May 21, 2008

Software code problem means Moody’s overrates debt

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Coding errors are not unique to Moody’s and affect other rating agencies “every day”, according to Ralph Silva, senior analyst at financial services advisory firm Tower Group. But he said this case appeared to be particularly severe.

“Ratings agencies never put sufficient emphasis on their technology resources,” he said. In spite of technology playing a key part in ratings decisions, “they simply haven’t felt getting technology right was important enough to business processes, unlike banks”.

Complex mathematical algorithms are written by traders, to produce the ratings, and these are then turned promptly into software code by software developers. Silva said that while banks made sure traders were held responsible for the algorithms they wrote, it was less clear how much mathematicians and risk analysts were held responsible in the ratings agencies.

“The lessons are: One, you cannot make assumptions about the market, there have to be more clear variables in the coding. And two, you have to hold people responsible.”

Ken Vollmer, principal analyst at Forrester Research, said the mathematical equations, not the technology, were at fault. “People blame computer systems all the time. But the systems are just executing what people ask.”

“The weak area is risk management, companies need to control the people making the models.”

It is not the first time that the use of computer algorithms advising on billions of dollars worth of investments has been questioned. Last year in an unrelated incident, Goldman Sachs had to spend £1.5 billion to bail out a hedge fund after computer models incorrectly read volatility in the financial markets.

Nor is it the first time observers have pointed out the importance of governance in the financial industry. Earlier this year in a separate event, Societe Generale trader Jerome Kerviel ran up losses at the bank estimated at £3.6bn using his "in-depth knowledge" of the bank's fraud control systems to circumvent internal checks.

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