House of Commons - Treasury

Select Committee on Treasury Sixth Report

2 Changes in financial markets

The economic backdrop—the 'great moderation'

10. The period since the economic downturn of the early 1990s, which affected almost all developed countries, came to be known as the 'great moderation' in the United States and the 'great stability' in the United Kingdom.[12] This 'great stability' was described by Professor Willem Buiter, from the London School of Economics, as being characterised by low and stable global inflation, as well as high and stable global real GDP growth over the past decade.[13]

11. Another striking feature of the global macroeconomic environment, according to Professor Buiter, was the declining level of real interest rates, and specifically the marked decline since the bursting of the so-called 'technology bubble' at the end of 2000.[14] Professor Buiter explained that the proximate determinant of the trend decline in real interest rates was "an ex-ante savings glut, caused by the rapid growth of new emerging markets like China, which have extraordinarily high propensities to save" as well as more recently "the global redistribution of wealth and income towards a limited number of producers of primary energy sources (especially oil and natural gas) and raw materials".[15]

12. The Governor of the Bank of England concurred with Professor Buiter's explanation for the declining and low level of real interest rates, stating in his 9 October 2007 speech in Belfast that prevailing low real interest rates were primarily caused by high rates of saving in other parts of the world:

The primary explanation is the high rates of saving in other parts of the world. Japan has been a net saver for more than a quarter of a century. Following the Asian crisis in the mid-1990s, many of Japan's neighbours also raised their national saving rates. That group includes the country which is now the world's biggest saver—China. And more recently, after the tripling of oil prices, they have all been joined by the oil-producing nations from Saudi Arabia to Norway.[16]

The Governor went on to explain that savings from these countries flooded into world capital markets with the consequence that borrowers were able to attract long-term loans at remarkably low interest rates. These low interest rates encouraged borrowing and spending (and reduced saving) in much of the developed world, resulting in large and expanding trade deficits. The Governor noted that, in order to keep overall demand growing and inflation stable, in the face of these trade deficits, central banks in the developed world responded by keeping official short-term interest rates low.

The 'search for yield'

13. These low official interest rates helped depress interest rates on low-risk assets such as government debt and encouraged investors to search for investment options that offered a higher yield, a phenomenon sometimes referred to as the 'search for yield'. Jeremy Palmer, Chairman and Chief Executive, Europe, Middle East and Africa, UBS, noted that "over the past few years, as is now well known, we have lived through a period of stability and low interest rates which has led investors to search for high yield".[17] The Governor of the Bank of England explained the consequences of this 'search for yield' in his speech in October 2007:

the price was unusually low interest rates—both short and long-term—which were considerably below the levels to which most investors had become accustomed in their working lives. Dissatisfaction with these rates gave birth to the 'search for yield'. This desire for higher yields could not be met by traditional investment opportunities. So it led to a demand for innovative, and inevitably riskier, financial instruments and for greater leverage. And the financial sector responded to the challenge by providing ever more sophisticated ways of increasing yields by taking more risk.[18]

14. The generally benign macroeconomic environment combined with low real interest rates and the subsequent 'search for yield' has provided the backdrop to a number of important developments in financial markets over the last decade and a half. Two of the most important developments have been the rise of new actors in financial markets and the growth of new and more complex financial instruments and markets, both of which we discuss below.

15. The 'search for yield' has spawned the growth of complex new financial instruments as well as new types of institutional investors. This 'search for yield' encouraged many investors to invest in high-yielding complex products that it turns out they did not always fully understand and is at the heart of the problems which have affected financial markets from mid-2007 onwards. We discuss the consequences for financial stability of this 'search for yield' in greater detail later in this Report.

Rise of alternative capital pools

OVERVIEW

16. The economic backdrop and, in particular, the 'search for yield' phenomenon and the global redistribution of income described earlier in this chapter, has led to the rise of alternative pools of capital. These alternative pools of capital, primarily hedge funds, private equity funds and sovereign wealth funds, have emerged as important actors in global financial markets and in the economies of developed countries, including the UK.[19]

HEDGE FUNDS

17. There is no legal or regulatory definition of a hedge fund in the UK and the range of funds covered by the term is very wide. The term hedge fund was originally used to describe a type of private investment fund that charged investors a performance fee, used leverage to magnify returns and short selling to limit market risk. This description still fits many hedge funds, but by no means all.[20]

18. The number of hedge funds has grown significantly over the last decade with an estimated 9,800 hedge funds operating globally by the end of 2006. These funds have attracted strong inflows of capital over the last decade, with assets managed by hedge funds totalling US $1.4 trillion at the end of 2006. The growth of hedge funds over this period has been attributed by the Reserve Bank of Australia to the prevailing low interest rate environment which the Reserve Bank says "may also have encouraged a shift in investments towards hedge funds as, in the past, hedge funds have achieved higher average returns than traditionally managed investments, albeit in exchange for greater risk".[21]

19. The active investment approach of hedge funds means that they account for a high proportion of market activity. For instance, hedge fund trading activity was estimated to account for around 40%-50% of daily turnover on the New York Stock Exchange and London Stock Exchange in 2005.[22] Hedge funds are also significant investors in structured credit markets. Hedge funds operate under conditions of reduced disclosure and oversight compared to many other institutional investors and, whilst often managed on-shore, are usually based off-shore, although hedge fund managers in the United Kingdom are subject to regulation by the FSA in respect of their governance and market conduct.[23]

20. The increased prominence of hedge funds makes it important to analyse the role they play in financial markets. We intend to examine the role of hedge funds as part of our ongoing work on financial stability and transparency.

PRIVATE EQUITY

21. The term 'private equity', meaning the equity financing of companies not quoted on the stock market, covers a wide range of businesses, from small venture capital firms to large portfolio companies. Private equity deals tend to be of two general types: management buy-outs and management buy-ins. In the former case the existing management raise the funding to take a company private and in the latter management comes from outside. Some private equity deals, principally those that involve management buy-ins, have generated considerable controversy. We started an inquiry on private equity during the first half of 2007, publishing an interim Report in July 2007.

22. The private equity industry has grown strongly in recent years, with the value of private equity funds in the UK trebling between 2003 and 2006. The UK is the largest market for private equity outside the USA, accounting for over half of total European private equity investment in 2005. As we noted in our Report on private equity, private equity deals until mid-2007 had been increasingly characterised by a high degree of leverage, which we argued then had been facilitated by the benign macroeconomic environment and the extremely low price of credit, reflecting factors such as low interest rates, lower default rates by companies and lower compensation for liquidity risk as well as the increase in liquidity in the leveraged loan market as a result of the development and deepening of secondary markets for such loans.[24] The benign environment until August 2007 facilitated a rising number of takeovers of very large companies by private equity firms, with the purchase of Alliance Boots in May 2007 for £11 billion being the first takeover of a FTSE 100 company by a private equity firm.

23. At the larger end of the private equity market, private equity represents an alternative to the listed company model of ownership. Our July 2007 Report discussed the nature of the private equity industry and the differences between the private equity and the Public Limited Company model. We concluded that there were benefits and potential problems associated with both private equity and Public Limited Company ownership and that different forms of ownership might be appropriate at different times for a particular company.[25]

24. Our Report also discussed possible risks to financial stability posed by recent developments in private equity. We noted that:

however extensive the due diligence conducted, higher levels of leverage are likely to create additional risk, and … this becomes more significant the more important highly-leveraged firms become in the economy. We also note that the recent increase in the number of highly-leveraged private equity-owned firms has occurred during a period of economic growth and stability, which is not guaranteed to continue. We therefore urge the Bank of England to examine the potential impact of an economic downturn, both on highly-leveraged firms and on the wider economy. We also urge the FSA to investigate the operation of due diligence in highly-leveraged firms.[26]

25. Since we published our Report on private equity in July 2007, Sir David Walker has published his report on guidelines for disclosure and transparency in private equity. [27] The environment for private equity deals has also deteriorated as a result of developments in the credit markets and the more uncertain macroeconomic outlook.

26. We are continuing our work on private equity, examining the proposals in Sir David Walker's report as well looking at the impact on private equity of the changing economic environment. We will also continue to explore the implications for financial stability of the growth of private equity in recent years as part of our ongoing work on financial stability and transparency.

SOVEREIGN WEALTH FUNDS

27. Sovereign wealth funds, which are State-owned funds accumulated through State trading and investment activities, have risen to prominence as they have started to play an increasingly important role in developed economies, including the UK. Sovereign wealth funds have grown, as was discussed earlier, in response to the global redistribution of wealth and income towards a limited number of producers of primary energy suppliers as well as the rapid growth of new emerging markets such as China with high propensities to save, which has sharply increased the foreign reserves of these countries.

28. The IMF estimated in 2006 that Sovereign wealth funds were worth between $2 trillion and $3 trillion and that they would continue to grow by around $800-$900 billion per annum.[28] In 2007 China became one of the latest countries to launch a Sovereign Wealth Fund with the establishment of the China Investment Corporation, which it is estimated has about $200 billion under management. Other countries with Sovereign wealth funds include Kuwait, where the Kuwait Investment Authority, together with the General Reserve Fund, and Future Generations Reserve Fund, has assets estimated at between $160 billion and $250 billion; Singapore, where the Government Investment Corporation and Temasek Holding have a combined $200 billion in assets; Russia, whose Oil Stabilization Fund has approximately $130 billion in assets; and Saudi Arabia with over $250 billion in assets.[29]

29. Sovereign wealth funds have played an important role in the aftermath of the financial market turbulence of 2007. Beginning in late 2007 a number of Sovereign wealth funds have invested in financial institutions, primarily the large Wall Street investment banks, which suffered large losses on sub-prime mortgages. These investments in financial services firms, which are described in greater detail in chapter five, have increased the presence of Sovereign wealth funds in the financial services sector of developed economies. This may present a new set of challenges to policymakers, including implications for financial stability. In addition, there is an ongoing debate about whether Sovereign wealth funds have appropriate structures of governance and transparency in place as well as concerns over possible political intervention and the impact of potential large-scale market moves.[30]

30. We recognise the important role that Sovereign wealth funds have played in helping to stabilise the financial system through their investments in financial services firms in 2007. However, the increasing prominence of such funds as institutional investors does raise valid public policy questions about governance, transparency and reciprocity. We intend to examine the role of Sovereign wealth funds as part of our ongoing work on financial stability and transparency.

Off-shore financial centres

31. An IMF working paper, published in April 2007, offers the following definition of an offshore financial centre (OFC):

An OFC is a country or jurisdiction that provides financial services to non-residents on a scale that is incommensurate with the size and the financing of its domestic economy.[31]

Offshore financial centres have often been linked with the notion of a 'tax haven'. While the low tax environment present in many OFCs is important in explaining their popularity, an IMF background paper outlined other reasons why offshore financial centres might be used by individual financial institutions:

OFCs can be used for legitimate reasons, taking advantage of: (1) lower explicit taxation and consequentially increased after tax profit; (2) simpler prudential regulatory frameworks that reduce implicit taxation; (3) minimum formalities for incorporation; (4) the existence of adequate legal frameworks that safeguard the integrity of principal-agent relations; (5) the proximity to major economies, or to countries attracting capital inflows; (6) the reputation of specific OFCs, and the specialist services provided; (7) freedom from exchange controls; and (8) a means for safeguarding assets from the impact of litigation etc.

They can also be used for dubious purposes, such as tax evasion and money-laundering, by taking advantage of a higher potential for less transparent operating environments, including a higher level of anonymity, to escape the notice of the law enforcement agencies in the "home" country of the beneficial owner of the funds.[32]

32. One increasing use of offshore financial centres is as the host of a 'special purpose vehicle'. For instance, Granite, the Special Purpose Vehicle of Northern Rock, was located in the offshore financial centre of Jersey. The IMF explains the advantages of using an OFC as part of a special purpose vehicle:

One of the most rapidly growing uses of OFCs is the use of special purpose vehicles (SPV) to engage in financial activities in a more favourable tax environment. An onshore corporation establishes an International Business Corporation in an offshore centre to engage in a specific activity. The issuance of asset-backed securities is the most frequently cited activity of SPVs. The onshore corporation may assign a set of assets to the offshore SPV (e.g., a portfolio of mortgages, loans credit card receivables). The SPV then offers a variety of securities to investors based on the underlying assets. The SPV, and hence the onshore parent, benefit from the favourable tax treatment in the OFC. Financial institutions also make use of SPVs to take advantage of less restrictive regulations on their activities. Banks, in particular, use them to raise Tier I capital in the lower tax environments of OFCs. SPVs are also set up by non-bank financial institutions to take advantage of more liberal netting rules than faced in home countries, reducing their capital requirements.[33]

33. These potential uses of offshore financial centres mean that they remain relevant in any discussion of financial stability. There is an element of competition between major financial centres and offshore financial centres around taxation and regulation. As well as this, the links between offshore financial centres, the institutions and entities registered in OFCs, and the financial institutions regulated by UK authorities means that there is the potential for a further opacity to be added to the financial system, as the lines of sight to where economic risk actually lies may be obscured by the link with an offshore financial centre.

34. We will undertake further work on offshore financial centres in the context of our ongoing scrutiny of financial stability and transparency to seek to ascertain what risk, if any, such entities pose to financial stability in the United Kingdom.

The growth of global markets in asset-backed securities

35. A number of analysts, including Lucas Papademos, Vice President of the European Central Bank, have linked the 'search for yield' with the growth of global markets in asset-backed securities. Mr Papademos in a speech in December 2007 explained that "in an environment of historically low risk-free asset yields, the 'search for yield' by investors made it necessary to seek and acquire alternative assets offering higher returns but associated with greater risks".[34] This 'search for yield' helped spur the rapid growth of global markets in asset-backed securities, which are securities or bonds backed by the cash flows on underlying loans and other assets, including residential mortgages (known as residential mortgage-backed securities), credit card debt and loans such as those for cars. This process of creating asset-backed securities or bonds backed by the cash flows on underlying loans and other assets is known as securitisation.

36. Many asset-backed securities have subsequently been turned into structured finance products, which involve the pooling of assets and the subsequent sale to investors of different classes of securities, each with differing risk-return profiles, on the cash flows backed by these pools.[35] Mr Gerald E Corrigan, Managing Director at Goldman Sachs, told us that the driving force behind the growth of markets in structured finance products was the 'search for yield' phenomenon:

in a very real way the fundamental driving force that goes a considerable distance in explaining the explosion of structured credit products—I agree with that characterisation—was the long period during which there were abundant amounts of liquidity on a worldwide basis and very low nominal and real interest rates. To a significant degree it has been the reach for yield on the part of institutional investors in particular that goes a considerable distance in explaining this very rapid growth of structured credit products.[36]

37. One structured finance product which has grown strongly is collateralised debt obligations (CDOs), which can be defined as securities backed by a portfolio of fixed-income assets that are issued in tranches of varying seniority with different tranches having differing repayment and interest earning streams.[37] The process of creating CDOs works through the purchase of underlying asset-backed securities by other financial institutions, such as managers of collateralised debt obligations (CDOs), which, as the Bank of England describe, "create new and often complex instruments with high embedded leverage, which they sell on".[38] This process adds a further layer of complexity because underlying securities, including asset-backed securities such as residential mortgage-backed securities, investment-grade bonds and leveraged loans, have subsequently been repackaged into new structured finance products such as CDOs.

38. Given the complexity of such instruments, we asked representatives from the investment banks to explain what a CDO and a CDO-squared were. Lord Aldington, Chairman of Deutsche Bank, London Branch, explained to us that he had not "come before this Committee as an expert on CDOs". Lord Aldington, when questioned further as to whether Deutsche Bank was involved in collateralised debt obligations replied that "my organisation is involved in a very broad range of products and I would not claim to be an expert on all of them". Jeremy Palmer told us that "a CDO-squared is a derivative structure designed to give investors exposure to a CDO" whilst Mr Corrigan replied that:

A CDO carves out of a plain vanilla mortgage-backed security certain credit tranches of that security and reformulates them in what is called a structured credit product into a particular class of credit standards affecting those particular mortgages, not the full pool of mortgages.[39]

39. Our inquiry has highlighted the complexity of many new financial instruments, such as Collateralised Debt Obligations. Nevertheless we are surprised that the Chairman of the UK branch of a leading investment bank could not explain to us what a CDO is, a financial product in which he told us that his organisation deals. The fact that senior board members may not have sufficient understanding of products that their organisations are originating and distributing is a major cause for concern. If the creators and originators of complex financial instruments have only a limited understanding of these products then it raises serious questions about how investors in these products can possibly understand such complex products and the risks involved in such investment decisions. We discuss this issue in greater detail later in our Report.

40. The Bank of England in its October 2007 Financial Stability Report argued that the 'search for yield' was behind rising investor demand for US sub-prime residential mortgage-backed securities as well as leveraged corporate loans and had stimulated a wave of innovation, creating often opaque and complex financial instruments with high embedded leverage. The Bank also attributed the rapid rise in issuance of collateralised debt obligations (CDOs) to this 'search for yield' on the part of investors.[40]

41. According to the Bank of England, the size of the global market in asset-backed securities was estimated at $10.7 trillion at the end of 2006.[41] The market was dominated by securities backed by residential mortgage-backed securities, which were worth $6.5 trillion, with the US market worth $5.8 trillion and the European market $0.7 trillion. The $5.8 trillion US market in residential mortgage-backed securities includes £0.7 trillion of non-agency sub-prime mortgages, which are mortgages held by sub-prime borrowers (who do not meet prime market standards because they are perceived as a relatively bad credit risk to the lender). Such sub-prime mortgages represented around 6.5% of the market for securitised assets. A total of $3.5 trillion was accounted for by non-mortgage asset-backed securities which included securitised home equity loans, auto loans, consumer loans, credit card debt, student loans and other sorts of non-mortgage loans.[42]

42. Despite this strong growth in recent years, the total size of the market of asset-backed securities and sub-prime residential mortgage-backed securities is small when compared with other securities markets, such as those for corporate equities and corporate debt. According to the Bank of England, the biggest securities markets are for corporate equities, which had an estimated global value of $50.6 trillion at the end of 2006, whilst corporate debt markets had an estimated value of $17.1 trillion at the end of 2006.

The shift from an 'originate and hold' to an 'originate and distribute' banking model

43. The growth of markets for asset-backed securities and structured finance products marks a fundamental shift in the business model adopted by banks. Traditionally, banks have operated under an 'originate and hold' banking model, so-called because banks held loans to maturity. Many banks have now moved toward an 'originate and distribute' model where loans are made but then sold to investors. Professor Buiter explained that under the traditional 'originate and hold' model:

banks borrowed short and liquid and lent long and illiquid. On the liability side of the banks' balance sheet, deposits withdrawable on demand and subject to a sequential service (first come, first served) constraint figured prominently. On the asset side, loans, secured or unsecured to businesses and households were the major entry. These loans were typically held to maturity by the banks (the 'originate and hold' model). Banks therefore transformed maturity and created liquidity. [43]

44. Professor Buiter told us that the move away from the 'originate and hold' banking business model first developed in the United States in the 1970s as Fannie Mae (Federal National Mortgage Association), Ginnie Mae (Government National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) began the process of securitisation of residential mortgages, operating increasingly under an 'originate and distribute' model.[44] The International Monetary Fund noted in December 2007 that this market structure, with government-sponsored enterprises at its centre, was a 'tremendous success' and attracted competition from other major financial institutions, with the major Wall Street firms launching an aggressive move into the issuance of mortgage-backed securities.[45]

45. Professor Buiter explained how securitisation has evolved, and become more complex over time, by contrasting 'simple' securitisation—which involved the pooling of reasonably homogenous assets with a given (and generally lower) risk profile—with second-tier and higher-tier securitisations:

However, second-tier and higher-tier-securitisation then took place, with tranches of securitised mortgages being pooled with securitised credit card receivables, car loan receivables etc. and tranched securities being issued against this new, heterogeneous pool of securitised assets. Myriad credit enhancements were added. [46]

46. Recent years have seen an increasing number of banks in the USA moving away from the 'originate and hold' model and placing an increasing emphasis on an 'originate and distribute' model. As a result, whereas in 2003, government sponsored enterprises were the source of 76% of the mortgage-backed and asset-backed issuances in the USA with 'private label' issues accounting for the remaining 24%, by 2006 private sector banks were the source for almost 60% of mortgage-backed issuances in the USA.[47]

47. Under the 'originate and distribute' model, loans that banks make are then sold to an off-balance sheet special purpose vehicle (SPV). In theory at least, the insolvency of any such SPV should have no impact on the bank which originated the loans: the risk is said to have been distributed. Mr Corrigan told us that the use of special purpose vehicles was common amongst financial institutions in that "most financial institutions have at least some form of off-balance sheet activities, typically in the form of special purpose vehicle." [48] The special purpose vehicle is simply a corporation registered in what is usually an offshore financial centre.[49] The special purpose vehicle parcels together these loans into securities backed by the cash flows from those loans (asset-backed securities) with these securities sold to investors such as pension funds, insurance companies, mutual funds, hedge funds and other banks. This process is known as 'disintermediation'. Securitisation allows the banking originator to earn fee income from their underwriting activities without leaving themselves exposed to credit market or liquidity risk because they sell the loans they make.[50]

48. Securities have also been sold to off balance sheet investment vehicles, many of which have been established or sponsored by the banks themselves. These investment vehicles include conduits and structured investment vehicles. The essential difference between a conduit and a structured investment vehicle is that conduits are established and owned by banks whilst structured investment vehicles are not owned directly by banks, although banks have close relations with them as sponsors. Professor Buiter expanded on the difference between the two, explaining that conduits were structured investment vehicles "closely tied to a particular bank" while structured investment vehicles were special purpose vehicles investing in long-term, often illiquid complex securitised financial instruments.[51]

49. Professor Buiter told us that structured investment vehicles "fund themselves in the short-term wholesale markets, including the asset-backed commercial paper markets".[52] Asset-backed commercial paper is commercial paper collateralised by loans, leases, receivables, or asset-backed securities. Conduits are also largely funded through asset-backed commercial paper. The proceeds from these short-term instruments, such as asset-backed commercial paper, are then used by investment vehicles to fund the purchase of assets of longer duration, such as asset-backed securities and collateralised debt obligations. This maturity mismatch, where the assets held by conduits and structured investment vehicles have a long maturity whereas asset-backed commercial paper is of short maturity, can leave these vehicles vulnerable to disruption in investor demand for asset-backed commercial paper. To mitigate this 'rollover' risk, conduits and structured investment vehicles typically hold committed liquidity lines provided by commercial banks.[53]

50. One of the key drivers behind the establishment of conduits and structured investment vehicles was regulatory arbitrage, as was explained to us by Professor Buiter:

Most of the off-balance sheet vehicles … I am familiar with are motivated by regulatory arbitrage, that is, by the desire to avoid the regulatory requirements imposed on banks and other deposit-taking institutions. These include minimal capital requirements, liquidity requirements, other constraints on permissible liabilities and assets, reporting requirements and governance requirements. Others are created for tax efficiency (i.e. tax avoidance) reasons.[54]

51. Professor Buiter explained the attraction of the 'originate and distribute' model to private banks as they took advantage of securitisation techniques, using them to:

liquefy their illiquid loans. The resulting 'originate and distribute' model had major attractions for the banks and also permitted a potential improvement in the efficiency of the economy-wide mechanisms for intermediation and risk sharing. It made marketable the non-marketable; it made liquid the illiquid. There was greater scope for trading risk, for diversification and for hedging risk [55]

52. The Governor of the Bank of England cited some of the advantages of the 'originate and distribute model' for banks, telling us that it "has been a very healthy development … and had enabled a number of smaller financial institutions to obtain funding from others by borrowing against the securitised form of mortgages.[56] Mr Sants added that securitisation programmes which created long-term secure funding are a very good source of funds.[57] The 'originate and distribute' model has also helped drive strong profit growth in the banking sector. The Bank of England stated in its October 2007 Financial Stability Report that profit growth in recent years in the banking sector had been driven by the 'originate and distribute' business model, with UK banks' and Large Complex Financial Institutions' enjoying returns on equity often well in excess of 20%.[58]

Credit rating agencies and the tranching process

THE GROWING ROLE OF THE AGENCIES

53. The credit rating agencies play a key role rating structured finance products, a role which is particularly important given the complexity of such products. The ratings agencies have long played a role in rating traditional debt instruments, such as the financial obligations of corporations, banks, and governmental entities. The credit rating agencies subsequently moved into the structured finance market, providing ratings for 'tranched' securitised or structured finance products. This was natural territory for credit rating agencies to occupy given their experience in rating traditional debt instruments. A small number of internationally recognised rating agencies, including Standard & Poor's, Moody's and Fitch, account for most of the rating of complex financial instruments, including asset-backed securities.[59]

54. Credit ratings are, broadly speaking, used by investors as indications of the likelihood of receiving their money back in accordance with the terms on which they invested. Moody's told us that their credit ratings are forward-looking opinions that address just one characteristic of fixed income securities, the likelihood that debt will be repaid in accordance with the terms of the security. Credit ratings reflect an assessment of both the probability that a debt instrument will default and the amount of loss the debt-holder will incur in the event of default.[60]

CREDIT RATING SCORES

55. We asked the credit ratings agencies to explain their scoring system. Standard & Poor's explained that their "ratings range from the highest category of AAA, through AA, A, BBB (which is the lowest of what are referred to as to the 'investment grade' ratings) to D (indicating a situation where an obligation is in default)". They went on to tell us that ratings for AA to CCC might be modified by the addition of a plus (+) or minus (-) to show relative standing within the major rating categories. Standard & Poor's said that their highest rating of AAA denoted that, in their opinion, an issuer or security has an extremely strong capacity to meet its financial commitments.[61]

56. Moody's had a slightly different scoring system and explained that their "ratings are expressed according to a simple system of letters and numbers, on a scale that has 21 categories ranging from Aaa to C". They told us that their "lowest expected credit loss is at the Aaa level, with a higher expected loss rate at the Aa level, an even higher expected loss rate at the A level, and so on down through the rating scale".[62]

THE IMPORTANCE OF A 'GOOD' CREDIT RATING

57. One of the key reasons issuers of structured instruments wanted them to be rated according to scales that were identical to those for bonds was so that investors, some of whom were bound by the ratings-based constraints defined by their investment mandates, would be able and willing to purchase the new instruments. Mr David Pitt-Watson, Chairman, Equity Ownership Services at Hermes, explained that credit ratings were often used to give mandates with investors sometimes only allowed to invest in bonds that have a certain credit rating. As a result "to get a good credit rating is worth so much to the issuer because it means the interest rate is lower and the amount of money it raises can be a lot higher".[63] The Association of British Insurers concurred, telling us that "institutional investors frequently receive mandates from clients limiting them to investments above a certain credit rating.[64] Mr Frederic Drevon, Senior Managing Director at Moody's, told us:

in the specific context of securitisation, arrangers who create these transactions have a goal to achieve a higher rating, typically a triple-A rating, so they will structure a transaction in a way that achieves the highest rating possible.[65]

TRANCHING

58. To achieve a triple A rating, especially from lower rated sub-prime mortgages, often requires a degree of financial engineering. This financial engineering is achieved through various credit enhancements (described below) which are designed to ensure that triple A or other investment grade tranches—often referred to as 'senior' tranches—are relatively secure against credit risk, thus enabling the creation of at least one class of securities whose rating is higher than the average rating of the underlying collateral asset, with the end result that AAA security tranches are often backed in part by BBB securities. [66]

59. Credit enhancement is achieved through tranching, which refers to the issuance of several classes of securities against a pool of assets, each with distinct risk-return characteristics.[67] The creation of distinct classes of risk allows investors to purchase tranches that match their appetite for risk, allowing, for example, more risk-averse investors to purchase AAA tranches or 'senior' tranches which offer lower yields, but greater protection against default.

60. In a common three-tranche, the least risky, or 'senior', tranche has the first claim on payments from the pooled mortgages. The 'senior' tranche has the highest credit rating, often triple-A investment grade, but receives a lower rate of interest than the other tranches. After the senior claims are paid, the middle or mezzanine tranche receives its payments. Mezzanine represents greater risk and usually receives below-investment grade credit ratings and a higher rate of return. The lowest, or equity, tranche receives payments only if the senior and mezzanine tranches are paid in full. The equity/first-loss tranche absorbs initial losses. Equity tranches are therefore the most risky tranche and consequently often unrated, but as a consequence offer the highest rate of return. This process, whereby losses are applied to more 'junior' tranches before they are applied to more 'senior' tranches, is known as subordination and is one, albeit important, form of credit enhancement. Ian Bell, Managing Director and Head of European Structured Finance at Standard & Poor's explained to us "that in order to have a triple A you have to have a credit cushion [whereby more 'junior' tranches take initial losses] so the pool of mortgages can absorb a certain amount of losses before there are any losses at the triple A level".[68] Mr Bell went on to tell us that the credit cushions in the case of sub-prime were very substantial so as to protect more senior or triple A tranches against losses.[69]

61. Other commonly used credit enhancements designed to protect 'senior' tranche holders against losses include:

Monoline insurance: Third-party insurance or other financial guarantees may be provided to protect investors from losses.
Excess servicing: A pre-set amount of interest is explicitly set aside from the servicing of the collateral each month to be used to make up any shortfalls in cash flows for senior tranches.
Residual tranching: Additional cash flows above and beyond excess servicing are set aside to cover losses as needed.[70]

62. The 'search for yield' phenomenon and strong investor interest has led to the rapid growth (or explosion) of structured finance instruments with triple A or 'investment grade' ratings. Representatives of the credit ratings agencies told us that there were perhaps 30 or 40 triple A rated sovereign credits, whilst globally only a 'handful' of banks and corporates enjoyed a triple A rating. The agencies acknowledged that, by way of contrast, there were thousands of structured finance products with a triple A rating.[71]

63. The relatively recent innovation of tranching, whereby a pool of assets is converted into low-risk, medium-risk and higher-risk securities, has led to a mushrooming of triple-A securities available for investment. Rating these securities has been an increasing source of income for the credit rating agencies. Tranching has proven successful at tailoring investment opportunities to meet the risk-appetites of investors, particularly those bound by strict investment mandates, specifying AAA investments. This market innovation has, however, led to greater complexity.

WHO PURCHASED ASSET-BACKED SECURITY TRANCHES?

64. We asked witnesses from the investor community whether they or their member companies had invested in asset-backed securities. All said that they had invested in asset-backed securities, but stressed that their involvement in these markets was limited. The National Association of Pension Funds said the industry's exposure to such products amounted to 1-2% of assets.[72] Peter Montagnon, Director of Investment Affairs the Association of British Insurers, estimated that asset-backed securities amounted to around 0.5% of ABI member companies' portfolio.[73]

65. Chart 1 below, from the 2007 IMF's Global Financial Stability Report, show, that a wide range of financial institutions, including insurance companies, asset managers, banks and hedge funds, have purchased asset-backed security CDOs, with hedge funds the largest category of investor in such products. It also shows how different types of investors purchased different tranches of asset-backed security CDOs, with hedge funds and banks the largest purchasers of equity tranches and hedge funds also large purchasers of mezzanine tranches. Chart one also shows that the US institutions were the largest buyers of asset-backed security CDOs, but that European, Asian and Australian investors were also purchasers of these products.

Chart 1: Buyers of Collateralised Debt Obligations backed by Asset Backed Securities

Source: IMF, Global Financial Stability Report, October 2007, p 15

The sub-prime mortgage market in the USA

OVERVIEW

66. The initial trigger for the financial market turbulence since August 2007 was growing problems in the sub-prime mortgage market in the United States. The sub-prime mortgage market originated in the USA, and the US market is much larger relative to the economy than is the equivalent UK market. Mr Sants told us that the sub-prime market was much larger in the USA than in the UK, with around 25% of the US housing market characterised as sub-prime compared to just 8% in the UK.[74]

67. Sub-prime mortgages are loans made to borrowers who are perceived to have high credit risk, often because they lack a strong credit history or have other characteristics that are associated with high probabilities of default.[75] Sub-prime status is calculated on the basis of credit scores. The leading credit scoring agency is the Fair Isaac Corporation (FICO). Its credit scores are on a scale of 300 to 850.[76] A score of 620 or below usually denotes sub-prime status.

THE GROWTH OF THE SUB-PRIME MORTGAGE MARKET IN THE USA

68. A particular feature of the market in asset-backed securities has been the recent growth in sub-prime lending and, in particular, the growth of the market for US sub-prime residential mortgage-backed securities. Ben Bernanke, Chairman of the Federal Reserve Board, in a speech in May 2007 explained that "having emerged more than two decades ago, sub-prime mortgage lending began to expand in earnest in the mid-1990s". He went on to explain that the expansion of sub-prime lending was spurred in large part by:

innovations that reduced the costs for lenders of assessing and pricing risks. In particular, technological advances facilitated credit scoring by making it easier for lenders to collect and disseminate information on the creditworthiness of prospective borrowers. In addition, lenders developed new techniques for using this information to determine underwriting standards, set interest rates, and manage their risks.[77]

Mr Bernanke outlined how the growth of securitisation gave a further boost to sub-prime mortgage lending in the USA, explaining that "the ongoing growth and development of the secondary mortgage market has reinforced the effect of these innovations" and that:

whereas once most lenders held mortgages on their books until the loans were repaid, regulatory changes and other developments have permitted lenders to more easily sell mortgages to financial intermediaries, who in turn pool mortgages and sell the cash flows as structured securities. These securities typically offer various risk profiles and durations to meet the investment strategies of a wide range of investors. The growth of the secondary market has thus given mortgage lenders greater access to the capital markets, lowered transaction costs, and spread risk more broadly, thereby increasing the supply of mortgage credit to all types of households.[78]

69. Automated underwriting and securitisation were therefore key developments in reducing the cost of sub-prime mortgage lending and facilitated a relaxation of credit rationing for borrowers previously considered too risky by traditional lenders.[79] Mr Corrigan explained to us that sub-prime lending took off in the USA around 2003 and 2004 and that, whilst "there were elements of it before that" it emerged as a major business during this time frame.[80] Mr Palmer told us that "the huge growth of sub-prime lending in the USA is a relatively recent phenomenon" and that "the huge growth came about in 2005 and 2006".[81] Mr Palmer explained to us that this growth in the sub-prime market took place in the context of the 'search for yield' phenomenon discussed earlier in the chapter.[82]

70. The development of the sub-prime market was welcomed and even heralded by some as the "democratisation of capital",[83] and, as Mr Bernanke said in his May 2007 speech, made "home ownership possible for households that in the past might not have qualified for a mortgage … and has thereby contributed to the rise in the home ownership rate since the 1990s". In 1995, 65 percent of households owned their homes but this had increased to almost 70% by 2006. This increase in home ownership, according to Mr Bernanke, "has been broadly based, but minority households and households in lower-income census tracts have recorded some of the largest gains in percentage term".[84] Mr Sants expressed similar sentiments when he appeared before us, telling us that there was a genuine social purpose in the sub-prime market, which is to deliver affordable housing,[85] whilst Mr Corrigan argued that "the development of the sub-prime mortgage market was a noble idea, because what it sought to do was provide access to home ownership on the basis of individuals and families who by historic standards never had any realistic hope of being able to own their own homes".[86]

The financial stability and efficiency implications of the 'originate and distribute' business model

71. Mr Alexandre Lamfalussy, former General Director of the Bank for International Settlements, in a speech in Brussels on 23 January 2008, explained that:

until this crisis most market participants and a number of weighty officials argued that the ['originate and distribute'] model (just as securitisation) increased the efficiency of our system and that it had a stabilising effect on our global system, by diminishing the concentration of risk on the banking sector and distributing those risks more widely. [87]

72. Sir Callum McCarthy, Chairman of the FSA, stressed the risk argument to us, stating that the "originate and distribute" model "distributes risk much more widely, and that in itself is attractive because it stops risk being concentrated in highly geared banks.[88] In June 2007, Nigel Jenkinson, Executive Director, Financial stability at the Bank of England, summed up the advantages resulting from the evolution of financial markets and the growth of securitisation, described in this chapter, as follows:

Financial innovation has delivered considerable benefits. New products have improved the ability to hedge and share risks and to tailor financial products more precisely to user demand. That has enabled financial intermediaries and users of financial services to manage financial risks more effectively, and has lowered the costs of financial intermediation. And innovation and capital market integration have facilitated the wider dispersal of risks, which may have increased the resilience of the financial system to weather small to medium-sized shocks. [89]

Mr Jenkinson in the same speech went on to discuss some of the disadvantages and vulnerabilities of these changes:

Dependence on capital markets and on sustained market liquidity has increased, as banks and other intermediaries place greater reliance on their ability to 'originate and distribute' loans and other financial products, and to manage their risk positions dynamically as economic and financial conditions alter … And the greater integration of capital markets means that if a major problem does arise it is more likely to spread quickly across borders. So … the flip side to increased resilience of the financial system to small and medium-sized shocks may be a greater vulnerability to less frequent but potentially larger financial crises.[90]

12 Treasury Committee, Fourth Report of Session 2006-07: The Monetary Policy Committee of the Bank of England: ten years on, HC 299-II, Ev 15 Back

13 Ev 315 Back

14 Ev 319 Back

15 Ibid. Back

16 Speech by the Governor of the Bank of England at the Northern Ireland Chamber of Commerce and industry, Belfast, 9 October 2007, pp 2-3 Back

17 Q 1153 Back

18 Speech by the Governor of the Bank of England at the Northern Ireland Chamber of Commerce and Industry, Belfast, 9 October 2007, pp 2-3 Back

19 World Economic Forum, Global risks 2008: A global risk networking report, p 9 Back

20 Hedge Funds Standards: consultation paper, Part 1: Approach to best practice in context, Appendix C, p 33 Back

21 Reserve Bank of Australia, Statement on Monetary Policy, February 2005, p 25 Back

22 Bank of England, Financial Stability Report, April 2007, Box 5, p 36 Back

23 Ibid. Back