Legacy of Loan Fraud Haunts Housing
When he was trying to attract money into a fund that would bet against subprime mortgages bonds, the hedge fund manager Michael Burry wrote in 2005 to potential investors that, "One hallmark of mania is the rapid rise in the incidence and complexity of fraud." As Michael Lewis notes in The Big Short, Burry went on to point out to potential investors that reports of mortgage fraud to the FBI were soaring.
Nobody has a handle on just how much deception there was in the market during the bubble years, though Burry told investors that one reason he was willing to bet against subprimes was because fraud had become so common it was now "integral" to the market. The FBI reported that accounts of fraud increased from 3,425 in 2000 to about 17,000 in 2004, and then to 47,000 in 2007. But investigators acknowledge that those numbers represent the tip of the problem, just reports to the agency. Moreover the stats don't necessarily reflect when the fraud took place, but when it was uncovered. Last month, for instance, long-distance runner Charlie Engle, star of the movie "Running the Sahara," was charged with 15 counts of fraud, including inflating his income, on mortgage applications he made on two homes purchased in 2005 and 2006.
It's a good bet, in fact, that fraud become so prevalent that homes bought under false pretenses have represented a significant part of the problem mortgage market. When the market first started to head south in 2007, for instance, BasePoint Analytics, a fraud detection firm, took a look at large packages of mortgages that had gone bad and found in 70 percent of cases the applications they examined contained some misrepresentation by the borrower, the mortgage broker, or the appraiser. Many banks apparently closed their eyes to the deceptions. At Washington Mutual, for instance, supervisors in the underwriting department told employees that "a thin [mortgage application] file was a good one," according to testimony by former employees in civil suits against WAMU.
There are several troubling signs that we haven't entirely put the effects of the sham mortgages of the recent past behind us. One is the failure of the federal government's Home Affordable Modification Program, or HAMP, to hit anywhere near the number of reworked mortgages that the feds originally projected. Instead of between 3 million and 4 million reworked loans, the program has done only about 250,000 and may top out at less than 300,000 mortgages that homeowners continue to pay off successfully.
Although there are many problems with the program, it's difficult to ignore the huge gap between those who applied for HAMP modifications and those who stayed in the program once the banks started requiring documentation, including documents verifying income. In the trial phase of the program, banks initially asked homeowners for verbal statements of income and only later demanded documentation, which apparently many homeowners couldn't provide. Banks are now asking for documentation upfront, which is cutting down on those who enter the program and later drop out, but this isn't doing much to boost modification rates.
Other signs of trouble abound. One issue is the so-called "Jersey Shore" problem. No, that's not a reference to the controversial MTV reality show. Rather, it's an allusion to rising default rates in areas studded with vacation homes and investment properties. Apparently, in many foreclosures in these areas, lenders are finding the mortgages were obtained under what's known as occupancy fraud. That is, borrowers took the loans out claiming they were going to use the property as their primary residence, when they were actually buying properties in hot markets to flip, which is a risky strategy that demands tougher underwriting standards and higher interest rates. In some cases buyers even hid the fact that they owned another property elsewhere(this was only possible in an era in which bank underwriters were asleep, or simply didn't want to know the truth). No one knows how deep this problem goes, but in new housing developments, some builders have estimated that as many as 20 percent of the homes they sold during the height of the bubble involved buyers who committed occupancy fraud.
What makes the situation so volatile right now is that deception is piling on top of deception. Rather than decline as banks and regulators get tougher, mortgage fraud has continued to soar, to a reported 67,000 incidences last year. In some cases homeowners who bought houses they knowingly couldn't afford are now trying to qualify for modifications by altering bank statements or tax returns to show more income or assets. As the stock of foreclosed homes grow, occupancy fraud is also thriving as investors try to snap up properties without admitting they don't plan to live in them. The two most susceptible markets, according to the FBI, are Detroit and Miami, both places where there's plenty of stock available.
Finally, unscrupulous scam artists are working overtime to aid homeowners looking to game the system. Some of the schemes are so transparently deceptive that you have to wonder whether the government will ever be able to protect everyone from themselves. One rising type of fraud, for instance, is perpetrated by what the FBI describes as sovereign citizen extremists or "tax deniers" who don't believe in the sovereignty of the government. They have been persuading some homeowners that the government's laws regarding the housing market are invalid. For an upfront fee, the tax deniers promise to teach homeowners how to beat the system by filing fraudulent liens and other documents to prevent foreclosure and forfeiture of property.
It is telling that at a time when banks have tightened underwriting standards and federal regulators are supposed to be watching more carefully, reports of mortgage fraud are still rising. It's as if lying and cheating in the mortgage business has somehow become justifiable and, as Burry observed, ‘integral' to the market. It will make the housing recovery that much more difficult.