Examination of Witnesses (Questions 1379
TUESDAY 4 DECEMBER 2007
Q1379 Chairman: Welcome and good
afternoon. Perhaps you would introduce yourselves for the record.
Mr Montagnon: I am Peter Montagnon,
Director of Investment Affairs at the Association of British Insurers.
Mr Sears: I am Guy Sears, Director,
Wholesale, Investment Management Association.
Mr Pitt-Watson: I am David Pitt-Watson
from Hermes and I am Chairman of their Equity Ownership Service.
Mr Hitchen: I am Chris Hitchen,
Chairman of the National Association of Pension funds and Chief
Executive of the Railways Pension Trustee Company.
Q1380 Chairman: What factors explain
the rise in demand over the past decade among investors for a
range of higher-yielding but riskier financial products, including
US subprime residential mortgage-backed securities?
Mr Hitchen: Certainly, from the
perspective of pension funds our forays into the areas you mention
have been relatively limited. We try to run diversified portfolios.
But the secular change over the past 10 years among UK pension
funds is that they have increasingly been maturing and marked
to market by accounting standards, et cetera. They are now brought
onto company balance sheets. Therefore, there has been a desire
among pension funds to de-risk their investments and move towards
more bond-like investments which might be closer to their liabilities.
The problem is that the yields on long-dated bonds are very low
and there may be a supply/demand imbalance there. It may be that
some investors look for instruments which appear to have the characteristics
of bonds but perhaps have a slightly higher yield.
Mr Pitt-Watson: In looking at
the issuance of this paper one needs to look at the supply as
well as the demand. Clearly, banking regulation made it very attractive
for people to dis-intermediate loans and package them up as high
yield securities. Obviously, people want as high a yield and return
as they can possibly get and this can be achieved because special
purpose vehicles do not have the same capital requirements that
would be required if they were held on the balance sheet.
Mr Sears: I think there are three
points. With low interest rates people look for yield. There is
the originate and distribute model that has been pushed. There
is also a matter that has not been mentioned by the investment
banks. Part of the explosion was caused because mathematicians
started to put together better models on which people could rely
to assess joint risk.
Q1381 Chairman: Do you think there
are better models, Mr Montagnon?
Mr Montagnon: Our members are
quite large investors in the corporate bond market but they do
not have a huge amount of asset-backed securities. We have asked
them. What comes back is something in the region of 0.5% of their
portfolios. We have not been particularly large in this and it
is difficult to know why others have gone into it. Our impression
is that a lot of the paper we have been talking about has been
bought by banks around the world, not necessarily by traditional
long-term institutions. There has been some buying by such institutions
to diversify risk and get the right risk/return balance in the
portfolio, and clearly there has been some push down the risk
curve as interest rates have been very low and spreads have been
compressed, but we do not count ourselves as large players in
Mr Sears: Generally, with asset
managers we have about three point something trillion pounds under
management. We act for others; we do not do proprietary trading.
A very small part of that will be in this infected stuff. There
will be some pockets of stress, but they are a very small part.
Q1382 Chairman: Do investors have
a sufficiently good understanding of credit ratings? Does more
need to be done on that?
Mr Montagnon: As provided by the
Q1383 Chairman: Yes.
Mr Montagnon: I think they do,
at least insofar as they understand the limitations of a credit
rating. When I talk to our members who are large institutional
investors they regard the credit rating as only one factor in
their investment decision; they do not rely on them. Sometimes
their clients give them a criterion which requires them to invest
in paper above a certain credit ratingan investment gradeand
that affects their behaviour, but in terms of individual ratings
they like to make their own judgments. They take note of a credit
rating but do not rely on it completely.
Mr Hitchen: I reiterate that.
Certainly, the bond managers we have employed in our scheme would
make their own credit assessment. The credit-rating agency rating
would often be something that they could use in a way to gain
an advantage over the market by assuming that other investors
are relying on it, if you like. I believe that the credit-rating
agencies provide to the market a good basic level of information.
Mr Pitt-Watson: I would put a
caveat on that and consider where the question is coming from
and some of the Committee's earlier questions. People do use external
credit-rating agencies in thinking about value, but the bond market
like the equity market, is characterised by trading rather than
ownership. You will probably remember Keynes' description of professional
investors. He described them as those who try to guess who it
is will win a beauty contest, which requires not just knowing
which person you think is beautiful but which one you think the
other person thinks is beautiful. Therefore, when people trade
bonds what they look at is how it is they beat the market, whatever
it is that the market does. That means that the concentration
on ownership and fundamentals is perhaps less than it ought to
be, whereas masses of resources are put into thinking about how
it is, over a relatively short period of time, you can manage
to out-perform the other actors in the market in which you are
Q1384 Chairman: Is there an inherent
conflict of interest in the fact that rating agencies are paid
by the same banks for whose products they provide ratings?
Mr Montagnon: Yes. We have been
aware of and concerned about the conflict of interest particularly
in some of the structured finance products where the credit-rating
agency is involved both in assisting the bank prepare the product
and in rating it. That is a source of concern. We do not however
believe at this stage that it needs to be addressed by formal
regulation. We would prefer that it be done through a robust code
of practice, probably under the sponsorship of IOSCO, rather than
formal regulation because we believe that the latter may have
some unintended negative consequence with regard to competition
Mr Pitt-Watson: Some of you may
know that last year I wrote a book entitled The New Capitalists:
How Citizen Investors are Reshaping the Corporate Agenda which
raises precisely this question. Clearly, if you are paid by somebody
there is an inherent conflict of interest.
Q1385 Chairman: I have read it.
Mr Pitt-Watson: I will add that
as a blurb on the back of the second edition! It is not just the
payment for the credit rating; it is also that they (the ratings
agencies) will provide additional services to the companies they
are rating. The three credit-rating agencies are a protected oligopoly
and there may be a question about whether or not that is a constructive
thing to do in terms of having appropriate competition in the
Mr Hitchen: The way credit-rating
agencies get paid is nothing new, but the job has become more
complicated. Despite the fact that clearly they do get paid for
providing the ratings, my perception as an outsider is that their
business model is not as robust, say, as that of investment banks,
ie they cannot pay for quite the same level of talent as the issuers
of paper. There might be something there that we need to think
Mr Pitt-Watson: But they did get
Worldcom, Enron and Parmalat wrong, and that is why they are mentioned
in The New Capitalists. Now they have got this wrong. There
are some things that perhaps we should dig up by the roots this
time, and sort out.
Mr Sears: We have been talking
about the conflict of interest in this area for years and years,
but in this context sometimes credit-rating agencies are almost
given a special role by the regulators or those who set capital
treatment. This conflict also appears in the context where there
can be a massive difference between, say, getting investment grade
and not getting it. There is a very high risk area of conflict
as well as just generally.
Q1386 Mr Dunne: Mr Montagnon, you
said just now that you believed your members held a very small
proportion of asset-backed securities. The banks tell us that
the process of dis-intermediation means they are not holding liens
on their books, although one of you said earlier you thought that
banks did so. Who knows where this paper is? How do we get to
the bottom of this? If you are the institutional investors and
you do not hold it and the banks do not have it where has it gone?
Mr Montagnon: That is a very good
question and one of the reasons why this present moment is so
difficult. Nobody really knows where the risks have ended up and
who hold them. I repeat that our impression is that a lot of this
paper has found its way into banks. It is slightly different from
traditional lending, but you have seen a couple of German banks
where there have been problems. It has definitely been a banking
rather than a long-term institutional problem. All we can say
is that we cannot trace a lot of it back to our members.
Mr Sears: I am not sure either.
We have not gone through all the clients of all of our firms to
work it through. I certainly think that the percentage across
some of the institutional funds may well be above 0.5%, but it
is certainly not significant. Perhaps some is sitting inside hedge
funds. I think that in particular the enhanced yield money market
funds, not the constant net asset ones, will be carrying some
of it as well.
Q1387 Mr Dunne: That is a very interesting
point. Is that not where the public at large may get hurt by this?
There may be more sophisticated financial products created to
provide a pooled money market fund that holds instruments which,
although they have been rated triple A, are contaminated and may
start to unravel. Is that not where the man in the street can
get hit but so far it is hidden?
Mr Sears: There are two ways in
which the man in the street may be hit. To explain, there are
money market funds and money market funds. The French enhanced-yield
ones are somewhat different from the institutional money market
funds that will be triple A-rated. They will have quite a small
percentage of this asset-backed security, and certainly over the
past couple of months they have been exiting that. One of the
advantages is that the maturities are very short so you can get
out. There are two very different products out there: treasury-type
products in the form of institutional money market funds and more
investment-type products. I believe that those do have infection
and mainly institutional people have gone into them, but they
are in France and across Europe. You are absolutely right that
through repackaging, whether it is direct or through secondary
effects, with loss of liquidity, retail people will be hurt, as
we all will if this continues.
Q1388 Mr Dunne: Do you agree that
we are only a short way through the process? The contagion effect
of the potential of other funds being unable to price because
one risk goes wrong is yet to be unravelled. It has happened.
How long will the process take before it becomes apparent how
widespread it is?
Mr Sears: I think it is spread
across the whole economy. When we get to the year ends, construction
companies may worry about getting their facilities renewed. How
long will it take? I do not know, but there will be a certain
critical points. I believe that the interim results that come
out in January will be another moment of confidence and perhaps
crisis of confidence.
Mr Hitchen: Commentators are now
talking about maybe two years for the full effects to become apparent,
but if you go back less than one year given that the market was
not focused on these issues much at all I suspect that may be
an underestimate. I agree with Mr Sears that if we get an economic
downturn as a result of the credit crunch it may be much more
Q1389 Mr Dunne: Mr Pitt-Watson, do
you believe that investors understand the relative pricing of
investment grade and non-investment grade tranches of some of
these CDOs? Are they relying entirely on what the rating agency
says or because they are so sophisticated are they looking behind
Mr Pitt-Watson: More sophisticated
investors know what is going on but are typically motivated to
try to trade in the market rather than be good owners in the market.
The person whose investment money they are investing is the ordinary
man in the street. You asked who has lost from this. Clearly,
the pension funds that own Northern Rock have lost up to £4
billion. I would guess that public sector pension funds have lost
between £250 million and £300 million simply as a result
of the fall in the value of Northern Rock since this crisis began.
Lord knows how much they have lost through their equity holdings
in the banks overall. Clearly, the banks did have these investments
(subprime CDO's) because they have been writing them down; that
is where the losses have come from. Pension funds with lots of
hedge fund investments will not even know what those hedge funds
are invested in. I checked for Hermes. I was told they are not
entirely sure about the many hedge funds in which the British
Telecom pension scheme is involved but they know that one of them
bet against subprime mortgages because it came back to tell them
what a good return they had had as a result of the crisis. We
do not know whether the money of ordinary people is directly affected
by what is happening here. We do not know the value of these things.
Accounting standards have focused on mark to market rules instead
of prudence, principles. When the market dries up and we start
marking to model (as people were already doing perhaps because
that helped with the bonus at the end of the year, if it appeared
markets were going up). The accountants simply do not know how
to give a market value when there is no market. That knocks back
on all your banking ratios. People start to get scared about credit.
The banks hold on to their credit and the interbank lending market
that works any longer. The man in the street is very firmly affected
by this. Did sophisticated investors know what they were doing?
Yes, they did and they were trading; they were trying to beat
the market. In my view what sophisticated investors were not doing
to the extent they should have done, was behave as owners, like
the old bank manager would have done when he took on a mortgage.
He would ask, "Does this person have a secure job and will
he be able to pay back the mortgage? Do we have a house that has
security?" That was what failed. It went straight through
the system. The credit-rating agencies and the accountants did
not do their job and as a result we have this problem today.
Mr Hitchen: Pension fund trustees
will have a varying level of understanding of these things, but
what they are not doing is trading in the market day to day. What
they do is appoint professional investors and ask them to beat
a benchmark. It is the action of trying to beat that benchmark
that results in the behaviour to which Mr Pitt-Watson refers.
Q1390 Mr Dunne: Perhaps this is a
question for Mr Montagnon. Are your professional investors not
relying on the credit rating as their primary determinant not
just of the creditworthiness of the instrument but whether or
not it will have liquidity? Do they use a separate measure to
Mr Montagnon: Our large investment
members certainly do not rely solely on the credit rating. The
credit rating does not in itself say anything about liquidity.
That has been a problem. In some parts of the market they may
not have been properly understood. What our members believe is
that sometimes the information they need to assess the issues
they getthis applies more generally across the bond marketis
not as available, accessible or readily forthcoming as it might
be. Certainly, with regard to structured products they need information
about collateral in order to be able to assess the risk they are
taking. They would like to know more about the models underlying
these transactions and sometimes that is not so easy to get at.
The investment banks said it was there. It may be there but in
a format that is not at all digestible. That is difficult sometimes
when one has to make quite quick decisions.
Q1391 Mr Dunne: Do you believe that
the treasury departments of local authorities, for example, who
may be deciding where to plant their cash deposits through the
year have the capability to look behind the credit rating and
do anything other than take it just because it is investment grade?
Mr Pitt-Watson: Obviously not.
The credit ratings are often used to give the mandate. Funds are
allowed to invest in bonds that have got a certain credit rating.
That is why getting good credit rating is worth so much to the
issuer, because it means the interest rate is lower, and the amount
of money it raises can be a lot higher.
Q1392 Mr Dunne: If we look beyond
the confines of the CDO market we see liquidity starting to dry
up across the economy. Today we read in the newspapers that property
funds are starting to impose non-redemption periods because of
issues affecting the property market. Do you see evidence of contagion
spreading into other financial instruments?
Mr Sears: As I read in the FT
this morning, the property funds which imposed in this 12-month
period are institutional funds. Because of the way the FSA rules
work, you cannot for a retail fund impose a 12-month period, so
the ones that have been announced have been the institutional
side of it. Are people seeing stress everywhere? Yes, they are.
Certainly, as far as asset managers are concerned the difference
at the moment is that compared with the period prior to the summer
people now manage this full-time. People are exiting and becoming
more liquid as time goes on. I suggest that that is a very different
dynamic from six months ago when some of the signs were there.
Q1393 Chairman: I asked the banks
about problems with a mortgage in Chicago. I asked whether it
was a matter of garbage in, garbage out if they did not have the
market information. How do you view that?
Mr Pitt-Watson: When suddenly
the very basis on which securities are traded and valued is called
into question it is quite dangerous. That was the problem with
the credit-rating agencies to whom you talked. I go on to say
that there is a continuing problemMr Cousins has focused
on it in some of the things he has written in the past few yearswith
the way in which accounting standards are developing. Accounting
standards are based considerably less on the principles (on which
they used to be based) than they on market prices. That is another
Q1394 Nick Ainger: I asked the banks
whether they considered their actions to be reckless or cautious.
You seem to be saying from the way you react to CDOs that you
are being cautious. Do you think the banks have been reckless
in the way they became involved?
Mr Hitchen: The banks operate
in a different environment and over very different timescales.
We represent in the main institutions that invest very much for
the long term and that colours the way we think about things.
We are naturally cautious about getting into areas of which perhaps
we do not feel we have a perfect understanding.
Q1395 Nick Ainger: Mr Pitt-Watson,
earlier you referred to the issuing of mortgages and the image
of the old-style bank manager. Do you think that within their
organisations the banks have old-style bank managers?
Mr Pitt-Watson: No. It is not
being done in that way any longer. The central point is that loans
were being "originated" and then put onto the money
market providing a rating for them could be obtained. One of my
colleagues in the States is a director of a bank which got out
of subprime in the past year. He told me that one of the numbers
he looks at is the first payment default on auto-loans. A person
buys a car and does not make the first payment, let alone the
second or third payments. These defaults have gone shooting up
in the United States. Those sorts of indicators simply mean that
people have been giving out injudicious loans and the market has
been happy to accept them because it has not been thinking of
itself as the owner of those loans but as the trader of them.
I do not criticise trading; it is very important that we have
it, but if we trade without ownership and move from the old bank
manager system, to loans being monitored by traders on Wall Street,
without anything else taking place, ultimately it is the pension
funds, insurance companies and little savers who lose because
the market collapses, as it has done this summer.
Mr Sears: We talk about sell and
buy side firms. I think it is a very different dynamic. All of
our firms will be remunerated by performance over time. There
are two lifestyles, one of which is transactional: people are
paid transaction by transaction just to sell something. The other
activity is performance-oriented. These are two very different
ways to approach the market. I think that is the modern analogy
to your bank manager and the salesman.
Q1396 Mr Mudie: That is what worries
me. I shall ask about pension funds. The answer is that they are
not in these products, but those products that would deliver money.
If you are benchmarking you would not your advisers be pushing
into that field? Why are you not in it?
Mr Hitchen: I can speak only for
the pension fund which I run. We set guidelines for all our external
professional fund managers; we set not only a benchmark but the
rules of the game that they play against. It just so happens that
for CDOs as an example of what we are talking about, although
we are not talking about them specifically today, we have told
our managers they cannot invest in them. If they want to do so
they must come back and make a very reasonable case to us. We
have adopted the same approach to most other investments.
Q1397 Mr Mudie: I read your submission.
You say that only 1% to 2% are involved but it still represents
£60 billion which is a lot of money. That is just your estimate.
Does that estimate also include private equity, for example?
Mr Hitchen: Pension funds tend
to take the equity part of private equity investments. They will
have some investments in the loan part of the deals, but they
are mainly in the equity piece. Clearly, that brings its own risks,
but we accept that when we invest in equity we do so for return
and we have to take it on the chin if a particular equity goes
Q1398 Mr Mudie: When we have investigated
private equity we were particularly worried about your industry
in terms of pils in returns and then something happens and you
have real problems in terms of paying pensions. You are quite
relaxed in terms of the amount of money invested in these particular
financial instruments. How firm are you on that 2%?
Mr Hitchen: It is the best estimate
we have at present.
Q1399 Mr Mudie: You spell out your
investment policy or strategy which is apparently coming out of
equities and going into bonds. In your paper you complain about
the shortage of bonds, so where is your money going?
Mr Hitchen: You hit on a very
good point. There is a definite shortage of good quality bonds
in this country and the world in general in which institutions
can invest if they want to de-risk. The approach that we have
tended to take as pension funds is to diversify as much as we
can into different kinds of assets. We still have large amounts
of money invested in quoted equities; certainly, my fund of £20
billion has about half in quoted equities diversified around the
world. For the other half we have tried to invest in as many different
kinds of assets as we can.
Mr Pitt-Watson: We do not know
how much pension funds have invested directly, but both Mr Hitchen
and I say that, as large pension funds, we both have a large hedge
fund programme. We are not quite sure in what those hedge funds
will have been invested, but we know that one and possibly two
are coming back to us to say they have "short positions".
They have been short and have made a lot of money in the past
three months. Typically, the ones which will have been long in
this market will not be picking up the phone to tell us how badly
they have been doing. When you ask whether pension funds are investing
here we need to be careful. This is a very complex market where
money, securities and investment start with the individual but
end up with a hedge fund manager. At the end of the day it is
to do with railway workers' or telecom workers' pensions, but
it is often being managed in a way that is at several layers distant
from that pension fund. The people who manage it tend to try to
make their money by trading and the concern is that there is no
one sitting there saying, "Hang on a minute! I want to make
sure the security in this company is as strong as it ought to
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