Philip McBride Johnson, head of exchange-traded derivatives law practice Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates, and past chairman of the Commodity Futures Trading Commission, delves into the closed-door discussions surrounding the subprime crisis
It is no secret to anyone that the US financial community has
taken a major hit recently with the losses aggregating to tens
of billions of dollars. Often dubbed the "subprime crisis [or
mess]", mortgage-backed instruments were passed from hand to
hand between originators, packagers and ultimate investors like
live grenades that, sooner or later, would blow up in
someone’s face. But whose?
Least at risk were the originators, who made the initial
loan commitment because the paper would almost surely be at the
packager or the final investor before the payment defaults
began. As a result, the originators cared least about the
ability of borrowers to repay mortgages that were often
designed to grow more burdensome over time.
The packager had greater risk because it takes some time to
structure a special investment vehicle whose pieces could be
sold mostly to institutional investors. First, the host vehicle
must be created, then the securities needed to be promoted and,
finally, the sale must be made. The final step could be tricky
because some vehicles offered several different instruments,
some with low risk (and low yield) and others with the reverse
profile. Needless to say, different powers of persuasion were
needed to unload all tranches quickly.
The final investors would take the greatest risk as the
ability to pay and the payment obligations worsened among the
borrowers as the months and years went by. It is little comfort
that most investors would be institutions such as pension
funds; after all, that is our money.
In this case the grenade seems to have exploded in the hands
of the packagers, also known as premier commercial and
investment banks, whose names are often spoken with awe. It
will be some time before the full scope of the damage can be
calculated but mention has been made of potential losses in the
hundreds of billions of dollars. Several leading
packagers have already written down tens of billions of dollars
and analysts believe that there is more to come.
This article, though, is not about the past errors of firms
that navigated this previously lucrative business, but about
the way they are being solved.
Commercial and investment banks have sought successfully to
attract many billions of dollars in new capital from abroad to
staunch their losses. At first blush, this outcome seems right
and just. After all, the US and its business community have
spent the last century acting as lender of last resort to other
nations with failing economies.
The sobering reality is that much of this capital inflow is
coming from sources directly controlled by foreign governments
that have their own priorities, their own aims and their own
grudges that could clash with the best interests of Americans
who rely daily on the domestic banking community – and
from foreign governments in countries where the US has
interests that transcend simply attracting investment
Consequently, let us imagine that the investment arm of a
foreign government accumulates a position in US securities or
commodities that could move the market to the detriment of
domestic investors, or that would affect the decisions of
critical companies in ways that are not in the best interests
of the US. Let us also imagine that this foreign government is
our principal source of a vital product, or an active ally in a
military conflict, or a critical vote at the United Nations on
a result keenly desired by our own government. Then, let us
contemplate the following telephone exchange between the
chairman of a regulatory agency and the US deputy secretary of
Chairman: "Good morning, Mr Secretary. I am returning your
Deputy secretary: "Thanks for that. I was told yesterday
that your agency is thinking about sanctioning the XYZ company
[controlled by a certain foreign government] for some market
action or other decision that you think violates US law. Is
Chairman: "Yes, sir. Our enforcement team has strong
evidence that serious violations have occurred and that action
needs to be taken to stop them."
Deputy secretary: "I cannot get into details but such a step
would impact adversely and seriously, perhaps irreparably,
other interests of the United States at this time. The
president and the secretary have asked me to bring that fact to
your attention as you reach a final decision in this matter.
This involves both vital national interests and domestic
security. Do you understand?"
Chairman: "Yes, sir. Goodbye."
Chairman to subordinate: "Back off, Charlie. There is
something bigger going on. No less than the president and the
secretary of state have said so."
Subordinate: "@#$%^&*! Again!"
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