When Barack Obama took office, he faced the biggest combination of crisis and opportunity that any incoming president had since Franklin Delano Roosevelt. In 1932 the Great Depression had ravaged the country and was only getting worse. Even as he prepared to move into the White House, a fresh wave of banking panic swept through the nation, and it was clear that if Roosevelt was to save American democracy, he needed to put forward a sweeping set of reforms, which is exactly what he did via two major rounds of policy initiatives in 1933 and 1935.
In 2008, Obama faced a similar crisis: The economy was in free fall, and the financial system was gripped by panic. Unemployment had not yet come anywhere close to Depression levels, but like FDR, Obama had the opportunity—even the mandate—to enact far-reaching reforms. Unfortunately, he did not use this opportunity. Faced with a shattering economic breakdown, Obama and his key advisers largely sought to restore the wobbly precrisis status quo, inaugurating a decade of economic stagnation and dislocation that culminated in the election of Donald Trump.
The story of Obama’s missed opportunity to fix the rot in the American economy is frequently noted by the left, but it is also the subject of two recent books written mainly by Obama administration insiders—
A Crisis Wasted: Barack Obama’s Defining Decisions, by Reed Hundt, who worked on Obama’s transition team, and
Firefighting: The Financial Crisis and Its Lessons, by Ben Bernanke, Tim Geithner, and Henry Paulson (the former Goldman Sachs chairman and CEO who served as George W. Bush’s treasury secretary). The former is a brutal and devastating indictment of Obama’s strategic missteps as he confronted the crisis, while the latter attempts an apologia for the Bush-Obama crisis management strategy that inadvertently confirms Hundt’s key points. What both books show is that Obama and his administration burned up most of their political capital rescuing the banks from a crisis caused by their own mistakes, and they offer us a warning about doing the same thing again as we face yet another potentially disastrous recession.
As the winds of financial crisis gathered strength in late 2007, the key question faced by both policy-makers and those in the banking industry was what should be done about the supposedly too-big-to-fail firms. Several keystone institutions—the gigantic insurer AIG, the megabank Citigroup, the investment banks Bear Stearns and Lehman Brothers, and many of the other big Wall Street players—were heavily invested in mortgage-backed securities that turned out to be stuffed with the financial equivalent of toxic waste, and it was clear that, left to their own fate, they would implode.
Worse, the wholesale funding market—the unregulated “shadow banking” system that provided the daily credit flows on which the whole global financial system depended—was experiencing a kind of bank run, and financiers could no longer get the loans necessary for their daily operations. Savvier firms like Goldman Sachs and JPMorgan Chase had already shorted (or made bets against) the housing market and so were able to defend themselves against a disaster centered there—but if any of the other big players went down, they were all too aware that they would likely go, too. After all, the counterparty for many of those shorts was the now-ailing AIG. If it failed, it would take down Goldman and probably most of the rest of Wall Street as well, since they were all so intertwined. Thus, without some kind of government rescue, the entire financial system would collapse.
Yet even if everyone agreed on the necessity of a rescue, there was much less agreement on the form it should take. This was the question that the economic advisers for both the president and the president-elect were grappling with in the last months of 2008. One option, which Paulson favored, was simply to buy up toxic mortgages in order to get them off the banks’ balance sheets. A more compelling option was the one favored by Timothy Geithner, then head of the New York Federal Reserve Bank and soon to be Obama’s treasury secretary: He recommended “capital injections,” in which the government bought a whole bunch of bank stock—in other words, a partial nationalization—that would help strengthen the banks’ balance sheets and thus stabilize the financial system. The banks could then lend against the government’s fresh capital and further fortify themselves with more good assets to offset the bad ones.
For those financial companies in dire straits, the government would also have the option to simply buy them outright should their collapse threaten financial stability. The Federal Reserve had broad powers to buy up failing firms by declaring an emergency under Section 13(3) of the Federal Reserve Act. In “unusual and exigent circumstances,” the Fed could use its money-creating authority to simply purchase a failing company. Once owned by the government, a problem firm could be prevented from going bankrupt, and there would be time to examine its books and either fix it up or isolate it from the rest of the market and let it collapse.
Paulson opposed Geithner’s plan on ideological grounds, saying that it was “socialistic” and “sounded un-American.” But as the crisis gathered strength and it became clear that asset purchases would not be enough to save the system, the “socialistic” options won out. In early September, Paulson directed the Treasury Department to take control of the mortgage giants Fannie Mae and Freddie Mac (already partly backed by the state anyway), which were then teetering on the brink of collapse. A worried Bush informed Paulson that “we have to make it clear that what we are doing now is transitory, because otherwise it looks like nationalization.” But this caveat never came to pass; to this day, Fannie and Freddie are still owned by the government (and incidentally have turned a steady profit since 2012).
But Paulson refused to do the same thing for Lehman Brothers, which was nearing collapse a couple of weeks later. As Hundt writes, he maneuvered to prevent a Fed rescue and instructed the company to declare bankruptcy, thereby setting the stage for the largest bankruptcy in American history. This instantly caused market panic and put AIG on the brink of failure as well. As the markets tanked, Federal Reserve chairman Ben Bernanke threw caution to the wind, declared a Section 13(3) emergency, and rushed in with an $85 billion loan in return for almost 80 percent of AIG’s stock—making good old Uncle Sam the owner of the world’s largest insurance company. [...]
Regardless of whether the government should have purchased Lehman Brothers too, the issue with the bailouts of AIG, Fannie Mae, and Freddie Mac was that they were wildly unpopular—but not because people were worried about the government becoming “socialistic.” What infuriated them was the unfairness: AIG blew itself up making stupid bets, and now the government was leaping to its rescue with $85 billion (later increased to $180 billion). And yet the Bush administration did little about the company’s executives, who had played such a crucial role in wrecking the American economy in the first place. Meanwhile, the people suffering from their atrocious decisions were not similarly bailed out; they continued to see their jobs disappear, their homes foreclosed on, and their pension funds devastated.
Paulson recognized this growing outrage, and so he turned to the Democratic-controlled Congress for additional powers and money—$700 billion in all—thereby pinning “the tail of responsibility on the Democratic donkey,” as Hundt puts it. The bill, to create something called the Troubled Asset Relief Program (TARP), was voted down by Congress the first time, but with Obama’s support as president-elect and more oversight and structural controls built into it, TARP passed the House and Senate the second time around, thus making it “the first and most significant decision” of Obama’s presidency, Hundt writes: one in which he “let Paulson pick his presidential priority” and “chose bank bailouts—euphemistically, stabilizing finance—as his top strategic goal.” [...]
Once in office, Obama only doubled down on Paulson’s agenda, nominating Geithner as his treasury secretary and turning the foreclosure policy over to him. The TARP bill included a sweeping grant of authority and an unspecified appropriation to pursue foreclosure relief—meaning interest rate reductions, payment reschedulings, principal reductions, and “other similar modifications.” Obama previously promised to pursue “cramdown,” a policy that would have allowed homeowners to write down their mortgage to the home’s assessed value during bankruptcy proceedings. But since real homeowner relief would have harmed the banks (by reducing the value of their mortgage assets), Geithner refused to include principal reductions in his foreclosure plan and made the program such a Kafkaesque nightmare that few participated in it. Those who did found themselves at the mercy of mortgage servicers who had direct financial incentives to foreclose, and that is exactly what they did: They proceeded to trick thousands of homeowners into foreclosure. While more and more Americans lost their homes, Geithner quietly and successfully lobbied Congress to stop cramdown altogether. Through it all, Obama did nothing—just as he did nothing when Geithner disobeyed a direct order to draw up plans to wind down Citigroup.
In Hundt’s interviews with administration officials, the logic of this choice is discussed explicitly. “The only problem was that there was $750 billion of negative equity in housing—the amount that mortgages exceeded the value of the houses,” says Obama economic adviser Austan Goolsbee. “For sure the banks couldn’t take $750 billion of losses and for sure the government wasn’t willing to give $750 billion in subsidies to underwater homeowners, to say nothing of the anger it would engender among non-underwater homeowners.” Christina Romer, the head of Obama’s Council of Economic Advisers, puts that figure higher but comes to a similar conclusion. “There was about $1 trillion of negative equity,” she tells Hundt, “and getting rid of it would have helped increase consumer spending and heal the economy. But for the government to just absorb it would have been very expensive.”
Thus, since the banks couldn’t handle these losses and the government was unwilling to do so, the Obama team decided to quietly shove them onto homeowners. This choice would result in about 10 million families being forced out of their homes through foreclosure or some other process—roughly one out of every six homeowners. These foreclosed properties would then become economic time bombs, since abandoned houses damage neighborhoods and the value of adjacent homes. The political side effects were also disastrous. As Hundt writes, “In swing states affected severely by the housing market downturn, the reduction of mortgage credit supply had five times the negative effect on votes for the presidential candidate of the incumbent party than the increase in the unemployment rate.” Eventually, Rust Belt states were the hardest hit. “Chicago had the highest rate of negative equity among large markets,” he writes. “The surrounding states proved fertile territory for Donald Trump’s campaign.” [...]
Obama’s advisers often explained many of his choices by invoking legal constraints, but there was no technical or legal reason that a more just and thoroughgoing overhaul of the financial sector, coupled with support for homeowners and the rest of the American people, couldn’t be done. The administration could have insisted that any financial company receiving government support must fire its top management, ban all bonus payments, end dividends and share buybacks, and break itself up into smaller pieces—and that any company that refused would be left to fend for itself. The Fed could also have nationalized any company whose failure posed the risk of taking down too many others with it, as it did with AIG. Directly owned companies could then have been restructured, their bad debts written off, and sold once they were sound again. This would have purged the bad debt from the system, allowed the Obama administration to actually help underwater homeowners, and reduced the power of the banking lobby, which hamstrung the administration in Congress at every turn. Hell, the government could have even hung on to some of the banks to give to the US Postal Service to set up a public option for banking.
Politics would have been an obstacle to this plan but not an insurmountable one. Obama could have insisted on stringent conditions for the TARP bill, given the fact that Democrats were providing most of the votes for its passage. “We could have forced more mortgage relief. We could have imposed tighter conditions on dividends or executive compensation,” Goolsbee admits to Hundt. Failing that, Obama could have simply bided his time until he took office. Bernanke at the Fed was a bigger obstacle, given that his term was to last until 2010, but Fed chairs are still susceptible to political pressure. For example, Obama could have threatened to publicly attack Bernanke’s policy if he didn’t go along—especially his backdoor lending programs, which he was very keen on keeping quiet. Obama could have driven the big banks into bankruptcy and forced the Fed to take action. Most obviously, he could have appointed reformers to the Federal Reserve’s governing board. Instead, he left two Fed seats open for the critical first year of his administration and renominated Bernanke when his term was up.
In all likelihood, the government would have ended up owning a good portion of the American financial system for a time, though it’s worth noting that then-FDIC head Sheila Bair dismisses the fears of a nationalization-induced panic. “I didn’t believe in a domino effect,” she tells Hundt. “If you have a controlled failure, the markets will adjust.” Whatever the case, while the Republican right would have howled bloody murder—just as it did over every Obama policy—the rest of the US electorate almost certainly would have been satisfied, so long as the bankers were made to pay and regular folks got a cut of the bailout money. And the financial system would have been much more stable and far safer in the end. What happened instead was a hideously unfair and economically disastrous mess. Obama spent most of his considerable political capital on defending a cabal of corrupt, rotten financiers who very nearly ruined the world economy. His party alienated millions of voters, who felt abandoned and betrayed by the Democrats, which ended up costing them thousands of seats in state and local government. Thus, when the 2016 presidential election rolled around, Obama’s successor could not even beat a tawdry game-show demagogue.
[ed. Worth a revisit, I think, with the stock market continuing to hit new records every other week (for no obvious reasons). Incredibly, many people have forgotten the details and/or never really understood the cause and effect nature of bad policy decisions during the 2008 banking "crisis" (Chernobyl meltdown would be a more apt description). The fundamental issue being of course "moral hazard" ie., when institutions (and individuals) are encouraged to take excessive risks because there are no consequences - in this case, because the government will bail your ass out when things go south (too big to fail). This attitude now infects nearly every part of the economy not just banks: from hedge funds, to tech companies, healthcare, ag, - nearly every major corporate sector. So this precedent has now become institutionalized. The first tell was when Obama nominated Larry Summers to be his treasury secretary, but the most egregious example has to be Hank Paulson's arrogant one-page request/demand that Congress approve... what, $700 billion? $900 billion? in bank bail-out money immediately, with no strings attached. Various versions of TARP then followed, mortgage holders got shafted, massive bonuses continued across Wall Street using taxpayer money, and almost no one was criminally charged. The Federal Reserve which is supposed to focus on two main responsibilities - fighting inflation and promoting job growth, now has a third unstated mission: propping up the stock market. So the system is now much worse than it was prevously. But, by virtue of carefully crafted post-presidential narratives emphasizing empathy, stability and technical proficiency, Obama is now considered an elder statesman who did the best he could.]
