CPDOs expose ratings flaw at Moody's

When the craze for CPDOs – constant proportion debt obligations – erupted in financial markets in late 2006, some observers quipped that these new products were like something out of a sci-fi blockbuster. Not only was the ingracious acronym amusingly close to C3PO, one of the hapless robots from the Star Wars movies, but also like the heroes of Star Trek the products seemed “to boldly go” where no credit product had gone before.

According to an article published recently by Financial Times, in a time of ever shrinking returns from investments in credit at the height of a raging bull market, early versions of these highly structured and complex deals promised to pay 200 basis points – that is 2 percentage points – over Libor, or the “risk-free” rate at which banks lend to each other. And that spread came with the top-notch triple A ratings that indicate an incredibly low probability that investors could lose their money.

To put this spread in context, triple A rated European prime mortgage backed bonds at the time typically paid less than 20bps, more than 10-times smaller than the CPDO coupon, for example. However, the triple A ratings that Moody's awarded to some early deals were based on a model that contained an error in its computer coding and these ratings should have been up to four notches lower, according to internal documents seen by the Financial Times. Billions of dollars could have been affected.

The very first deals from ABN Amro in August 2006, which were rated triple A by Standard & Poor's alone, provoked huge excitement among bankers, investors, traders in the underlying credit markets and of course the media. Moody's followed up with its first rating of an ABN Amro CPDO in late September 2006.

By December, a range of banks had copied the deal and this new kind of product had been credited by some with adding new impetus to the rally in corporate credit – a rally which meant that a number of the follow-up products could not pay the same high returns promised by the original deals.

Plenty of people thought these products sounded too good to be true. “Once again, the rating agencies have proved that when it comes to some structured credit products, a rating is meaningless,” Janet Tavakoli, an independent consultant, told the FT in November 2006. ”All AAAs are not created equal, and this is a prime example.”

Nonetheless, some of the first deals performed very well before the credit crunch struck and investors had already unwound them early and taken profits.

The agency is conducting a thorough review into the matter.

Read more here.