Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 1180 - 1199)

TUESDAY 4 DECEMBER 2007

MR E GERALD CORRIGAN, LORD CHARLES ALDINGTON, MR JEREMY PALMER AND MR WILLIAM MILLS

  Q1180  Mr Dunne: Are you admitting that it takes a shock of the kind we have just had for the banks to recognise that there is something inherently wrong with the structure?

  Mr Corrigan: Unfortunately, that is a fact of life which I cannot dispute.

  Q1181  Mr Dunne: Did any of your institutions take heed of the warnings that were issued in this country by the FSA in January and by the Bank of England in April about the consequences of this spiral of such sophisticated instruments running out of steam?

  Lord Aldington: The comments of the Bank of England and the FSA at similar times were very sensible observations about what was going on the market. We read those and factor them into our processes, as we do other opinions.

  Q1182  Mr Dunne: Who within your organisations looks at the fundamental building blocks of these products? The rating agencies who came before us the other day claimed that their models were constantly being validated and challenged by the investment banks, but models do not price as well as markets, so there is a failing somewhere either between the rating agencies or within your deal teams in working out where the flaws are in the models. Is any of the witnesses close enough to the practices of his deal teams to know whether or not the models have validity?

  Mr Mills: I would answer that the models are based on historic precedents. What all of our due diligence has not taken into consideration is the impressive level of delinquencies and defaults. I think that we are in a period that is a scenario that should have been tested more rigorously but, frankly, we were basing most of our decisions on what the rating agencies referred to as depression-type scenarios. Secondly, I would also just mention thatin terms of the guidance from the FSA and the Bank of England, one thing that we did not anticipate was the liquidity crisis—we did not anticipate that the liquidity would dry up to the extent that it did in August and that, frankly, added on to the issues.

  Q1183  Mr Dunne: Most of us are not here to beat you around the head but to try to find some solutions to make sure it does not happen again. If we are looking at historic data and carrying out regression analysis without sufficient risk-testing of what may go wrong going forward, how do we come up with better models or methodologies for pricing product that takes these things into account so this does not happen again?

  Mr Corrigan: As some Members of the Committee may know, two years ago I was chairman of an industry group that looked at the subject of complex products, among others, which included institutions not only in the United States but in the UK and Europe. We devoted a lot of attention to the question you have just raised. I think the answer has a couple of components to it. First, you are precisely accurate when you suggest that models by definition are backward and not forward-looking. That is a reality that we all have to deal with. The way we try to deal with it, with a great deal of impetus from the regulatory side, including the FSA in London, is by trying to enhance scenario analyses, stress-testing and things like that to allow us to try better to look at what we call the tails of these frequency distributions which are the essence of these models. I think we have become better at that. Do I think we are as good as we could be? No. If you look at the recent example of the subprime situation in the United States with its unfortunate and tragic consequences clearly almost no one anticipated the combination of factors, including the bubble in the first place and then declining home prices superimposed on a rapidly changing credit environment.

  Q1184  Mr Dunne: But in the US you had identified post-Enron a deficiency within the rating structure and legislation was introduced to regulate the rating agencies. Clearly, that has failed in this case. Are there lessons we can learn internationally about how rating agencies are essentially used by investment banks to validate a product which does not do what it says it will do on the tin?

  Mr Corrigan: You are right that in the post-Enron environment in the United States substantial effort was devoted to taking a fresh look at the rating agencies which resulted in legislation. That was finally passed in 2006, I think. That goes some distance in terms of reform in the way the rating agencies operate. In addition to that, international security regulators as a group effectively instructed the rating agencies in 2006 to adopt formal best practices, codes of conduct and ethics. I think those things have helped but obviously they have not fully resolved the issues to which you refer and as part of the normal post mortem from this episode we need to revisit that question. One thing I would like to see—others may not agree—is a joint effort by a relatively small group of highly professional and sophisticated investors to work in collaboration with the rating agencies themselves to come up with a fresh cut at a framework of best practices, including the question of how better to manage potential conflicts and interests. To get top quality institutional investors involved in that review is a very constructive way to think about how to we can make still further progress.

  Q1185  Nick Ainger: Mr Corrigan, reading your submission to the Committee[1] it seems that everyone is now wise after the event, but I am sure that Members of the Committee and the British public expect bankers to be cautious rather than reckless. With hindsight, do you think that a number of financial institutions to the degree that they became involved in CDOs were reckless?

  Mr Corrigan: I think and hope the answer is yes. Since you have made reference to the statement that I submitted to the Committee, which I hope Members have found useful, one of the points I emphasise is that, having myself lived through more of these financial disruptions than I would like to admit to over 40 years, the fact of the matter is that all of us need to continue to devote relentless energy to learn from these experiences when they occur in the process of what I call strengthening the so-called shock-absorbers in the financial system. Unfortunately, it is sad but true that in the nature of things these periodic disruptions will occur. When they do so we have to learn from them and step back and rebuild certain elements of things we have done in the past as with, say, the question of rating agencies. But I think we must also be honest with ourselves and recognise that as hard as we work at this in some point in the future another surprise will occur.

  Q1186  Nick Ainger: But, looking at your analysis, with which I agree, it seems so obvious that if these CDOs were so opaque—one American academic described them as "too clever by half"—there would be a major reckoning at some time. If you are buying a product and do not know what the risks are throughout its life surely that is reckless.

  Mr Corrigan: I have a lot of sympathy with what you say, but in fairness I would simply observe that for sophisticated investors the disclosures associated with CDOs were pretty good. Could they have been better? Yes. 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. Speaking from personal experience—I do not consider myself to be exactly feeble-minded—you have to work at it. Those documents are not bedtime reading.

  Q1187  Nick Ainger: But an awful lot of people in all your organisations are paid extremely well to read the detail of those products. Mr Mills, was Citigroup reckless?

  Mr Mills: As it relates to distributing product, I do not believe that we were reckless but I believe we gave all the appropriate disclosures and I believe that we were dealing with what we thought were sophisticated institutions. We thought that from the point of view of suitability these were instruments that they could analyse and understand. In response to your earlier question, I think the issue around the subprime and sub-structured product occurred much earlier in the chain and I think that had to do with basic lending to borrowers and as to whether or not they were creditworthy or appropriate to lend money to.

  Q1188  Nick Ainger: But errors made in the sale of a mortgage to a householder in Chicago should not end up with the crisis that we face in this country with Northern Rock. Admittedly, the contagion started with the mis-selling of a mortgage in Chicago, but it was your institutions and the linkage through CDOs that caused that contagion. If you had done your job properly and deeply examined these products, as Mr Corrigan says should have been done, perhaps that contagion would not have occurred. Clearly, that was not done, was it?

  Mr Mills: I think that people used the best analytics available to them. I think that with the benefit of hindsight, you cannot disagree with your conclusion.

  Q1189  Chairman: Lord Aldington, one of your analysts, Mike Mayo, is quoted as saying that the whole question of CDO exposure and off-balance sheet vehicles is such a black box in many ways but "that is investing in financials". Do you agree with him?

  Lord Aldington: Chairman, this discussion is really about the way—-

  Q1190  Chairman: I am asking about Mike Mayo's comment about the black box?

  Lord Aldington: Do I agree with Mike Mayo?

  Q1191  Chairman: One of your analysts at Deutsche Bank, Mike Mayo, has said that the whole question of CDO exposure and off-balance sheet vehicles is such a black box in many ways but "that is investing in financials". Do you agree with your own analyst?

  Lord Aldington: I would not have chosen those words. This is a serious topic and sometimes analysts are a little provocative in what they say. What we are talking about here is the way in which the financial markets for a sophisticated products work and what is acceptable in terms of information is something that is developed between the arrangers and distributors and the sophisticated investors.

  Q1192  Chairman: If you had agreed with him I would have gone on to ask another question, but it is more alarming that you do not agree with him. You have people in your organisation saying to the financial community that this is a black box and you come here to say it is not. Whom do we believe? This is a person who is on the street every day, if you like, telling the financial community that it is a black box and you disown that.

  Lord Aldington: We are all aware of the role that analysts play in our organisations.

  Q1193  Chairman: Should you review the way analysts play their role?

  Lord Aldington: Analysts have always been required to have an independent voice; indeed, in most countries in the world that is now legally enshrined.

  Q1194  Chairman: He describes CDO exposure as a black box. How would you describe it?

  Lord Aldington: The process of investing in CDOs? We have just been addressing that.

  Q1195  Chairman: Do you have some sympathy for those who view it as a black box?

  Lord Aldington: I would not view it as a black box at all. The information is available if one chooses to seek it.

  Q1196  Mr Love: I want to ask about the consequences for the individual financial institutions that have suffered loss whether there are any knock-on effects on other financial institutions. I start with Lord Aldington.

  Lord Aldington: What type of financial institutions are you talking about?

  Q1197  Mr Love: I am referring to those that have suffered loss through this process.

  Lord Aldington: And the consequences for others?

  Q1198  Mr Love: What are the consequences for others in the marketplace?

  Lord Aldington: Some of the large investment banks have to varying degrees taken losses and those have been absorbed within their capital base and loss reserves. Speaking for my own house, we are in a healthy position and will move forward.

  Q1199  Mr Love: Mr Corrigan, do you have anything to add to that?

  Mr Corrigan: I have two thoughts. First, as you know well, 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. I go back to one observation by the Chairman a little earlier. We know that on a smaller scale there are other classes of institutions, including pension funds for an example, that have undoubtedly experienced some losses. I believe that major financial institutions—I can speak only for one—have an affirmative responsibility to work with pension funds, foundations and institutions like that to try to help them better understand the nature of some of these investments. On behalf of Goldman Sachs in particular, I have spent a great deal of time over the past couple of years doing exactly that. I have worked directly with these institutions to help them enhance their own risk management and due diligence capabilities. I consider that to be an inherent responsibility of major financial institutions in this area.


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