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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 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.
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.
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.
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.