Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 1000 - 1019)

TUESDAY 13 NOVEMBER 2007

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

  Q1000  Ms Keeble: When it is peeled off now, it is quite clear that there was gross mis-selling, or what would be deemed to be mis-selling—people could not repay, they did not have the income, all kinds of things—so how reliable can your statistical tools have been? I could understand that if you applied them to middle income mortgages they might be very reliable, but sub-prime is different, is it not?

  Mr Bell: It is, and that is why our rules for sub-prime and the way in which we stress them is very different. We do not stress them at all the way we stress prime mortgages. Clearly there are lessons that we are going to have to learn about the US sub-prime. Clearly we are looking at what went wrong and how we could possibly learn from this and how we can change our criteria, change our tools of analysis. Are there any items we should be looking at that we did not look at before? Such crises are always an opportunity for us to learn.

  Q1001  Ms Keeble: I want to ask you in a minute about the lessons you have learned, but you have also said repeatedly that your advice functions are different from your ratings functions and that you have got different structures, different agencies. You say that, but everybody else who is coming here (and obviously we all talk to people informally too) says there are conflicts of interest: that you advise and that you rate on the same products. How is everybody else so mistaken about what you are doing?

  Mr Bell: I cannot answer that. What I can say is that we have a potential conflict of interest which is known and managed. We simply do not provide advice. It is very difficult for me to say anything more than that. We do not have advisory functions, we do not have a consultancy function for structured finance, our analysts are hired and our company is hired to rate transactions. We do not have any advisory contracts.

  Q1002  Ms Keeble: Okay. You have sat here, Mr Bell, and you have talked about the cushion that is needed, this and that and the other, to get a triple-A rating. That comes perilously close to saying, if you do this so we can tick these boxes, you can get a triple-A rating. You have sat there and said it, and we will see it when the transcript comes out. How do you actually make sure that other people do not listen to you, say "Oh, well, to get the triple-A, I have to do X, Y and Z and then I will get it, and that is the model and that is all I need to do"? How do you safeguard against that?

  Mr Bell: All our ratings are done by a committee; all of our rated transactions and structured finance are analysed. Because our criteria are transparent and available to the market and available to investors so that they can understand how we rate, we are very conscious that there will be a tendency by investment bankers and market participants to game our ratings and, therefore, the rating process is never a mechanical one. We always look at each transaction and try to understand and try to see whether or not anybody has tried to game our criteria.

  Q1003  Ms Keeble: Can you say whether, as a result of this, you have actually tightened up things? Do you actually sit on doing the final assessment or do you have a completely arms-length group of people who get all the data, a bit like the MPC, I suppose, and look at it all and then think, "Right"?

  Mr Bell: Different from whom? Because we do not have an advisory function.

  Q1004  Ms Keeble: You have sat here and described how we could go about—. You have described briefly some of the things that are needed to get a triple-A rating. Do you actually take decisions on the ratings that people get or do you have some people who will assess a product, do all the reports and then a separate group of people who take the decisions on what ratings they should get?

  Mr Bell: The latter. Maybe it is easier if I just explain the way in which we operate. Our criteria are public so that market participants know how we apply the rules. They have provisions so that we can have different criteria if we feel someone is gaming them, but basically our criteria is public. The client will approach us; an analyst will be assigned to a particular transaction—that is the primary analyst. Sometimes on big transactions, complex transactions, there may be two analysts. They will gather the information; they will ask the questions that they believe they should have obtain answers to in order to achieve the rating. They will then, once they have done this, go to a committee and they will present the conclusions of their work to the committee. The committee will vote on the rating. That is how we operate.

  Q1005  Ms Keeble: Do the assessors get information from separate sources or just from the client?

  Mr Bell: They will get assessment, they will get information from all the sources they deem relevant, so they will get it from the client, they may get it from the press, they will get it from other market participants if need be.

  Q1006  Ms Keeble: What happens if the client says, "If I tweak it here or there, will I get a triple-A"? What do you do then?

  Mr Bell: We basically answer the issue of our criteria. So if a client says, "I thought I had followed your criteria. I thought I would get a triple-A. I have not got a triple-A. What is wrong? Why did I not get a triple-A?" We will give them an answer and say the criteria had not been followed.

  Q1007  Ms Keeble: But before hand, I mean, when you are doing the assessment?

  Mr Bell: This is what I am talking about. When we are doing the assessment the client will sometimes come to us and say, "I do not understand; I thought I had met the criteria", and we will explain, "No, we do not believe the criteria has been met", and then they will decide whether they want to go ahead with the transaction or maybe they want to change the transaction.

  Q1008  Ms Keeble: How about the others? How does what you have described compare with the other agencies?

  Mr Drevon: I think the committee process is probably somewhat similar. One thing to note which I think is important is that the reason why we have transparent methodology being made available to the market is because we think it is good practice. We were being accused a few years ago of being black boxes: a client, an arranger comes to us and asks us to rate a transaction, we give the rating but we do not explain the rationale for that rating. We have taken many steps over the last few years, in fact, to become much more transparent and make available our criteria to the market place. From a policy point of view, I think this was the right track to take.

  Q1009  Mr Simon: Going back to the extent to which you agree or not and why, you started off by saying that the ratings that you issue measure different things, they are not all the same; so S&P measures default probability, Moody's measures expected loss. Then, the next thing you said is that it is not true that there is an extraordinarily high degree of agreement between the things that you rate. So far that would make sense. If you are all measuring different things it is not surprising that there is not an extraordinary high degree of agreement, although it is surprising that there are people in the market saying that there is an extraordinary high degree of agreement. Then Mr Taylor told us that the reason there is an extraordinary high degree of agreement is that the facts are the same, at which point I am starting to lose it. The facts are the same, so there is an extraordinary high degree of agreement, but you are all measuring different things, so it is not surprising that there is not an extraordinary high degree of agreement. If there is an extraordinary high degree of agreement, what is the point of having three of you in a normal market where the product is the same and the price is roughly the same? What would be the point of having three providers if you are not in any competition, if you agree about everything, even though you are measuring different things?

  Mr Madelain: Let me answer the first point, which is that we are measuring different things. When you talk about investment rate security, the difference between measuring expected loss and default probability tends to be very small. The reason it is very small is because the difference is made up by the expected recovery, effectively.

  Q1010  Mr Simon: What are you adding to the market by measuring these things differently? What is the point? Why do you not measure the same thing?

  Mr Madelain: Obviously Fitch can comment on their own practices, but we feel that what is important for the investor is to actually know the ultimate recovery, pay-out, effectively, that he can expect from the investment he is making.

  Q1011  Mr Simon: So you think that is the best way. You need to measure the loss, not just the probability of default?

  Mr Madelain: That is correct.

  Q1012  Mr Simon: And you are Moody's?

  Mr Madelain: Yes.

  Q1013  Mr Simon: S&P, you think that is wrong. You think that you only need to measure the probability of default?

  Mr Taylor: No, I am Fitch. I do not think it is wrong actually. A lot of this is nuanced, to be honest. For an investment grade security the impact of recovery assessment is very limited, because if you are taking a healthy, strong investment company and saying, "Let us predict what it is going to look like as it is about to go down the pan", there is hardly any purpose for doing that, there is no value we can add. We actually do this for our ratings at the lower end of non-investment grade; we build in the assumption of recovery. So we are actually doing the same thing, but we are saying, as you start getting down to the much riskier levels of assessment, we think it therefore adds value to talk about recovery prospects as the risk becomes greater.

  Q1014  Mr Simon: So you are only measuring very slightly different things?

  Mr Taylor: In practice, yes.

  Q1015  Mr Simon: The facts are the same, and you are all talking to the same people and using similar procedures to establish the facts, so it is not surprising that you all come up with the same answers all the time, which you obviously do even though you do not like admitting it. In which case, going back to the fees that you charge and receive, if I am a typical participant in this market would I normally be attempting to have a relationship with all of you: I pay you all and you all rate me.

  Mr Madelain: It depends.

  Q1016  Mr Simon: I know that sometimes you decline to rate. I know that you do not all rate everybody every time.

  Mr Madelain: Exactly, yes.

  Q1017  Mr Simon: If I want to make a good impression, would I not want to be rated by all three of you?

  Mr Hancock: There will be a number of clients who are rated by all three, there will be a number who are rated by two and there will be some who are just rated by one. There is different market practice in different countries and sectors of the market that we operate in.

  Q1018  Mr Simon: Roughly how would that break down? Would two be the most common, would you say?

  Mr Hancock: Yes, probably.

  Q1019  Mr Simon: Why is that? Speculate a little from a very informal position as to what I as a punter gain by being rated by two of you when you almost never disagree with each other and you are measuring the same things and the same facts?

  Mr Madelain: The point is we can disagree.


 
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