Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 1080 - 1099)

TUESDAY 13 NOVEMBER 2007

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

  Q1080  Mr Dunne: If I can quote to you from this article, it comes from a Bloomberg's market report in July which said that corporate bonds rated BAA, the lowest Moody's investment grade rating, had now reached 2.2% default rate over five-year periods from 1983 to 2005, according to Moody's, but from 1993 to 2005 CDOs, which have only been going that long, with the same BAA grade, suffered five-year default rates of 24%. Are you going to suggest that that CDOs have much higher default rate with the same rating than corporate bonds over their life?

  Mr Drevon: No, it does that in general. It does it in specific rating levels, and I think you commented on one rating level for a specific horizon, but even within the CDO categories there are a number of different types which will have different performances.

  Q1081  Mr Dunne: Can we turn for a moment then to how you decide at a certain point that credit is deteriorating? We have touched on what happened in Northern Rock, where you did not decide it was deteriorating until the Bank of England had stepped in. Is it the case that you tend to reduce grades of debt that you see heading towards default shortly before the final default in order to improve these performance statistics that we have just been talking about?

  Mr Hancock: Certainly not. Indeed, the way the statistics are actually published, you can look through that, so the investor is quite able to look at what the rating was one year, two years, five years before the default, so there is absolutely zero incentive to do that, and it will be seen through by the users, who have access to all of this information.

  Mr Madelain: I think what is important to note is the performance of the rating. There is a very high degree of transparency about that. I think all agencies publish a huge volume of statistics, either at the aggregate level or at the asset class level, actually tracking the performance of our ratings. So, it is certainly an area where transparency is very high.

  Q1082  Mr Dunne: Have you read Peter Warburton's report? This is language which you may disagree with, I expect. It says, "The final trick that rating agencies pull is to post-validate their assignment of a rating by making sure that very few bonds actually default from a high rating. Hence, by heavily downgrading a nearly bust bond a few weeks before its final demise, the agencies can claim that it defaulted as a C-rated bond rather than a DD-rated bond which it was when the bad news hit?

  Mr Hancock: Can I just reinforce that the user of all our ratings has all of the data available to identify if that behaviour is prominent.

  Mr Bell: I would also say, if you look, for example, at the table that we include in our submission of the default rates in the US RMBS, they are from initial rating not from final rating.

  Q1083  Mr Dunne: I think your best defence to that charge actually is what happened with Northern Rock, because you failed to downgrade them and perhaps you should have seen the warning signs a bit earlier. A couple more questions, if I may, Chairman. One is in relation to the information that is available to you as a rating agency in the US compared to Europe. You routinely receive information not generally available to the public markets from issuers, but in the US information on underlying collateral is generally available to investors, whereas it is not in Europe, and a charge has been made that during the summer crisis prices of securities began to show investors perceiving risk well ahead of the rating agencies in the US. That did not happen in Europe because the information was not available. Would anybody like to comment on that?

  Mr Taylor: I do not think we have any problem at all with greater transparency in the markets. We have no problem whatsoever with the market seeing absolutely what data we get.

  Q1084  Mr Dunne: You would be quite happy to see information made available to investors in Europe in the same way as it is in the US? That does not happen at the moment.

  Mr Bell: Yes, absolutely, in fact we welcome it and we have been, in some cases, urging, particularly in this crisis, our clients to make that information available, because we think it is good for the market that it should be available.

  Q1085  Mr Dunne: Do you see any parallels with what is happening in the US banking sector: losses being generated by investors, particularly in these CDOs, between other market failures such as the Lloyd's insurance market? If you take the example of the Piper Alpha loss of one billion dollars, because the way the reinsurance arrangements worked, that translated into a 16 billion dollar Lloyd's reinsurance loss. Do you see investment in CDOs by CDO funds as creating a spiral in a similar way to that, or potential risk of a spiral?

  Mr Bell: I think you need to distinguish between a credit loss and a mark to market loss. The credit risk never disappears, but neither is it necessarily magnified by being repackaged, it is just moved around. In terms of credit losses, the credit losses suffered so far in the global market as a result of the events of the summer have been actually very small. The losses you are looking at which are being announced by all the banks are mark to market losses. Undoubtedly, if you have many transactions, including in this synthetic area, then you have much greater value of issues out there, and on a mark to market basis you clearly have a greater chance that the losses will be magnified. In terms of credit losses, there is no magnification because the loss does not get magnified as it gets moved around.

  Q1086  Mr Dunne: Until somebody defaults, and then it does get magnified.

  Mr Bell: Sure, but there is no magnification. The ultimate default, the borrower in the sub-prime who borrowed 25,000 or 100,000 dollars, can only default to the 100,000 dollar tune even if that loss has been repackaged in an RMBS or a CDO. It has been moved around, but he cannot default more than 100,000 dollars. The losses that you are now witnessing in the system are mark to market losses as these securities' values have been marked down, and I think this is one thing that is worth bearing in mind. In terms of the magnitude of those mark-downs, we, for example, looked at one triple-A prime UK RMBS bond that traded at 80 cents in the dollar or 80 pence in the pound. That loss, taking into account the credit enhancement already in the bond, assumed that the person who sold it at 80 pence in the pound was selling it on the assumption that in a UK prime residential mortgage backed security 80% of the pool would default and the price of properties in the UK would fall by 40%. I do not think that on any valuation theory, other than Armageddon, anybody believes that eight out of ten UK borrowers are going to default on their mortgage and the price of houses in the UK is going to fall by half. What you are seeing in the market today, all those enormous mark to market losses, does not reflect credit deterioration, they also reflect a clear element of panic.

  Q1087  Mr Dunne: Are any of you considering liquidity and introducing a measure of liquidity as part of your rating methodology?

  Mr Prescott: We are setting up a working party to look at liquidity in financial institutions.

  Mr Hancock: It is certainly something we will be looking at.

  Q1088  Chairman: Why do you need a working party in the light of Northern Rock? Why do you not just go ahead and ensure that you assess liquidity? For God's sake, you have all given Northern Rock a really good rating, the disaster happened and now you are saying, "We are going to set up a working party because we never assessed liquidity." Why do you not just say here and now you are going to assess liquidity?

  Mr Hancock: Certainly within the rating of Northern Rock we did assess liquidity. Now clearly our assessment of liquidity did not withstand the repercussions—

  Q1089  Chairman: So they failed.

  Mr Hancock: I think what Philip was referring to—tell me if I am wrong—was some sort of separate indicator for liquidity in addition to the probability of loss indicators.

  Q1090  Mr Dunne: My question is how do you do that if you are not participating in the market?

  Mr Taylor: We are looking at it. We are investigating it because market participants are asking if we can provide that kind of service. We will investigate and do the best we can to look into it and see if we can put something together. Maybe we need to buy in new expertise, new tools and new data. There is no guarantee we can come up with that kind of product, but it is work in progress.

  Mr Bell: The decision to do such a process is fairly easy to take; the creation of such a scale is actually quite complex.

  Chairman: Okay.

  Q1091  Jim Cousins: Looking at the events of this summer and, indeed, the autumn as well, would you expect a bank approaching the Bank of England's credit facility to inform you?

  Mr Hancock: We would not be at all surprised if they did not, given the hugely sensitive nature of that discussion.

  Q1092  Jim Cousins: You seemed to imply earlier that you would have such an expectation?

  Mr Madelain: What I said is that—. I said earlier that—

  Q1093  Jim Cousins: A lot earlier. My memory is quite good.

  Mr Madelain: I said earlier that we were expecting systemic support to be made available to the bank, yes.

  Q1094  Jim Cousins: No, you said that Northern Rock had told you that they had approached the bank.

  Mr Madelain: No, I did not say that, or if I said it I should have—

  Q1095  Jim Cousins: If you did say that—

  Mr Madelain: I do not think I meant to say that.

  Q1096  Jim Cousins: You did not mean to say it?

  Mr Madelain: No.

  Q1097  Jim Cousins: Would you expect a bank approaching the credit facilities of the Bank of England to tell you?

  Mr Prescott: I think they would only do that at the very last minute.

  Q1098  Jim Cousins: They would only do it at the very last minute?

  Mr Prescott: Yes.

  Q1099  Jim Cousins: How many banks have in fact told you that they have approached the credit facility of the Bank of England? You have just said to this Committee that you want very high standards of transparency. I have asked you a rather simple and obvious question and you are dumbstruck?

  Mr Madelain: No, I think the answer to your question is—


 
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