka tranch, you're far more likely to get paid than if you buy the junior tranches that are expecting payments 30 years from now.
Here's where the fun stuff happens. Those earlier tranches that are more likely to get paid will usually be given very high credit ratings, as it's likely that the owner will collect the income from the pooled debtors. Since the security their holdings is so highly rated, perhaps AAA, then other institutions are willing to accept that AAA security as collateral for additional borrowing. This all continues on in a crazy cycle of leveraging until you have hunders of dollars of leverage to cents of actual income. All the while, these leverage products maintain a high credit rating, because it's all based off of AAA securities.
What happens when people start to default on the orignal loans and the person who bought that orignal pools of loans doesn't get paid? They can't pay their interest to a person who in turn can't pay their interest to a person who gets screwed and has to bring this "safe" security onto their balance sheet and write it all off as a loss. TADA! Credit crunch.
It's more complicated than simply reducing correlation. To hugely simplify: let's take 10 mortgages of equal size, and sell 2 securities related to them:
* The "senior" security is the size of 5 mortgages, and pays it's buyer as long as *any* 5 of the 10 mortgages are paid.
* The "junior" security is also the size of 5 mortgages, and assumes all the risk for all 10 unless 6 or more of them go unpaid (but pays a really nice interest rate).
How reliable is the senior security? If you look through all historical American data and see that failure of 60% of mortgages has never happened (assuming here that we're taking the mortgages from different markets in theis simple example) then you have created a security that, based on all available historical data, is quite reliable.
Of course, the reality of thse securities is far more complicated, but this gets the basic idea across: in order for the AAA rated securites to fail, we'd need a fall in house prices unprecedented in American history. A few of have been predicting such a fall for years, but so what? There are always some loonies predicting doom and gloom, and the hard data supported the ratings.
Socialism: a lie told by totalitarians and believed by fools.
Read the last two paragraphs of this paper (p26). It states that the credit ratings shouldn't have been relied on for certain types of CDO's because they had hidden risk that wasn't obvious.
The interesting part... the paper was written in 2004.
http://www.federalreserve.gov/Pubs/feds/2004/200436/200436pap.pdf
S&P first publishes the ratings and (maybe?) senior staff at Moody's don't stick to their guns when their own models didn't agree with S&P. Given that institutions are pushing hard for those credit derivative products, Moody's yields to pressure. The only game outcome that makes everyone look good is to give AAA's away together, despite common sense, otherwise they risk breeding a credibility crisis throughout the ratings industry.
Then the market comes down. Both S&P and Moody's are pressured to defend their credibility, but they do so in different ways: Moody's acknowledges the error, but it causes them to look bad, as S&P still insists their models are good (despite all the evidence to the contrary). The only outcome that makes everyone look good is either to acknowledge the error or defend it together.
And now, because no one defends their own position, the public will demand regulation of the industry, but the topic itself is so abstract (after all, all you're selling is an expectation of a certain outcome - i.e. "default" vs. "not default" - which one cannot truly guarantee if their life depended on it) that any regulation, by default, cannot be effective here. It's like demanding regulation of weather forecasts. There are quality parameters but, ultimately, how should the government punish a forecaster if he said it would rain but actually it was a sunny day?
Maybe the only fact is that the structure and governing logic behind commercially-sold ratings is just broke. There are so many vested interests that it's nearly impossible to be impartial.
... from the lenders to the credit-ratings agencies.
Yes folks, it was the purveyors of the toxic-waste that *purchased* the ratings rather than the consumers - so naturally the ratings were good, bug or no bug.
There were other lesser known agencies at the time rating the same shite at 4 points lower, but then they were rating it for buyers, not sellers.
See here for more.
Oh please! It's pathetic to want to earn an income to keep a roof over the head of my wife & two children who depend on me? Uh okay.
You may wish to note I stated that I did not participate, period. I don't agree with fraud hence I don't participate in it.
I'd like to know how you would have liked me to handle the issue? I was the loan writer in the company of four people, two people were receptionists, the other person was the Managing Director who was wanting fraud to take place and did defraud the banks. Take the issue to the lenders? at the end of the day the lenders don't care because they want the client - the loan isn't the real product either, it's just what they sell - so they need lots of loans to group together and then securitise, that securisation process is where the money is.
Another thing, the economy didn't go to shit because of people applying for these dodgy loans, they are a small proportion of the issue, you know the largest problem?
NINJA Loans.
No, it's not some funky cool slang, it means: NO INCOME, NO JOB, ASSETS that is, dirt poor, companies en masse lent to clients identified as such.
The economy went to shit due to the multinational corporations who;
A) Widened credit critea to include unemployed people with little to no asset base
B) Misrepresented the risk of the securitised products
C) Borrowed excessive funds to plough into securitisation programmes
D) Drank their own knoolaid believing the misrepresented risk ratings
E) Invested heavily in securitised products
Then low and behold these NINJA loans flicked off the honeymoon interest rate and the USA's lending institutions had doomed credit markets world wide thanks to greed. Homeowners couldn't make the repayments with interest now ticking up. They did the only thing they could and tried to sell the house, but when everyone else is in the same boat you can no longer sell the house for what you bought it for, and so the cycle begins.
I suggest you allocate you blame where it belongs: The banks & lending instituions.
Two Parts Swash, One Part Buckle
Well, for one thing, the _rest_ of society is made up of simpletons whose mantra is "I want to believe."
Everyone in the US (and a few other places such as France and the UK) wanted to believe that they could buy expensive houses and flip them in a month or three, that the price of housing outside of big towns will continue to grow indefinitely (which is idiotic, in a world where there is a finite amount of oil), that everyone will keep paying their loans...
All this, because the alternative is believing in a resource-limited world which gets poorer in real terms (available energy, available raw materials, arable land) by the minute - a world not conducive to peace of mind.
Something bad is coming when people are suddenly anxious to tell the truth.
Again, what exactly is "raise the alarm"?
Secondly, as I already said, things going to shit had VERY LITTLE to do with this type of fraudulent loan. Especially considering our (Australia) economy is still rock solid & growing rapidly despite such issues.
So again, what options existed to raise the alarm? You think a newspaper honestly would run a story about someone no one cares about?
At the end of the day regulation failed as all parties were interested in gaming the system - compliance & auditing works on the basis that Party 1 and Party 2 have different interests, when Party 1 & Party 2 have the same goal compliance & audit measures fail.
And seeing as you didn't catch it the first few times, I didn't stand by and do nothing - I put down barriers as well as protecting myself - I didn't just accept orders and sign off on junk loans.
Two Parts Swash, One Part Buckle
But it sounds so much cooler saying "tranche" because then people arn't 100% sure what it really means. Its designed to obfuscate to people not in the know like a lot of the financial system.
I agree, perhaps I can make a convincing argument as to why though.
They have changed their story. Their first story was a lot better. The fact that they are now changing their story makes me and I am sure the SEC call their bluff.
Anyway, their first explanation (revealed in a multi-page NYTimes article) was that the data supplied by the mortgage lenders was wrong. And this makes some sense- For years the model worked like this: Loan officers went and made loans, verified income, assets, their credit rating, etc. and made sure that the borrower could afford the loan. The interest charged depended on which tier of credit healthiness they were put into, and these loans were later resold to banks. The banks would package these up in a group and ship them off to Moody's and Fitch, who would then give them a credit score to say how likely each package was to default. A higher default rate would mean that a buyer would demand a higher interest rate return. What Moody's essentially did at this point was take the Loan Officer data and rate the tier of loans based on macro conditions in the market (general direction of the real estate market, rate of defaults by the tiers of borrowers, etc.) Their story is that they took the Loan Officers' word that these mortgages were affordable to the people they made the loans to, and this was not true. I can *kind of* understand this to a point, for years this is how the system worked, and it worked well, so I can understand that a slip in their standards would go unnoticed for awhile. However, there was signs all over the F'ing place that things were seriously wrong. "Option Arms" aka negative amortization loans (you owe *more* money after each month, not less) were used all over the place, incomes didn't even begin to match up with what these people owed each month.
To use the car analogy, imagine you were getting cars from Honda for years, and they worked as expected. If Honda started to cut corners here and there, you might not notice for awhile. But the drop in quality in the mortgage borrowers would be akin to Honda dropping off cars that were billowing out white smoke as you drove them off the lot. You would have to have your head in the sand and screaming lalala I can't hear you to not notice that something was wrong. At what point these companies switched from being duped to negligent is subjective, and that is what will be hotly contested in the months to come.
As an aside, lets talk about who these brokers are that were making these loans. I graduated in 2002, in more or less the trough of the downturn, at least from a hiring perspective. Yet a lot of the lets say, "not so academic" people I knew, the comm and psych majors were all getting hired at mortgage companies, which astounded me because many of them had no idea what an interest rate even was, let alone knew how to calculate a payment from one. But they went through a week long training course, put on a suit and tie or some stilettos and a skirt, and started calling people, pushing products they didn't understand, using the pitch script they were handed in training. And it worked, I was insanely jealous that some of these, pardon my french, dumbass jocks, were making 90k a year out of school while I was making less than half that putting in crazy hours at an entry level programming job. Some of them figured out what was going on, but they were so drunk on the money that they didn't care anymore.
As a final point, lets talk about the "coding errors." I have no inside knowledge, but I work in the industry, and I am pretty sure what they mean is that the models they use to predict the expected returns (which are all written in code these days) had a problem, and the code was probably entirely to spec but the spec was wrong. Of course it is much easier to spin it as a "bug" that some "programmer" made, rather than admit that the very core of their business was based on flawed assumptions. These models are tested extensively in any halfway decently run group, and usually run through a vigorous set of what-if scenarios to see how likely it is they would lose value.
I completely agree with this. People don't want to be bothered with the reality of things. They don't want to take responsibility for themselves. They want to follow the herd and believe that everything will be okay because they are going along with what everyone else is doing.
I almost caved in. I almost bought some property at the peak but I realized that things were screwed up. I realized that real estate values were inflated. The thing that boggled my mind and messed me up is that I thought I was poor. I thought I was some how out of sync. "Everyone" around me seemed to be able to come up with some money for some property. The questions I was asking myself were, "Is there really so much money in the economy?" "What kind of jobs are these people doing that they can afford these housing prices?" "Where are all of the jobs that are letting people buy these houses?" In the end it looks like I dodged the bullet... kind of. The hidden tax of inflation is already here and it's only going to get worse. The Federal Reserve and the government are going to bail out all of the assholes. They have to keep "the economy" going. We don't produce anything in America anymore and we're running out of shit to sell each other. All we have is debt. I heard a rumor that they're going to collaterialize car debt. That's what it is coming down to... the wealth of our nation is based on our ability to reliably pay off our automobiles?!??