Reflections on A Promised Land by Barack Obama

Part IX: The Obama Analysis of the Financial Crisis

As Obama wrote, “nobody – not the public, not Congress, not the press, and (I’d soon discover) not even the experts – really understood just how much worse things were about to get.” (240) Who were his own experts?

Obama was sold on men like Hank Paulson and the economic managers Obama continued or put in his place (e.g. Ben Bernanke, Larry Summers and Tim Geithner) who were cut from the same cloth. They were almost singularly focused on rescuing the banks, insurance companies, and the mortgage holders rather than the homeowners, even when they sympathized with the plight of those homeowners. If they had focused on the latter, it would have been much cheaper to rescue financial institutions and even make significant profits for the government in the process. As it is, when the government bailed out Freddie Mac and Fannie Mae, which between them held or guaranteed 90% of the residential mortgage debt in America, with $200 billion – only $187 was actually used in the end – the government made money on its investment. It could have made a lot more, but most of the increased value of the properties when the market recovered went to speculators. instead of the government and homeowners, if the latter had been induced to hold on.

The longer-term result was both more rapid increases in residential house prices and an expanding distrust in the financial system. As the Nobel-prize winning economist, Michael Spence, noted, “There are many reasons for declining confidence and trust in key institutions, both inside and outside government. Complexity is one of them. (my italics) Over the last several decades, as economies and financial systems have become increasingly interconnected, they have also become increasingly complex. Today, not even the most educated and experienced experts can pretend to comprehend fully these systems’ workings. Amid such complexity – and, indeed, opacity – questions about whose interests are really being represented abound, fueling mistrust and creating fertile ground for misinformation and conspiracy theories.”

In rescuing the economy, the rescuers punished the financial institutions but low-income homeowners much more. If they had recognized that the problem was complexity and ignorance, a key element would have been in place to recognize how both the private owners and the financial institutions could have benefitted by a rescue plan.

Instead, the focus was on the stock market rather than homeowners. For the mortgage financial crisis had sent a tsunami towards Wall Street. On 15 September, Lehman Brothers, a $649 billion company, filed for bankruptcy protection. The government determined it was both too weak to prop up or induce others to buy the company at fire sale prices. Further, the government was busy protecting AIG, the largest mortgage insurance company, with an $85 billion rescue package.

It did not help that everything began falling apart during an election in the Fall of 2008 and political shenanigans helped gum up the works temporarily for a rescue package. Obama in his analysis paid more attention to McCain’s playing games at the time than in understanding why the package might save Wall Street but sacrifice the homeowners who were underwater – that is, who owed more on property than its current worth on the market precisely at a time when it was only possible to sell at fire-sale prices and when the homeowner had been laid off and no longer had the funds to pay his. her or their mortgage. Instead, the focus was on ideological Republicans opposed to government intervention in capital markets. Can you imagine the opposition to a scheme that could be easily labeled socialist?

The alternative scheme that was proposed, and that Hank Paulson deemed unworkable, was a government insurance program against losses to banks. A government capital investment rather than insurance program was neither proposed nor investigated. That would have involved expanding the liquid capital available to the federal government by as much as two trillion dollars, but money that could easily be foreseen as bringing in a very large return on the investment. By 2020, most legislators had overcome their mindblindness to the government finding two trillion dollars in this way. However, in the memoir covering 2008, Obama concentrated on how the financial crisis had benefited him politically – and it certainly did, given the way McCain had responded.

But the solution could have been presented as an investment opportunity rather than a package of subsidies for business and homeowners. Projections could easily have been produced showing how the government as well as the people would have profited. The anti-socialists would have screamed louder than even the neo-liberal crowd, even though the package would have saved many more businesses and kept the little guy in the capital market as a homeowner and the best system for providing for his old age security. The socialist believers in more state-owned rental subsidized housing might have screamed even louder.

In the meanwhile, problems were piling up. “Despite the eventual passage of the Temporary Asset Relief Program (TARP) eventually passed by the Bush administration, with most of the support coming from the Democrats, “the financial system remained paralyzed. The housing market was in a nosedive. The economy was shedding jobs at an accelerating rate, and there was speculation that the Big Three automakers would soon be in jeopardy.” (196) (I will not be writing about the Obama rescue of the auto industry because I believe it was accomplished with aplomb and justifiably motivated by the need to retain tens of thousands of jobs of voters in Michigan, Illinois and Ohio.)

“In 2008, the US experienced the traumatic chaos of a financial downturn, whose effects rippled throughout Europe and Asia. Many economists consider it the worst crisis since the Great Depression…The causes are manifold, but can be found substantially rooted in illogical investments and greedy schemes [my bold and italics]…The banks then created a new idea—linking investors to homeowners through mortgages. Ordinarily, a mortgage broker would connect a house-buying family to a mortgage lender, who would then supply them with a mortgage. In this system, everyone is happy—the mortgage broker earns a handsome commission, the mortgage lender earns a new mortgage, and the family is now a homeowner in a market of increasing housing prices.”

“In the new system, an investment banker buys the mortgage from the lender, borrowing millions of dollars to buy thousands of mortgages, and every month he gets payments from homeowners for each of the mortgages. The banker then consolidates all the mortgages and splits the final product into three sections: safe, okay, and risky mortgages, which make up a collateralized debt obligation (CDO). As homeowners pay their mortgages, money flows into each of the sections, with the safe filling first and the risky filling last, contributing to their respective names. Credit agencies stamp the top two safer mortgages with a triple A or triple B rating, which are then sold to investors who want a safe mortgage, while the risky slice is sold to hedge funds who want a risky investment.”

The basic problem was not moral turpitude but complexity. Briefly put, a PhD student in Waterloo University in Ontario at the end of the twentieth century invented an algorithm for both combining mortgages and slicing them into tranches for investors where a package could have a mixture of risks that balanced out. The effect was to create a new source of capital for the residential housing market. In the early part of this century, Wall Street and the big firms adopted this innovative way of increasing the amount of capital available for the real estate market. The problem is that, because it was an algorithm, that is a set of instructions and computer rules to facilitate this activity, brokers, who were generally computer illiterate, never understood the system. The response was not to increase understanding but to bail out the system in a way that dried up rather than expanded the source of monies to finance residential home building.

By 2006, acute observers had begun to notice that the algorithm was being used just to combine and sell mortgage debt with insufficient and often no appraisal of the underlying value. It did not help that rating agencies, such as Moody’s, employed staff that were equally computer illiterate. Complexity bedazzled the implementors. Complexity also induced them to turn their backs on the system that created more capital and less upward pressure while providing monies for lower income individuals to get into home ownership. This was not a bad thing. This was good. What was bad was the misuse of the system largely as a result of ignorance rather than malfeasance. What was really bad was closing down the system altogether because of that ignorance.

Though moral turpitude was indeed involved, though the normal quest for earnings and profits were clearly at work providing incentives, the major problem was systemic. And once things began to fall apart, no one knew where to go to fix it. Hence Obama’s summary that in complex systems you cannot tell the bad guys from the good guys. But moral assessments were largely irrelevant. The issue was understanding the system and how it could be used to benefit homeowners and the government, and then indirectly save some skin for banks and investors.

Obama proposed what became the American Recovery and Reinvestment Act (ARRA). (244) $800 billion would be “divided into three buckets of roughly equal size. In bucket one, emergency payments like supplementary unemployment insurance and direct aid to states to slow further mass layoffs of teachers, police officers and other public workers. In bucket two, tax cuts targeted at the middle class, as well as various business tax breaks that gave companies a big incentive to invest in new plants or equipment now instead of late.” The third bucket took longer to both design and implement and was designed for long-term impact – not only the usual infrastructure projects, but high-speed rail, solar and wind power, broadband internet services for rural areas and educational reform incentives.

It is quite clear that bucket three could have absolutely no immediate impact on the financial crisis. Rather, the crisis provided an opportunity to include laudable plans for infrastructure investment. In bucket two, Obama argues that, “The Tax cuts had the added benefit of potentially attracting Republican support,” (244) but to get any support, the Democrats even had to extend the cuts to the top 2%. 

There is no question that bucket one was invaluable and required in an emergency like this. But tax cuts? At the time (15 April 2009), Obama had claimed that the tax cuts were targeted at Americans who needed them while also “jump starting growth and job creation in the process.” “Across America, families like the folks who have joined me here today have had tough choices forced upon them,” Obama said. “Many have lost a job or are fighting to keep their business open. Many more are struggling to make payments, to stay in their home, or to pursue a college education. These Americans are the backbone of our economy, the backbone of our middle class… They need a government that is working to create jobs and opportunity for them, rather than simply giving more and more to those at the very top in the false hope that wealth automatically trickles down.”

The cuts eliminated $288 billion not only in taxes but in the annual income to the federal government. Did they also restore confidence and help end the Great Recession? At the time, Obama claimed that his tax cut was the most progressive in modern history” and “will affect some 120 million families and put $120 billion directly into their pockets.” And in their bank accounts. And used to reduce their debt. The other half of the one-third in bucket two went to business incentives.

Though the benefits outweighed the costs, though the tax deductions and incentives appeared to help reduce unemployment, the question remained whether there were alternative uses of the money that would have had an impact that was both greater, more targeted to those who needed it most and with a more immediate affect. Further, the political costs were enormous. As Obama said, in spite of his concessions, not one Republican voted for ARRA. “The next day the Recovery Act passed the House 244 to 188 with precisely zero Republican votes.” (258) Further, it spurred the rise of The Tea Party, the predecessor to Trumpism. Finally, the Democrats lost control of Congress in the 2010 elections.

The Nobel prize winning economist, Paul Krugman, in his usual fashion put it bluntly – too little with the effects too late, and he could have added that those most in need of help did not get a significant enough share. $45 billion went to extend unemployment benefits and increase them by $25 a week. As well, assistance went to various forms of charity – $19.9 billion to the Food Stamp Program, $14.2 billion for supplementary $250 Social Security payments, $3.45 billion for job training, $3.2 billion in supplementary welfare payments plus a smattering of other smaller amounts to worthwhile causes.

However, virtually none had a direct impact on the housing crash at the centre of the economic crisis. Obama would justly argue that it was not intended to do any such thing. After ARRA was passed in February, he turned his attention to the collapsing housing market. By the end of 2008, home prices on average had fallen 20% and, in some areas, by as much as 50%. As Obama put it, “Other than job loss, no aspect of the economic crisis had a more direct impact on ordinary people. With more than three million homes having gone into some stage of foreclosure in 2008, another eight million were now at risk. Over the final three months of the year, home prices fell almost 20 percent, meaning that even families who could manage their payments suddenly found themselves ‘underwater’ – their house worth less than they owed, their primary investment and nest egg now a millstone around their necks.” (269-270) Progressives were pushing mortgage relief by forgiving a portion of the debt and subsidizing mortgage payments. The costs were considered prohibitive.

Instead, two much more modest programs were introduced, “the Home Affordable Modification Program (HAMP) designed to reduce the monthly mortgage payments of eligible homeowners to no more that 31 percent of their income, and the Home Affordable Refinance Program (HARP) which would help borrower refinance their mortgages at lower rates even if their homes were underwater.” (271)  These programs would not help “those who through subprime loans had bought way more home than their income could support.” Nor flippers. Did the programs help those whose homes were “underwater”?

Next: Part X: The Impact of HAMP and HARP

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