Examination of Witnesses (Questions 1200
TUESDAY 4 DECEMBER 2007
MR E GERALD
Q1200 Mr Love: Mr Palmer, are there
any consequences for financial stability from the losses suffered
by the larger institutions?
Mr Palmer: So far, despite the
losses suffered by some major institutions the overall consequences
have been fairly well contained. Of course, the process is never
finished. We have seen the larger institutions which have taken
losses adapt and modify. We have seen changes of management as
they take responsibility and efforts to adjust and improve risk
management systems which are clearly very important as we move
from this backward-looking way of thinking which in the past has
driven risk analysis to a much more forward-looking stress analysis-type
situation. From what we have seen so far all of those things mean
that the institutions that are adapting reasonably well up to
Q1201 Mr Love: Why is it that a lot
of the banks have failed to quantify the exact losses?
Mr Palmer: I think that is a matter
of opinion. At any one time the banks must assess, first, what
their exposures are, second, the likely losses and, third, respond
to their legal requirements in terms of what they can and cannot
say at any one time. As we move into next year and see the audited
full year results coming from a lot of the bigger institutions
that are involved we will have a much clearer picture of exactly
what has happened.
Q1202 Mr Love: Mr Mills, one investment
banking institution assumed that its exposures were now worth
63¢ on the dollar while other suggested 90¢ on the dollar.
Why is there such a huge variation in the quantification of the
losses being suffered?
Mr Mills: What occurred in August
and September was the fact that these markets stopped functioning
and so there was no visible trading taking place. Typically, investment
banks set their prices on their inventory and their positions
based on the visibility of other trades that are taking place
in the marketplace.So, for a period of timeroughly two
or three weeksinvestment and commercial banks had to come
up with a different methodology for establishing values on their
portfolios and fundamentally had to deconstruct these complex
securities, look at the underlying collateral and come up with
a valuation. So, there was a period of time when there were significant
differences between institutions as it relates to that. I think
that most of those have converged at this point. I believe that
given the level of disclosure that has been forthcoming through
the month October that those price distortions should not be as
great as they were in September.
Q1203 Mr Love: The 63¢ that
I quoted would be considered pessimistic by some. Mr Palmer, how
does UBS come to that conclusion?
Mr Palmer: First, the fact is
that every institution has different types of exposure; they are
not always strictly analogous. Second, everyone has to make his
own estimate of what he thinks the future impact of the economic
environment will be and so there is bound to be an element of
subjectivity in these things. Unfortunately, it is very hard to
arrive at a common number. The nature of every organisation is
different, not just by degree but in terms of the details of the
Q1204 Mr Love: If you look at your
competitors, would you assume there are any decisions taken to
admit only to a small amount of loss but to drip feed it over
a period rather than be more realistic in the valuations they
make? Is there any assumption that that is happening in the marketplace
at the present time?
Mr Palmer: I can speak only for
my own firm. Obviously, we are driven by the natural principles
of transparency. Frankly, I think it is in everybody's interests
to drive towards transparency as soon as possible. Of course,
the rules determine what we can say and when we can say it.
Q1205 Mr Love: Lord Aldington, how
long before we overcome this problem?
Lord Aldington: The key to that
lies in the answer to the question you posed earlier: people retaining
confidence in the value of what is on their books. That is the
most important thing that must happen. Markets have to be confident
in the values that are there.
Q1206 Mr Love: I understand that,
but how long will it takethree months, six months, a year?
Lord Aldington: I would say we
have made a very good beginning. One can always be a little optimistic,
but the start of a new year has its own effect. I hope that we
see things settling down in the first half of next year.
Q1207 Mr Love: Mr Corrigan, companies
report quarterly in the States. In this country that does not
happen yet. Everyone tells us that all should be open and transparent
about what the losses are. Why is no one doing that?
Mr Corrigan: With all due respect,
I am not sure I agree with that characterisation. On the whole,
what we have seen so far, certainly compared with earlier experiences,
suggests that loss recognition at individual institutions has
been pretty good. Another observation directly germane to your
line of questioning is that one of the single most important things
we should look for in major financial institutions is the true
independence within those organisations of the people who are
responsible for price verification. That is usually found in something
like the controller's division. How it is labelled across individual
institutions probably varies, but when inevitably there are differences
of judgment as, for example, a sales person and a controller's
person about the best possible valuation of a particular trade
or item in inventory naturally there should be discussions, but
at the end of the day the controller's judgment should prevail.
That independence as the basic principle of corporate governance
is the single most important thing we can do to help ensure the
best possible job is being done in response to the question you
phrased. In the international supervisory community, certainly
including the FSA in the UK, a renewed and aggressive effort is
being directed at that issue.
Q1208 Chairman: Mr Palmer, my colleague
asked you about the figure of 63¢ on the dollar. Given that
the market for many credit instruments has frozen up, thereby
making it impossible for the banks to mark their assets to either
model or market, are these figures not largely pie in the sky?
Mr Palmer: Obviously, the biggest
problem is that there is no visible benchmark in the market which
is normally from where you start. When that does not exist you
have to use your best efforts through statistical analysis.
Q1209 Chairman: It is a guesstimate?
Mr Palmer: The modelling process
is very complex and must take into account an estimate of what
is likely to happen in the economy. There is always an element
of judgment in it. How fast will the US economy decline? How bad
will delinquencies be on mortgages? These kinds of things are
very difficult to assess.
Q1210 Chairman: Mr Mills, do you
agree that these figures are pie in the sky in light of the frozen
Mr Mills: No Mr Chairman, I would
not characterise them as pie in the sky but as a fairly sophisticated
effort to try to determine the value of the underlying collateral.
Q1211 Chairman: Just explain to us
in simple language how, if it is impossible for banks to mark
their assets to either model or market, there can be an accurate
Mr Mills: I think you can come
up with a range of values. As we mentioned, if there is a lack
of a marketplace and there is no visible price benchmarks that
you can look to, you have to look at the underlying collateral
and look at the underlying cash flows of that collateral, because
they are performing, and determine through different statistical
Q1212 Chairman: On a scale of one
to 10 how accurate do you think they are?
Mr Mills: Mr Chairman, what I
can benchmark for you is when we announced our earnings warning
we gave a range. We said that the losses we would incur would
be in a range of $8 billion to $11 billion.
Q1213 Chairman: I am a simple chairman
looking for a range.
Mr Mills: I would say it is 80%
to 90% accurate.
Q1214 Chairman: Lord Aldington, what
do you say?
Lord Aldington: A valuation is
a valuation and I think to say that it is only 90% accurate is
always a difficult thing to say.
Q1215 Chairman: You say it is nine?
Lord Aldington: We arrive at our
valuations and attach huge importance to what Mr Corrigan has
said, what our IPV (independent price verification) people say
and then there are the accountants.
Q1216 Chairman: What valuation do
Lord Aldington: We stand by the
valuations that we have on our books.
Q1217 Chairman: To go back to my
question, Mr Mills has given eight in the range of one to 10.
What do you give?
Lord Aldington: I can only repeat
what I have said. We stand by the valuations we have on our books.
Q1218 Chairman: Therefore, you do
not give any range at all?
Lord Aldington: A valuation is
a valuation, and it has to be supported by the accountants.
Q1219 Chairman: Mr Corrigan, what
do you say?
Mr Corrigan: Let me respond at
two levels. First, I make it my own personal business to review
in great detail the procedures and policies that we as a firm
follow in the area of price verification. I have spent a lot of
time kicking the tyres, if I may put it that way, to try to satisfy
myself as best I can that what we come up with in terms of valuations
is state of the art. To answer your question, on a scale of zero
to 10 I would say it is 9¾ based on my experience and the
amount of time and effort I have put into the task.