Select Committee on Treasury Sixth Report

6  Securitisation markets: product complexity, investors and the role of the credit rating agencies


155. Our inquiry has identified a number of underlying weaknesses in the 'originate to distribute' banking model and in the market for securitised and structured finance products. These weaknesses have been illuminated by the problems in the US sub-prime housing market and the consequent international financial market turmoil since August 2007. This chapter examines the complexity of securitised products and whether investors have sufficient understanding, and have exercised sufficient due diligence on, the products they have invested in. This chapter will also outline particular features of the 'originate and distribute' business banking model that can result in over-reliance by investors on credit rating agencies.

Product complexity and investor understanding

156. Our evidence revealed concerns that many investors appear not to have fully understood the risks associated with the complex products they were purchasing. This lack of understanding combined with a lack of due diligence on the part of some investors in the financial products they are purchasing has contributed to the turbulence in financial markets since mid-2007.

157. The growing complexity of financial products was acknowledged by a number of witnesses, including representatives from investment banks: Citigroup, UBS and Deutsche Bank.[212] Mr Corrigan told us "there is no question that over recent years the inner workings of the financial system have become enormously more complicated and complex".[213] Professor Buiter described many securitised structures as "ludicrously complex" and said that it was doubtful that even the sellers and designers of these products knew what they were selling.[214] Alexandre Lamfalussy, former general Director at the Bank for International Settlements, in a speech in Brussels on 23 January 2008, pointed out the lack of standardisation of products which meant that "purchasers have to face up to the daunting challenge of trying to understand on a case-by-case basis the risks implied by each specific instrument or transaction". There is also a danger that product complexity results in senior management not understanding investments. This risk was highlighted by Alexandre Lamfalussy in his Brussels speech: "I know of cases when these in-house experts were unable to carry the message to the top management".[215]

158. The complexity of structured finance products and the risk that top management have insufficient understanding of such products was brought home forcefully to us by the inability of Lord Aldington, Chairman of Deutsche Bank UK, when appearing before the committee to explain what a CDO-squared was, despite the fact that Deutsche Bank is involved in the CDO market.[216]

159. We share Professor Buiter's assessment that many of the new financial instruments are ludicrously complex. Such products have introduced opacity into the financial system, as is demonstrated by continuing uncertainty over the scale and distribution of losses in the banking sector resulting from exposure to sub-prime mortgages. There is also heightened ambiguity about where risk is borne within the financial system. This is a serious concern because it exacerbates the risk that senior executives might not fully understand investments or strategies adopted by banks and so lack a clear picture of the risk-profile of their financial institution.

160. The role of investors, and whether they had sufficient understanding of the complex products they were purchasing or the risks involved, was raised by a number of witnesses. Representatives of the investment banking industry, whilst acknowledging the complexity of structured finance products, such as CDOs, argued that many investors did understand, or were capable of understanding, the products they were investing in.[217] Mr Corrigan stressed that products such as CDOs were aimed at sophisticated institutional investors rather than retail investors.[218] However, Lord Aldington acknowledged that in "certain isolated cases … it is not clear that the investors fully understood what they were buying".[219] Sir Callum McCarthy said that "it is clear that there has been a degree of complexity of product which has been distributed, and not everyone who has bought these products properly understood them".[220] The Governor in his Belfast speech explained that "some of these new instruments were so opaque and complex that investors lost sight of the risks involved". [221] The Governor expanded on this in evidence:

The key point here is that the investors themselves know what risks they have taken on … I think the problem has been that many investors, ranging from German public banks to other banks, have discovered that they did not know exactly what risks they had taken on.[222]

161. The Governor went on to tell us that the 'search for yield' was partly responsible for investors investing in products they did not fully understand:

there is an element of (as I call it) search for yield. Alan Greenspan would call it human nature; others might call it greed. Imagine two neighbours on a Saturday afternoon talking over the fence, and one says, "I have got a terrific investment adviser. He has told me to buy these things called CDOs. I have got no idea what they are, but you should see how much money they make." And the other one says, "I will have some of that". [223]

162. The Governor, on several occasions, stressed the role of investor responsibility: "I think it is up to the people who are buying the paper to employ the experts to properly understand the nature of the financial arrangement that they are buying into".[224] The Governor added that, "investors must take responsibility for what they buy. As Warren Buffett said, do not invest in what you do not understand." [225] The Governor also said that people responsible for investment decisions needed to say to themselves "I am not going to be seduced into investing into something I do not understand, even if I get criticised by people for not earning a high enough rate of return as the next man last year". The Governor attributed these pressures on investors to invest in high-yielding products that they may not understand to short-termism:

One of the difficulties here is this immense pressure from short-termism to demonstrate, even as a fund manager, that you have to have each quarter an above average return. This is a collective madness, the idea that everyone can have above average returns, and that is the sort of psychology that needs to be changed. [226]

163. Mr Corrigan argued that it was not just up to investors to exercise greater responsibility. Mr Corrigan suggested that major financial institutions which originated complex products also needed to exercise greater responsibility, telling us that "major financial institutions … have an affirmative responsibility to work with pension funds, foundations and institutions like that to try and help them better understand the nature of some of these investments".[227]

164. We are concerned by the sheer weight of evidence which suggests that many investors did not have sufficient understanding of the products in which they were investing. We share the Governor of the Bank of England's assessment that many investors were seduced into investing in products that they did not fully understand, and that this was in part driven by their 'search for yield', as well as short-termism on the part of many investors. The end result is that many investors appear to have 'thrown caution to the wind' when making investment decisions. Going forward, we agree with the Governor of the Bank of England's view that investors must take responsibility for what they buy and the decisions they make.

165. A number of witnesses highlighted the fact that information about products was available to investors, or potential investors, from which they could make informed decisions and that the issue was not lack of transparency, but lack of due diligence on the part of some investors. Lord Aldington phrased it to us as investors "not taking advantage of the possibility to do their homework".[228] Mr Sants said that, despite the fact these were complex instruments, "if you choose to and you take the time and you have the expertise, you can unpick these structures".[229] Mr Mills stressed that end-buyers had the opportunity to review all the structures and documents associated with them.[230] A similar point was made by Mr Corrigan:

I think the question of opacity must be kept in a little bit of perspective, because even for very sophisticated investors if you took the trouble to read the disclosures and the offer documents at a minimum you should have been able to start asking the right questions. Unfortunately, I suspect there are cases in which the amount of diligence that went into looking at and thoroughly studying these disclosures was probably not always what it should have been. [231]

However, Peter Montagnon, from the Association of British Insurers, told us that the information "may be there but in a format that is not at all digestible. That is difficult sometimes when one has to make quite quick decisions." [232]

166. We believe that there is an urgent need for enhanced transparency around complex financial products so that investors are able to undertake their own due diligence on the products they are investing in. Even where such information exists, it is, as the Association of British Insurers stated, often indigestible for investors. We believe the originators of complex financial products must ensure greater transparency of products whilst there is a pressing need for investors to undertake greater due diligence on the products they are investing in.

167. A number of witnesses believed one of the consequences of the present market turmoil would be a shift away from overly complex products. Professor Buiter told us that the solution to some of the problems created by securitisation was simpler structures. He thought that "this will in part be market-driven, but regulators too may put bounds on the complexity of instruments that can be issued or held by various entities".[233] The Governor of the Bank of England suspected that "there may be less demand" for overly complex products such as derivative instruments and CDOs. He went on to suggest that such products will:

still exist for those people who genuinely believe they really understand the instruments, and there are those in specialised financial institutions who do that, but I rather think that pension funds and others may come to recognise that securitisation is fine but just follow the basic maxim: only invest in what you understand. [234]

However, he rejected the need to regulate, telling us that "I do not think there should be intervention in that area":

My own belief in this, and I think experience bears it out, is that if you try to pass some detailed regulation saying a particular kind of security cannot be sold to certain people, then there are very clever people out there who will just devise a new kind of instrument that has not yet been prevented from being sold to others and people will get round it that way. [235]

168. The evidence presented to this Committee suggests that many investors did not have a sufficient understanding of, and failed to exercise due diligence on, the complex financial products they were investing in. This failure on the part of some investors is linked to the complexity of many securitised products. Detailed regulation of products is one response to the problem of product complexity, although not one that we instinctively favour. However, if the market and, in particular, the investment banks prove unable to address the problem of overly complex products, then regulation will need to be seriously examined in the future.

Incentive structures and information loss under the 'originate and distribute' model

169. The events since August 2007 have placed the spotlight on the 'originate and distribute' banking model and the structure of incentives as well as information problems facing market participants under this model. Jean Claude Trichet, President of the European Central Bank, said in late January 2008 that:

There will also be lessons to be drawn in terms of the structure of incentives in all stages of the securitisation process and the 'originate to distribute' model. All the relevant players—including originators of loans, arrangers of securitised products, ratings agencies, conduits and SIVs, and final investors—should have the right incentives to undertake a proper assessment and monitoring of risks. [236]

170. A key concern which emerged from our inquiry was that the 'originate and distribute' model created a principal-agent problem whereby:

  • those originating loans and constructing financial instruments may not face strong enough incentives to assess and monitor credit risk as carefully as end-investors would wish; and
  • investors at the end of the investment chain, who bear the final risk, have less information about the underlying quality of loans than those at the start.

171. As we discussed earlier, the 'originate and distribute' banking model separates the originator of the loan from ownership of the loan. Professor Buiter explained to us how this separation under 'originate and distribute' model destroyed information compared to the 'originate and hold' banking model:

The information destruction occurs at the level of the originator of the assets to be securities. Under the 'originate and hold' model the loan officer collecting the information on the creditworthiness of the would-be borrower is working for the Principal in the investing relationship (the originating bank). Under the 'originate and distribute' model, the loan officer of the originating banks works for an institution (the originating bank) that is an Agent for the new Principal in the investing relationship (the SPV that purchases the loans from the bank and issues securities against them). With asymmetric information and costly monitoring, the agency relationship dilutes the incentive for information gathering at the origination stage. Reputation considerations will mitigate this problem, but will not eliminate it.[237]

172. Alexandre Lamfalussy said in January 2008 that "it is arguable that the bank which initiated the granting of the credit, but knew already at that time that it had no intention of carrying the risk until maturity, had less incentive to look at the creditworthiness of the debtor than it would have otherwise".[238] Both Sir John Gieve and Sir Callum McCarthy told us that underwriting standards had been loosened and that the incentive structures facing originators of loans were responsible for many of the bad loans and large number of defaults in the US sub-prime mortgage market. Sir John Gieve told us that the consequence of the incentive structure facing originators was that "the originators of mortgages had a strong incentive to go for volume rather than quality with the result that an awful lot of bad loans were made".[239] Sir Callum McCarthy stressed that failures in the standards of underwriting in the originator have been one of the fundamental causes of the sub prime problems.[240]

173. Mr David Pitt-Watson believed that the problem of originators not facing strong incentives to adequately monitor credit risk lay in the fact that structured finance markets are characterised by trading rather than ownership. He said that this meant the concentration on ownership and fundamentals was less than it perhaps should be, and that "we have to learn exactly the lessons we spent twenty years learning in the equities markets, namely that these markets will not be successful unless you have someone who takes ownership responsibility". [241]

174. The Bank of England's October 2007 Financial Stability Report drew out some of the implications of the long investment chains which are a key feature of the 'originate and distribute' banking model, concluding that the greater the number of links in the chain, the greater the scope for information on the underlying credit quality of the assets to be lost.[242] (See chart two below for a description of where information gaps can occur under the 'originate and distribute' model).

Chart 2: Stylised sub-prime securitisation chain

Source: Bank of England, Financial Stability Report, October 2007, p.41

175. Professor Buiter agreed, stating that the ultimate holder of risk—the end investor— was too far down the investment chain for monitoring to work effectively and that this further added to complexity:

complexity is inherent in the process of securitisation which by the time you get to the ultimate investor, who is six transactions or more away from the originator of the loan, neither the buyer nor the seller has any idea as to the underlying risk characteristics of the security they are buying. That gets worse when the securitised mortgage loans get packaged with credit card receivables, the square root of car loans, and whatever else. The structure they have put together became so complex they probably were not even understood by their designers. Due diligence does not mean anything if you cannot understand what you are dealing with…[243]

176. The Bank of England, in its October 2007 Financial Stability Report, concluded that current safeguards to maintain credit quality had not worked well and that "while there are reputational incentives and market mechanisms to maintain credit quality … the reported evidence of fraudulent practices in the origination of US sub-prime mortgages suggests those mechanisms have not been fully effective". [244]

177. Professor Buiter argued that one way to increase incentives for loan originators to maintain careful credit origination was the retention of equity tranches of securitised issues by the originators of loans, explaining that:

The equity tranche or "first-loss tranche" is the highest-risk tranche—the first port of call when the servicing of the loans is impaired. It could be made a regulatory requirement for the originator of residential mortgages, car loans etc. to retain the equity tranche of the securitised loans. Alternatively, the ownership of the equity tranche could be required to be made public information, permitting the market to draw its own conclusions. [245]

178. The market turbulence since mid-2007 has illuminated a number of serious flaws in the 'originate and distribute' business model. In particular, the evidence suggests that originators of loans did not have had sufficiently strong incentives to assess and monitor credit risks as carefully as investors would expect, given that risk would subsequently be dispersed to investors. This incentive problem places greater responsibility on investors to exercise sufficient due diligence over the products in which they invest. However, the fact that end-investors have less information about underlying loans than those at the beginning of investment chains makes it much more difficult for investors to exercise such due diligence. We are concerned that these features of the 'originate and distribute' model have led to over-reliance by investors on credit rating agencies.

Investors and credit rating agencies

179. The credit rating agencies are particularly significant in structured finance markets. This significance is largely a result of the complexity of many new financial products as well as the information problems which are a feature of the 'originate and distribute' model discussed in the previous section; these appear to make reliance on external ratings more important for investors. This is because, as Professor Buiter explained to us, that the "information gaps could be closed or at least reduced by using external rating agencies to provide an assessment of the creditworthiness of the securitised assets and this has been used widely in the area of residential mortgage-backed securities and of asset-backed securities".[246] However, he added that the use of ratings agencies as a solution to the information problem "brought with it a slew of new problems".[247]

180. A large number of witnesses to our inquiry, including representatives from the credit rating agencies, expressed concern that some investors in securitised products were over-reliant on the credit ratings agencies. Such over-reliance could take one of two forms. First, investors might substitute ratings for their own credit risk assessment and due diligence procedures. Second, investors might use ratings to make investment decisions, rather than using ratings as one factor amongst many when making investment decisions.

181. Representatives from Standard & Poor's acknowledged that investors could mistake a group credit rating for a green light to invest, but added that the credit rating agencies "go to great lengths in trying to educate investors and others on how to use ratings".[248] Representatives from the sector stressed that their ratings did not address many other factors in the investment decision process, including liquidity risk, price risk and the potential for price appreciation or volatility. Ian Bell from Standard and Poor's said that "no investor should base a decision to invest or not invest in any debt solely on the rating; this is just one component of all the risks that investors should take into account".[249]

182. Peter Montagnon, from the Association of British Insurers, told us that large institutional investors regarded the credit rating as only one factor in their investment decision; they did not rely on them.[250] However, despite the fact that witnesses from the investor community said investors were not overly-dependent or mis-using credit ratings,[251] our evidence sessions revealed continuing widespread concern that credit rating agency scores were used as a 'green light' to invest by some investors who were overly-reliant on ratings scores when making investment decisions. Professor Buiter told us that "the fact that many 'consumers' of credit ratings misunderstood the narrow scope of these ratings is not the fault of the ratings agencies, but it does point to a problem that needs to be addressed".[252] Angela Knight, from the British Bankers' Association, agreed that there had been too great a reliance on something being called triple A or triple B that is probably the case.[253] This point was echoed by Sir Callum McCarthy: "people have relied too much on the rating agencies rather than doing their real analysis of whether "this investment is something that I understand".[254] Sir John Gieve told us that "people definitely relied on ratings agencies' ratings in an inappropriate way" and that many investors believed that "if it is triple A it is all right, not distinguishing between different sorts of instruments".[255] The Chancellor of the Exchequer agreed, telling us that "a lot of institutions give the impression that if the credit ratings agency says something is triple A, that is fine and they do not make any further inquiries".[256]

183. The Bank of England, in its October 2007 Financial Stability report, argued that investor over-reliance on the credit ratings agencies was increased by information gaps inherent in the 'originate and distribute' model, which we discussed earlier in this chapter. The Bank went on to state that investor-over-reliance was compounded by the complexity of products which meant that investors "relied heavily on ratings as summary indicators of asset quality" and this was partly related to concerns about the loss of information on underlying credit quality, which might be particularly great when assets were repackaged further, for example, into CDOs.[257]

184. We are concerned that many investors were overly-reliant on the ratings provided by credit rating agencies and that some investors misunderstood the narrow scope of these ratings. This over-reliance on credit rating agencies by some investors appears to have been compounded by the lack of due diligence on the part of some investors in the products they were purchasing, with many investors taking a triple A score as a 'green light' to invest. It is incumbent upon the credit rating agencies to work together with investors to ensure that investors have adequate information to undertake their own effective due diligence and a clear understanding of the meaning of a rating.

185. As part of the debate on reforms to the credit ratings agencies, the Bank of England, in its October 2007 Financial Stability Report, put forward a number of suggestions to improve the information content of ratings.[258] These suggestions are designed help tackle some of the information asymmetries identified previously and to reduce investor over-reliance on credit rating agencies. The Bank's suggestions, which do not represent the Bank's final position on credit agency reform are:

  • Agencies could publish the expected loss distribution of structured products, to illustrate the tail risks around them;[259]
  • Agencies could provide a summary of the information provided by originators of structured products;
  • Agencies could produce explicit probability ranges for their scores on probability of default;
  • Agencies could adopt the same scoring definitions;[260]
  • Agencies could score instruments on dimensions other than credit risk.[261]

186. We asked witnesses whether they supported the Bank of England's suggestions for the reform of credit rating agencies. Mr Sants told us that the that the first four proposals put forward by the Bank of England "are eminently sensible" and were "around the point that the principal purpose of the credit ratings agencies … is to measure credit risk as opposed to liquidity risk". Mr Sants said that the first four proposals would help improve the measurement of credit risk, as well as investor understanding and that therefore the FSA was supportive of the reform proposals.[262] He told us that the FSA was very active in encouraging IOSCO to revisit its code of conduct for ratings agencies to see whether some of the issues raised the Bank need to be incorporated into a revised code.[263]

187. Mr Sants was more cautious about the fifth proposal that agencies could score instruments on dimensions other than credit risk, telling us that evaluating liquidity as well as credit risk would be a good idea if it "could be done in a way that was credible and robust and simple to understand". He thought that "we have to leave it to the agencies to see whether that is really something they can deliver … they are commercial organisations and they have also to decide whether that is a commercially worthwhile offering to make".[264] Sir Callum McCarthy added that the fifth proposal needed to be subjected to a lot more thought before signing up to it:

One of the comments I think made correctly is that people have relied too much on the rating agencies rather than doing their real analysis of whether 'This investment is something that I understand'. It is somewhat ironical that one of the responses is to try and seek from the rating agencies even more work and even more assessment not just of credit but of liquidity. [265]

Professor Buiter appeared more supportive of the fifth suggestion, stating that "the merits of offering (and requiring) a separate rating for, say, liquidity risk should be evaluated.[266] Sir John Gieve, from the Bank of England, acknowledged these concerns about suggestion five, telling us he agreed with Mr Sants that "if it is going to confuse people further, then they should not do it".[267]

188. We also asked Standard & Poor's, Fitch and Moody's for supplementary written evidence outlining their position vis-à-vis the Bank of England's reform proposals, which we have published.[268] We support the principle of improving the information content of credit ratings. To this end we welcome the Bank of England's proposals to improve the information content of ratings. We urge progress on measures to improve the information content of ratings and, to this end, will continue to monitor progress towards greater transparency of credit ratings. However, increased information content should not imply to users that they have any less obligation to pursue due diligence.

189. A number of witnesses stressed the need to educate investors about the role of credit rating agencies and the exact service such agencies offered. Professor Buiter believed that "there has to be an education campaign to make investors aware of what the ratings mean and don't mean".[269] Mr Sants told us that "it is vitally important that people understand the limitations of the service that a credit rating agency delivers and do not use it as a shorthand way of avoiding their obligations to look properly at the structures and the risk they are taking on".[270]

212   Qq 1167, 1168, 1169 Back

213   Q 1161 Back

214   Ev 312 Back

215   Looking Beyond the Current Credit Crisis, Speech by Alexandre Lamfalussy, at the meeting of the Economic and Monetary Affairs Committee of the European parliament with national parliaments, Brussels, 23 January 2008 Back

216   Q 1170 Back

217   Qq 1155-1159 Back

218   Q 1177 Back

219   Q 1275 Back

220   Q 1465 Back

221   Speech by the Governor of the Bank of England, at the Northern Ireland Chambers of Commerce and Industry, Belfast, 9 October 2007, p 3 Back

222   Q 100 Back

223   Q 1686 Back

224   Q 1577 Back

225   Q 102 Back

226   Q 1688 Back

227   Q 1199 Back

228   Q 1275 Back

229   Q 1476 Back

230   Q 1158 Back

231   Q 1186 Back

232   Q 1390 Back

233   Ev 312  Back

234   Q 1674 Back

235   Q 1694 Back

236   Speech by Jean Claude Trichet, President of the European Central Bank, at the meeting of the Economic and Monetary Affairs Committee of the European Parliament with national parliaments, Brussels, 23 January 2008 Back

237   Ev 311  Back

238   Looking Beyond the Current Credit Crisis, Speech by Alexandre Lamfalussy, at the meeting of the Economic and Monetary Affairs Committee of the European parliament with national parliaments, Brussels, 23 January 2008 Back

239   Q 1674 Back

240   Q 1465 Back

241   Qq 1383, 1401 Back

242   Bank of England, Financial Stability Report, October 2007, p 42 Back

243   Q 926 Back

244   Bank of England, Financial Stability Report, October 2007, p 42 Back

245   Ev 312 Back

246   Ev 312  Back

247   Ibid. Back

248   Qq 1038-1039, 1041 Back

249   Qq 945-946 Back

250   Q 1383 Back

251   Qq 1382-1383 Back

252   Ev 313 Back

253   Q 1584 Back

254   Q 1487 Back

255   Q 94 Back

256   Q 806 Back

257   Bank of England, Financial Stability Report, October 2007, p 42-43 Back

258   Bank of England, Financial Stability Report, October 2007, pp56-57 Back

259   Tail risk refers to the risk that extreme losses are more likely than what would be expected from a normal distribution. Back

260   The Bank pointed out in its October 2007 Financial Stability Report, that some credit ratings agencies use probability of default, some loss given default and others a combination. Back

261   Possible additional categories suggested by the Bank include market liquidity, rating stability over time or certainty with which a rating is made. Back

262   Q 1486 Back

263   Ibid. Back

264   Ibid. Back

265   Q 1487 Back

266   Ev 313 Back

267   Q 1698 Back

268   Ev 264-266, 276-279, 285-288 Back

269   Ev 313 Back

270   Q 1487 Back

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