Capital Markets

Moody’s Computer Glitch Intensifies Probe

Connecticut attorney general, studying antitrust in the big three credit-rating agencies, tackles the question of whether one type of bond was mis-...
Marie Leone and Stephen TaubMay 22, 2008

As part of a six-month investigation into potential antitrust violations at the big three credit rating agencies, Connecticut’s attorney general added a probe of the reported Moody’s Investor Services computer glitch that may have created mis-rating problems involving an instrument known as a constant-proportion debt obligation, or CPDO.

“The so-called computer error and the potential favoritism toward certain bond issuers in return for additional business at the rating agency is part of our ongoing investigation,” Attorney General Richard Blumenthal told

Blumenthal said that his office had heard reports about the possible computer errors and mistakes in analytical models at Moody’s, which reportedly caused the agency to give its European CPDO a rating that was considerably too high. Currently, the probe remains an investigation into civil, rather than criminal, violations.

The computer snag was first reported in the Financial Times on Wednesday, and on Thursday, Moody’s said it retained the law firm of Sullivan & Cromwell to initiate a thorough external review in response to questions raised by the British paper. “The integrity of our ratings and rating methodologies is extremely important,” Moody’s said in a statement.

According to the FT, which cited internal Moody’s documents, some senior staff knew early in 2007 that products rated the previous year had received triple-A ratings and that, after a computer coding error was corrected, their ratings should have been lower by as many as four notches. Moody’s would not confirm for that there was a computer glitch related to CPDOs, but would say that there is an external review going on. Moody’s spokesman Anthony Mirenda said that the credit rating agency had hired Sullivan & Cromwell after becoming aware of the questions raised in the FT report.

Meanwhile, Senator Charles E. Schumer (D-NY) urged the Securities and Exchange Commission to investigate the matter, according to the New York Times. Because the CPDOs were assigned in Europe, and therefore do not affect U.S. investors, some observers questioned whether the SEC has jurisdiction to bring an enforcement action against Moody’s.

While it is true that the SEC only launches investigations into violations of U.S. securities laws, new rules formalized in September, gives the regulator the authority to “inspect and examine” the procedures, policies and systems of the agencies. What’s more, inspections can result in a case being referred to the SEC’s enforcement division for further review.

In response to calls by Blumenthal and Schumer for an investigation, Moody’s told “As you would expect in this environment, we receive various government inquiries and fully assist in those inquiries. But we don’t think it is appropriate to comment on any specific inquiries at this time.”

Moody’s rated 44 European CPDO tranches, representing $4 billion in rated securities. The instruments promise to deliver an attractive one-two punch: annual interest of as much as two percentage points above money-market rates as well as the highest credit ratings, according to Bloomberg. The wire service said Standard & Poor’s also awarded top rating grades to CPDOs.

The credit rating firms have already been in Blumenthal’s cross-hairs. In September, Connecticut’s attorney general issued subpoenas to S&P, Moody’s and FitchRatings as part of the antitrust investigation into the industry. “The debt rating industry is a highly concentrated market controlled by a handful of companies,” said Blumenthal at the time.

The legal move was made public in a regulatory filing by McGraw-Hill Cos., which owns S&P, that noted that it was responding to a subpoena alleging that the agency violated the Connecticut Antitrust Act.

The subpoenas came as rating agencies faced intense scrutiny for their role in the recent subprime-mortgage crisis; for having a monopoly in the market for ratings; and for issuing ratings that could potentially benefit their businesses, under the protection of free speech. As fallout from defaulting subprime mortgages has spread, some have accused the rating agencies of inflating the grades they apply to debt.

The SEC, meanwhile, is investigating whether ratings firms face pressure from Wall Street to give mortgage bonds high ratings.

“Without a good credit rating, many loans cannot be made,” said Blumenthal in the fall. “My investigation seeks to determine whether credit-rating agencies may be exploiting their dominant positions to unfairly raise prices or exclude competitors.” According to a press release issued in October, the Blumenthal was planning to investigate “unsolicited” ratings — when an agency rates an issuer’s debt against its wishes and then demands a payment. He also was to look into the practice of “notching,” which is when agencies allegedly threaten to downgrade an issuer unless they receive a contract to rate the issuer’s entire debt pool. Finally, he will probe exclusive contracts that offer issuers discounts, thus hindering competition.

Lack of competition has been a key criticism of rating agencies: Standard & Poor’s, Moody’s and Fitch represent about 80 percent of the market. In May 2007, the SEC voted to adopt rules to implement the Credit Rating Agency Reform Act of 2006, giving it greater oversight of the agencies and welcoming fresh competitors into the market.