Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 1379 - 1399)



  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 this market.

  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 credit-rating agencies?

  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 rating—an investment grade—and 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 trading.

  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 and choice.

  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 market.

  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 about.

  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 long term.

  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 that?

  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 determine liquidity?

  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 get—this applies more generally across the bond market—is 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 problem—Mr Cousins has focused on it in some of the things he has written in the past few years—with 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 continuing issue.

  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.[10] 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 wrong.

  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 be."

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