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Bond grader Moody's stock dives on fear of ratings fraud

May 21, 2008 | 11:23 am

People have become very suspicious of the major bond rating companies in the wake of the sub-prime mortgage crash and the number of AAA-rated securities that really weren’t.

They’ll have more reason to be suspicious now: Moody’s Investors Service stock is down more than 14% today after London’s Financial Times reported that a bug in the firm’s computer models caused Moody’s to award "incorrect triple-A ratings to billions of dollars worth of a type of complex debt product."

According to the FT report, "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." Yet the ratings were maintained at AAA.

At issue are ratings on so-called constant-proportion debt obligations, investment vehicles that borrowed heavily to bet on credit-default swaps. (Swaps, in turn are a way to bet on, or hedge against, companies defaulting on their debt.) Trying to understand CPDOs will make your brain explode, but suffice to say they were designed by Wall Street’s rocket scientists to pay investors high returns at what appeared to be low risk.

That’s exactly how many sub-prime mortgage bonds were structured, of course. Whoops.

Moody’s stock was down $6.40 to $37.50 at about 11:15 a.m. PDT. Investors are petrified that the company could be charged with fraud. Interestingly enough, Moody's biggest shareholder is none other than Warren Buffett's Berkshire Hathaway Inc.

Brokerage Jefferies & Co. cut its rating on the stock to "underperform" from "buy" today, saying the FT report means that "the litigation threats facing Moody's are far more serious" than had been expected.

The FT says Moody's said in a statement that the company "regularly changes its analytical models and enhances its methodologies for a variety of reasons, including to reflect changing credit conditions and outlooks. In addition, Moody’s has adjusted its analytical models on the infrequent occasions that errors have been detected.

"However, it would be inconsistent with Moody’s analytical standards and company policies to change methodologies in an effort to mask errors. The integrity of our ratings and rating methodologies is extremely important to us, and we take seriously the questions raised about European CPDOs. We are therefore conducting a thorough review of this matter."

UPDATE: Moody's issued another statement late in the day. Read it here.