Examination of Witnesses (Questions 489-503)
Mr Paul Taylor, Mr Alastair Wilson and Mr Dominic
Crawley
18 JANUARY 2011
Q489The Chairman: Gentlemen, thank you very
much indeed for coming in. I apologise for the fact that we are
starting a bit late but, as you can see, we have tried to combine
a number of different witnesses this afternoon because we are
coming towards the end of our inquiry. Thank you for your patience.
When you first speak, could I ask you to give your names for the
benefit of the recording of this session, and to speak fairly
loud and clearly? In order to not prolong the discussion, if in
answer to a particular question, the person who first answers
is covering the subject completely, or you are happy with the
answer, please don't feel that you need to supplement it, but
we are very happy to hear from you in any way you wish. Could
I begin with the first question? In the same way as an audit opinion,
a rating agency's rating is relied upon by parties as a form of
assurance. In parallel with auditing, is it satisfactory that
companies needing such a rating can both shop around between rating
agencies and pay the rating agency for their work in rating? How
do you preserve your independence and that of the auditors?
Mr Taylor: I'm Paul Taylor; I'm President of
Fitch Ratings. I think it's very important to start with, to go
back to your word of "assured", assurance in rating.
There's a fundamental difference between a credit rating and an
audit report. A credit rating is a forward-looking view; we're
trying to predict the future. You can't have assurance in trying
to predict the future so, at some stage some ratings will always
be wrong. You look at default data going back 40 or 50 years,
and an investment grade rating doesn't say there's no risk; it
tells you there is a level of risk and the risk should go down
as the level of rating comes down. So, you can't take an assurance
from a credit rating; you can use it as a guide, as one of the
inputs into the process of assessing a particular situation or
company or debt instrument. Perhaps I should stop now and pass
over to someone else to speak.
Mr Crawley: Dominic Crawley, I head up the Financial
Services Rating Business for Standard & Poor's for Europe,
Middle East and Africa. I would concur with what Paul has said,
but I would just add something on the particular question of shopping
around. As Paul has said, ratings are forward-looking opinions
and they are derived from sourcing information from a wide variety
of sources, but they are used against a framework of published,
public criteria and analytical methodologies. We stand and we
fall based on the criteria we use, which is public. So it isn't
as if we offer different levels of service or product to different
people dependent on what they might or might not pay us.
Mr Wilson: Alistair Wilson, Moody's. I agree
with both of the previous comments. I only add that whatever you
think of our performance over the past two, three, four years,
rating agencies have a very, very strong incentive to build and
to try to maintain a strong reputation. That reputation will rest
on the accuracy, however defined, of its ratings. That reputation
will, in the long term, ensure that the rating agency overcomes
any short-term incentives it might have to accommodate issuers.
Q490 Lord Tugendhat: You heard what
we were talking about with Lord Myners; the auditing profession
is very highly regulated. You are very much less regulated. When
you look at your position and the work you do and the auditing
profession and the work it does, would you feel the auditing profession
is over-regulated, too prescriptive as we heard earlier this afternoon,
or what do you think the balance might be?
Mr Taylor: I think your statement was correct
two years ago. I think it's not correct now. Rating agencies have
become very heavily regulated over the last couple of years. It
started four or five years ago. We've just finished a consultancy
period with the European Commission, who have just launched their
third round of suggested regulation within the last couple of
years. Interestingly, most of the market—the market in terms
of treasury associations bank and investor organisations,—and
the UK Government came out with a statement; I think I saw it
today—are really pushing back quite strongly against the
commission in particular, because they are starting to try to
interfere with how we do the work, how we reach our decision and
how we assign ratings. To give you a specific example, the commission
is suggesting that we should give sovereign nations extra time
to think about a decision we've come up with. So dictate that
we can't announce the decision we've come to until three days
after we've told the sovereign. We think that opens up all kinds
of potential problems. Dodd-Frank in the US is another good example;
of increased regulation. You can look at Japan and Australia and
many other jurisdictions. We are very heavily regulated now. I'm
not sure the sum total of that new regulation is going to add
any more than the lessons we've applied ourselves from what we've
learned from what's happened in this crisis that we have been
living through. It helps to give a framework of regulatory confidence
around the industry and some of the ideas are sensible, but a
lot of it is just simply bureaucracy for the sake of it.
Q491 Lord Tugendhat: So, you are
more regulated than you used to be, but you think that the auditors
are over-regulated, or not?
Mr Crawley: For the record I would have to say
that I'm certainly not qualified to make that observation.
Q492 Lord Smith of Clifton: Gentlemen,
do you consider that a rating agency's rating of a securitisation,
for instance, can be regarded by auditors as a reliable guide
to asset quality?
Mr Crawley: Let me take that first. Paul has
already said that ratings are forward-looking opinions of uncertain
future events. Certainly, we do not carry out due diligence on
assets or pools of assets; that is not the role we play in the
market. What we are assessing is relative credit-worthiness; we
are looking at the potential of default. We are not looking at
many other factors that go into the assessment of assets in terms
of liquidity, value and so on.
Mr Wilson: It's probably worth adding that credit
ratings are usually intended to reflect more than one objective.
For example, credit rating agencies will try to ensure that their
ratings are both accurate, but stable—which is a balance
that needs to be achieved—and the ratings that come from
those objectives will not be necessarily directly related to an
asset's value at any one point in time. By "value" you
mean its market price, because market prices will reflect a range
of factors that are not germane to a credit rating.
Q493 Lord Smith of Clifton: Could
you give me some indication of what methodologies you do employ?
You just don't go in and feel the seaweed and say, "up market"
or "down market". What do you actually do at nine in
the morning? How do you start your day?
Mr Wilson: If by that you mean how does the
credit rating process work, we have a range of methodologies that
apply to industries—to particular sectors, particular types
of issuer. These are intended to enable us to standardise and
systematise the way in which we credit-assess issuers, whether
those issuers are from the financial institution sector, structured
finance or corporate finance.
Q494 Lord Smith of Clifton: Is it
largely a mathematical analysis you're going for?
Mr Wilson: No, there's a significant degree
of judgment involved in assessing credit-worthiness. The methodologies
will employ some mathematical models, but even the methodologies
themselves are about trying to systematise judgment, and the rating
that ultimately comes from those methodologies will reflect the
judgmental overlay from the rating committee. The methodologies
are intended to be a starting point for any analysis of credit-worthiness.
Q495 Lord Smith of Clifton: So there
is still a lot of tea leaves and seaweed around?
Mr Wilson: There's a lot of judgment.
Q496 The Chairman: What view do you
take, for example, in looking at a company's accounts, and what
the auditor says about the accounts? Is that of great value to
you in making your judgment?
Mr Crawley: We would look at a wide range of
information that we will then bring and apply against the framework
of our criteria. We will look at a wide range of information that's
provided directly from the company that we're engaged with; we
will look at audited financial statements; we will look at market
information. Certainly—in terms of the question that was
asked earlier on—it is not our role and we do not carry
out due diligence, but, when we look at audited financial statements,
we clearly will be looking at the audit certificate and will be
taking a certain level of comfort or validation from who that
audit is conducted by, and the facts of the audit certificate.
Q497 Lord Hollick: Mr Crawley, you
made a couple of remarks, which I hope I noted down correctly,
which puzzle me. You said that when you do a rating, you are looking
at a forward-looking opinion, and secondly, you said you don't
look at the underlying assets in a bond. My source on this is
Mr Michael Lewis's book, The Big Short, and he describes
the rating agencies giving AA ratings to bonds where the information
was available by careful and diligent inquiry, that the underlying
assets in the bonds—the CDOs—were already not performing
properly, keys were already being handed back in, and that enabled
those who did that work to make a fortune by betting against those
bonds. I'm puzzled at how you can form a judgment as to a rated
bond without doing diligent inquiry as to the assets that underlie
it. It's nothing to do with a forward opinion; it's actually what
happened today and what happened yesterday.
Mr Crawley: My Lord, I wish to be helpful to
your question, but what you are referring to is the structured
finance side of the ratings business, which is not my area of
responsibility or my area of specialisation so it is difficult
for me to comment on that. I don't know whether—
Mr Taylor: Let me try and answer it. We do look
at the underlying assets, of course we do. If you take a mortgage
bond, for example, it's a transaction which is, say, several thousand
individual mortgages packaged into a cash-flow instrument. We
look at the mortgages in aggregate and you rely upon the data
given to you, which is generally audited so it is checked. We
don't, for example, go and revalue several thousand properties;
we rely upon that data being accurate. We then apply stresses
to it, but we are looking at underlying data. The fact that our
assumptions on the underlying data prove to be incorrect, or not
stressful enough, was the issue that caused all the problems—
I enjoyed reading The Big Short as well, though some of
the stories are embellished. There are always a few people who
take the counterargument, of course. Time has passed and it's
amazing how many people now say they saw the problem coming.
Q498 Lord Hollick: What was interesting
in the book is that they did so based upon publicly available
information, rather than guesswork.
Mr Taylor: To keep things in context here, the
major problem in the US housing market was the sub-prime assets,
the lower quality assets. For prime assets—normal US mortgages—the
typical loss number for AAA credits was something like 3% to 5%,
so we assumed a loss level of 3% or 5%, which compares to less
than 1% historically. For sub-prime assets, the average assumption
was something like 20% to 25%, and the number was increased between
2004 and 2006. It went up by a few per cent; it went from 25%
to 26% or 27%, so we were building in the declining quality of
asset analysis. What we should have done is to build in a 50%
enhancement level. The level of meltdown was way in excess of
our worst-case assumptions.
Q499 Lord Shipley: Just to pursue
that then: what has changed following the financial meltdown in
the criteria that you are using in your businesses? What is it,
since people rely heavily upon the ratings that you give? What
are you now doing differently in terms of those criteria?
Mr Wilson: To pick a couple of examples, and
following up on what Paul has said, I think that we understand
that the assumptions that we made—particularly in the structured
finance area, and particularly where US mortgages were concerned—about
loss rates and correlations between assets were undercooked, and
we have changed many of the key assumptions that underlie the
models and the methodologies. I think, more broadly, we, like
many other commentators including regulators and central banks,
understand far better than we did two, three, four years ago the
degree of interconnection within the financial sector and within
the global economy, so that we understand better the need not
to look at financial institutions in isolation from the people
they lend to and the sovereigns under whose jurisdiction they
sit, for example. So we understand better the need to try to look
at the issues—as we rate—in their broader context.
Mr Taylor: It's important to mention as well,
when we talk about criteria, that there are dozens of criteria
to apply to different types of credit. We have corporate credit
criteria, we have bank criteria, and even within structured finance
you have dozens of types of criteria, whether it's German auto
loans or Japanese houses. Most of the structured market, which
again tends to be missed through most of the dialogue, has actually
performed very well in the face of incredible economic crisis.
So, if we look at the UK housing market, AAA bonds have done particularly
well. As has the $1 trillion European residential mortgage market,
it has generally done fine. We still tweak some of the criteria
in different markets but US residential mortgages, and more importantly
the repackaging of those assets into CDOs or CDO2, is really where
the big changes have come. The second big change, I think, is—and
this is something that's ongoing at the moment—how we treat
banks going forward. In the past we had a very heavy reliance
on the assumption that we'd get support. We built in support to
our credit ratings, and it generally worked. That's why our ratings
have been fine in banks with a few exceptions but we think that's
going to be different going forward and that's a huge area of
debate at the moment.
Q500 Lord Shipley: By support do
you mean support from the Government?
Mr Taylor: We are rating the debt instrument.
Will you get your money back on a particular bond or security?
Lord Shipley: Sorry, Mr Crawley, are
you—
Mr Crawley: I would certainly endorse what the
others have said. Certainly correlation of risk, how that then
led to very significant concentrations of risk and then, when
cycles were turned, how they turned very viciously in terms of
impact. That's what we saw and, frankly, all the market learned
through the last three and a half years. The one thing that I
would add, which has been touched upon by both Paul and Alistair,
is about rating stability. That's certainly something that at
Standard & Poor's we have spent a lot of time over recent
months looking at, debating, drafting and now discussing with
the market around how better to ensure that highly rated entities
and highly rated securities are able to perform with a high level
of stability demonstrable by the high ratings that they are given.
The Chairman: Do you want to go on to
the next question about Big Four?
Q501 Lord Shipley: Do any of you
employ Big Four firms to assist you with any of your work and,
if so, do you find market concentration of public accounting firms
sometimes unduly restricts your choice?
Mr Crawley: The straight answer is, no, we don't.
We make use of audited financial statements, but we do not engage
in a contractual sense with firms of auditors.
Mr Wilson: We occasionally use consultancy arms
to carry out small projects—
Lord Shipley: Sorry, I missed that.
Mr Wilson: Sorry, we occasionally use consultancy
arms of the Big Four to carry out projects for us, but as regards
the audit practice, it's precisely as Dominic says.
Q502 Lord Hollick: When we talked
about the Big Four's concentration, we referred to concentration
in other parts of market, and obviously the rating agencies are
a case in point. How did the concentration come about? Do you
feel it acts against public interest, that there is lack of choice?
For instance, why isn't there a rating agency that has a different
economic model that is paid for by investors rather than the banks
themselves, which might lend it a greater degree of independence?
Mr Crawley: There are two questions. Perhaps
if I take the first one. I think how we have a fairly small number
of large rating agencies probably comes from two basic characteristics.
One is that our relevance in the market is built upon reputation
and it's built upon performance, and therefore a long-time series
track record of our ratings performance and ratings transition
is important and clearly that is something that is established
over a long time. I think the other issue is that a relationship
between an entity and ourselves—whether it's a large corporation
or insurance company, bank, local authority, whatever it is—is
a fairly intense relationship. It is regular contact, a lot of
dialogue and, therefore, from the client's side, so to speak,
it's fairly intensive. Therefore to have a large number of similar
individual types of relationships from their side probably would
not make sense. I think an element of the concentration has developed
as a result of those two features.
Mr Wilson: Yes, I would say I agree with Dominic.
The concentration has risen to a large extent because of the way
commercial firms have responded to what they think their clients'
investors want. Investors want ratings that are comparable across
regions, globally comparable, comparable across time. That tends
to be best delivered by large firms with large global resources.
I think it's also, and this is long before my time, fair to point
out that originally—certainly for Moody's; I am not sure
about the other two—the model was "investor pays"
until the early 1970s, but it moved away from that towards "issuer
pays". As I understand it, and, as I say, this is way before
my time, that was to enable Moody's to help meet investor needs
and wishes for more research. So we have moved from the "investor
pays" model to the "issuer pays" model.
Mr Taylor: Sir, our current industry structure
is largely a result of inertia. We always have here the Big Three;
actually we're a third the size of these two guys. We're the new
player in this market and we have really only existed in this
form for about 10 years. We're the result of putting together
some of the smaller agencies in the market to try and compete
with the big two players. The inertia in our market and the inclusion
in investor guidelines, for example, is immense. There are thousands
of individual accounts that we have to get out to. We were doing
pretty well at that until a few years ago when the whole market
had its own problems. So a lot of it is inertia. There are something
like 150 rating agencies in the world, of which a good number
are "investor pays", so that model does exist. There's
nothing stopping that model. It comes down to economics at the
end of the day. It's very, very hard to build up a significant
team with just an "investor pays" model, because investors
are used to getting things for free. Even the new players that
have been announced—there have been a number of new launches,
pretty high-profile launches with significant financial support
behind them—have all launched as "issuer pays"
models. It comes down to us to manage the conflicts inherent in
that model. There are conflicts in the "investor pays"
model as well. If you have an investor who is providing a large
proportion of your revenue, the investor might have an interest
whether your rating goes up or down, so there are conflicts whichever
way you look at it. If you use a government-funded approach, that's
probably the most conflicted path you could go down. So what does
the UK Government-funded agency do when it wants to take action
on the UK, or a big UK bank? You can imagine the conflict. In
our industry there are lots of players; the challenge you have
is how many ratings does an entity want? You can push hard to
get in there as an additional rating if you're the third player
coming in; if you're a bank do you really want four, five, six
credit ratings? The answer is, no, you don't. Really the first
two places are taken and it's incredibly difficult to get rid
of an S&P or Moody's rating if you are a rated entity. That
was just beginning to happen a few years ago, and we've just started
to see the signs of that happening again.
Q503 Lord Moonie: Do auditors have
access to any information from the rating agencies beside published
ratings? Is there any dialogue between auditors and rating agencies
about the quality of assets and bank balance sheets? Do you consider
such a dialogue needs to be developed, or perhaps institutionalised?
Mr Crawley: My Lord, there were two or three
questions there. To answer the first one, no, they do not. Like
everyone else in the market they have access to the ratings and
the information and research opinions and analysis that gets published
and placed on our public website. I think in response to the second
question what I would say is the market knows what we do and the
market understands what we do, and the market knows what auditors
do and understands what auditors do. We talked earlier on about
what our ratings are and how we go about constructing them, and
we don't see there would be any benefit through additional dialogue.
They do what they do, and they've done it for a long time, they've
established processes, procedures, resourcing and everything,
and that is their specialisation. Our specialisation is what we
do.
Mr Wilson: I think you could imagine a situation
in which an issuer was prepared, or wanted its auditors to talk
to the rating agencies in order that the rating agencies had a
better understanding of, for example, the control framework in
the issuer. So I can imagine a situation in which the information
flow would usefully work in that direction. I think it's very
difficult to imagine a situation in which information was flowing
in the opposite direction because it would raise some real confidentiality
independence issues.
The Chairman: Any other questions? Gentlemen,
thank you very much indeed for coming. We are very grateful to
you for giving an insight from your point of view, and apologies
again for a late start. Thank you.
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