Mortgage and Foreclosure Fraud Mushroom in the Wake of Housing Bubble

By Evelyn Black, on October 20th, 2008

A recent article splashed across the front page of the mid-size mid-western city where I live tells a surprisingly unfamiliar story about how ordinary people have pocketed hundreds of thousands of dollars by investing in subprime real estate. Though the current financial crisis has brought about intense discussion about the moral hazard of borrowing beyond one’s means, as well as the irresponsible underwriting that went hand in hand with the subprime borrowing fever, much less attention has been paid to the phenomenon of mortgage fraud.

We know mortgage fraud mushroomed during the boom times of subprime loans. Yet it continues to hover just off the main radar screen, remaining conveniently just outside of public awareness. What exactly is mortgage fraud anyway?

In the case recounted in my local paper, two men–let’s call them Mr. Smith and Mr. Jones–decided to go into the real estate development business by buying up properties in depressed neighborhoods, ‘flipping’ (that is, renovating) the houses they bought, and then selling the houses or renting them out and thereby making a profit on their investment.

So far, that doesn’t seem like a bad idea, especially when credit is readily available and the houses in question are close to a university or a major manufacturing center, or are part of a boom market like some areas in Florida or California. We’ve all watched TV shows on the Learning Channel and on the Discovery Network that chronicle the adventures and misadventures of these flipping entrepreneurs, and many of us have vicariously enjoyed their journeys while eating Cheetos and keeping our own hands soft and clean.

What we don’t see, however, are the house flippers who never flip, never sell, and then default on the loans.

Here’s how it works:

Mr. Smith buys a home in a slum neighborhood for $20,000. He hires an appraiser to value the home at $80,000. The appraiser is committing a crime at this point–the house is not worth $80,000 in anyone’s imagination–but the appraiser and Mr. Smith know each other and are working together to defraud the mortgage industry. Mr. Jones comes along and offers to buy the house (which is actually worth $20,000 or slightly less but is now appraised at $80,000) for $100,000. Mr. Jones is a ’straw buyer’. He doesn’t really want to own the house; he is working with Mr. Smith and the fraudulent appraiser.

Mr. Jones approaches an out-of-state mortgage broker who, not knowing or caring too much about the value of local real estate, is only too happy to make Jones a loan of $80,000 or even $100,000. When Mr. Jones explains he will be improving and then reselling this hot property, the broker envisions repeat business and repeat commissions when Jones buys and flips his other houses.

Mr. Jones then repeats this same process with a dozen or more other properties, all in league with Mr. Smith and his fake appraiser. They pocket the profit on the homes ($60,000 or $80,000 on just the first one alone) and then Mr. Jones proceeds to default on every single mortgage, sticking the out-of-state company who wrote the first mortgage with a $100,000 debt on a nearly worthless house.

Although FBI tables show that mortgage fraud has increased dramatically in recent years, the cases that are actually investigated are really just the tip of a very large iceberg. The FBI doesn’t have anything close to the staff it needs to launch a thorough and comprehensive investigation into this kind of scam because of the sheer volume of cases since 2006 alone.

In my own town, with our own local Mr. Smith and Mr. Jones, neither man has ever been formally charged with anything and neither have paid anything to the mortgage companies that made them the loans. The FBI will neither confirm nor deny whether the two of them are under investigation for fraud. These two men, under their own initiative, have purchased, sold, and defaulted on over 60 homes in the worst neighborhood in this city over the past two years for a net profit of over $1.5 million for Mr. Smith and over $750,000 for Mr. Jones. Their defaults account for more foreclosures in that specific neighborhood than all the other individual foreclosure cases combined.

Both Mr. Smith and Mr. Jones now claim to be disabled and speak to the press only through their spouses, who both insist no wrongdoing has occurred. None of the homes were ever rented or improved. All of them are currently vacant and in a state of serious disrepair. Mr. Jones never took out a single building permit. He claims that he planned to do the work himself but health issues intervened.

Is it possible that these two men are just a couple of enterprising fellows who fell down a flight of stairs at the same rather convenient time? I guess so. Is it likely?

What do you think?

A new and particularly nasty wrinkle on this scheme is called foreclosure fraud. While many different scenarios can be set up, by far the most common involves a ‘foreclosure rescue’ agency that approaches (or is approached by) a longtime homeowner behind on his or her house payments. You’ve probably seen signs posted around your town that say, “We Buy Houses!” Many of these agencies are set up to defraud people in danger of foreclosure. If you try to track them down or investigate them, all you will find is a list of post office boxes and vague nonspecific names attached to no specific person.

Here’s how it works: The foreclosure rescue agency offers to buy the house from the mortgage company about to foreclose on the property and then rent it to the homeowner for a set period of time, during which the homeowner hopes to improve his or her financial situation. At the end of that mutually agreed-upon period (typically two or three years), the foreclosure rescue agency promises to then resell the property to the homeowner on terms they can actually afford. The rescue agency claims to make their money on fees and appreciation, the people get to stay in their house, and everybody is happy.

Except, what really happens is that the minute the homeowners sign the house over to the ‘foreclosure rescue’ folks, the rescue agency runs right out to the easiest lender on the farthest block, cashes out the equity in the home, then disappears off the face of the earth, leaving the homeowner still about to foreclose and owing more in some cases than the house is even worth.

Foreclosure fraud is off the charts in recent years and is growing so fast no one is quite sure how many people have been hit. If you are in danger of foreclosure, read up on some of the most common schemes before you agree to talk about your situation with anyone except your original lender.

As we listen to the most recent attempts to bail out and/or stabilize the U.S. economy, we have also been hammered by lots of campaign rhetoric meant to push our emotional hot buttons by assigning blame for the current mess to individuals we might already mistrust or dislike: certain ethnic groups, minorities, members of certain financial occupations, Wall Street bankers, mortgage brokers, Democrats or Republicans, and so forth. What we are witnessing is a veritable frenzy of blaming, and it gets to be contagious. For some reason, it feels reassuring in times of crisis to find a scapegoat, to blame somebody, anybody, for what is happening. Blame, when properly or improperly placed, always creates the illusion of control. We think that if we find the right person or persons to blame, we can then proceed to hold them accountable and then fix the problem at hand.

While the need to assign blame is completely understandable, especially in an election year, it unfortunately obscures the sheer volume of criminal activity that took place at every level of commerce during the height of the housing bubble. Even at the most basic level–the level of buying a single house–an underpaid local reporter was able to uncover millions of dollars of what was, for all intents and practical purposes, most likely out and out fraud. And that’s just in one small mid-western city. All the poor people on that entire side of town didn’t cause as much damage as those two guys and their fast thinking. And that’s at the very lowest, most transparent level of the whole mess. Now multiply that scenario by every city in the U.S., and square with every level of finance and speculation, and you’ve got the mother of all criminal messes.

So far, few people are going to jail for any of this. But maybe at some point a few should.

At the very least, it’s food for thought.



8 comments   Citizen Economists   , , , ,  

Did the Community Reinvestment Act Lead to the Present Financial Crisis?

By Evelyn Black, on October 17th, 2008

With the U.S. credit crunch gone global and the $700 billion bailout package now looking like a small drop of water in a tidal wave of woe, the question of blame is now all over the media.

Who caused this mess?

If you read the Wall Street Journal you could easily come away thinking that the whole problem started when Jimmy Carter decided to sell houses to minorities.

Jimmy Carter did sign legislation that required retail banks to make an effort to make loans to minority groups. The Community Reinvestment Act or CRA was passed in 1977 under Carter’s watch and was a bipartisan attempt to address the real and serious issue of housing discrimination based on racial or ethnic heritage.

The policies initiated under Carter in the CRA were supported by both Bill Clinton and George W. Bush, as pointed out in a recent Floyd Norris column in the New York Times entitled “Who’s to Blame?”

Norris quotes a speech given by Bush not long before the housing bubble burst, in which the president underscores the government’s policy of aggressively lending to minority groups and other Americans who could not formerly afford home ownership. This policy even had a name under the Bush Administration: “The Ownership Society,” the idea being that a person who owns something has more of a stake in supporting the free enterprise system than a person who feels left out of the loop.

The Republican embrace of Bush’s “Ownership Society,” itself an outgrowth of the Carter and Clinton years and the CRA, was taken to extremes never imagined by the authors of the original legislation. In an excellent Newsweek feature entitled “Subprime Suspects” reporter Daniel Gross explains that the CRA only applied to retail deposit banks and said nothing about forcing these institutions to provide subprime lending; it only stated that lending had to be fair and had to include reasonable attempts to lend to all groups regardless of race or ehtnicity.

Gross points out that the while some major retail banks did make subprime loans to minorities in an attempt to satisfy the requirements of the CRA, the problem didn’t become truly cancerous until unregulated financial firms like Argent and American Home Mortgage began to sell “creative financing” to subprime borrowers, many of whom were actually professional people with shaky credit, real estate speculators, and middle class buyers in “bubble” states like California and Florida who were looking to purchase homes priced well beyond their means, egged on by real estate agents who were on a roll.

Gross goes on to say that

…lending money to poor people and minorities isn’t inherently risky. There’s plenty of evidence that in fact it’s not that risky at all. That’s what we’ve learned from several decades of microlending programs, at home and abroad, with their very high repayment rates. And as the New York Times recently reported, Nehemiah Homes, a long-running initiative to build homes and sell them to the working poor in subprime areas of New York’s outer boroughs, has a repayment rate that lenders in Greenwich, Conn., would envy. In 27 years, there have been fewer than 10 defaults on the project’s 3,900 homes. That’s a rate of 0.25 percent.

On the other hand, Gross remarks,

…lending money recklessly to obscenely rich white guys, such as Richard Fuld of Lehman Brothers, or Jimmy Cayne of Bear Stearns, can be really risky. In fact, it’s even more risky, since they have a lot more borrowing capacity. And, here, again, it’s difficult to imagine how Jimmy Carter could be responsible for the supremely poor decision-making seen in the financial system. I await the Krauthammer column in which he points out the specific provision of the Community Reinvestment Act that forced Bear Stearns to run with an absurd leverage ratio of 33:1, that instructed Bear Stearns hedge-fund managers to blow up hundreds of millions of their clients money, and that required its septuagenarian CEO to play bridge while his company ran into trouble.

Poor regulation and oversight and the repeal of interstate banking laws that enabled fly-by-night mortgage brokers and retail banks to sell bad loans immediately to investment banks who then chopped these loans up into creatively-conceived investment vehicles which were then sold and resold and resold again with leveraged money – none of these issues have anything to do with poor people buying houses.

It appears that there is plenty of blame to go around, but the blame ultimately rests not with the understandable and noble desire for home ownership, but rather with the very human tendency towards greed during boom times. The refusal of the government to enforce existing regulations or to maintain proper oversight fed this greed. Many financial firms in turn completely ditched any voluntary adherence to fiduciary responsibility, overthrowing such archaic notions easily and quickly when faced with the promise of enormous profits. Stockholders were loathe to stop this runaway train while their returns were still spiking, and soon they came to expect these consistently ridiculously-high returns no matter what the market conditions.

What was so terrible about the boring old days when lending institutions had to stand by the mortgages they wrote? Wells Fargo, one of the few big subprime lenders that actually kept and serviced its own mortgages, is still in fairly decent shape. Underwriting a mortgage you have to keep on your books is bound to be a more serious process than underwriting one you intend to sell to a glorified gambler minutes after closing the loan. This makes such simple sense it is hard to believe today that it was overlooked.

But that’s what happens when people catch boom fever. Reason goes right out the window.

Right now, one out of six American homeowners is upside down on their mortgage, with no end in sight to the downward spiral. Blame Jimmy Carter if you must. But don’t expect any of those homeowners, many of whom probably live right on your block, to take you seriously.



13 comments   U.S. Economics   , , , , , ,  

Is It Time to Repeal the Community Reinvestment Act?

By G.L.C., on August 4th, 2008

Financial institutions have a continuing and affirmative obligation to help local communities meet their credit needs. The Community Reinvestment Act (CRA) passed in 1977 requires financial institutions to reinvest deposit funds back into the communities in which they are located and encourages institutions to meet the credit needs of the local communities consistent with safe and sound operation of the institution. When evaluating an application for a deposit facility such as the opening of a branch, relocation of a home office, a merger, or acquisition, the authorities take the institutions’ CRA record into account.

A study by the Federal Reserve Bank of Boston in 1992 found that overt discrimination, whereby minorities with unblemished records are denied credit, is not pervasive. Ninety seven percent of such applicants are approved, but there was a statistically significant gap associated with race.

A 1993 article in Fordham Urban Law Journal by Allen J. Fishbein claimed that the CRA resulted in new credit commitments of $30 billion. The government was quick to take a note of this and began citing this to show that CRA was indeed a success. This led to a demand that credit unions, insurance companies, and other non-bank and thrift companies such as mortgage banks should be included under the CRA.

However the more recent studies including those identified by the U.S. Department of Housing and Urban Development paint a slightly different picture. The study by the Joint Center for Housing Studies at Harvard University – The 25th Anniversary of the Community Reinvestment Act: Access to Capital in an Evolving Financial Services System – concluded that while the CRA has helped expand access to credit even with the increasing number of bank mergers and acquisitions, decreasing numbers of bank branches in low-income communities has limited its value. The study found that banks struggled to determine how to meet the CRA standards and do not always meet the expectations of the community.

Bigger, Faster…But Better? How Changes in the Financial Services Industry Affect Small Business Lending in Urban Areas, a report by the Woodstock Institute, concluded that while CRA encourages small business lending, its traditional focus on home lending and banking consolidations reduces low-income borrowers’ access to credit.

CRA prevents lending in low income and minority areas. Small financial institutions are more likely to open in such neighborhoods, and the act discourages the chartering of those institutions. This limits regulated institutions’ ability to compete with non-regulated institutions such as credit unions, pension funds, and mortgage banks. Minority-owned institutions that target low income or minority groups have been criticized by authorities over the past few years because they have not been aggressive enough in lending to low-income borrowers within their communities and for focusing on too narrow a segment of the community.

Recent changes to the CRA such as strengthening disclosure requirements of loan and recipient characteristics, publicly disclosing CRA ratings, and refining how regulators assign CRA ratings have increased bank activity in low-income communities, but the continued consolidation in the banking industry poses a threat to the effectiveness of the act.



One comment   Politics and Government   ,  

Fannie Mae & Freddie Mac: When Will the Government Learn?

By G.L.C., on July 20th, 2008

The subprime crisis in the U.S. has resulted in the decline of many companies. Many banks including large ones had to write off millions. The decline is not limited to banks and home loan companies alone.

Out of the total $12 trillion in mortgage debt today, two companies – Fannie Mae and Freddie Mac – own or guarantee half of the debt. Both were established by Congress to make homes affordable for lower and middle income families. They do not provide home loans. Both buy mortgages from banks and home loan companies allowing them to make even more mortgages. They take on the risk of possible default.

The decline of Fannie Mae and Freddie Mac is not an overnight event. It has been building up over the years. Some experts feel the main reason for the decline is their unfair insulation from the real world – they are not subject to the same financial standards and taxes as their competitors. They are also exempt from state and federal taxes.

To be fair, the government did try to regulate them by setting up the Office of Federal Housing Enterprise Oversight in the early 1990s.

They were required to meet certain capital reserve requirements but still much less than their competitors. When the accounting scandals broke out at both companies a few years ago, the government had the perfect chance to set up a powerful regulator and rein them in, but the fear of stemming the housing boom probably held the government back.

It would be wrong to blame the lack of regulation alone for the decline of these two companies. The Securities and Exchange Commission tried to get more actively involved in regulating them, but both companies stymied their efforts.

Instead of addressing their critics, these companies forged alliances with them and other activist groups and made huge contributions to non-profit groups. These alliances and contributions were made to buy off the activists and groups and to make it more difficult for them to criticize the companies.

Congress is now debating on a legislation which if passed could give these companies even more power and allow them to venture into new mortgage-related businesses. Instead of making these companies more powerful, what Congress needs to do is to set up a regulator who can effectively regulate these companies and, at the same time, decide on some sort of a capital cushion for them.

The value of Fannie Mae and Freddie Mac’s mortgage assets are declining along with home prices everywhere. If these companies fail, the taxpayers could be left with the losses.



2 comments   Citizen Economists   , , , , ,  

Why Zoning Laws Are No Longer a Benefit to U.S. Home Buyers

By G.L.C., on July 12th, 2008

Virtually every town in the United States has zoning laws which affect land use, lot size, building heights, density, setbacks, and other aspects of property use. Zoning laws are government regulated restrictions on how a particular piece of land can be used – residential, commercial, industrial, agricultural, and recreational. They impose many use restrictions, such as the height and overall size of buildings, their proximity to one another, what percentage of the area of a building lot may contain structures, and what particular kinds of facilities must be included with certain kinds of uses.

Zoning laws were introduced to tackle a real problem – if you do not want a noisy bar next to your house, there should be a law to prevent the bar from coming up in your neighborhood. Zoning law does not target the starting of the bar but the damage that you may suffer if the bar starts in your neighborhood.

Zoning laws restrict freedom by constraining the right to private property. If you own a piece of land and you want to build a factory on that piece of land and your neighbors have no problem, then you should be allowed to build the factory. But zone laws will not allow you to build the factory on your own land if your land is located in a residential zone. Not all factories are polluters. By preventing factories from being set up in an area even if the inhabitants have no problem, zoning laws hamper the local economy.

The negative impact of zoning laws is not restricted to the local economy. It has an impact at the national level, as well.

America is in the midst of an affordable housing crisis. How does zoning contribute to this? The cost of land is about 20% – 25% of the total cost of the house.

In simple economic terms, the price you pay for a house is the price of land + construction costs + a reasonable profit for the developer. But that is not the case in many American cities. The cost of land is about 20% – 25% of the total cost of the house.

Housing prices are determined by both demand and supply concerns. If the demand for housing is very high and the developers are able to make a fortune, then the market ought to be flooded with new houses which will drive the prices down. But that is just not happening. There is something wrong on the supply side. Edward Glaeser of Harvard and Joe Gyourko of the University of Pennsylvania studied this problem and attributed the error on the supply side to zoning restrictions. They studied the data from over two dozen American cities and concluded that zoning restrictions kept the housing prices high and did not allow competitive forces to correct the supply and demand position. The average American home buyer ended up paying not just the price of land + construction costs + a reasonable profit for the developer, but also the cost for regulatory compliance – zoning laws.



2 comments   Politics and Government   , ,