If you are going to succeed in rewriting history, a necessary condition is that the public doesn’t remember it very well. Unfortunately, that requirement is not in place for the architects of the Administration’s blatantly bank-friendly crisis responses.
Timothy Geithner’s book Stress Test, in which he tries selling the idea that rescuing the banks was unsavory but necessary, and wanting to hold individuals accountable was a mere desire vengeance, is not only doing poorly in terms of sales, but is producing pushback on multiple fronts. Not only have quite a few reviewers taken issue with Geithner’s sense of priorities and his factual claims, but he’s gotten raspberries from the public. If you look at the one-star Amazon reviews, for instance, a large portion come from people who state that they haven’t read the book but have such antipathy to Geithner that they want to discourage everyone from buying it. Similarly, a sympathetic interview of Geithner by Andrew Ross Sorkin elicited overwhelmingly negative (and often extremely articulate and detailed) comments from New York Times readers.
A less high-profile effort at revisionist history, this one by Larry Summers in the Financial Times, is landing with a similar gratifying thud. Summers’ effort at Team Obama brand-burnishing came in the form of a review of an important new book, House of Debt, that analyzes the drivers of the financial crisis and its aftermath.
The book’s authors, economists Amir Sufi at the University of Chicago and Atif Mian at Princeton, performed extensive empirical work and found that over-indebted consumers, particularly the lower-income ones targeted by aggressive and often predatory lenders, had markedly cut back on spending before the fourth and final acute phase of the crisis, triggered by the Lehman collapse. That means that real economy factors, and not financial system dynamics, were drivers of the downturn in the US.* Sufi and Mian performed zip-code level analysis and found that the areas where home prices fell the most and consumers therefore had the biggest hits to their net worth were also the ones that suffered the biggest job losses.
Sufi and Mian also stressed that there’s no precedent for this response to a financial panic. Historically, bank crashes and financial implosions recognized that many of the loans could simply not be paid on their original terms. They provided either for suspension of borrower payments for a period of time, or restructuring, as did the Home Owners Loan Corporation in the Great Depression, or in biblical times, via debt jubilees. Similarly, the Chapter 13 process recognizes that keeping the borrower viable and having him pay what he can pay will usually provide the best economic outcome for lenders.
In fact, treating banking as a critical apparatus to the economy is a modern phenomenon; the Bagehot rule, of lending freely against good collateral at a penalty rate, dates to the late 1860s and was a measure to a measure to save otherwise solvent institutions from being pulling into a vortex, and not backstop banks generally. The Fed was created out of the recognition that the Panic of 1907 came close to exceeding the resources of JP Morgan and his fellow financiers and that frequent banking crises were exacting a large toll on the real economy. The deposit guarantee was a Great Depression innovation.
Nevertheless, past responses, including the now-abandoned Bagehot rule, recognized that bank failures were the result of bad lending decisions, and that reckless or sloppy lenders needed to bear the cost of their recklessness. Restructuring loans thus was not seen as charity to borrowers, but just like the Chapter 13 process for corporate bankruptcy, a pragmatic recognition that getting half a loaf from the borrower is better than trying to bleed him into failure (or in the case of individuals, penury).
Dave Dayen described last week how schizophrenic Summers’ reaction was to House of Debt, first lavishing it with praise, then disagreeing vehemently with the authors’ well-documented views:
It starts off with almost unvarnished praise for the book, saying “it could be the most important book to come out of the 2008 financial crisis and subsequent Great Recession.”…
And then, Summers calls them naive and says they didn’t understand the reality of what policymakers faced in 2008 and 2009. Specifically, he says that “We all believed in 2009 what Mian and Sufi have now conclusively demonstrated – that reducing mortgage debt would spur consumer spending,” saying they did not have a narrow banking view of crisis response. Yet almost every one of Summers’ objections – to supporting bankruptcy judges rewriting terms of primary mortgages, to forcing principal write-downs, to buying underwater mortgages through a Home Owners Loan Corporation-type structure – comes with the warning that the preferred policy of mortgage debt relief would hurt the banks..
This is precisely what Mian and Sufi attack in the book! First off, they argue that it makes no sense to want to spur lending into a deeply indebted economy. They also add that “The idea that financial firms should never take losses is indefensible.” Their entire point is that the losses from the housing bubble collapse were poorly distributed through the system, heaped on those who lost the most in net worth and had the highest marginal propensity to spend. Meanwhile, those most equipped to absorb the losses, those who finance the banking system, were relatively untouched. This is the PRECISE CAUSE, in Mian and Sufi’s view, why the recovery has been so sluggish: the families who couldn’t withstand heavy losses took the brunt of them, and they had to cut back, and demand suffered.
It’s extremely weird that Summers says House of Debt should inform policy responses, and then gives all the reasons why it can’t inform the last policy response. Summers is effectively saying, “We didn’t have a banking view! It’s just that mortgage debt relief would hurt the banks.” In a way, that is nicely revealing. People long suspected** that the White House economic team’s policy response foregrounded the idea of protecting the banks at all costs, with homeowners a secondary concern at best. Summers just said it out loud.
Adam Levitin, Georgetown law professor and special counsel to the Congressional Oversight Panel, has a more detailed takedown of the Summers article. Levitin, a bankruptcy expert, objects strenuously to Summers claiming that he supported “cramdown”. In all other types of collateralized consumer lending, when a borrower is in bankruptcy, the loan is written down to the value of the collateral and the rest is treated as unsecured and written down based on how much the borrower has left to pay off all unsecured loans. Cramdown was seen by supporters as the best way to cut the Gordian knot of considerable complications and bad incentives impeding the restructuring of mortgages.
I’m taking the liberty of quoting Levitin at some length because the details matter and Levitin is very persuasive in marshaling them:
The FT op-ed was, admittedly, supportive of cramdown. But that’s not the whole story. If anything, the FT op-ed was the outlier, because whatever Larry Summers was writing in the FT, it wasn’t what he was doing in DC once he was in the Obama Administration.
Let’s make no bones about it. Larry Summers was not a proponent of cramdown. At best, he was not an active opponent, but cramdown was not something Summers pushed for. Maybe we can say that “Larry Summers was for cramdown before he was against it.” …
Summers main critique of Mian and Sufi’s book is that they’re (very good) ivory tower economists, but that they don’t understand the complexities of the policy world. I am sympathetic to Summers’ point that “it’s complicated”. Cramdown was, but policy isn’t like an academic debate in which noting nuances is how one scores points. Policy requires up or down decisions that swallow the good with the bad, and the Obama Administration (and Summers) made the wrong decision on cramdown. At the end of the day, that’s what matters.
A. Responding to Summer’s Technical Claims
Still, Summers raises five major points Mian and Sufi do not address. He is correct that Mian and Sufi do not address these points, but that does not mean that there are not answer, only that it isn’t Mian and Sufi’s fight. Let me go through these points systematically:
(1) Cramdown risked crashing the banking system. Allowing cramdown posed three possible concerns for the banking system. Let’s address each in turn.
First, there would be large scale loss recognition from cramdown itself. So what? If the banks are insolvent as a result, recapitalize them. Recapitalizing a bank is not rocket science….Perhaps some bridge financing would be needed, but giving the ingenuity that the Fed and Treasury displayed when they wanted to, I’m sure they would have found a way, legality be damned.
Second, there would be some people filing for bankruptcy for relief who would otherwise have continued to pay on their mortgages. The cramdown legislation took pains to ensure that bankruptcy wasn’t going to be unduly attractive and to limit eligibility. Perhaps more could have been done to avoid opportunistic filing, but there were ways to address the issue, and it bears emphasis that people do not usually file for bankruptcy lightly.
And third, bankruptcy filings would have affected not just mortgage debt, but credit card and auto debt, etc. The effect on other types of debt was a reasonable concern, but it could also have been addressed legislatively (that’s what my Chapter M proposal aimed to do).
The bottom line here is that cramdown would have resulted in loss recognition. That would have wiped out equity and possibly some bondholders in the large banks, which would have to be recapitalized. That was a result the Administration found politically unacceptable. But legally and technically it was quite feasible. Instead the Administration preferred to extend and pretend. We’re still paying the price.
(2) Cramdown risked chilling future lending. Nonesense. Everyone understood that 2008 was a 100-year storm and that the government wasn’t going to be in the business of abrogating contracts willy-nilly. In any case, however sacred contracts might be, they aren’t economic suicide pacts and never have been. Markets have responded very well in the past when the government acts like a grown-up and puts aside contracts that are socially detrimental, such as the case with gold indexation in the 1930s…
Yves here. I have to interject that of all the Administration’s justifications for inaction, this is the most patently ludicrous. Banks and financiers LOVE lending to cleaned-up post bankruptcy borrowers. And a robust Chapter 13 process clearly has not scared away creditors from lending to corporations. Back to Levitin:
(3) Cramdown posed a danger of prolonging the housing market’s problems. To the extent that problems are caused by negative equity, cramdown would have fixed them. Chapter 13 bankruptcy confirms plans pretty darn fast. We’re talking months, not years….cramdown would have forced the housing market to clear. Instead, we got HAMP, which did exactly what Summers claims was a problem–delaying inevitable foreclosures through insufficient mods that were designed primarily to extend rather than resolve troubled mortgages.
(4) Cramdown would have raised regulatory issues. I don’t know what Summers possibly means by this. There were ZERO regulatory issues involved in cramdown…
Other, non-cramdown alternatives, such as pursuing something on the Home Owners’ Loan Corporation model would have raised regulatory issues, but that’s not cramdown. Moreover, for Summers to state that the problem with a HOLC-type proposal is that it would have to buy mortgages at par is wrong. The original HOLC didn’t buy at par. Buying at par would be a subsidiy to the banks, but it’s rather laughable for Summers to claim that the Adminsitration was opposed to a “massive backdoor subsidy to banks,” given the enormous backdoor and frontdoor subsidies it doled out to the banking system.
(5) Cramdown had implementation issues. No, not really. That was the beauty of cramdown. It would have been very easy to implement. It would have just added a change to the terms of what bankruptcy plans could be confirmed, but the entire infrastructure was already there….
In any case, the Administration had no understanding of the bankruptcy system.*** This was one of my great frustrations in 2008-2009. The Administration was staffed with economists and the occasional non-bankruptcy lawyer, none of whom had the foggiest notion of how consumer bankruptcy works, but a tremendous fear of the process…
The bottom line here is that of the five issues Summers raises, one is a made-up ideological concern (#2) and three weren’t actually possible with cramdown (#3, #4, and #5) but instead conflate cramdown with a bunch of other housing relief ideas. In the end, we’re left with #1, which was a genuine concern, but was ultimately a question of whether immediate loss recognition and recapitalization (that is, a market clearing solution) was preferable to extend and pretend (delaying loss recognition to let the banks recapitalize with retained earnings). There was no body of scholarship clearly supporting extend and pretend; if anything, we knew the problems of that approach from Japan’s experience. Instead, the only grounds for the choice were distributional. The Obama Administration needs to own that one.
B. Responding to Summers’ Political Claim
Finally, Summers writes that “critics who disagree at this late date are obliged to provide an alternative analysis of the political calculus, not a mere recitation of the arguments for cram-down.” Let me take up the gauntlet.
Not pursuing cramdown was the Obama Administration’s worst political mistake. Period. It may well have cost Democrats the House in 2010 and ushered in the current era of complete Congressional dysfunction. Democrats took a licking in 2010 for two reasons. First, they were held responsible for the state of the economy, irrespective of the shared blame for the crisis. Second, Democrats took a licking because the Administration was perceived (rightly) as caring more about Wall Street than Main Street. Cramdown would have gone a long way to mitigating both criticisms. If cramdown had succeeded, it might have turned around the economy. Maybe not fast enough to matter for the 2010 elections, but we can’t be sure. And even if cramdown had failed, had the administration had put some muscle into the effort, it could have painted the GOP as obstructing help for real people during the 2010 election. The Obama Administration could have carried the banner of the champion of Main Street instead of the protector of Wall Street. By dropping the ball of cramdown, and then doubling down on the incompetent HAMP program (which was patently flawed from inception as was regularly pointed out by the Congressional Oversight Panel), the Administration ended up owning the financial crisis instead of pinning it on the GOP. The Administration is still paying the price.
Summers’ political story seems to be “We didn’t have the votes, so it wasn’t worth the coin.” Of course, one reason they didn’t have the votes was that they didn’t put in the effort. They didn’t have the votes on the CARD Act until the President put in some muscle, and lo, it passed.
Yves again. So on the one hand, the Administration and the Democrats generally are reaping the bitter harvest of their “cream for the bankers, crumbs for everyone else” crisis responses. But the troubling part, as Geithner’s Stress Test and Summers’ op-ed suggest, they have so managed to isolate themselves in the Versailles of official Washington that even warnings of insiders like Levitin are unlikely to penetrate their flattering, insulated world view. Unfortunately, seemingly unsustainable conditions have a nasty way of lasting longer than seems possible. While we can hope for Summers to face an ugly day of reckoning, it may be historians that are the ones to hold him to account
* I quibble with how strongly they state their conclusion. The fall in fourth quarter 2008 GDP was 8.9%. The spectacle of the financial system implosion led to businesses and consumers cutting back dramatically on spending, so to present this as “real economy v. financial system” is a false dichotomy. However, the role of real economy dynamics has been sorely neglected in most accounts of the crisis, and even more so in policy responses.
** Um, suspected? Please see this post for a more pointed take.
*** This was demonstrated by the fact that no one in the Administration could be bothered finding out what a bankruptcy for Lehman would entail (we’ve written about this at some length in older posts). Lehman had retained the top lawyer in the US, Harvey Miller, yet Miller with his famed acute sense for odds of a filing, was blindsided because the Administration had kept him out of the loop, an idea that is still hard to understand. It isn’t simply that Lehman filed for bankruptcy, but as Miller pointed out on September 14, it was obvious it would be highly disruptive based on past failures of much smaller securities firms. Worse, by not consulting Miller, he was forced to file for bankruptcy with a thin form document, which greatly increased how disruptive the failure was.