TUESDAY 4 DECEMBER 2007

MR E GERALD CORRIGAN, LORD CHARLES ALDINGTON, MR JEREMY PALMER AND MR WILLIAM MILLS

  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 2006—it may have been in 2005—that 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 credit ratings.

  Mr Corrigan: I think that is fine.

  Q1248  Chairman: Does everyone agree with that?

  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 payment model?

  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 $100,000—full 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 field—the subprime market—do 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 success—I do not want to overstate it—in 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 eye—I have not done the arithmetic—my 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 talking about.

  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 in May.

  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.