House of Commons - Treasury

Select Committee on Treasury Sixth Report

4 Events since August 2007

106. This chapter examines developments in financial markets since August 2007, focussing on problems in the banking sector, including the admission of large losses by a number of banks involved in securitised markets. Uncertainty about the scale and extent of losses in the banking sector resulting from exposure to sub-prime mortgages and consequent concerns about the adequacy of bank capital have both impeded the renewed smooth functioning of global money markets. These problems in the banking sector led to subsequent coordinated money market interventions conducted by central banks in December 2007, to provide liquidity to the banking sector as well as to reduce the threat that problems in the banking sector would feed through to the real economy.

107. In December 2007, the Governor of the Bank of England appeared before us and summarised developments in financial markets since his last appearance before the Committee in September 2007. The Governor told us that problems in the financial sector still remain, before going on to say that "a painful adjustment faces the global banking sector over the next few months as losses are revealed and new capital is raised to repair bank balance sheets". The Governor added that "uncertainty about the possible scale and distribution of losses means that interbank lending rates have risen further relative to expected official interest rates. The behaviour of those spreads has been very similar in the sterling, dollar and euro markets, exacerbating concerns about a 'credit crunch' in the major industrialised countries."[146]

Growing problems in the banking sector

108. The period since August 2007 has seen a period of adjustment in the banking sector. Investor reappraisal of risks within asset-backed securities and leveraged loans has caused an unanticipated expansion of major UK banks'—and other international banks' balance sheets. The Bank of England, in its October 2007 Financial Stability Report, explained that this process of "reintermediation" has operated through two channels:

the crystallisation of warehousing risk and off balance sheet commitments. Both have resulted in additional funding and capital requirements for UK banks, potentially impeding their ability to extend new lending to the household and corporate sectors.[147]

109. The reduction in investor demand for asset-backed securities has required banks to hold on their balance sheets for longer than intended assets which were originally envisaged for securitisation. As discussed in chapter two, these underlying assets intended for securitisation will have been funded on a short-term basis only, in anticipation of their subsequent removal from the lender's balance sheet. However, the inability of banks to issue and distribute asset-backed securities as intended has meant that banks have been left needing to fund growing stocks (or 'warehouses') of assets that they had not expected to retain on their balance sheet, this in turn representing an unanticipated increase in funding requirements.

110. As discussed previously, many banks established off balance sheet vehicles, including conduits and structured investment vehicles prior to mid-2007. These vehicles have been an important source of demand for structured credit products and have been funded largely through the issuance of asset-backed commercial paper. However, as uncertainty about the value of their assets has increased, the cost and availability of funding to these investment vehicles has tightened as we discussed in chapter three. In consequence, the drying up of liquidity has forced some banks to support their sponsored asset-backed commercial paper conduits and structured investment vehicles, and in some cases to take these vehicles' assets back on balance sheet, adding to pressures on the banks' capital.[148] William Mills, Chairman and Chief executive of City Markets and banking, Europe, Middle east and Africa, Citigroup, explained to us that Citigroup had such sponsored vehicles with "outside investors who have provided the equity to support these vehicles". Mr Mills went on to explain that Citigroup's exposure to sponsored vehicles:

arises from the fact that from a business model point of view they are funded short term and their assets are long term. What the market is trying to estimate is, if, in fact the liquidity crisis continues, will we, Citigroup, provide the liquidity to fund these vehicles so they do not have to go into an asset disposal mode, especially in an environment where people feel that that would just add more fuel to the fire.[149]

Mr Mills went on to explain that the support Citigroup was providing to off-balance sheet vehicles was motivated by reputational considerations, telling us that "There is the moral hazard issue as to whether or not from a reputational point of view if we do not step in and support these vehicles it will somehow hurt our reputation in the market".[150]

111. The Governor of the Bank of England, in his letter of 12 September 2007 to the Committee, explained that as a consequence of these funding difficulties:

Some investment vehicles will need to be wound up. In many cases, however, the sponsoring bank will have written a backup line to the vehicle, guaranteeing its funding. Many of the securitised loans may now be re-priced, restructured or taken back by the banks. A process is starting that will expand the balance sheet of the banking system. But how far that process will go is hard to tell.[151]

112. The Governor explained to us in our September 2007 evidence session the consequences for UK banks of taking off-balance sheet vehicles back onto balance sheet:

The UK banking system as a whole is well-capitalised. In this context we should be grateful that banks did make profits in the last five years. They have a large capital cushion. They can take the conduits and vehicles that they set up in recent years back on to their balance sheets. It will take a little time and the banks will make lower profits than they would have wished but there is no threat to the stability of the banking system.[152]

Banking losses and valuation difficulties

113. Concerns in the banking sector were initially focussed on attempts by banks to protect their liquidity position, but as the Governor of the Bank of England noted in his January 2008 Bristol speech, attention has now turned to a second and more fundamental concern. The Governor stated that "as a range of asset prices fell, banks began to report large losses" and that "uncertainty about the scale and location of losses led to concerns about the adequacy of bank capital and hence the ability of the banking system to finance continued economic expansion".[153] In evidence to us, the Governor explained that:

the most important step that is required here is that the private sector (and it can only be the private sector) needs gradually to restructure and re-price many of those complex instruments which people are now very reluctant to lend against or buy, and that will take time, but the process is slowly beginning.[154]

114. The investment bank BNP Paribas' 9 August 2007 announcement underscored the difficulty for financial institutions in valuing complex financial instruments. Instruments such as asset-backed securities are difficult to value as they are often complex and frequently trade in illiquid markets, if they are traded at all. Market participants commonly use three types of valuation techniques. These are:

Mark-to-market, which refers to the use of quoted prices for actively traded, identical assets;
Mark-to-matrix, which is a technique used for less actively traded assets, such as emerging market securities, municipal bonds, and asset-backed securities. Mark-to-matrix involves estimating a credit spread of the asset relative to a more actively traded instrument that can be priced more easily;
Mark-to-model is a technique that market participants are often forced to use for the least liquid assets, including complex structured securities such as certain tranches of CDOs. Mark-to-model assigns prices based on statistical inference.[155]

Mr Corrigan explained that the credit re-pricing process was "hindered by the break down in the price discovery process for some classes of complex financial instruments including but not limited to sub-prime mortgages and their derivatives such as CDOs" and that as "the markets for such instruments became illiquid, the price discovery process was further impaired".[156] The British Bankers Association summed up the valuation difficulties thus: "it became harder to mark to market the value of securities a firm held—because there was no market to mark to".[157]

115. The absence of market quotes has forced market participants to rely more heavily on mark-to-model as opposed to mark-to-market or mark-to-matrix techniques. However, the use of pricing models that relied on historical data was impaired by the fact that the recent performance of some sub-prime loans has been much worse than the record would have suggested, causing valuation models to break down.[158]

116. The Governor explained to us that the process of restructuring and repricing complex instruments would be a lengthy process, telling us that the Bank of England was encouraging financial institutions to move as quickly as possible in this process. The Governor went on to outline some of the difficulties of restructuring and repricing products:

It is not easy, because when markets are open, and deep and liquid, then marking to market, as is the current convention for establishing losses, makes a great deal of sense and can be done without an enormous degree of exceptional effort, but once those markets have closed, it then becomes extraordinarily difficult to know at what prices you should value some of those instruments, and that is exactly the difficulty that some of the banks have had.[159]

117. Witnesses from the investment banking sector also explained the difficulties for institutions trying to value complex instruments and ascertain losses. Mr Mills from Citibank told us that:

What occurred in August and September was the fact that these markets stopped functioning and so there was no visible trading taking place. Typically, investment banks set their prices on their inventory and their positions based on the visibility of other trades that are taking place in the marketplace. Therefore for a period of time roughly two or three weeks—investment and commercial banks had to come up with a different methodology for establishing values on their portfolios and fundamentally had to deconstruct these complex securities, look at the underlying collateral and come up with a valuation. So, there was a period of time when there were significant differences between institutions as it relates to that. I think that most of those have converged at this point. I believe that given the level of disclosure that has been forthcoming through the month October that those price distortions should not be as great as they were in September. [160]

118. Mr Palmer told us that "the biggest problem is that there is no visible benchmark in the market which is normally where you start. When that does not exist you have to use your best efforts through statistical analysis."[161] Mr Palmer went on to say that "the modelling process is very complex and must take into account an estimate of what is likely to happen in the economy. There is always an element of judgment in it".[162] Mr Mills explained that "if there is a lack of marketplace and no visible price benchmarks … you have to consider the underlying collateral and cash flows on that collateral".[163]

119. The fall in asset prices for a wide range of asset-backed securities has led to large losses for many banks and a growing number of banks and other large financial institutions have begun the process of estimating and reporting losses resulting from their exposure to the sub-prime mortgage market in the USA. We asked representatives from the investment banks, when they came to give evidence to us in October 2007, about the consequences of reported losses and writedowns for individual financial institutions.

120. Lord Aldington, from Deutsche Bank, confirmed that some of the large investment banks had to varying degrees taken losses and that those losses "have been absorbed within their capital base and loss reserves" adding that speaking for Deutsche Bank, "we are in a healthy position and will move forward".[164] Mr Palmer, from UBS, told us that "we have seen the larger institutions which have taken losses adapt and modify. We have seen changes of management as they take responsibility and efforts to adjust and improve risk management systems".[165] Mr Corrigan, from Goldman Sachs, said that:

very substantial losses have been incurred by a broad cross-section of financial institutions over the past several quarters. I observe that in some ways it was a testimony to the work of those institutions over the years, including the supervisory community, that they were able to absorb those losses as well as they did. As far as I know, despite the size of these losses in the major institutions none appears to threaten their viability.[166]

121. We asked Professor Wood about the wider financial stability consequences of the losses in the banking sector. Professor Wood told us that these losses:

make the institutions which have lost capital more fragile than they were before they lost capital, but one would hope it also makes them more cautious in the future, which makes them less fragile. So, in the short term, yes, they are more fragile, in the longer term perhaps not.[167]

122. Since we took evidence from the investment banks, there have been further announcements of losses in the banking sector. For example, Morgan Stanley reported a fourth quarter 2007 writedown, stating in a press release that "the additional $5.7 billion writedown of US sub-prime and other mortgage related exposures in November, and the $3.7 billion writedown as of 31 October, result in a fourth quarter writedown of approximately $9.4 billion".[168]

123. Similarly, Citigroup reported a fourth quarter net loss of $9.83 billion reflecting "write-downs on sub-prime related direct exposures in fixed income markets and increased credit costs related to US consumer loans. Results include $18.1 billion in pre-tax write-downs and credit costs on sub-prime related direct exposures in fixed income markets".[169] A third bank to report heavy losses was UBS which "reported around $12 billion in losses on positions related to the US sub-prime mortgage market and approximately $2 billion on other positions related to the US residential mortgage market".[170]

124. The eventual scale of losses in the banking sector remains uncertain. Mr Bernanke, testifying before the Joint Economic Committee of the US Congress on 8 November 2007, estimated losses from exposure to sub-prime mortgages could total $150 billion.[171] German Finance Minister, Peer Steinbruck, speaking at the G7 conference in Tokyo in February 2008 is reported as saying that write-offs related to the US mortgage crisis could reach as much as $400 billion.[172]

125. The Governor explained in evidence to us that patience around the scale of losses in the banking sector was required until around February, March 2008 when:

financial institutions will have had to reveal most of those losses marked to market and take whatever resulting steps are necessary to rebuild their balance sheets, and at that point I would hope that we will have made a big step forward.[173]

126. As losses have been declared, a number of financial institutions—including UBS, Merrill Lynch, Citigroup and Barclays amongst others—have sought to attract new capital in an attempt to rebuild their balance sheets. Much of this capital has come from sovereign wealth funds. For example, in November 2007, the Abu Dhabi Investment Authority, acquired a 4.9% stake in Citigroup for $7.5 billion,[174] whilst in December 2007, UBS announced an investment by the Government of Singapore Investment Corporation in return for a potential future stake in the bank.[175] UK banks have also been involved in deals with sovereign wealth funds with, amongst others, Temasek Holdings from Singapore acquiring a stake in Barclays and Dubai International buying a stake in HSBC Holdings.

International coordinated action by central banks

127. Due to continued problems in global money markets, on 12 December 2007, joint action by the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank was announced.[176] The Bank of England stated that "the total amount of reserves offered at the 3-month maturity will be expanded and the range of collateral accepted for funds advanced at this maturity will be widened".[177] The Governor of the Bank of England explained these moves demonstrated that "central banks are working together to try to forestall any prospective sharp tightening of credit conditions that might lead to a downturn in the world economy".[178]

128. The Governor suggested that, by December 2007, a shortage of liquidity was no longer the key issue affecting the banking sector, and that, while in "August and September when the banks were trying to accumulate as many liquid assets as possible" the "large banks are now awash with cash":[179]

The issue is not whether they have enough cash; the issue is whether they are willing to lend, and in recent weeks (and this was the reason for the coordinated action and the concern shared by all central banks) what has become evident is that banks are concerned about the capital position of other banks. They do not know where the losses resulting from the array of derivative financial instruments will finally come to rest, and, I think, in the last four weeks we have also seen a more disturbing development, which is that the banks themselves are worried that the impact of their reluctance to lend collectively will lead to a sharper downturn in the United States and perhaps elsewhere, thus generating further losses outside the housing and financial sector which will feed back onto bank balance sheets and reinforce their reluctance to lend because of the need to generate more capital. That concern is a serious one, because it does hold out the prospect that, if banks behave in that way, there will be a self-reinforcing downturn in credit and activity.[180]

129. The coordinated action by the central banks was taken to prevent this "self-reinforcing downturn" until after the year-end, by when the Governor hoped "banks will gradually realise that, once all the losses have been revealed and once they have taken steps to rebuild the capital of their balance sheets, which several big banks have already done, then conditions will return to a more sustainable position".[181] We discuss problems in the banking sector and the steps banks have taken to rebuild their balance sheets in the following section.

130. The Governor argued that the coordinated action of 12 December achieved the objective of demonstrating that the central banks were working together:

One [objective] was to demonstrate that the central banks were working together—perhaps that had not been as evident as it might have been since August, and, secondly, it was a clear recognition that all the central banks were saying to the market, Yes, we do understand the deterioration in sentiment in credit markets, which had been very evident over the previous four weeks, and we are conscious of the concerns that you have and we are determined to take whatever set of policy action is necessary to ensure that we do not see a serious downturn in the world economy.[182]

131. The Governor doubted that the coordinated action would, of itself, lead to a significant reduction in inter-bank interest rate spreads, but thought that "the demonstration that central banks are working together is important".[183]

132. The 12 December operation by the Bank of England did not involve a specific penalty rate, in contrast to its operations earlier in the period of turmoil. When asked whether this was a reversal on his policy, the Governor of the Bank of England disputed such an interpretation. He felt that the 12 December auction process would impose a penalty rate on those who participated, and that in fact this auction saw a reduction in the range of collateral being accepted, when compared with previous term tenders offered by the Bank of England.[184] Pressed further on whether the Bank of England had given up on the principle of the penalty rate, the Governor replied:

we have not given it up, in the sense that the auction this morning that was conducted did produce an effective penalty rate of around 60 basis points in terms of the interest rate which people obtain money against this wider collateral; so the mechanism for doing it did, in fact, produce exactly that; but the nature of the problem in the last four to five week has changed quite markedly, and when that changes we too will change. When I sent my document to you in September before coming on 20 September, I made very clear in it that the judgments we were making about the nature of operations are ones that we looked at almost daily, and in the last four or five weeks there has been a palpable sense of (I use the word) fear in financial markets about the capital position of banks, and that was a point where I think all of us in central banks decided that, collectively, we needed to take action.[185]

133. The decision of the Bank of England to take part in coordinated action with other central banks in December 2007 is to be commended. We will continue to monitor the Bank's actions, and consider the effects of continued financial market disturbances on the macroeconomy as part of our regular work scrutinising the Inflation Reports of the Bank of England.

Real economy consequences of banking losses

134. Dr. Andrew Sentance, an external member of the Bank of England's Monetary Policy Committee, told us in September 2007 that there had not then been much impact on the real economy from the problems in the credit markets, but that "we would expect it to take some time if there are going to be impacts" and that it "would most likely be through the cost of borrowing and through the availability of borrowing in various forms, both to companies and individuals".[186]

135. Since September 2007, signs have begun emerging that the financial market turmoil is beginning to have an impact on the real economy. There are strong indicators that recent developments in financial markets have begun to affect the supply of secured credit to households and corporations with banks increasingly cutting back their lending. The Bank of England's December 2007 Credit Conditions survey reported that:

the availability of secured credit to households had been reduced in the three months to mid-December, and that there had been a marked increase in spreads on secured lending. Looking ahead, lenders expected a further reduction in secured credit availability. A small reduction in the availability of unsecured credit to households over the past three months was reported. Lenders reported that they had reduced corporate credit availability significantly, in line with their expectations in the Q3 survey. Lenders expected that corporate credit availability would be reduced further over the next three months.[187]

Professor Buiter also highlighted this potential real economy impact in evidence to us:

In the short term, by impairing their capital or at least reducing the margins, it will make them more reluctant to lend, and that means that the cost and availability of loans for the real economy is going to be more restricted in times to come, so a net contraction on demand is imposed.[188]

Recent research by Ernst and Young (EY) shows that profit warnings at the end of 2007 were at a six year high. The largest single number of warnings in the EY report was attributed to the problems in the US sub-prime housing market and the subsequent marked drop in the availability of credit. The Governor, in his 22 January speech, acknowledged the fact that developments in financial markets and the banking system have started to affect activity in the economy more widely, stating that "interest rates charged to both households and companies have risen relative to Bank Rate, reversing the relative fall in the year or so" before going on to warn that:

tighter conditions will discourage borrowing to finance spending on residential and commercial property, on business investment and on consumption. The impact on property prices is already clearly visible. Commercial property prices have fallen by 12% since the middle of last year. And, after rising sharply earlier in 2007, house prices stagnated in the final quarter. Although there is a considerable stock of equity in owner occupied housing, with banks tightening the supply of both secured and unsecured credit, consumers will find it more difficult to borrow to finance spending. So in 2008 it is likely that a less buoyant housing market will go hand in hand with slower growth of consumer spending.[189]

136. The impact of the financial market turbulence since August 2007 has also led to a downward reassessment of economic growth forecasts in many developed countries, including the UK. The UK Government downgraded its forecast for GDP growth in 2008, from 2.5% to 3% at the time of the 2007 Budget, to 2 to 2.5% in the 2007 Pre-Budget Report.[190] In our Report on the 2007 Pre-Budget Report we acknowledged that the Government had downgraded its forecast for economic growth in 2008 due to the effects of both the rises in interest rates in the first half of 2007, and the recent disturbances in financial markets. We cautioned, however, that "the risk remains that the credit crunch will have a greater macroeconomic effect than expected".[191]

137. As the Governor of the Bank of England has said, uncertainty about the scale and location of losses has led to concerns about the adequacy of bank capital and hence the ability of the banking system to finance continued economic expansion. There are now growing signs that developments in financial markets are feeding through to the wider economy in the United Kingdom. The continuing health of the UK economy therefore depends to a significant extent upon the banking sector's ability to re-establish reliable pricing and the restoration of confidence in each others' balance sheets. A prolonged failure to do so by the industry would have implications for economic growth. We recognise that some banks have already taken steps to establish losses and repair balance sheets. Nevertheless, the risk remains that if the banking sector does not put its house in order then the problems in that sector will have a significant adverse macroeconomic effect.

The impact on private equity

138. The private equity sector has also been impacted by the market turbulence since mid-2007. As we noted in our Report on private equity, "looking at leveraged buy-outs alone, completions in the first half of 2007 were over £25bn, close to the full-year record in 2006 of £26.5 billion".[192] However, whilst private equity leveraged buy-outs continued at a rapid pace until early summer 2007, since August 2007 the flow of new leveraged buy-outs has come to a virtual standstill.[193]

139. Research by BDO Stoy Hayward indicated that "market turbulence in August and September 2007 has led to fewer deals being completed at the top end of the market (£250 million plus) as banks look to steer clear of post-deal syndication risk". BDO went on to state that "bank debt is still readily available in the mid-market and particularly for sub £50 million deals where banks can hold the debt facility without the need to sell down post-deal". BDO went on to say that on deal values between £50 million and £250 million, banks were having to club together pre-deal to provide debt facilities, thereby avoiding syndication risk, but making for a longer deal process.[194]

146 Q 1608 Back

147 Bank of England, Financial Stability Report, October 2007, p 32 Back

148 Bank of England, HM Treasury, FSA, Financial stability and depositor protection, January 2008, p 21 Back

149 Q 1229 Back

150 Q 1230 Back

151 Ev 215 Back

152 Q 4 Back

153 Speech by the Governor of the Bank of England, at a dinner hosted by the IOD South West and the CBI, at the Ashton Gate Stadium, Bristol, 22 January 2007 Back

154 Q 1675 Back

155 IMF, Credit Market Turmoil Makes Valuation Key, IMF survey magazine, IMF research, by Manmohan Singh and Mustafa Saiyid, January 2008 Back

156 Ev 333 Back

157 British Bankers' Association submission to the Tripartite authorities: recommendations regarding financial stability, regulatory coordination and issues in the international mortgage backed securities and credit markets, British Bankers' Association, p 21 Back