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Moody's launches inquiry after rating error report

Moody's Investors Service, already under fire over its role in the US mortgage crisis, took another blow as it launched an external investigation after a report that it wrongly assigned "triple-A" ratings to complex European debt products.

Shares of Moody's Corp closed almost 16% lower, the most ever in a single day, after the Financial Times newspaper said a coding error in a Moody's computer model caused the products to be given a rating four notches higher than they merited.

Moody's said in a statement it recently hired law firm Sullivan & Cromwell and initiated a “thorough external review” of its rating process for the securities and would take any appropriate actions after the review is completed.

The FT reported that internal Moody's documents the newspaper had obtained showed the agency had discovered the error early in 2007.

Moody's corrected the coding glitch at that time and instituted changes to its methodology, the FT said. But the products, called constant proportion debt obligations, or CPDOs, kept their triple-A rating until January 2008, when turmoil in financial markets worldwide led to hefty downgrades, the newspaper reported.

Moody's said in a statement it rated 44 European CPDO tranches totaling about $4 billion.

A Moody's spokesman said the company hired the law firm to conduct the review after it heard the FT's story was in the works.

“This is a serious hit,” said Andrea Cicione, a credit strategist at BNP Paribas. “The FT is reporting that some people in (Moody's) have known about the problem since early 2007. Clearly the (ratings) should have been lowered.”

Moody's said in an earlier statement on Wednesday that the company regularly changes its analytical models and methodologies for a variety of reasons. It said it has adjusted its models occasionally when 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 statement said.

“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.”

Roger Kirby, a managing partner with law firm Kirby McInerney LLP in New York, said the outcome of Moody's inquiry may affect an existing class-action lawsuit against the rating company.

The Teamsters Local 282 pension fund is lead plaintiff in a case charging that Moody's stock prices were inflated due to withholding of important information or due to bad information about a company or ratings on debt, said Kirby, whose firm represents the plaintiffs.

“If it's proven to be true, this bears directly on charges that Moody's failed to tell the marketplace some very important information that had a direct bearing on its stock,” Kirby said.

US investor Warren Buffett said that Moody's, 20% of which is owned by his Berkshire Hathaway Inc investment company, would not suffer a big hit.

“I don't think one day will permanently change the franchise value of Moody's,” said Buffett, the world's richest person, at a news conference in Madrid.

US Sen. Charles Schumer, a Democrat from New York, on Wednesday sent a letter to the US Securities and Exchange Commission urging the agency to impose sanctions against Moody's if it can verify Moody's covered up the error for a year after company officials learned of it.

Rep. Paul Kanjorski, a Pennsylvania Democrat, also asked for an SEC investigation if US investors were impacted.

The SEC said earlier on Wednesday it is unclear if it has jurisdiction over the reported computer coding error at Moody's.

“It is my understanding that reports thus far concern activities in Europe over which the SEC may or may not have jurisdiction,” commission Chairman Christopher Cox told reporters after an SEC meeting.

Regulators in Britain and the European Union have not adopted any formal oversight of the ratings agencies, leaving them to an industry code of conduct.

Agencies like Moody's, McGraw-Hill Cos Inc's Standard & Poor's and Fimalac's Fitch Ratings are under scrutiny by regulators and politicians over the role they have played in the US subprime mortgage crisis. They face allegations they assigned ratings that were too high to bonds backed by poor-quality mortgages.

Losses from deteriorating subprime mortgage and repackaged debt have led to more than $400 billion of market losses, according to Fitch Ratings.

Shares in S&P's parent company McGraw-Hill lost 5.5% on Wednesday, while Fimalac's stock fell 1.5%.

CPDOs were controversial from the start and came to mark the peak of the credit boom.

The instruments take leveraged bets on credit derivatives indexes such as the iTraxx Europe. They were designed to pay investors very high coupons -- around 200 basis points over Libor -- and yet gain very high ratings.

The triple-A ratings assigned by Moody's and Standard & Poor's generated controversy, with both Fitch Ratings and DBRS saying they could not justify assigning such high ratings.

Credit market participants too questioned whether the structures were too good to be true. Critics said the performance of the instrument relied more on market risk than on default risk, the traditional area of expertise for the agencies.

The extreme market volatility early this year caused very sharp falls in the values of the instruments and led Moody's and S&P to cut their ratings on them as fears built that investors would end up losing money on the instruments. (Reuters)