SPECIAL REPORT: How Widespread Mortgage Fraud Toppled the U.S. Housing Market
In the first two parts of this three-part series, we examined how a speculative mania had engulfed the housing market during the bubble years of 2004-2005 and then how it was financed by a total collapse in lending standards by the mortgage industry. In this final segment, we will explore how widespread mortgage fraud undermined the housing market and helped to bring it crashing down.Fraud for Profit Schemes
AFG Financial was no ordinary mortgage brokerage firm. Last July, Manhattan D.A. Robert Morganthau announced an indictment of the principals in a press release which declared that "AFG's business model was focused solely on defrauding the lending banks of millions of dollars."
According to the press release, here is how it worked. Property locators were paid to find suitable properties for their scams, usually homes owned by people in financial distress. Other paid recruiters found what have become known as "straw buyers" with good credit ratings to stand in for the real buyers. They were told that they would be well paid, often receiving a small upfront fee, and that they would not have to make any mortgage payments.
Then the conspirators swung into high gear. Forgeries and fraudulent documents were used to enhance the straw buyer's creditworthiness. Forged W-2s and bank statements were created to inflate the straw buyer's income and assets so the maximum amount of money could be borrowed. Corrupt appraisers provided inflated appraisals for the property, much higher than its market value. Bank employees who were part of the conspiracy verified that the bank statements were accurate. Co-conspirators employed at lenders such as Countrywide and New Century
Mortgage made sure that loan applications were processed quickly without any due diligence.
At the sale closing, lawyers were brought in to make sure that everything went smoothly, that no one asked any questions, and that the bulk of the sale proceeds went to the AFG principals. Title company principals made sure that funds which were supposed to go to the sellers ended up in a shell account controlled by the AFG owners. The conspirators were so brazen that in one transaction, they created a sham appraisal with a stated value of over $500,000 for a 2-family home which was, in reality, only a vacant lot.
The net result of their fraudulent schemes was that the AFG principals walked away with most of the cash which was supposed to go to the sellers, nearly $12 million. Since they made only a few loan payments at most, the houses went quickly into default and then foreclosure leaving the straw buyers with ruined credit and the banks with worthless mortgages.
By creating these phony residential sales between mid-2005 until the end of 2007, the co-conspirators were charged with defrauding the banks of more than $12 million. The D.A.'s press release concluded by stating that, in total, the defendants appeared to have defrauded the banks of more than $100 million and that the investigation was continuing.
If you think this highly organized mortgage fraud gang was a rare exception, you would be wrong. Similar fraudulent rings could be found in nearly every state during the bubble years. Why? Two main reasons. First, there was big money to be made. Second, the FBI's white collar crime budget for fraud had been emasculated by the focus placed on radical Islamic terrorists after 9/11.
The type of fraud perpetrated by the AFG gang became known as "Fraud for Profit." We can also include "house flipping" under this category. Flipping a residence has always been a part of the real estate market. A flip was usually where an investor bought a house, often a fixer-upper, then resold it quickly at a substantial markup.
In a five-part series published in July 2009, however, the Miami Herald Tribune
declared that house flipping became a national pastime during the bubble years and that Florida had become "one of the key playgrounds" where fraudulent flipping "ran rampant." Its massive year-long research and review of 19 million real estate transactions found fraudulent flips in at least 50,000 of them during the last decade. The authors argued that suspicious fraudulent flips in Florida involved some $10 billion dollars. Professor William Black, one of the nation's foremost authorities on real estate fraud, believed that this figure was much too conservative.Lying Became the Ticket to Real Estate Speculation
In September 2004, the FBI reported that there was a "growing epidemic" of mortgage fraud in the country that could eventually cause the collapse of the housing market. No one paid much attention. After all, this was right in the middle of the housing bubble, home prices were soaring, and nearly all homeowners felt wealthier because of it.
The following July, a syndicated real estate columnist named Ken Harney wrote an article asserting that there was widespread and growing fraud in mortgage applications which was "a multi-billion dollar problem." Still no reaction.
Then in September 2005, a firm named the Prieston Group which insured against mortgage fraud announced that in the first half of that year, the most prevalent type of mortgage fraud - 53% of all claims -- was something called "occupancy fraud." This fraud involved an investor who falsely claimed on the mortgage application that he/she intended to occupy the property as a primary residence.
Speculators had good reason to lie about intending to occupy a purchased property. Because owner-occupied houses had lower rates of default than investor-owned properties, lenders would give owner occupants an interest rate that could be as much as 40% lower than what they gave an investor. They would also require a smaller down payment as well as lower cash reserves. With stated income loans which did not require documentation of a borrower's income having become so widespread by 2005, the temptation of a speculator to lie on the application to obtain mortgages for one or more properties became irresistible.
The Prieston report claimed that based on its experience, as much as 10% of all mortgage applications involved fraud and that 25% of all foreclosures involved some kind of application misrepresentation. It turns out that these estimates may be much too low.
A previous REAL ESTATE CHANNEL
article entitled Investors Played a Key Role in Creating Housing Bubble cited a 2009 Florida study which found that 44% of all foreclosures in Hillsborough County between 2007 and 2009 were on homes owned by investors who did not occupy their properties. An earlier 2005 study of that same county had reported that 40% of all homebuyers in 2004 did not apply for a homestead tax exemption because they admitted being non-occupant investors. If you add to this the large number of buyers who lied about being an owner-occupant to obtain the tax exemption, it seems clear that a majority of 2004 buyers in this county were speculators.
This egregious lying by speculators about intending to live in the property is illustrated by an article which appeared in the Arizona Republic in November 2005. It described a Phoenix attorney who was surprised to learn that nobody there was checking for mortgage fraud. So he did some checking on his own. A spot search of public records found large numbers of homeowners with two or more of their properties listed as owner-occupied. One property owner actually had fifteen of his houses listed as owner-occupied. Apparently no one else had ever looked into this or even cared.
The domination of the housing market by speculators in key bubble metros is also shown by an August 2005 study of house flipping put out by First American Core Logic. It found that in 2004, nearly 45% of all home sellers in the Las Vegas and Miami-Dade metro areas were flippers who had purchased the property within the previous two years. In Orange County, California, nearly 30% of all home sellers were similar flippers. In two zip codes of Las Vegas, 40% of these flippers had bought the property within the previous 12 months.
How much lying on applications was done by investors during the bubble years in hot markets such as California, Florida, Las Vegas, Chicago and Phoenix? An incredible amount. The comprehensive report on the nonprime mortgage market sent to Congress by the GAO in July 2009, which was referenced in a previous REAL ESTATE CHANNEL
article, Terms of Endearment: How the Speculative Madness Was Financed, found that 92% of all subprime borrowers in 2004-2006 claimed that they were owner-occupants. Incredible! This was outright lying by millions of mortgage borrowers which was encouraged by lending institutions that were simply not interested in checking.Mortgage Brokers and the Liar Loan
As I explained in the second article of this 3-part series, Terms of Endearment, commission-based mortgage brokers had become the source for a majority of all nonprime mortgages applications during the bubble years of 2005-2006. At its peak, there were nearly 90,000 brokers around the nation in more than 50,000 small firms. Many states did not have any licensing requirements for mortgage brokers. It was much like the Wild West. Telemarketing was the favorite tool for finding loan applicants. These brokers took the information from applicants, sent it on to the wholesale lenders and received a commission for all mortgage applications which were accepted by lending giants such as Countrywide and New Century
A May 2007 article in the Washington Post
described what it was like inside New Century
, one of the largest subprime lenders in the industry. In one of the offices, the atmosphere was described by an employee as resembling a fraternity -- the average age was only 23.
The article portrayed the plight of one woman in underwriting whose job was to weed out bad mortgage applications that were probably fraudulent. She explained to the author that as soon as you rejected a loan, the whole office was immediately notified: "Two guys would come with a bat and they were all ticked off because you cut their deals." One salesman used the intimidating method of banging the sides of nearby desks with a baseball bat and yelling expletives as he approached her. She claimed that she was eventually fired for rejecting too many weak loan applications. Other employees interviewed by the author said they quit because they could not take the pressure of "unofficial quotas" of loans that had to be approved each day.
The environment was not much different at another large mortgage lender - Long Beach Mortgage - which had been acquired by Washington Mutual (WaMu as it became known) in 1999. An article published by the Huffington Post in December 2009 described what went on there to carry out the unofficial directive of "How many loans can we push out [today]?"
The author researched mortgage records and court documents and interviewed numerous former employees. He found policies coming from top management and lax lending practices which "enabled fraud to run rampant." Former employees explained that these policies were treated by thousands of brokers as "an invitation to fraud." One former employee said that she "knew brokers who were doing fraudulent documents all day long." Another said that these lax standards led to New Century
salespeople actually "coaching brokers how to fake documents."
A February 2008 article in the San Francisco Chronicle described how a broker coached the applicant to lie. The broker didn't tell her to lie, explained the applicant, but he just made strong suggestions. He asked her: "Are you sure you don't remember any more income, like alimony or consultancies, because if you made $80,000, we could get you into a better loan with a better interest rate and no prepayment penalty." The applicant told the author, "It was such a big differential that I felt I had to lie. I'm lying already so what the heck." So she told the broker, "Come to think of it, you're right, I did have another job that I forgot about."Massive Fraud Finally Toppled the Subprime Mortgage Market
Lying by homebuyers using the stated income loan application became so flagrant and so massive that at an August 2006 Federal Reserve hearing, the President of an organization called The Mortgage Broker Association for Responsible Lending declared that stated income loans were "being used fraudulently in alarmingly high rates." He insisted that they "must stop now." To buttress his argument, he pointed to a recent review of 100 stated income loans by the Mortgage Asset Research Institute (MARI) which compared the loan applications to the borrowers' IRS tax returns (allowable under U.S. Treasury form 4506 signed by all applicants). The analysis found that 90% of all the applicants had exaggerated their income and more than half of these borrowers had inflated their actual incomes by more than 50%.
Another important report published in November 2007 by Fitch Ratings confirmed this pervasive loan fraud. They reviewed the loan files of 45 borrowers who had defaulted soon after taking out the mortgage. What they found shocked them: "there was the appearance of fraud or misrepresentation in almost every file." Multiple fraudulent entries were discovered in nearly every application.
Two-thirds of the applications in this Fitch report revealed occupancy fraud by investors who claimed that they were going to occupy the home. More than half had inflated appraisals. Over 40% had exaggerated income levels or questionable employment. Nearly one in five had credit reports of questionable ownership. One out of six showed evidence of straw buyer schemes or fraudulent flips. What was most damning was the review's assertion that these misrepresentations could have been detected with almost any diligent underwriting by the lender.
These findings by Fitch Ratings seemed to be confirmed in an April 2008 article written by Paul Jackson, publisher of the widely-read real estate publication, Housing Wire, who had seen estimates by mortgage insiders that anywhere from 40-70% of the entire pool of 2006-2007 nonprime mortgages were "fraudulent originations."
The evidence appears to be overwhelming that by 2006, mortgage fraud had reached epidemic proportions. Although the housing market still looked fairly strong to the public in 2006, warning signs were appearing inside New Century
and other subprime lenders that a crisis was about to erupt.
A growing number of New Century
's recent loans had been defaulting within the first few months after origination. Known within the industry as early payment defaults (EPDs), they had begun to exceed 10% of all originations in the second half of 2006. Because New Century
was obligated to buy back any loans from institutional investors where the borrower failed to make the first payment, this was a serious problem. By the end of 2006, these loan "kickbacks" to the firm had reached 15% of new originations. New Century
did not have the capital to absorb all these returns.
Industry insiders were baffled by the high rate of these early defaults. Some thought it was the result of homebuyers who had gotten in over their heads. Others said it was all those adjustable rate mortgages that had started to reset at much higher interest rates. Still others wondered whether it was all those speculators who could not flip their properties or refinance. What they completely overlooked was the massive number of defrauders who never intended to pay back the loans.
For example, let's take the scammer in New York City whom we will call L. V. At the end of 2006, he went on a two-month buying spree in which he purchased ten investment properties in south Queens by obtaining 20 mortgages from ten different banks putting little or nothing down on any of the purchases. Apparently none of the banks was interested in checking his other purchases to see whether he had the means to handle 20 mortgages. Of course, L. V. never told the banks that he had no intention of making the payments on any of these loans.
One by one, L. V. defaulted on the loans. By the end of 2007, eight of the homes were in foreclosure. Undeterred, he continued to collect rent from tenants whom he had put into these two-family homes. When the article about his scam appeared in a December 2009 New York Daily News article, he was trying to evict tenants from two of the properties for non-payment of rent even as foreclosure actions against him were proceeding.
By early 2007, one subprime lender after another was collapsing because of the avalanche of defaulting loans that investors were sending back to them. New Century
filed for bankruptcy in April and the entire subprime market came to a screeching halt. All that fraud had finally caught up with them. The housing market would never be the same.