Part VI: The Financial Crisis of 2008 – Moralism versus Structural Analysis

 (A 2010 scholarly article of mine analyzing the source of the disaster provides a more in depth analysis: “Trust and Transparency: The Need for Early Warning,” in Iain MacNeil and Justin O’Brien (eds.) The Future of Financial Regulation, Oxford: Hart Publishing, Ch. 18, 322-336.)

I presented Obama’s very brief summary of his analysis of the housing and financial crisis in my last blog. A Later blog will provide a much more detailed review. For now, a few basic questions. What was Obama’s substantive depiction and analysis of the financial crisis, more specifically, the mortgage crisis?

Obama first clued in that something was really wrong when “the nation’s second largest subprime lender, New Century, declared bankruptcy.” (177) The Federal Reserve had forced the largest subprime lender into a shotgun marriage with Bank of America. In September 2007, Obama decried “the failure to regulate the subprime lending market.” He proposed stronger oversight. Though ahead of the curve compared to most of his colleagues and competitors, he was well behind the bonfire already underway. However, he was correct in pointing at a failure in regulation but never offered a diagnosis of the reasons for that failure except to imply greed was at fault.

Subsequently, “financial markers saw a flight to safety as lenders and investors moved their money into government-backed Treasury bonds, sharply restricted credit, and yanked capital out of any firm that might have significant risk when it came to mortgage-backed securities.” (178) In October 2007:

• Merrill Lynch announced $7.9 billion in losses related to mortgages
• Citigroup projected possible losses of $11 billion

The situation was unravelling fast. By March 2008, Bear Stearns stock value plummeted from $57 to $30 in a single day, forcing a fire sale to JP Morgan Chase. Goldman Sachs, Morgan Stanley and, especially, Lehman Brothers were all hemorrhaging capital at alarming rates. While some looked on with self-righteous glee at the comeuppance to these capitalists and their firms, Obama determined that “in a modern capitalist economy it was impossible to isolate good businesses from bad or administer pain only to the reckless or unscrupulous.” (178) “Everybody and everything was (sic!) connected.” By that Spring, the consequences had been dire – contracting demand, widespread layoffs, canceled orders, deferred investments and literally millions of foreclosures.

But surely the COVID-19 economic crisis of 2020 should have been a clue for Obama that the problem was systemic and not simply a matter of sorting out good businesses from bad ones. In the Great Recession that followed, the financial crisis of 2007-2008 witnessed property values dropping by 20% to 50%, depending on the location. Stock portfolios lost 30% of their value. Pension plans were big losers putting at risk the plans of millions of pensioners. However, a period of collapsing asset prices combined with high unemployment and shrivelling demand also provided an opportunity for the government, as the largest potential buyer of last resort, to purchase stock and other assets at fire sale prices. Falling prices are short term and provide enormous opportunities for perceptive investors. And many less-panicked entrepreneurs cashed in – especially in the Florida and Arizona real estate markets where properties were selling for at least 50% less than their pre-recession values.

Is this not a cold-hearted way to look at the situation? On the one hand, brokers and firms according to Obama had been unscrupulous. “They (irate Republicans and mortgage brokers) didn’t appear chastened by the fact that the game they played had been rigged up and down the line, if not by them then by their employers, the real high rollers in wood-paneled boardrooms. They didn’t seem concerned by the fact that for every ‘loser’ who had bought more house than he could afford, there were twenty folks who had lived within their means but were now suffering the fallout from Wall Street’s bad debts.” (273)

If you look at the economic calamity from a moralist perspective, then working to save the financial institutions seems hypocritical. If you bracket morality and do your utmost to save as many financial institutions as possible because the system is so complex and interconnected and too many failures of TGTF (too big to fail) institutions would bring the whole system crashing down, then you save the economy but come across as an amoral capitalist enabler. In either case, millions of small homeowners lose their homes.

Obama recognized the unfairness of applying a moral calculus to those losing their homes. “Was it fair to devote the hard-earned tax dollars of those Americans to reducing the mortgage payments of a neighbour who’d fallen behind? What if the neighbour had bought a bigger house than they could really afford? What if they’d opted for a cheaper but riskier type of mortgage? Did it matter if the neighbour had been duped by a mortgage broker into thinking they were doing the right thing? What if heir neighbour had taken their kids to Disneyland the year before rather than putting that money into a rainy-day fund? – did that make them less worthy of help? Or what if they had fallen behind on their payments just because they’d put in a new swimming pool or taken a vacation but because they’d lost their job or because a family member had gotten sick and their employer didn’t offer health insurance or because they just happened to live in the wrong state – how did that change the moral calculus.?” (272) Obama rejected this approach, both because it offered no practical route to a solution, because it took the moral weight off those he thought were primarily responsible, and because the government’s function then was to be a fire department and stop the fire from spreading rather than assessing the credit worthiness of the homeowner.

However, Obama is as guilty of playing the blame game as his Republican colleagues, blaming the brokers and bankers though rather than imprudent home buyers and owners. However, if you see the problem as systemic, a structural error that encourages immoral behaviour rather than inherently immoral, then you can concentrate on correcting the faults in the system rather than simply applying bandages. But what if it is too late to close the proverbial barn door? What if the system is totally aflame? Isn’t the first priority bringing in the fire department rather than either looking for the arsonists who started the fire? Is the priority not rescuing what you can? Perhaps you simply have to accept that whole communities will be destroyed in the conflagration.

If the problem is that the core of the fire was a faulty electrical transformer rather than a domestic greasy oil fire on which you had to pour tons of foam, then fixing the transformer after temporarily disconnecting it could limit the damage. Further, recognizing the right source and correcting the problem may mean that you can use the electrical grid itself as a critical tool in limiting the spread of the fire. At the heart of the matter, you can use prospective profits to offset the short-term costs of helping homeowners get past the crisis. But how can one consider the government making a profit from the calamities of others?

A simplistic answer – by turning a negative sum game in which there are greater and lesser losers into a positive sum game in which the benefits are skewed in favour of the homeowners rather than the banks and financial institutions. The objective would be to ensure that everyone benefits to some degree. Further, the prudent lenders would benefit more than any imprudent ones, but the effort should be made to save as many homeowners’ homes as possible from foreclosure.

Let me digress for a moment and examine a situation where the government itself was directly responsible for depressed real estate prices. In Ontario in the eighties, rent controls meant that apartment buildings were for sale at very depressed prices related to their replacement costs. While the government costs for building new apartment units for subsidized housing was costing on average $150,000 per unit, older rental apartment buildings could be purchased at $30,000 per unit. Many of these buildings were in need or repair and updating, since it did not pay the owners to make improvements. That could be done then at a cost of $30,000 per unit bringing the cost of a renovated unit to $60,000 compared to $150,000 for a new unit.

There were two ways to accomplish this. On one hand, rent controls could be eased to allow, and even encourage landlords, to renovate their properties so that renters paid for the costs over time and the assets of the 0wners eventually more than doubled in value. Alternatively, you could create a system that facilitated the tenants purchasing those units – they would get the benefit of the capital cost improvements rather than the owners of the buildings. But that would mean users rather than owners would get the advantage of the capital gains.

The latter approach was taken to a very limited extent in the conversion of about 1,000 units to co-operative ownership in Toronto. Renters were provided with a unique opportunity for many to buy and own apartments when they otherwise could not afford to do so. They could get on the capital ownership ladder on rungs much closer to the ground. However, by far the major effort focussed on saving the assets and capital appreciation for the landlords and reserving the yearly increasing system in which over half the population lived in rental housing with decreasing opportunities to gain home ownership. Indeed, pressure was put on the government to allow apartment owners to renovate their buildings and pass the costs onto tenants while, at the same time, effectively doubling the value of their assets.

The opportunity to convert the bulk of tenants to owners was not only lost when a social democratic government was in power, but laws were subsequently passed preventing the conversion of rental housing to co-operative ownership by the inhabitants on the specious argument that it would deplete the rental housing stock even further. Though the facts indicated otherwise, that is that renters who were able to get on the ownership ladder at a much lower rung, went on to “buy up” and thereby decrease the pressure on the rental market. Within a few years, they went on to buy their own homes and leave the inventory of what had been or continued to be rental housing units to a smaller pool. These facts were ignored for very different reasons by conservative and socialist provincial governments alike.

Imagine the government not building subsidized housing units at $150,000 each, saving on both capital costs and continuing rental subsidies even though supporters of increased government owned or rent subsidized housing might strenuously object. Imagine if the government had set up a lending facility to help tenants both buy the buildings they occupied and renovate them with the government purchasing the minority of units where tenants would not take up the offer. There would be no cash outflow, just loan guarantees or assets purchased securitized by the property. Reducing the costs of building new units and subsidizing rents would, in fact, decrease the outflow of expenses to the government. Further, by purchasing units not bought by tenants, the government continued to have rental units on the market while benefitting considerably from the capital gain to those units. Effectively, the government would be buying property at very depressed prices for the benefit of renters and allowing those renters who could otherwise not purchase property to become home-owners.

This is not just an abstract model. We demonstrated it in practice in the 1980s as I indicated above. Further, if the government wanted to be fairer to property owners because of guilt over buying their property at depressed prices when it was the government itself that was responsible for those low prices, the government could have provided added incentives to encourage property owners who wanted to – and many were eager to do so – to get out of the rental market and retrieve their investments by offering concessions on capital gains taxes when buildings were sold to tenants.

How does this example apply to the depressed value of real estate in the 2008 crash? Very simple! And I mean simple. While quick-on-their-feet entrepreneurs bought up enormous swaths of property at very depressed prices only to sell them four or five years later at recovered prices, realising very large profits, the government would facilitate homeowners retaining their homes at the depressed prices when mortgage companies foreclosed. It could do so by taking three actions – 1) delaying forced evictions as the government is doing currently in the COVID-19 crisis, 2) requiring foreclosed homes to be first offered to occupants, and 3) offering mortgages on those repurchased homes at 100% of the depressed value, but with the government retaining an interest – say 25% of any profit realized when the home was sold.

This was not done. Instead, the financial institutions were directly bailed out and most saved from insolvency. And tens of millions lost their homes. Many if not most, were never again able to re-enter the home ownership market. What about the home occupier who had also lost his or her job and could not even afford payments on a mortgage even when it was reduced by 50%? For those cases, the government could introduce a mortgage repayment forgiveness program and gain incrementally up to another 25% of the increased profit of the home when it was sold.

As I will show in a future blog, the government did introduce a limited version of this but without any gain for the government. Why? I believe it was because the dominant analysis of what went wrong was erroneous. It was not primarily a combination of unscrupulous mortgage lenders and gullible and greedy buyers who could not afford their purchases. Obama would himself later agree about the misrepresentation of the buyers, but when it was too late. And he never really understood the core of what happened.

Next VII: The Obama Analysis and the 2009 Rescue