THIS week’s print edition reviews two new insider accounts that describe the dark underside to America’s bank bailouts. The common theme of both Neil Barofsky’s Bailout and Sheila Bair’s Bull by the Horns is that the U.S. government cared a lot more about saving the incumbent banks and bankers than it did about helping regular Americans blindsided by the collapse of the housing market and the ensuing contraction. As a result, many Americans now believe that the rules are rigged against them for the benefit of a few politically-connected financial speculators: privatized gains and socialized losses. It is difficult to disagree.

On one side of the ledger, we see that the big banks are bigger than ever, more than 90% of the gains in GDP in the past four years have accrued to those in the top 1% of the income distribution, and total Wall Street pay is still near record highs despite a sharp drop in employment. On the other, we find that median net worth fell by 40% since 2007, real median income is still 8% lower than in 2007, there are still more than 7 million fewer full-time jobs than in 2007, and there have been at least 4 million foreclosures, many of which could have been prevented through investor-friendly government policies.

A few excerpts from the review:

Mr Barofsky reports that no one in the Treasury Department and almost nobody at the Federal Reserve seemed concerned that some might try to exploit the government’s largesse. Whenever Mr Barofsky tried to ensure that banks were using TARP funds to make loans—the stated purpose of the programme—he was told that it would be impossible because “all money is green”. Yet the bankers themselves had no problem telling journalists how they planned to use the cheap capital to buy competitors or hoard cash for a rainy day. [...] The Obama administration devoted much more energy and attention to helping Wall Street than to stemming the foreclosure crisis, despite having been given TARP money to do so. Ms Bair recounts how the methodology used to calculate the “stress tests” was cleverly altered so that Citi would keep its tax breaks. This resourcefulness was not applied to help keep people in their homes, however. Whereas incompetence was common—the rules determining which mortgages would be modified were changed nine times in the first year alone—a bigger problem was that these schemes were not designed with ordinary people in mind. When asked how the government’s efforts were supposed to help homeowners, Timothy Geithner, the treasury secretary, responded by explaining that they would aid the banks by slowing down the pace of foreclosures.

Both books are full of colorful episodes as well as excellent explanations of complex concepts. Ms Bair does an especially good job of describing a wide array of toxic financial products, such as the hybrid adjustable rate mortgage. This subprime loan came in two parts. For the first two or three years borrowers paid a “teaser” interest rate of around 7% or 8%, after which they would then have to pay a much higher rate for the remainder of the thirty-year mortgage—often between 11%-15%. These products were literally designed to be unaffordable. The theory was that borrowers would be forced to perpetually refinance into new hybrid ARMs after the teaser periods expired, which would generate a fortune in fee income. Steep prepayment penalties discouraged refinancing from occurring until after the higher interest rate had already kicked in.

The Federal Deposit Insurance Corporation (FDIC), which Ms Bair ran, did a study showing that the “teaser” rates were often slightly higher than the interest rates offered to other subprime borrowers with similar credit scores for thirty-year fixed-rate loans. In other words, many of the borrowers who got hybrid ARMs were eligible for better deals but did not receive them. Why, then, did so many people obtain mortgage financing through these toxic products? According to Ms Bair's account, the lenders who originated hybrid ARMs deliberately misled borrowers—precisely the sorts of financially unsophisticated households who could least afford the risks and obscured fees presented by them. This might not have been illegal but it was definitely distasteful.

By late mid-2007, the incipient financial crisis had made it nearly impossible for borrowers to refinance these loans before getting crushed by the higher interest rates. While some might have been driven into default irrespective of the interest rate because they had been betting on future home price appreciation that did not materialize, many others, according to Ms Bair, could have afforded to keep paying their mortgage at the level of the teaser rate. Preventing a wave of defaults, foreclosures, and short sales that would depress the broader housing market and weaken the rest of the economy would have been in almost everyone's interest. Investors generally make less money liquidating a foreclosed home than they do from restructuring a mortgage to make it more affordable. In this vein, the FDIC tried to work with investors to renegotiate the terms of these mortgages so that the scheduled rate hikes would not take effect. But these efforts failed.

Fannie Mae and Freddie Mac, the government-sponsored mortgage insurance companies, had bought about one-third of all the toxic securities issued during the height of the bubble. As a result, the government should have been able to exert leverage over other investors to come to a deal. Few seriously expected to earn anything above the teaser rate on these products, since they were designed mainly for creating churn fees. Yet Ms Bair reports that Fannie and Freddie were particularly resistant to any modification of the loans in their securities portfolio. While they were "government-sponsored" and capable of borrowing without limit at a cost similar to that of the federal government, they were nevertheless private corporations. Ironically, it is entirely possible that Fannie and Freddie would have lost less money overall had they done more to ameliorate the collapse of the subprime real estate market in 2007.

In October, 2007, Ms Bair gave a presentation to a group that had been involved in bundling together subprime loans into toxic securities. She asked them why they were refusing to do something that was fundamentally in their interests. Subprime borrowers were deadbeats, they said. Give them a gift like this and they’ll blow it on a new flat-screen television. In that case, Ms Bair wanted to know, why had these Armani-clad dealmakers lent out the money in the first place? “Bad regulation,” she was told.

Another great story is from Mr Barofsky’s account of the Term Asset-Backed Securities Loan Facility (TALF). Matt Taibbi provided an excellent retrospective analysis of the programme for Rolling Stone, but Mr Barofsky’s story is full of new damning details about the government’s internal attitude towards oversight. Lee Sachs was in charge of implementing TALF, which would subsidize the speculative purchase of distressed securities by providing cheap non-recourse loans. When Mr Barofsky questioned Mr Sachs about the details of the programme, Mr Sachs responded that

This type of leverage is typical, as is the non-recourse nature of the loans; we see it all the time in this market. There’s no difference in how this will work and how it worked in the private market.

Meanwhile, Bill Dudley, the president of the New York Fed (and previously the chief U.S. economist of Goldman Sachs), was also confident that there was no danger in the programme:

We’re not planning on doing anything with compliance other than have them submit certificates. If we had to oversee compliance, we wouldn’t participate in TALF…We don’t have the resources to conduct compliance…The ratings agencies performed pretty well in these asset classes and we’re confident they won’t risk being embarrassed again.

As Mr Barofsky dispiritingly concluded:

These guys were going to risk hundreds of billions of dollars of taxpayer money on the integrity of the exact same rating agencies that had sold their souls for a few basis points of profit. The same rating agencies that would downgrade 90 percent of the AAA ratings given to subprime residential mortgage-backed securities in 2006 and 2007 to junk…Treasury and the Fed weren’t just trying to restart a securitization market that had ground to a halt, they were proposing to replicate the very same flaws that had just crippled the global financial system.

Both books also provide delightful accounts of Tim Geithner, the Treasury Secretary. Mr Barofsky focuses on his record as a tax cheat. Mr Geithner had worked for several years at the International Monetary Fund (IMF), an organization whose employees pay no tax, unless they are American citizens. Americans who work at the Fund still owe their Social Security (pensions) payments to the IRS even though it is not automatically withheld from their salary. Mr Geithner neglected to pay his Social Security contribution while he was at the IMF. When he was he audited by the IRS and found to have missed several years of payments, Mr Geithner only chose to repay some of the money he owed. Mr Barofsky’s commentary on the episode is worth reading:

Geithner’s explanation as to why, after being caught by the IRS in 2006, he had only paid for the years for which the statute of limitations had not run out (2003-2004), didn’t seem credible to me…The president of the FRBNY, the most important of the U.S. Federal Reserve Banks and one of the key players in setting monetary policy for the United States, told Congress that it ‘did not occur to’ him that if he had violated the tax laws in 2003 and 2004, he might have also done so for 2001 and 2002. I suspected that Geithner and his lawyer were carefully selecting their words to give them impression that he had been unaware of his 2001-2002 obligations, when it was more likely that it ‘did not occur’ to him to pay taxes that the IRS wasn’t forcing him to pay. Geithner, of course, would survive the controversy and be confirmed, but this approach—what I suspected to be a careful and potentially misleading parsing of the truth—would soon characterize many of Treasury’s public statements about TARP.

Incidentally, Mr Barofsky leaves out the most damning detail of all. Employees of the IMF are acutely aware of the differential tax treatment between the American and non-American workers. The Americans, therefore, are generally quite conscious of the need to carefully pay all of their taxes because the IMF does not do it for them.

To be clear, Mr Geithner did eventually pay the remainder of his back taxes, despite being under no strict legal obligation to do so. This occurred after Congress made it an issue during his confirmation hearings.

Ms Bair prefers to focus on Mr Geithner’s obsession with saving Citi and his relationship with Robert Rubin:

Tim Geithner’s mentor and hero, Bob Rubin, had served as the chairman of the organization and, as the Financial Crisis Inquiry Commission would later document, had had a big impact in steering it toward the high-risk lending and investment strategies that had led to its downfall. I frequently wonder whether, if Citi had not been in trouble, we would have had those massive bailout programs. So many decisions were made through the prism of that one institution’s needs.

Ms Bair makes the interesting observation that Citi’s large losses in the beginning of 2007 should have caused regulators to step in and prevent it from paying bonuses that year. Had it been normally-sized, this is surely what would have occurred, as well as management changes. Instead, Citi paid out the third-largest volume of dividends of all American firms in 2007. Who was Citi’s top regulator during that time? Timothy Geithner. To be fair, the New York Fed as an institution seems congenitally prone to support bailouts, whether it is Continental Illinois, Penn Central, or LTCM. Nevertheless, it is one of many revealing episodes.

Looking back four years after the bailouts began, it is worth taking stock, as these authors did, of the paths not taken. The proponents of the status quo like to present a false narrative that there were only two choices: do exactly what was done, or unleash Armageddon. As Mr Barofsky and Ms Bair show, there were alternatives. A subsequent post will focus on the government's foreclosure-prevention schemes, and why they failed.