Bill Black: Arnold Kling’s Cunning Hairdresser Theory of the Financial Crisis

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Yves here. I have to confess that I love this title. It serves as a reminder that the meme that lenders in the crisis were somehow victimized by borrowers is a lame defense of rank incompetence or worse. The basic rule of lending is that all you have is downside from a credit perspective. The borrower is never going to perform better than the terms of the agreement, and he may well do worse. Any competent lender knows that borrowers can be overly optimistic, naive, unlucky, or downright crooked. Lenders therefore need to take prudent measures to protect themselves from these well-known borrower foibles, the most important being not lending to obvious bad risks, and adding enough margin to your cost of borrowing to cover debtor bad luck and your own miscalculation. So to have a huge explosion of borrower defaults, including a meaningful swathe of subprime borrowers defaulting in the first 90 days, is proof not of massive borrower chicanery, but massive lender incompetence or corruption (as in presuming they could dump the dodgy loan on the next fool in the securitization pipeline).

By Bill Black, the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. Cross posed from New Economic Perspectives

Arnold Kling is a libertarian economist who once worked for Freddie Mac.  This article discusses a blog and an article he wrote about the causes of the crisis.  Both (unintentionally) illustrate key theoclassical economic positions critical to understanding the origins of the crisis.  Kling’s blog was in response to a January 29, 2013 post by Thomas J. Sugrue.  Sugrue provided data demonstrating that blacks and Latino homeowners suffered far greater wealth losses in the crisis than did whites.  This upset Kling, who responded:

Sugrue can only process this through the oppressor-oppressed model. He blames predatory lending. If he could open his eyes a little wider, he might be able to see the role played by government housing policy. Some notes:

1. From a wealth-destruction perspective, you cannot just look at the people who lost their homes. People who stayed current on their mortgages nonetheless experienced wealth destruction.

2. Probably more borrowers were “victimized” by Freddie Mac, Fannie Mae, and FHA than by Wall Street. That is, my guess is that a majority of the homeowners whose wealth has been crushed paid for their homes with loans backed by one of those agencies.

Some notes on Kling’s notes:

First, Kling presents no basis for his claim that Sugrue is incapable of thinking of causes of problems other than oppression.  Second, Kling does not assert there are any errors in Sugrue’s data.  Third, Kling does not provide any basis for ignoring oppression by the powerful against those with minimal power.  Fourth, Sugrue did not ignore wealth losses by homeowners who did not lose their homes.

Fifth, why is Kling conflating Fannie and Freddie with the FHA and why is he implicitly distinguishing Fannie and Freddie from “Wall Street?”  FHA is a federal agency.  Fannie and Freddie were privately-owned and privately-managed.  They are based in the Washington, D.C. metropolitan area, but it is common to refer to banks like Bank of America and Wells Fargo as part of “Wall Street.”  Unlike Wall Street investment and commercial banks, Fannie and Freddie did not originate loans and did not contract with loan brokers.

Sixth, Kling does not even attempt to show that Fannie and Freddie “victimized” borrowers.  Fannie and Freddie were not the “but for” causes of those loans being made.  If Fannie and Freddie had not purchased the loans it is most likely than some other Wall Street financial institution would have done so.  Fannie and Freddie lost substantial market share in the early years of the crisis to Wall Street rivals who made large secondary market purchases.  It is also not true that the secondary market was essential to producing the crisis.  The savings and loan debacle and the Icelandic and Irish crises did not rely on large-scale secondary market sales.

Seventh, purchasing a mortgage in the secondary market is not morally equivalent to a lender knowingly making a fraudulent loan to demographic groups its loan brokers’ view as having less financial sophistication and power.  As I have explained many times, it was lenders and their agents who created the “Gresham’s” dynamic designed to produce an epidemic of appraisal fraud.  It was lenders and their agents who overwhelmingly put the lies in “liar’s” loans.

Eighth, Kling then proceeds to make a second-handed citation to a study he has not located that he implies supports his belief that any exploitation operated in reverse – the borrowers were deceiving the lenders.  Kling does not understand the study, but he does reveal his “priors.”

Speaking of housing, Luigi Zingales finds some numbers regarding occupancy fraud.

In fact, the authors find that more than 6% of mortgage loans misreport the borrower’s occupancy status, while 7% do not disclose second liens.

You get a lower rate by saying you plan to live in the home, so speculators will often lie about that. One of the reasons that programs to ‘help owners stay in their homes’ are not doing very much is that a lot of those owners never occupied the homes in the first place.

Zingales references a working paper that I cannot find. Thus, I cannot tell whether the borrowers defrauded the lenders or the lenders defrauded the investors who bought the loans. I always presume that it is the borrower instigating the fraud. However, Zingales says that the bankers should be prosecuted. He makes it sound as if the lenders would record a loan internally as backed by an investment property and report it to investors as an owner-occupied home. That would require a much more complex conspiratorial action on the part of the lender, and until I learn otherwise, I will doubt that it happened.

The study Zingales referenced was “Asset Quality Misrepresentation by Financial Intermediaries: Evidence from RMBS Market,” Tomasz Piskorski, Seru & Witkin (2013).

Kling misses several critical analytical points about the study.  As the title makes clear, it was a study of fraud by mortgage lenders in their sales to the secondary market.  The fundamental point is that by 2006, fraudulent lenders were originating over two million fraudulent liar’s loans annually and that the only well to sell such loans to the secondary market was to compound the loan origination fraud with fraudulent “reps and warranties” about the quality of the loans.  Piskorski and his colleagues confirmed that are “most reputable” banks fraud against secondary market purchasers was “pervasive.”  (The study’s authors, being good, conservative finance scholars, were not engaging in intentional irony when they used the term “most reputable” to describe banks engaged in “pervasive” fraud.)

The study found that the banks overwhelmingly made both the first and second lien loans contemporaneously to the borrowers – then frequently made false reps and warranties promising that there was no second lien in order to sell the loans to secondary market purchasers.  The study did not investigate by far the most common forms of loan origination fraud – appraisal fraud and fraudulent liar’s loans generated by the lenders and their agents.  Kling also fails to understand how speculators were able to defraud lenders.  The authors of the study show that they were able to get the data revealing the fraudulent representations by speculators about whether they intended to occupy the home.  Lenders could have gotten the same data and detected the fraudulent representation and avoided making the loan.  The problem is that the accounting control fraud “recipe” requires lenders to gut their underwriting and other controls and inherently leaves the fraudulent lenders open to external frauds.  The speculators, however, were the most sophisticated purchasers and generally wealthier.  They were less likely to be blacks and Latinos.  Kling, unintentionally, has supported Sugrue’s analysis about power and exploitation.

Ninth, Kling reveals his biases in these two sentences.

“ cannot tell whether the borrowers defrauded the lenders or the lenders defrauded the investors who bought the loans. I always presume that it is the borrower instigating the fraud.

“I always presume that it is the borrower instigating the fraud.”  Recall that Kling is writing this in 2013, about fraudulent lending during the crisis, when there was no tenable basis for the claim.  Kling portrays himself as an expert in housing finance.  He has ignored the savings and loan debacle where it was overwhelmingly the lender instigating the fraud.  He has ignored the Enron-era frauds in which it was overwhelmingly the controlling officers who instigated the accounting control fraud.  He has ignored the fact that Fannie and Freddie were accounting control frauds caught red-handed by the SEC in 2003-2005 and that their new controlling officers quickly reverted to that strategy by 2005.  He has ignored the criminology literature.  He has ignored the work of a Nobel laureate in economics.  George Akerlof and Paul Romer explained in their 1993 “looting” article why the lenders’ fraudulent controlling officers maximized their income by deliberately originating fraudulent loans with a negative expected value at the time they made the loans.  Akerlof and Romer’s article explains why no honest lender would make liar’s loans and why loan brokers are so likely to originate many fraudulent loans.

I have explained in depth why it was almost exclusively lenders and their agents who instigated appraisal fraud and the origination of fraudulent liar’s loans.  Even the Mortgage Bankers Association’s (MBA) anti-fraud experts (MARI) emphasized that the (Bush!) regulators warned the industry about the grave risks of making liar’s loans.  The government never mandated or recommended that lenders make liar’s loans.  No honest mortgage lender would make liar’s loans because, as MARI warned every MBA member in writing, the incidence of fraud in such loans was “90 percent.”

But most surprisingly, Kling (2013) has ignored Kling (2009) – writing about what Kling had learned two decades earlier about liar’s loans.  Kling’s September 2009 article about the crisis makes it clear that he knew at the time he wrote his blog comment that liar’s loans were endemically fraudulent, that the officers controlling the lenders desired this result, and that the lenders sold the fraudulently originated loans to Fannie and Freddie through fraudulent reps and warranties in the late 1980s.  Indeed, he emphasized that Fannie and Freddie had refused, in 1990, to purchase liar’s loans because of their fraudulent nature.  (He leaves out of the story the role of the West Region of the Office of Thrift Supervision (OTS) in driving liar’s loans out of the savings and loan industry in 1990-1991 because we realized that the loans were endemically fraudulent.)

[A] program of reduced documentation becomes a magnet for fraud.  Under such programs, swindlers operating as mortgage originators can concoct remarkable schemes to sell mortgage loans and abscond with millions of dollars. The GSEs experienced this sort of fraud in the late 1980s, and that is why in 1990, when a trend toward reduced documentation of mortgage loans was building, Freddie Mac and Fannie Mae issued a joint policy against purchasing “low-doc” loans. For a time, this put a halt to the trend.

Kling, however, “always presume[s]” that it is the hairdressers of the world that instigate fraudulent lending.  The poor Wall Street firms are putty in the hands of the ultra-sophisticated hairdressers who descend in packs that lay waste to our largest banks.  Of course, prior to the crisis, theoclassical economists assured us that the Commodities Futures Modernization Act of 2000 (by which industry lobbyists eliminated any ability to regulate vast amounts of financial derivatives) posed no risks because the financial institutions were so financially sophisticated that fraud was inconceivable.  Apparently, Goldman Sachs lacks the sophistication to defraud Lehman and Bear, but millions of hairdressers and their peers robbed them blind.  It is one of the most preposterous tales anyone has ever manufactured.  The willingness to propagate the hairdresser theory of the crisis is the definitive test of the ultimate Wall Street shill.

Tenth, Kling is dismayed that Zingales’ would favor the prosecution of the leaders of the lending control frauds for selling their fraudulent loans through false reps and warranties.

[Zingales] makes it sound as if the lenders would record a loan internally as backed by an investment property and report it to investors as an owner-occupied home. That would require a much more complex conspiratorial action on the part of the lender, and until I learn otherwise, I will doubt that it happened.

The “complex conspiratorial action on the part of the lender” turns out to be neither “complex” nor to require a “conspira[cy]” with any other party.  All that was required was false reps and warranties from the seller to the buyer, but that is apparently inconceivable to Kling.  He’s very prepared to believe that masses of hairdressers were born cunning liars but that bank officers are the soul of probity.  There are four reasons why Kling should have “learn[ed] otherwise” even if we ignore the study that Zingales was trying to alert readers like Kling to.  Fraudulent reps and warranties were commonly made by the sellers in the secondary market.

  1. Recall that Kling (ala 2009) wrote that liar’s loans were a “magnet for fraud” by loan “originators” who sell the loans to the secondary market through fraudulent repos and warranties.  It turns out that Kling admits he “learn[ed] otherwise” no later than 1990 – over two decades before he cast scorn on Zingales in 2013 for viewing the secondary market sales through fraudulent reps and warranties as fraudulent.
  2. There were over a dozen lawsuits by governmental entities alleging that virtually every elite lender engaged in widespread fraudulent reps and warranties in order to sell mortgage loans to the secondary market.
  3. Logic.  At the 90% fraud incidence found by MARI there were over two million fraudulent liar’s loans originated in 2006 alone (and additional millions originated in 2003-2005).  Studies and investigations confirmed the accuracy of the appraisal profession’s express written warning through the petition in 2000 about the lenders’ deliberately inducing a Gresham’s dynamic in order to produce endemic appraisal fraud.  These fraudulent loans were overwhelmingly being sold to the secondary market and they could only be sold through false reps and warranties designed to hide the twin epidemics of loan origination fraud.
  4. The Financial Crisis Inquiry Commission (FCIC) report documented that Clayton, the largest “due diligence” firm used to (not) review loan quality, found that 46% of the mortgage loans were tendered for sale through false reps and warranties (FCIC 2011: 166).  The FCIC report and an affidavit by a former Clayton underwriter introduced in litigation over the fraudulent secondary market sales also make clear that the purchasers designed Clayton’s review to be farcically weak.  It was the financial version of “don’t ask; don’t tell” and the whole system was designed to help the fraudulent purchasers create plausible deniability and to knock the price down slightly.

The key to understanding “don’t ask; don’t tell” in secondary market sales is that the “recipes” for the controlling officers of originators and purchasers of fraudulent mortgages are mutually compatible.  They could both obtain the “sure thing” of immediate wealth by pretending that liar’s loans were prudent, relatively low-risk assets earning a true premium yield.  Ultimately, what Kling (2013) proves is the charge he made but failed to support against Sugrue: Kling’s anti-governmental dogmas prevent him from “open[ing] his eyes a little wider” and seeing the return of the accounting control frauds that he recognized in “the late 1980s” and from understanding that it is the anti-regulatory policies that Kling has championed that have created the perverse incentives that drove the twin epidemics of loan origination fraud, the epidemic of fraudulent mortgage sales to the secondary market, and the epidemic of sales of fraudulent MBS and CDOs “backed” (so inadequately) by these endemically fraudulent mortgages.

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  1. Amateur socialist

    I liked this post quite a bit. Only quibble: Why pick on cunning hairdressers? Aren’t crafty postal workers and school teachers just as likely to hoodwink the likes of B of A?

    1. Doug Terpstra

      Exactly, and why excuse all those wily immigrants and shrewd minorities? The moral paragons of banking have fallen victim to villains from all sides, now increasingly preyed upon by the drug cartels, arms merchants, utility companies, county officials, and student borrowers. It’s hard to sustain one’s purity and virtue under such a sustained assault. They are fortunate to have defenders like Kling.

    2. redleg

      Why not pick on hairdressers? They have all of those sharp objects to wield against meek, helpless banksters!

    3. J Sterling

      It’s because you don’t want it to get round to those Vietnamese nail bar girls that you’ve been talking about their financial activities. They’ll mess you up, man.

  2. skippy

    Geez Yves…. you really now how to decant the buzz kill from Mr. Black.

    skippy… is there any remnants of clothing on the emperor left at all?

  3. Richard Lyon

    The really sad thing about excuses and justifications like this is that they have worked. The corruption and incompetence of the financial industry has been documented over and over again. Yet nothing of substance has been done to prevent its reoccurence. When the next disaster comes along the captains of industry will expect and very likely get a government bailout.

    1. James Levy

      This is where I line up behind Banger. The Enlightenment notion was that we line up all the data and we see what it says. Some things may be open to interpretation, but other things will become impossible to maintain. Those ideas which cannot be maintained would be dismissed from the discourse (be they phlogiston or phrenology or racial superiority). That process has completely collapsed. Experts no longer gather to look at an issue and see what’s going on. They get hired by think tanks to present papers proving that what the people who pay their salaries want is true. And they feed into a media which believes with all its heart that pointing out an obvious falsehood demonstrates “bias” and there are two sides to every story and that checking on which side is telling the truth is again a sign of “bias.”

      And as for Libertarians, at the risk of garnering a hailstorm of abuse (which is what one gets on other sites if you dare challenge their shibboleths) the underlying sentiment amongst them is that if those blacks and other poor people who were assured that they could refinance for lower payments once they held an asset and could pay for it for a few months are inferior and deserve to get fleeced. Every Libertarian I’ve ever talked to is convinced that the blacks, women, and the poor are holding them back, wrecking the place, and would be swept away if it were not for special treatment. The Housing fiasco gives them an opportunity to confirm their favorite bias–that blacks and the poor are inferior to them and without government help would go off and die quietly and leave the earth for real men like Libertarians to inherit (as is their birthright).

      1. Banger

        As someone sympathetic with many libertarian ideas (legalizing drugs, ending Empire, returning to the Bill of Rights and so on) I think you make a valid critique. I think most libertarians are just simple-minded and, like most Americans, believe that history is bunk (Henry Ford’s learned opinion) and that we don’t have to deal with the results of past abuse. We believe when someone reaches a certain age they are now “responsible” and anything they do is completely their fault. Never mind that the young person has suffered from years of sexual and physical abuse because –all that doesn’t matter because most libertarians and most Americans can’t conceive of other people’s pain, feelings or motivations–they are abstractions reflecting the simple minded movies and TV shows they watch. So the generations of abuse that the descendants of slaves suffered is irrelevant to the present.

        The libertarian project has turned from a liberating and fresh perspective on government (it’s always good to question everything) to a quasi-atheistic religion based on comic book notions of reality. All the foundations for their ideology are suspect from “free markets” (a fiction that never existed and never can exist) to the belief that people acting in their self-interest are naturally virtuous–this last idea turns Adam Smith on his head but just like most Christians have never read the Bible so most libertarians have not read Adam Smith. And in the end isn’t this a result of mass illiteracy? We see the failure of both religion and the educational system as the source of our condition today.

        1. James Levy

          I purposely capitalized the “L” in order to set true believers apart from those who see good in some libertarian notions (and there is good in some libertarian notions). And from what I see the true believers are not motivated out of a desire to see men set free–they are motivated by the belief that if everyone is turned loose in an unregulated free-for-all they will emerge the victors. The losers will have the right to serve the winners or starve under a bridge. Perhaps I am being too harsh, but that’s the way I see it and when pushed Libertarians tend to confirm my estimation.

        2. s spade

          One small quibble: if individuals are not responsible for their actions (because there is always some plausible historical excuse like the ones you itemize), how is one to hold anyone responsible for anything? Surely, you do not suggest that white people can be held responsible but other people cannot be?

          That a good many Libertarians may be bigots (or even morons) is not enough to condemn all libertarian ideas, nor is a realization that most governmental regulation is counterproductive (generally as a result of capture and/or bureaucratic empire building and/or sloth) inevitably the product of a diseased or lazy mind.

          “We” have to do something about social problems, but the more serious question is, exactly what.

    2. Banger

      And you touch on one of the two major issues we face in our time. The first is that we lack common values other than selfishness is a virtue and compassion a vice. The second is that we don’t understand that moral degeneracy also leads to mental confusion and delusion. Paid whores in the academic, media, and corporate worlds moan on cue and are believed by large sections of the public who have no idea what critical thinking, philosophy or science is and live in a world of images and tribal slogans.

      How can anybody take the economic and political ideas of the right seriously? They are so stunningly stupid! To think hairdressers have ripped off honest mortgage bankers? How can anyone with a heartbeat believe such crap. Does anybody live in the real world? Do people actually believe commercials now? What has happened to us?

      1. s spade

        Which ‘ideas of the left’ do you suggest we take seriously?

        Those of Kropotkin, Marx, Lenin, Stalin, Castro, Bill Clinton, Al Gore, Nancy Pelosi, Barney Frank, Barack Obama? (choose one or more).

  4. Doug Terpstra

    Bill Black is implacable and effective in exposing banksters’ shills like Arnold Kling. He must be appointed AG of the DOJ after the revolution.

    This rebuts Kling’s post from January 2013, still relevant if dated, but his most recent post is more of the same. In Private Securitization and the Housing Bubble, he attempts to debunk Adam Levitin’s and Susan Wachter’s critique of supply-side deregulation. Kling submits that supply-side excess was caused by capital regulation (not by greed and fraud); then he writes:

    2. The “regulated” sector, namely Freddie and Fannie, lowered its standards at exactly the wrong time, in 2005 through 2007. Several private players, including AIG, either exited the market or tightened standards before the bubble burst.

    So let’s see: Freddie and Fannie lowered their standards because they were overregulated? Well of course; it makes perfect sense if you don’t think about.

    I could not find a tip jar anywhere to help support such a consistent, altruistic defense of supply-side virtue. I wonder how he pays the bills.

  5. craazyboy

    Clearly everyone has been barking up the wrong tree with all these ideas about “consumer protection” from predatory lending practices.

    What we need is a banker training program to protect bankers from predatory hairdressers, and probably all other consumers that would be inclined to use cutlery on bankers. (Not to mention the added benefit of “haircuts are contained” being a more believable prediction from the Federal Reserve, once again)

    Perhaps a government training program, “10 Weird Things That Can Happen To A Mortgage Banker”?

  6. anon y'mouse

    this story never made sense to me. it does, however, make sense to racists, authoritarians, and those who believe that nearly all of their fellow humans are -acting in their rational self interest- aka “trying to get over on me” and also view their fellow humans as shiftless, worthless nogoodniks who wouldn’t do a thing in life without the massah’s lash (more Punishers!).

    another story that didn’t make sense to me, which was handled quite well by Matt Taibbi, is that we had a financial crises that threatened the entire world simply due to hairdressers and janitors and farm workers taking out loans they shouldn’t have. as if all of the economic & financial world relied upon those people to keep it going. that would be some weird, inverted pyramid, that the people on the bottom who are paid less than everyone else are required to keep the entire financial enchilada rolling. how then can we justify their outsized effect on the major banks of the entire WORLD. a man who cleans toilets for 15k per year is keeping the whole thing glued together.

    sure. and yet these people are so unimportant, and their jobs create so little “value added” that they are not even worthy of a pay level that supports a single human life. something is not adding up here!

    we should create a children’s book of fairy tales, ala Bros. Grimm, about the strange tales told by bankers.

  7. chicagogal

    While Fannie and Freddie did not victimize anyone when buying mortgage loans in the secondary market, Freddie for sure is victimizing anyone unlucky enough to end up in foreclosure court or needing a loan modification. Though the government’s alphabet soup of “aid programs” was superficially intended to “help” homeowners in need (while actually being created to “foam the runways” for Wall Street), Freddie nevertheless created loan servicing guidelines for their mortgages to comply with those “aid programs.” For those unlucky homeowners, Freddie chose to hide behind the loan servicers instead of facing the homeowners in court and refuse to abide by – or make the loan servicers abide by – those guidelines, thus screwing thousands or millions of unlucky homeowners out of gaining a loan modification and purposefully refusing to provide the transition money provided by the HAFA program for a short sale or deed-in-lieu.

    As to the assertions regarding the cunning hairdressers, doesn’t every homeowner who sought out a mortgage fall into that category? Of course Wall Street was the victim in this mess, because why should they not be? (sarcasm intended)

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