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
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
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
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
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
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.