Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 980 - 999)

TUESDAY 13 NOVEMBER 2007

MR PAUL TAYLOR, MR CHARLES PRESCOTT, MR MICHEL MADELAIN, MR FRÉDÉRIC DREVON, MR IAN BELL AND MR BARRY HANCOCK

  Q980  Mr Fallon: But you did not take any action. You have written us a long submission here pointing out how Northern Rock was over-reliant on wholesale markets, its funding mix was historically very skewed, and so on, but you did not change your rating of Northern Rock before the interim results, nor between the interim results and the final crash on 14 September?

  Mr Prescott: That is correct.

  Mr Hancock: I would add that at S&P we have over 2000 clients who are rated within Europe and the fee from one of them is not going to influence a decision that we would make on their credit standing. We would be driven entirely by our belief on the likely probability of default.

  Q981  Mr Fallon: But you are taking fees from all of them, Mr Hancock, that is the point. You are the traffic-lights being fixed by the speeding motorist, are you not?

  Mr Hancock: We are driven entirely by our reputation. If we lost our reputation, if anybody doubted that we were driven by the fees we received from any individual client, that would be the end of our business model.

  Q982  Mr Fallon: Can you explain to me then why you did not flash any kind of warning up about Northern Rock between July and the middle of September?

  Mr Hancock: I think if you looked at the history of the rating of Northern Rock, we had indicated that in the 13 years that we have been rating them they were rated somewhat lower than many other financial institutions within the UK. We certainly highlighted their increased, or higher, reliance on wholesale funding. Certainly we did not expect the repercussions of the US sub-prime market to have the impact and repercussions on funding of all UK banks, but we have certainly highlighted the extra risks that were involved in their reliance on wholesale funding.

  Q983  Mr Fallon: I do not think you quite see this from the way we are seeing it. This is the first bank run for 140 years. You are the people who are supposed to be flashing up the warnings about the likelihood of banks getting into trouble and then you come here and tell us you are being paid by the very same banks and you did not give the warning.

  Mr Bell: I think it is worth drawing attention to two pieces of research or two investigations that have taken place. As the potential conflict of interest is well-known, we would like to draw attention to the fact that it has been researched in the United States. A few years ago the Federal Reserve Board asked a bunch of academics to investigate whether or not the conflict of interest did affect the way the rating agencies assigned their ratings. That academic research clearly came to the conclusion that they did not and that our reputational integrity was more important to us than the fees. In the same way, after 2003 there was a quite legitimate investigation of the rating agencies by the Committee of European Securities Regulators as well as the European Parliament that was quite extensive, and they also reached the conclusion that our conflicts of interest did not impact on the ratings we gave. So, although we absolutely accept that these are legitimate questions that should be asked, as there is a potential conflict we would like to draw attention to all the evidence that is accumulated in the case that that conflict does not impact on the rating process.

  Q984  Mr Fallon: Let us focus on the evidence on Northern Rock. Why was it that none of you flagged up after July the real danger facing Northern Rock from the closure of the financial markets?

  Mr Bell: I think the fact that needs to be borne in mind is that the crisis that unfolded in the international capital markets in August was of a very novel kind, one never seen before, and it took the entire market by surprise, it took the regulators by surprise, it took the Fed, the Bank of England, the ECB, by surprise, it certainly took the investment bankers by surprise and it took us by surprise. Our business is to express opinions. We do so based on our best understanding of how events are likely to unfold. Undoubtedly, if your business is, as our business is, to predict the future and try to see into the future, there are times and there will be things that you do not see. We did not see the way in which the sub-prime crisis would ripple through the capital markets of the world and impact an English bank, like Northern Rock.

  Q985  Mr Fallon: You all failed.

  Mr Madelain: I would like to give you my perspective on this situation. As has been provided to you in various submissions, I think we made an assessment of the liquidity situation and the risk situation, the funding strategy of Northern Rock. I think we felt that this risk was manageable. We had identified—. I think what is important to realise is that when you assign a rating you assign a rating to a scenario which you think is the most plausible scenario for that institution. You do not assign a rating to an extreme case. So, that is just to explain what was the background for our rating. Moving into the specifics, I think that we had obviously very early on measured the situation on liquidity that was affecting the market, and our view was that Northern Rock was obviously exposed. We did engage with the bank on that situation and we moved the rating when we were informed, effectively, of the decision of Northern Rock to seek assistance from the Bank of England.

  Mr Taylor: To answer your question directly, the rating did not change by much, the situation changed by a bit. Going back to your first question, which what is the rating actually doing, the rating is addressing—. If you hold a security from Northern Rock, what is the likelihood of you getting your money back? So, because of the strength of support that came in there, we did not have to change the rating, the rationale of the rating changed and was described by research issues by us, but the risk of the piece of debt did not change by that much if you were a bond holder.

  Q986  Peter Viggers: When you were asked whether each of you drew fees from Northern Rock, Fitch and Standard and Poor's said, yes; Moody's was slightly less forthcoming. Can I assume that Moody's also receive fees from Northern Rock?

  Mr Drevon: We do.

  Q987  Peter Viggers: In assessing these fees (and we would like you to let us know what the fees were) can you, please, also tell us whether these fees were proportionate compared with other institutions comparable to Northern Rock? In other words, were you remunerated in a manner which was perhaps in excess of that which one would normally see from such an institution? I would you like to put that question to you, please, and I hope you will be able to respond. You have been criticised for the speed with which ratings adjusted to the sub-prime crisis. Previously you were criticised for the speed with which you adjusted to problems with Enron. Were you satisfied with the speed that you responded and what plans have you to improve the speed with which you intend to respond?

  Mr Madelain: I think actually we feel we did effectively respond to the situation in a timely manner. I would like to make two comments. The first comment relates to what we have done. All over the summer we had very intense activity around the assessment of the situation and the communication to the investors of the impact of the situation on the bank we rated. We had weekly conference calls for global investors, we published more than 25 research reports through the summer on that very topic, so I think that the level of response and the expectation of the investors at that stage were effectively met. I guess the other question that one would have is what effectively we were able to communicate. I think it is very important that you understand that the opinions we produce are based on the public information that is available to us in the form of financial reporting as well as information that is made available by the banks that we rate; and there is obviously a limit in what we can do and that limit is affected by the amount of information that is available.

  Q988  Peter Viggers: But you are experts, otherwise it is just rubbish in, rubbish out.

  Mr Madelain: But the expert is forming an opinion using information that is made available to you. We cannot create information that is not available to us.

  Q989  Peter Viggers: Switching to another point, to Fitch, Fimalac claim that you warned investors about the dangers of a sub-prime mortgage market in 2005. Is that correct?

  Mr Taylor: It is correct, yes.

  Q990  Peter Viggers: What did you do about it?

  Mr Taylor: What did we do about it? One of the challenges we have had as an industry over the last couple of years is when the markets have been so buoyant, as we have put out comments about maybe credit deterioration or concerns in increasing leverage, for example, in transactions, many, many players in the investor community simply were not viewing credit perhaps at the forefront of their investing decision. So, even though we can draw attention to commentaries about deteriorating credit risk, it was not being reflected in investor behaviour. A good way of describing that is the average ratings we have been applying, for example, in leveraged corporate transactions in Europe have been coming down on average for the last two years. Until recently the price was coming down as well. The increase in risk as we reviewed it has not been reflected in market pricing; so there was an imbalance between what we were saying, the direction of credit and the way the market was responding to deals being placed.

  Q991  Peter Viggers: Were you content that the information you were putting out reflected the reality that investors would probably want?

  Mr Taylor: It is very difficult to say that, because what actually happened in the US sub-prime market was very much unprecedented. We had not seen anything like it before. You can argue about the magnitude of what happened versus the magnitude of what we were talking about, but I think the direction was clear, but it was not just us, many commentators in the market were saying similar things.

  Q992  Peter Viggers: Do you at Standard and Poor's and Moody's accept that Fitch was ahead of you in warning of the dangers of sub-prime?

  Mr Bell: I am not exactly sure when their warning came out. We had warnings at roughly the same time. They may well have been ahead. I think one has to remember two things. First of all, we did, as did the other agencies, warn investors about the deterioration in sub-prime, but also one has to bear in mind how you rate structured finance transactions, which is that the criteria require a credit cushion. In order to have a triple-A you have to have a credit cushion so the pool of mortgages can absorb a certain amount of losses before there are any losses at the triple-A level. These cushions were very substantial in the case of sub-prime. They reflect our analysis of past data. Those cushions are not simply reflective of what happened in the past. For triple-A ratings we simply do not say: "we assume the future will be the same as the past; what we do is we stress the past". We look at how bad things got in the past and we say: "we will multiply that level of rates to create a cushion that should survive not just credit problems in the past but a much worse credit scenario". What happened in the case of US sub-prime, however, is that the future was much worse than even our worst case assumptions—the deterioration in credit, the deterioration in underwriting, the deterioration on the fraud side, the amount of fraud involved, and also a series of very unusual and completely novel patterns of behaviour by sub-prime borrowers, things that had never been seen before in any other market. All of these combined to create a situation that was worse than our worst case assumptions and also completely novel, not just to us but to the entire markets. As a result, with hindsight, if we had known exactly what was going to unfold, we would have rated these transactions differently. However, we maintain that we rated them with all our knowledge and all our skill to the best of our ability.

  Q993  Peter Viggers: But you are experts and presumably well paid. Did you study the initial sub-prime market, notice the way they were collateralised and then draw conclusions to enable you to warn people?

  Mr Bell: Absolutely. I think also one needs to remember that we have been rating sub-prime transactions since the early 1990s. This was not a new market for us. In 2001 there was a crisis in the then sub-prime markets, so we drew all the lessons that we could from this. What happened is that the crisis in 2007 was of a speed and amplitude much greater, not just than in the past, but much greater than anything we had seen as a worst case scenario in the future.

  Q994  Peter Viggers: Can I turn to Moody's. Brian Clarkson from Moody's said in the Financial Times on 18 September, "A more uniform method of valuation is essential for efficient and rational price discovery and to address future liquidity issues." Could you expand on that statement?

  Mr Drevon: I think it appears right now that one of the main reasons why we are in these very troubled times is not necessarily linked to the credit risk we are seeing but more to liquidity-related issues and liquidity-related issues due to the fall in values we are seeing on a number of securities. Why are we are seeing this level of falls? First of all, it is very clear that these instruments are complex and require significant amounts of time to fully understand and, therefore, to try to find a tool for valuation. There is no standardised solution to that. Different banks will come up with different solutions to value these securities and, by definition, this will result in different methodologies across different institutions across different markets. This creates generally concerns that institutions may have more risk than they have been disclosing because they are using different methodologies. So there certainly is, I think, a clear understanding in the market place that there needs to be more done in terms of agreeing on solutions to have a more standardised approach for valuations. From Moody's point of view, this is not an area that we are involved in at this stage. We provide credit ratings, but we think it is an area which may benefit in the market in the future. We plan on developing tools to provide fundamental valuations to help investors with valuing these securities.

  Q995  Peter Viggers: You have a unique status under US security laws. You profit from your privileged status and it was Mr Bell, I think, who referred to your reputational integrity. Do you think you deserve this unique status in the US?

  Mr Drevon: Moody's has generally been in a position to say that we are not in favour of using ratings for regulations. We have been very clear about that in all our observations. We think that ratings are used for many things already, including by investors, by issuers. They are used by investors who buy whole issues, investors who trade, by investors who will short sell. We think that adding regulations to that as an instrument that will be using ratings is not something that we recommend, in fact.

  Mr Bell: I would go further to say that, although undoubtedly we do commercially benefit from that status, we have always, at S&P, as well as Moody's, been opposed to being part of regulation. We did not ask for this status, we did not lobby for this status, we disagreed with the SEC when they created this status and we have said ever since that it is a bad idea. We welcome the changes in the law that provide more clarity about how this status is going to be provided in the future.

  Q996  Chairman: If I can go back to another question, roughly speaking you all rated Northern Rock the same.

  Mr Hancock: Not dissimilar. There were minor differences.

  Chairman: Not dissimilar, and you all had business with Northern Rock. I will be writing to you formally on that regarding your relationship with Northern Rock and the income you have, and if you decide to write back to me and say it is confidential, then it is going to be a matter of public record, but you will be getting a letter from me on that.[4] Sally.

  Q997  Ms Keeble: I must say what it reminds me of is the children's game, pass the parcel. You have got some risk bundled up, it gets passed from pillar to post and, when the music stops, people open it and find that there is nothing there, or next to nothing there. It makes me wonder how hard you actually looked at the securities that you were supposed to be rating: because once the information had come out about the sub-prime market, it is hard to imagine how anyone could have regarded them as sound investments at all. I just wondered, if you listen to what the professors said as well, how far you look and scrutinised what you were rating?

  Mr Bell: We have 30 years of experience of rating structured finance and the first structured finance transactions, both in Europe and in the United States, were residential mortgages. The advantage of residential mortgages is that because the pools are quite large, thousands and thousands of mortgages, they do respond fairly well traditionally to statistical analysis. We have used that statistical type of analysis, taken quite a lot of information from the pools, and we do a lot of due diligence in that sense, over the 30 years. Our record shows that actually it has been extremely successful in predicting the probabilities going forward.

  Q998  Ms Keeble: In this particular case it is not just that we had the first run on the bank and all that; a lot of people, a lot of my constituents, could have lost a lot of money, all their money, so it is desperately serious. How far down through the structure did you actually prod to test how viable these loans were and what this was built on? Not just general mortgages, specifically these risky loans, obviously risky because they are sub-prime, and it is very clear that there was basically pretty much nothing there?

  Mr Bell: I think that is not actually correct. What you are seeing is a large number of down grades. Right now we do not know what the ultimate default will be, but right now the defaults on these pools are very, very small; they are less than 1% of actual defaults. Those will almost certainly rise, but to say of something that was rated triple-A, for example, was downgraded to double-A or double-A minus that there is nothing there, in all likelihood those bonds will be paid out in full.

  Q999  Ms Keeble: If you bundle things up and pass them on and keep on doing that, it is just like pass the parcel: it keeps on going until somebody blows the whistle and it stops. What I want to know is how far down did you go, not just saying they have not defaulted, the record is good, we have got 30 years experience. What analysis did you actually do of what these securities were actually based on?

  Mr Drevon: Again, our analysis is really statistically based because we are looking at very large pools, in the case of US sub-prime we are looking it more than 40 different pieces of data on each loan to come to a conclusion, and that helped us to understand the level of risk in each individual loan and then, based on that data, make assumptions about the credit risk of those pools. It is a very serious amount of work, extremely detailed, and we make available to the market place the models we use to analyse that type of risk. We are very transparent about the process.


4   See Ev 258, 272, 280 Back


 
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