Examination of Witnesses (Questions 1180
TUESDAY 4 DECEMBER 2007
MR E GERALD
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
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 crisiswe 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 seeothers may
not agreeis 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
Q1185 Nick Ainger: Mr Corrigan, reading
your submission to the Committee
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 opaqueone 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
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 experienceI do not consider myself
to be exactly feeble-mindedyou 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
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
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
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 institutionsI can speak only for onehave
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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