Examination of Witnesses (Questions 1240
TUESDAY 4 DECEMBER 2007
MR E GERALD
Q1240 Peter Viggers: When banks were
in the world of buying securities and taking on mortgages in order
to hold them they would have a vested interest in making sure
that the security was solid. As banks have moved to a different
model of originate to distribute and put together or buying packages
which they know they will pass on, I put it to you that they do
not have the same vested interest in ensuring that the security
is completely solid. I am thinking here of subprime mortgages
in the United States in particular. Do you agree that there has
been a loosening in borrowing and lending standards?
Mr Corrigan: I think the evidence
is overwhelming that in the origination process in the subprime
markets in the United States the answer is yes. It is however
important to recognise that the development of the subprime mortgage
market was a noble idea, because what it sought to do was provide
access to home ownership on the basis of individuals and families
who by historic standards never had any realistic hope of being
able to own their own homes. Unfortunately, that novel idea fell
asunder in part because it is unambiguously true that the credit
standards particularly with regard to some of these exotic and
complex mortgages have not been what they should have been. That
is something we have to fix. As I suspect you know, there is legislation
pending in the US Congress that will go some very considerable
distance to try to repair that problem, but there is no question
as far as I am concerned that at the origination point the standards
of diligence, credit checking, marketing and promotion some of
these mortgages got out of hand.
Q1241 Peter Viggers: I put it to
you that when such mortgages, loans and other commercial paper
are collateralised or securitised at the first cut of securitisation,
as it were, the individuals would have a good understanding of
what is involved, but I put it to you that when they have been
repackaged several times the people who make the investment do
not know exactly what they have. Can each of you look at your
loan books and the CDOs you have taken on and unpick them? Can
you pull pieces out of the tapestry and know exactly what the
value is of what you hold on your books?
Mr Palmer: There is a well established
process of due diligence of portfolios of mortgages and the securities
that arise out of them. The process is to look at a sample of
the mortgages within each bundle, as it were. There is also a
stage when the portfolio is held for a period so see the delinquencies
and defaults in the first few months. There are well-established
processes for getting as much information as possible and providing
that to the buyers of the securities.
Q1242 Peter Viggers: Lord Aldington,
are you that confident in your involvement?
Lord Aldington: As I said earlier,
I am not an expert in this industry, but I support what Mr Palmer
has just said.
Q1243 Peter Viggers: Mr Mills, when
after management changes there is an £11 billion write-off
within Citigroup some commentators were concerned that many of
the losses were in the £43 billion of off-balance sheet exposures.
Does this follow through from what has been said before? The word
"sophisticated" has been used quite frequently. While
sophisticated investors understand the distinction between a bank's
own assets and off-balance sheet items, the fact is that you have
sufficient reputational risk to require you to make financial
commitment to off-balance sheet vehicles?
Mr Mills: The specific reference
I made was to an $8 billion to $11 billion potential loss that
would be crystallised in the fourth quarter. That directly related
to assets that we have on balance sheet, so that is directly related
to our mortgage-backed exposures. As it relates to off-balance
sheet exposures, we do have some exposures to some very distant
third-party investment conduits that we are supporting from a
commercial paper point of view. As it relates to our own sponsored
conduits, we have not disclosed or made any provisions in terms
of losses. Those conduits are in the normal course of business
selling down assets to meet their funding targets and have plans
in place to have an orderly unwind. The good news for us, Sir,
is that those conduits have very good assets and so they do not
rest in any subprime product.
Q1244 Peter Viggers: Do you discuss
this with your auditors?
Mr Mills: We discuss it with our
auditors and our regulators on an ongoing basis.
Q1245 Peter Viggers: Mr Corrigan,
you have $65.5 billion worth of activities related to collateralised
debt obligations, real estate investment, mortgage-backed bonds
and principal-protected notes. According to the Financial Times
of 8 November, auditors will be looking very closely at this area.
Are all of you discussing these issues with your auditors?
Mr Corrigan: Absolutely. I do
not recognise the number you cited, but we can deal with that
separately to the extent you wish. The auditors carefully review
the preparation of financial statements. I should also acknowledge
that in this area the supervisory authorities have spent a great
deal of time in recent weeks and months looking at the same questions.
Whether it is auditors, internal management or supervisory authorities,
we can say without the slightest hesitation that all of these
issues are under our microscope, and they should be.
Q1246 Chairman: Do you agree with
Christopher Cox, chairman of the Securities and Exchange Commission,
that in his opinion there is a need to consider whether rating
agencies were unduly influenced by issuers and underwriters who
paid for credit ratings?
Mr Corrigan: I do not like to
monopolise the conversation. First, in the United States legislation
was passed in 2006it may have been in 2005that was
essentially an outgrowth of the earlier Enron-type events. That
put in place a fresh oversight function as it pertained to the
rating agencies. Among many other things the provisions of that
legislation established new standards for record-keeping, authorisations
and so on. In addition, international securities regulators in
effect told the rating agencies in 2006 that they had to come
up with formal statements of best practices and codes of ethics
and behaviour, which has been done. I have looked at one of those
codes of conduct for at least one of the rating agencies and it
is pretty good. Is it good enough? We are in the process of learning.
Recent experience suggests that there are still further things.
Q1247 Chairman: But is there a need
for this? Christopher Cox wants to probe whether they have been
unduly influenced by issuers and underwriters who have paid for
Mr Corrigan: I think that is fine.
Q1248 Chairman: Does everyone agree
Lord Aldington: Yes.
Q1249 Chairman: Is there an inherent
conflict of interest in the fact that rating agencies are paid
by the same banks whose products they provide ratings?
Lord Aldington: This debate about
rating agencies has been going on for years and years and nobody
has yet found a better solution as to how to pay or compensate
the rating agencies. Certainly, in the "lessons learnt"
department in all of this it would be very sensible to bring that
question into it.
Q1250 Chairman: There could be a
conflict of interest here?
Lord Aldington: We all have to
manage conflicts of interest, but it is a sensible thing about
which to ask a question.
Q1251 Chairman: Does everyone agree
that there is a conflict of interest here?
Mr Corrigan: There is certainly
a potential conflict of interest.
Q1252 Chairman: Mr Corrigan, as to
the depositor protection scheme it has been suggested to us by
one US commentator that the Northern Rock crisis could have been
avoided if the UK had adopted the US model of depositor protection.
Do you share that view?
Mr Corrigan: Certainly, I agree
that deposited insurance is a prominent and necessary element
of the so-called safety net that surrounds financial institutions
in all countries. Whether there is anything absolutely unique
and magical about the US system as opposed to the current or a
newer system in the UK is a judgment that you and your colleagues
have to make.
Q1253 Chairman: I just wanted a US
perspective, because the issue of adequate legislation and instant
return of moneys is important. I shall be going to Washington
next week to speak to the FDIC.
Mr Corrigan: There are two observations
I offer. One is that the US deposit insurance system has a fee
system applied to the depositary institutions that is risk-based;
in other words, not all institutions pay the same fee. It is differentiated
based on the risk characteristics of individual institutions.
I think that is a pretty good idea.
Q1254 Chairman: It is an upfront
Mr Corrigan: Now it is an upfront
payment model, but what institution A pays may not be the
same as institution B based on the risks characteristics
as determined by the FDIC. The other point I make for your consideration
is that the payout provisions should be very simple and straightforward;
in other words, in the United States the payout provision is $100,000full
stop. As I understand it, the current system here in the UK is
a bit more complex than that and it has different layers and percentages.
I am a little concerned that that may be a bit of a structured
product in its own right.
Q1255 Mr Mudie: Listening very closely
to your evidence, you seem very regretful about it. I put a question
that perhaps the ordinary man in the street might ask. You have
declared interim losses, but in the course of the business you
have been conducting for several years in this fieldthe
subprime marketdo your profits exceed your losses; in other
words, although you are all very sorry that you have been left
with this exposure you have certainly made a lot of money over
the years in this field, have you not?
Mr Mills: I can answer for Citigroup.
Our losses greatly exceed the profits that we made in this field.
Q1256 Mr Mudie: Over what period?
Mr Mills: Several years.
Mr Corrigan: I am not sure, but
I suspect that in the case of Goldman Sachs on balance we have
made money over the period in question.
Mr Palmer: To be honest, I am
not sure. My suspicion is that it is in the same direction as
Mr Mills. I have not made the calculation, but I think it is going
in that direction.
Q1257 Mr Mudie: Why do you think
you are different from the others?
Mr Corrigan: That is a good question.
First, part of it is that Goldman Sachs is not involved in the
front end of this; in other words, we are not in the residential
credit origination space or the servicing space. Second, we have
had a measure of successI do not want to overstate itin
hedging some of our exposures in this space in the recent period.
When I try to put the whole thing together in my mind's eyeI
have not done the arithmeticmy sense is that on balance
we have probably made some money.
Q1258 Mr Mudie: Can you give us some
idea of the timeframe? This started in the States. When did you
start to go to subprime in such a massive fashion and begin to
securitise it? Mr Mills and Mr Palmer have said they think they
have lost money; Mr Corrigan believes he may have made money.
It would be interesting to discover what period of time we are
Mr Corrigan: As an approximation,
our assessment of the underlying conditions in that segment of
the market was in the timeframe of our second quarter which ends
Q1259 Mr Mudie: I do not mean that.
When did subprime lending in the States take off in a noticeable
way? How many years are we talking about?
Mr Corrigan: The key benchmark
for that would be the approximate timeframe of 2003-04. There
were elements of it before that. It really emerged as a major
business in that timeframe.