Tim Fletcher

Insufficient data is at the root of the credit market's ruined summer, Baseline Capital's sales and marketing director tells Matthew Attwood

Since 2003, Baseline Capital has been providing Basel II analysis for the UK mortgage market. Tim Fletcher, a 19-year veteran of Bradford & Bingley and former director of mortgage portfolios at the lender, joined the company in September 2004 from Homeloan Management Limited. No one is closer to the UK mortgage sector and he has been watching events in the US this summer with interest.

While confident that the risk of a US-style blowout on this side of the Atlantic is minimal, he insists that the paucity of data - a stick the rating agencies have been beaten with since the subprime crisis hit - is a barrier to the return to a more stable environment. With better information, he says, will come a restoration of confidence.

What did the rating agencies get wrong this summer and how should they improve their processes?

There is a lack of understanding of risk at the rating agencies: their models are not sufficiently sensitive to the migration of risk in portfolios. The models they use are quite simplistic: their concerns are about considerations such the loan-to-value (LTV) ratio of loans and the current status of loans in terms of repayment. These are all questions limited to the loans themselves.

If you look at the behavioural models deployed by most retail banks, you could see 15 or 20 characteristics being examined. Yes, they look at future loan performance, so LTV figures and current credit status are in there, but these models also look at behavioural statistics from a credit reference agency; so you look at a block of data such as Delphi scores and other information from credit referencing companies such as Experian and Equifax.

This approach makes sense as, if you assume that a mortgage is the most important debt for most borrowers, they are more likely to default on something else before the mortgage. Our models and those of retail banks allow people to see how indebted borrowers are and how they service those debts. The agencies have got to where they are now by using what I would call a typical investment bank model, asking 'will this obligation be met?' but only with reference to the loan itself.

Investment banks see themselves and their quants as superior to retail institutions, but in this context they are less sophisticated: it's the retail sector and third-party analysts who have access to the most granular data.

Surely the buy side must shoulder some of the blame?

End investors have been criticised for neglecting the principle of buyer beware, and it is true that we only see limited due diligence by the buy side. But there is a lack of data with which investors can perform their due diligence, and the problem is exacerbated by the way the modern securitisation market spreads risk across people. If everyone did their own detailed analysis the system would grind to a halt.

A critical issue is therefore getting someone independent to perform due diligence, and for that to become a reality the investment banks need to accept that retail banks understand retail risks with a degree of granularity that the investment banks lack. Better asset-mapping, along with models looking at performance, would enable investors to get a better handle on the information they need.

There are problems, not least the existence of data protection legislation, which mean that credit reference information is not available to the investment community. Any change to that would require legislative or regulatory intervention allowing that data to be used by investors, or some kind of summary of the information, providing enough anonymous data to model. Alternatively, the surrogate approach might work, mapping secured loans as a means of looking at future performance.

Could the problems in the US spread to the UK?

Subprime in the UK has been used as a catch-all term to describe loans that would not satisfy normal high street lending standards in the mid-1990s. This could be because of a shortage of information about borrowers' income, a lack of certainty about that income - in the case of people on short-term employment contracts, for example - or a history of credit problems. In the US, we can add a lack of equity from the borrower in the transaction.

A fundamental difference between the UK and the US is that in the UK there is no combination of factors: a problematic borrower here would pay a higher rate for a mortgage and suffer restrictions on their LTV ratio. For this reason, the UK is not due a US-style shock.

What lies at the heart of what is happening in the UK right now?

At the moment in the UK, while a repeat of what happened in the US is not on the cards, we are suffering from a lack of confidence engendered by this summer's events. People are asking how the rating agencies could have got it so wrong, and on whose profit and loss accounts the risk lies. IKB was a big wake-up call for many; people began asking who else was wounded. This in turn has frozen the interbank market, which led directly to the situation we see with Northern Rock.

There are two principal issues. First, there is no investor desire for structured assets, so holders of those assets are stuck with them as people who trade them can only price them in an environment where there is sufficient liquidity. Their second port of call is the interbank market, which is suffering the effects of the crisis in confidence in the wider market. These two scenarios have brought Northern Rock to where it is: it can't perform securitisations in the first place, so then turns to the interbank market but finds it shut. Most banks are watching liquidity like a hawk, withholding cash and causing the market to tighten more and more.

So Northern Rock was too dependent on the wholesale market?

Northern Rock, with its high rate of leverage, is highly dependent on the wholesale market. If you look at building societies, they legally must have 50% of their mortgages in the retail sector. If you take into account their boards' strictures in order to prevent that cap being breached, it could be limited to 35% to 40%. They are much less dependent on institutions in the interbank market.

More traditionally funded institutions with broader deposit bases are much less exposed than those heavily dependent on the securitisation market. They are not entirely insulated from the effects of this summer's volatility, because prices are going through the roof as everyone rushes to tap the retail market. I have seen rates above 7% and even though that is far in excess of the 5.75% base rate of interest, it's still cheaper than Libor, assuming you can draw money from the interbank market.

Other banks are having daily credit meetings - it is wrong to see Northern Rock as an isolated problem. It has had three profit warnings, but they were driven by mismatches between the base rate and Libor. The FSA is satisfied that it is solvent, but we must remember that mortgages by definition are illiquid. Northern Rock's big task is containing the lack of confidence in it as an institution: that could take some time to work out. Real instability could descend if someone else has to go to the Bank of England, which would make the current problem one of general institutional stability.

What's your view of the Bank of England's role in the crisis?

The Bank of England's lack of general intervention in the money markets is interesting. One possible explanation is that the Bank likes Libor being where it is, not because of the illiquidity that results but because it tightens the credit markets without the Bank itself having to increase the base rate.

This puts shackles on people's ability to lend and drives up credit quality as people shun riskier asset categories. It will hit the retail consumer, but as the margins of most small businesses are linked to the base rate, they won't take a hit that a hike by the Bank would represent. And all this is driven by the investment banks' funding costs - the Bank of England's hands are clean.

When I last looked, sterling Libor was 100 basis points over the base rate, while the equivalent figures for Euribor and dollar Libor were 15 and 30 basis points, a function of the liquidity being provided by central banks in those markets. It is, of course, probable that the Bank did not expect such a big liquidity crisis for such a big lender.

Are you going to change any of your processes in response to this summer's events? Should anyone else?

We are happy with our probability of default and loss given default models: they get better as the time series extends. Building models in a benign period and making them apply to less comfortable times is difficult, so this summer is good for us in that it provides us with more information upon which to base our assumptions.

We base our business on a process of continuous improvement. Typically, we would rebuild our models on an 18- to 24-month refreshment cycle. We have two reasons for this. First, we believe that all models deteriorate over time. Secondly, the more our models sample historical data, the less movement there is likely to be econometrically. We don't just look at the credit, but at the context.

The investment bank model just looks at loans and is insensitive to changes in the market. The credit rating agencies rely on data gleaned at the point of origination, which only gets worse as time elapses and more distance is put between the present time and the beginning of a loan's life. Nothing will change until the agencies refuse to rate transactions without more data.

Of course, this comes down to the issuer too, and it would be helpful if the issuer community put its credit analysis in the public domain in order to restore confidence, especially when a retail bank is involved in a transaction. Also there is no reason for a lender with a chunk of book that's securitised and a section that isn't not to put the securitised portion through models. One thing is certain, and that's that investors shouldn't rely on the issuers and agencies acting in concert. Not only is the prevailing methodology in question, but one has to ask if the agencies are sufficiently independent to provide a neutral view.

Investors should be asking if there is a role for other entities to provide more generic data, enabling the end purchasers to take a more informed view. It could be a retail bank or it could be a third party like Baseline - anyone with sufficient credit data.

Credit crunch or confidence crisis?

This is a confidence crisis. Arrears are still comparatively low historically, and there is no immediate danger of a substantial default with a substantial loss, but the market needs to be convinced of that. Institutions, trade associations and independent third parties all have a role to play; it will come down to the question of who the market trusts and what it is prepared to pay.

Are lending standards tightening?

Lending standards in the UK strengthened in the early to mid-90s, as lenders became much more diligent in how they looked credit quality and the risk of fraud. Scoring techniques for lenders' unsecured business were adopted for their secured lending, amid a general tightening which saw, for example, maximum loan-to-value ratios.

Over time, there has been some weakening of standards because people have been competing for business in a very buoyant market, and in some parts of the UK market one could question the assumptions behind some of the pricing. This, of course, nowhere near approaches the situation in the US, where mortgages were not adequately priced for the attendant risks.

You provide Basel II analysis. Will its introduction be affected and will the shape of Basel III change as a result of the crisis?

This isn't a solvency issue so the implications for Basel II are limited. It took 10 years for Basel II to arrive so I think we have a lot of things to worry about before considering the impact on Basel III.

Is more regulation the key to a more stable market?

Regulation never achieves what it was intended to achieve. Mortgage regulation, for example, was introduced in the UK to increase transparency, which it did achieve, and encourage consumers to shop around, which it has actually prevented. Previously, borrowers would speak to a few lenders before making a decision; now, they have such a lengthy interview with the first one they speak to that they either opt for that one or go to a broker. Consumers have in effect had their choices limited by regulations intended to have the opposite effect.

On the institutional side, costs would go through the roof if rating agencies were forced to provide more information: just like we saw with Sarbanes-Oxley in the US, the result would be a gravy train for accountants at the expense of investors. The art of regulation is to be light enough to get the market to behave properly while not changing the cost base of the marketplace.

So how do we go about restoring stability and confidence?

We need a constructive discussion with investors as to what additional information they need, and how we can move on from the horrible current tendency to rely on supply-led information. We need to decide what data investors need to feel a greater degree of comfort to avoid another liquidity crisis, and then decide how it should be supplied and what role issuers, originators and third parties should play.

The current lack of confidence in the market is rooted in a lack of confidence in the ratings data that most investors rely on. While end investors are being told to take more responsibility, they need someone to cost-effectively provide the necessary data, which they lack at present. Additionally we must find ways to apply pressure on issuers, to induce them to provide information on the performance of assets and their expected performance of assets. If they step up their efforts to share that information with the marketplace, they will go a long way to restoring confidence.

What changes will the summer volatility bring?

It's difficult to predict the wider fallout. The London market, for example, is very difficult to generalise about. In the short term, there will be lots of uncertainty and if I were a first-time buyer I'd hold fast: there is no upside in the medium term and potential for downside if things deteriorate. As long as house prices don't fall and general economic conditions remain benign, people will be able to sell housing stock without making material losses; if assumptions about the economic backdrop turn out to be wrong, there will be some losses.

Some borrowers will be priced out by the repricing of risk, which should increase stability, and standards in the securitisation market will tighten - lenders won't get paper away if they don't.

Fundamentally, there will be no increase in appetite for riskier lending on balance sheets until there is more information in the marketplace.