It Wasn't Us; It Was The Computers!

That's what Moody's appears to be saying, or at least laying the groundwork to say, in light of the many law suits that are waiting in the wings spurred by the collapse of so-called Aaa-rated securities. One of the biggest head-scratchers with the financial crisis has been how such high credit ratings could have been issued on securities that were so susceptible to default; with news that Moody's is now investigating a possible computer bug that caused the mismatched ratings, it certainly does look as though it's covering its proverbial ass.

Both Moody's and S&P only began to strip-away their previously issued triple-A ratings after some of the constant proportion debt obligations (CPDOs) defaulted. Are we to think, then, that S&P's rating system was inflicted by the same virus?

CPDOs are portfolios of index-based credit default swaps (CDSs) that include both risky and safer trenches that have, somehow, made them candidates for the highest investment grade ratings. These CPDOs represent the latest innovation in one of the largest markets - credit default swaps - allowing investors to collect even higher returns as a result of even higher leverage. From this short description alone, does it sound to you as though this would qualify as deserving a Aaa rating? When will investors learn that there's no free lunch; higher rates of return do necessarily mean higher assumed risk. Period.

Banks created at least $4 billion of CPDOs, promising annual interest of as much as 2 percentage points above money-market rates combined with the highest credit ratings -- described a ``holy grail'' for investors by Bear Stearns Cos. strategist Victor Consoli in a November conference call.

There's no holy grail; if there were, every investor, their brother, their sister and their cousin's nephew would be buying and the price of such assets would rise and thereby reduce its yield. It's a classic arbitrage opportunity that just can't exist for any extended period of time. If a broker or advisor is telling you differently, then they themselves probably don't understand the securities.

Here's a bit of a primer on CPDO's and credit default swaps from this bloomberg article:

CPDOs sell contracts on credit-default swap indexes and use the premiums to pay investors. If the perception of credit quality deteriorates, the cost of insuring the debt increases and CPDOs lose money. To make up for losses, the funds would typically increase their borrowing.

Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements.

Rating a CPDO involves making assumptions about the way the indexes of credit-default swaps will move, based on a limited history of the benchmarks. The U.S. index referenced by CPDOs was created in 2003; its European counterpart started in 2004.