Malcolm Cooper, Global Tax and Treasury Director, National Grid plc, Georg Grodzki, Head of Credit Research, Legal and General Investment Management, Mark Hyde Harrison, Chairman, National Association of Pension Funds, and John Grout, Policy and Technical Director, Association of Corporate Treasurers, today gave evidence to a Treasury Select Committee (TSC) hearing on credit ratings agencies. David Ruffley MP questioned the witnesses on the extent to which erroneously high ratings given by ratings agencies to structured products caused the faulty decision-making that led to the financial crisis. A full transcript of the exchange is below:

Q7 Mr Ruffley: Most of the credit rating agencies sleepwalked into the 2008-09 financial crisis, in as much as they mispriced risk, did not identify it adequately with mortgage-backed securities, CDSs, CDOs, and so on. What I would like to hear from each of you, is for you to tell me whether you thought there was any problem with the ratings that most of the agencies were giving; some of these very exotic and-as we found out to our cost-very risky products. Perhaps each one of you on behalf of either your company or indeed your members.

Georg Grodzki: I would agree that the rating agencies collectively failed.

Q8 Mr Ruffley: No; I am asking you, in relation to Legal and General. What were you thinking when you saw the rating agencies giving you assessments of X, Y, Z mortgage-backed security?

Georg Grodzki: We were not ourselves investing in any meaningful size in those securities. I can say, with some satisfaction, that at the time the crisis gained momentum and escalated, we were not overly exposed to the toxic parts of the market. Whether this was smartness or luckiness, I leave to you. We were not surprised to see, in 2008, the dominoes falling, starting in the US and then continuing in Europe, because we felt what was completely missed in a way, by the agencies as well as by the market, was the enormous leverage the system had built over the years, which was based on the assumption of markets remaining liquid and that debt could be rolled over and refinanced at any point in time. As soon as that assumption was shaken and called into question, that house of cards was bound to wobble, if not collapse. So the market's focus on the trees rather than the forest-i.e. risk-weighted capital ratios rather than unadjusted capital ratios, if you look at the bank balance sheet-was its downfall.

Q9 Mr Ruffley: Association of Corporate Treasurers, your members; were any of them just taking these rating agency assessments and ratings without any questioning? Did you rely on them? Did your members make mistakes by relying on the rating agencies' ratings?

John Grout: The ratings you are referring to were those of the structured finance industry. Companies are not investors in the way that a fund like L&G is. They are investing structural or temporary surplus funds. It is not their business. It is just money they need, so what they do tends to be very simple, and I would be very surprised if any company had certainly any significant investment in any of those sorts of activities. What you are suggesting is that users may pay too much attention to ratings as an indicator as such, rather than using other indicators as well. Absolutely right. Companies, particularly smaller companies, do not have staff devoted to that kind of credit assessment. They will tend to look at the credit rating of a Government or another company, which wants to deal with them, and certainly of a bank counterparty. Our own guidance note on the subject says, "Look at other indicators. Look at credit default swap spreads, since they came out, look at other factors", but if you are a small treasury-I was talking to a treasurer of Interpol yesterday. He has three people in his treasury. They have a structural finance surplus, and they invest using the ratings as their principal trigger. They read the press, they listen to other indicators, but their principal trigger is the credit rating, and I would say that would be true of most companies using it as the start. If you are a really small company, you probably don't look beyond the rating.

Q10 Mr Ruffley: I am guessing, Mr Cooper, that your answer will be similar to National Grid?

Malcolm Cooper: Yes, it is. National Grid did not invest directly in mortgage-backed securities. We could have had an exposure via our pension funds. We have some £20 billion of pension assets. Our UK mandate specifically precluded structured finance. In the US, we had a tiny exposure via an aggregated fund, which was allowed to invest in mortgage-backed securities.

Q11 Mr Ruffley: National Association of Pension Funds, what is your answer to the question?

Mark Hyde Harrison: The UK pension industry did not have any material exposure to those types of instruments. I think our members could see in the marketplace that the yields on those sorts of instruments were higher than other high creditworthy instruments, which indicated that they were risks, and the way in which risk could be assessed was difficult to assess; the cliff-edge nature of default rather than the gradual decline, which tends to happen with corporate debt. One of the concerns that we would have had is that the credit rating agencies, in giving a rating to different structured types of instruments, sometimes present a backdoor to allow our investment managers to invest it if we are not careful. It was alluded to earlier that our members give investment management agreements and use credit rating agencies, and the ratings given on bonds, to describe the portfolios-the riskiness of the portfolios that our pension funds want to have. So if they want a very safe portfolio, they will say, "We want triple A-rated paper". They are willing to be much more exposed to credit risk. They might go down to triple B paper; that is entirely fine, they expect to make a greater return.

What is difficult for them is if a different structure appears in the market, which then gets rated as double A, and if they have many managers and the manager says, "My investment management agreement allows me to invest in this structured product", and does not come back to the client and make clear what they are doing. Therefore, what we would say is that we are quite alive to new types of debt structures being created and we are wary about them getting credit ratings, which might allow them to access our members' funds where there has not been an explicit agreement between the investment manager and the client to allow that type of new structure to be invested in.