Who credits the credit raters?

An embarrassing indiscretion at Moody's is going to make it even harder for anyone to trust credit raters...

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Last Updated: 21 Sep 2010

Leading credit ratings agency Moody’s has ousted a senior executive and promised to give several other employees a good hiding, after an investigation proved that it gave the wrong rating to about £1bn worth of arcane financial securities. The sub-prime meltdown has already left credit agencies’ credibility in tatters, as it’s emerged that agencies like Moody’s gave impeccable credit ratings to all kinds of rubbish that wasn’t worth the paper it was written on. But now it turns out that it’s untrustworthy, as well as incompetent...

And it’s not as though today’s mea culpa was entirely voluntary. This fiasco only came to light because of an FT investigation back in May, which proved that a bug in Moody’s computer modelling software had caused some horribly complex securities called CPDOs (Constant Proportion Debt Obligations – it’s something to do with betting on credit risks, apparently, but frankly it’s far too complicated for our meagre little brains to grasp) to be given a cast-iron triple-A credit rating, four notches higher than it deserved. As a result, lots of hapless investors took a bath when it turned out they were actually worth about tuppence-ha’penny.

Worse still, a subsequent investigation by a law firm discovered that Moody’s staff knew about the problem last year – but chose to change their methodology in such a way that it maintained the AAA-rating, rather than coming clean about the bug. Moody’s has now admitted that some of its staff on a key credit committee had ‘considered factors inappropriate to the rating process’ after they learned of the error – and Noel Kirnon, the head of its structured finance division (who wasn’t on this committee, mind) seems to have taken one for the team and fallen on his sword, agreeing to disappear quietly at the end of next month.

But if Moody’s thinks this will be the end of the matter, they may have another think coming. It was noticeably silent on exactly what these ‘inappropriate factors’ were – it insists there was no evidence of a deliberate cover-up, but clearly the committee gave undue weight to the interests of someone other than CPDO investors, which is just as bad.

The problem is that these instruments have become so incredibly complex that you need incredibly sophisticated computer models to work out their value – and these are always liable to bugs. Moody’s has promised to overhaul its process to stop this happening again, but it may be a case of shutting the gate after the horse has bolted: next time some clever banker comes up with a tricksy new financial instrument, who’s going to believe the ratings agencies now? Nobody with any sense...

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