Largely lost in the cascade of outrage over Wall Street’s promotion of transactions that were likely (or even designed) to fail is the fact that most investors in those products were pension plans, retirement accounts, banks, college endowment funds and other institutions that have been assumed by the law to be able to take care of themselves.
What happened to the presumption that these large, wealthy aggregations of capital would be managed by the best and brightest financial minds? Or that the board of trustees would examine each transaction with the sceptical eye of a vigilant fiduciary? What were they doing as the odour grew stronger with each new proposal put to them?
Without any hard evidence of neglect by the managements of these institutions, one can only infer that they were more deferential to their brokers’ advice than they should have been, that they accepted the credit ratings of supposedly independent agencies whose interests were actually entangled with those of the instruments’ originators, and that – in cases like pension plans – they placed your money and mine at inordinate risk without a full appreciation of that fact.
No one, it seems, was minding the store or, if so, less diligently than the cashier at a 7-Eleven convenience shop.
To sue or not to sue?
If this is true, the decision makers at those organisations face a dilemma. On one hand, they could pursue legal action against the sellers of the toxic investments and hope to recoup some of their losses.
On the other hand, any trial would likely disclose their own negligence and leave them vulnerable to actions by the ultimate injured investors.
As a consequence, it would not be surprising if an institution’s management opted against seeking redress from the securities’ issuers, compounding the problem for its investors.
Hindsight is always 20-20. It is easy to criticise decisions after the full extent of their wrongheadedness becomes clear.
But that excuse may not work this time. After all, it was plainly evident to other market observers (like John Paulson) that the offerings were very risky indeed. This view was not based on some complicated analysis of their interconnected financial wiring, but on simple common sense.
Consider these facts. Banks offered mortgage loans to people who were likely to default on payments either soon or when the interest rates reset at much higher rates.
Why would any lender do that? Because the mortgages quickly flowed away to a packager on Wall Street who sold new instruments containing them to institutional investors. In some cases, what was sold were synthetic lookalikes of the real assets, so the risk was amplified even more.
Everyone – no MBA needed here – understands that quality counts if one remains responsible for the results but that, where one will not bear the ultimate risk, carelessness or worse is likely to follow.
In some cases, the phrase “it couldn’t happen to a nicer guy” might apply.
I have in particular mind the Ivy League endowment funds that lost big during the financial ugliness. Few of them provide any meaningful financial aid to students, preferring to build monuments to rich alumni or raise faculty salaries.
For some, the amounts lost would have been sufficient to provide a free, four year education to every undergraduate student. From an educational standpoint, the losses did little real harm, since these funds were not going to do any real good anyway. (Might the endowment managers use this defence if they are sued?)
Savings down the drain
Pension plans, on the other hand, are pools of savings made by thousands of people who will need the money some day. Here, the losses from toxic investments are real and painful.
It has always required a leap of faith to accept the idea that, while your funds and mine are treated as vulnerable and deserving of protection when separate, if we put them together with other people’s savings, they require fewer safeguards because of the size achieved.
Managers and trustees of these vehicles who authorised exposure to subprime mortgage risks should worry a lot.
So, where are the victims? The sellers collected millions of dollars in fees. True, some of them lost money on pieces of the offerings that they were unable to offload quickly enough to escape the collapse, but this is hardly cause for pity.
Meanwhile, the major buyers seem to have been clueless (or indifferent) to the risks involved. Besides, their managers and trustees had none of their own money at peril.
No, in the end the losses belong to the rest of us.
Philip McBride Johnson is a past chairman of the Commodity Futures Trading Commission and heads the exchange-traded derivatives regulatory practice at Skadden, Arps, Slate, Meagher & Flom in Washington.