Predatory Lending, or Mortgage Fraud?

By Steven Malanga

When Sen. Hillary Clinton addressed the subprime mortgage crisis in late March, she told a heartwarming story of how her husband Bill had proposed marriage to her by purchasing a home she admired. “I can’t live in it by myself," the future president told Sen. Clinton. That first home, Sen. Clinton said, was part of the American dream for them. “I know how much a home means to all of us,” she added in her speech, which went on to outline plans to have the federal government spend tens of billions of dollars to bail out homeowners who could no longer pay back their subprime mortgages.

Just a few days before Sen. Clinton’s speech, however, the Mortgage Asset Research Institute released a report which painted a somewhat less inspiring picture of contemporary home ownership. Mortgage fraud, the institute found, had soared in America, especially in states with a high concentration of subprime mortgages. From 2001 to 2007, in fact, reports by lenders to the federal government of suspicious activity on mortgage applications had climbed more than 10-fold to 46,717. Moreover, those numbers merely hinted at the full extent of the problem since they only included information submitted by federally-insured institutions, and only represented fraud that lenders uncovered. By one estimate, total losses from fraudulent mortgage applications were estimated to be about $3 billion annually—and growing. The deception was clearly widespread, including false statements on mortgage applications about family income and current levels of indebtedness, submission of phony documents, and lying about the intended uses of the property that was being purchased.

Sen. Clinton’s speech and the mortgage industry report, coming within days of each other, illustrate the two separate and often mutually exclusive tracks that the discussion of the subprime crisis is taking these days. On the one hand, remedies proposed separately by Senators Clinton and Obama, as well as the bailout package agreed to by both Republicans and Democrats in Congress last week, essentially treat many subprime borrowers as victims of seedy mortgage brokers, opportunistic lenders and aggressive Wall Street houses. Under this narrative many borrowers were ‘lured” (in a term used by both Sen. Obama and the New York Times) into mortgages they couldn’t afford, and the Bush administration’s rescue plan--which involves urging borrowers and lenders to work out new loan terms individually--amounts to too little help at too laborious a pace to make a difference.

And yet the more time that passes the clearer we begin to see the extent to which many borrowers themselves may have participated in creating the mess from which we are preparing to rescue them. As more mortgages go bad and enter foreclosure, their details are coming under scrutiny, and the facts are not always pretty. They suggest that while lenders became too careless and some brokers were clearly swindlers, many borrowers were more than simply naïve or overly optimistic; a good many were probably cheating. Any federal legislation package that provides the financing to rework millions of thousands of subprime mortgages quickly is likely to reward quite a few of these chiselers.

One place to look for the cheating is in the speculation which helped drive the market, and which has played so large a role in today’s rising default volume. Everyone, of course, decries speculators, and it’s de rigueur in any speech or editorial endorsing giant bailout packages to denounce these gamblers and exclude them from any help. But as more mortgages unwind, we’re discovering that not only was speculation more rampant than we thought, but that many of these gamblers were deceiving lenders and builders by hiding their intentions.

So-called ‘occupancy fraud’—in which a speculator claims he will live in a house he is buying when it is actually a property he is purchasing for investment purposes-- accounted for about 20 percent of all mortgage swindles during the go-go years of subprime lending, according to a study by BasePoint Analytics, which specializes in detecting mortgage fraud. Buyers hid their intentions because lenders generally require bigger down payments on purchases of investment properties, and some builders will limit the number of investors they allow into a new development, because these buyers are more likely to walk away from a property when the market tanks. Home builders in hot markets were especially susceptible to this fraud because investors would purchase houses in new developments with the intent of flipping them as soon as they were ready to be occupied. Several builders told the Wall Street Journal earlier this year that while they thought that only 10 percent of their sales were to investors in recent years, in fact, it now appears that as many as a quarter of their homes were being snapped up by speculators, who often lied about their intent even when builders required them to sign documents affirming they would reside in their homes.

The level of occupancy fraud is significant because it suggests that speculation accounts for a larger part of the troubled mortgage market than most people realize. For one thing, some of the country’s highest foreclosure rates are in states which until recently had a hot, investor-driven housing market, notably California, Nevada and Florida. In fact, among the five states with the highest rates of foreclosures, defaults by known speculators (that is, those who admitted they were buying investment properties) account for more than one-fifth of all mortgages going bad. We don’t know exactly how many additional defaults can be attributed to occupancy fraud, but some studies have suggested the misrepresentations were widespread. Fitch Ratings, for instance, looked at a portfolio of 45 subprime loans that defaulted within their first year and found that in two-thirds of the cases borrowers never occupied the property, though they said they intended to.

Mortgage fraud, however, doesn’t stop at cheating by investors. There’s evidence that a wide range of borrowers, many probably aided by unsavory brokers, were using inaccurate data and phony documents to purchase homes they otherwise couldn’t afford, and hoping that a rising housing market would keep the deception from coming back to hurt them. One measure of the possible extent of the fraud: BasePoint Analytics took a look at millions of subprime loans and found that in 70 percent of cases where mortgages go bad quickly (exactly the kinds of mortgages that account for a chunk of today’s rising default rates), there was some misrepresentation by the borrower, broker or appraiser, or some combination of the three. Those loans were five times more likely to default quickly than mortgages without falsifications.

One area of particular abuse was so-called ‘stated income’ loans which require little or no documentation of a borrower’s earnings. Originally designed to help self-employed borrowers who don’t have ready access to documents like W-2 forms, no-doc loans became widespread during the height of the real estate boom because lenders naively believed that borrowers wouldn’t lie about income to qualify for loans that they couldn’t afford to pay back. But as soaring housing values made it possible for homeowners to refinance out of unaffordable mortgages using their new homes’ rising equity, lying on no-doc loans became common. One lender which compared 100 stated income loans with IRS data found that in 60 percent of cases, the income that borrowers claimed exceeded their actual earnings by 50 percent or more. BasePoint found in its study that some applications exaggerated income by as much as 500 percent.

Housing advocates, some politicians and journalists have tried to portray borrowers with misrepresentations on their loans as victims rather than cheaters, people put into mortgages they couldn’t afford by dishonest mortgage brokers. But many of these borrowers were irresponsible at best, and complicit at worse. Many apparently sought ‘guidance’ from brokers in to how to tailor their personal details to qualify for mortgages they were seeking, and some merely turned over their applications to brokers and allowed them to fill in the details. In one illustrative case described by an Associated Press story, for instance, a woman who understood that she couldn’t afford a loan for a house was told by a broker that she could rent the property to make ends meet. She went ahead on that basis but couldn’t find a renter and defaulted because her income wasn’t sufficient to pay off the loan. She now claims she was victimized by the broker’s bad advice and by inaccuracies on her application that someone, not her, filled out. How did the inaccuracies get there? She merely signed a blank application and gave it to her broker to fill out, she says, with little concern for the accuracy of the data to be added to the documents she signed.

Untangling the true blame in such cases is going to be nearly impossible, but including such borrowers in government bailouts—as advocates and some politicians have urged--will make it hard to exclude just about anyone whose mortgage applications included misrepresentations.

One thing which suggests that many borrowers were in on the scam is the proliferation of services and websites designed to help people cheat on their applications. During the height of the frenzy borrowers could purchase a higher credit score by paying to attach their names to the accounts of people with better credit. Some services would, for a fee, issue check stubs to provide phony employment verification, and for an extra $25, even give over-the-phone employment verification to any lender checking on an applicant. Some websites even offered to set up phony bank accounts in an applicant’s name and fill them temporarily with real assets to provide phony proof to lenders that the applicant had cash on hand for a down payment.

Many borrowers who used such techniques could be bailed out by some of the large government aid packages currently being discussed, such as the proposal to allow subprime borrowers to refinance into government backed loans, which would essentially bury any misrepresentations in new, more affordable, “cleaner’’ loans. That prospect has prompted the Bush administration, as well as likely GOP presidential nominee John McCain, to temper their enthusiasm for some of the larger bailout plans being discussed.

But many of those advocating a massive government bailout of subprime borrowers now argue that such a move is necessary, even if it rewards some of the ‘undeserving.’ The threat to our economy is so deep and broad that the housing market must be saved, they argue, even if the unworthy are rewarded. Yet geographically the foreclosure crisis remains concentrated in a few places where speculation was rampant, like California and Florida, and is hardly a threat in many other places. Those two states alone accounted for 36 percent of all subprime adjustable rate mortgages that went into foreclosure in the fourth quarter of 2007, because that’s where much of the risky lending was taking place.

It’s common now when discussing the subprime mortgage crisis to talk about the frenzy that drove the market at its height. The question is to what extent ‘frenzy’ is now becoming an acceptable synonym for ‘fraud’.