Having A Moody (MCO) Wednesday

Yesterday's Financial Times report on Moody's Corporation's (MCO) apparent shenanigans created a huge drop in the stock price today - down over 15%. The culprits - Constant Proportion Debt Obligations or CPDOs - are the latest in the alphabet soup disaster area.

CPDOs are basically a strategy for selling puts on the credit standing of investment grade corporations. The soundness is based on the fact that investment grade corporations have better balance sheets than either consumers or governments. So far, so good.

The strategy employs a high degree of leverage so that the returns are worthy of investments. Here's where the fun begins. When leverage comes in, the risks increase. Not so, said MCO and Standard & Poor's.

While their view of risk seems contrary, the rating agencies are not paid to be conforming. However, insiders (investment banking houses, not investors) smelled a "free lunch" and began to pig out by creating lots of CPDOs. Again, typical behavior. Nothing new.

But many months into the strategy, MCO noticed a mathematical mistake that had positively affected the rating received by CPDOs. On these complex computer models, mathematical mistakes do occur. Because so many factors are involved, one mistake does not usually render the model inoperable. Further, Standard & Poor's had arrived at the same rating by its own analysis. But the real mistake apparently came next: MCO did not own the mistake.

Instead, it is reported that MCO sought to arrive at the same conclusion by adjusting other factors so as to not create a ratings shock. While some might argue that the "managed" approach is most suitable to functioning markets, I would argue that trustworthiness is even more important. As a good friend of mine says, "it takes seven lies to cover up one lie."

Rather than attempting to seem perfect, MCO would have been better off owning the mistake (assuming it is as reported), taking the heat, changing the rating and demonstrating honesty. In an attempt to appear flawless, MCO has apparently shown a lack of character by manipulating its facts to fit the conclusion.

Even if this reprehensible behavior is true, I continue to believe that MCO has an outstanding franchise whose markdown today seems appropriate, but the size of it seems excessive (and inviting): $1.5 billion.