The Mortgage Mess Began on Main Street

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Journalists like simple stories with clear-cut villains who are easy for readers (and journalists themselves) to recognize. And so, as the financial crisis has brought Wall Street to its knees in recent weeks, it’s become so much easier for journalists to cope. Time Magazine, for instance, tells us in its current issue that Wall Street “sold out” America, while the New York Times decries “Wall Street’s ….real estate bender.” John McCain has helped out the scribes by attributing the problems we now face to greed on Wall Street.

Listening to this sort of chatter, it’s easy to forget that this mess began with a heap of bad mortgages made by American consumers who never came within a hundred miles of the card sharps on Wall Street. The inability (and in a good deal of cases, the unwillingness) of these same ordinary Americans to pay back these loans, many of which are sitting in mortgage backed-securities held by institutions around the world, helped tilt us toward this systemic threat to our financial system. And even as we focus on bad bets and lousy leverage ratios on Wall Street, these toxic mortgages continue to unwind, and as they do, we are getting a better look at how they were made—and it’s not pretty. If it wasn’t clear before, it should be now, that speculation and fraud—much of it on the part of borrowers—were rampant.

As I have observed before, mortgage fraud soared in the run-up to this mess, and believe it or not, it’s continuing to rise. The FBI says that reports of suspicious mortgage activity increased by 10-fold from 2001 through 2007, and rose another 42 percent in the first quarter of 2008. As more and more mortgages have gone bad, researchers have looked into troubled portfolios and found startling rates of deception. BasePoint Analytics, a research firm, has estimated, for instance, that 70 percent of subprime loans that default before they reset (exactly the kind that trouble the market right now) contain some kind of misrepresentation by the borrower, lender or broker, or some combination of the three.

One big category of deception has been so-called ‘no-doc’ loans, where a borrower agrees to pay a slightly higher interest rate in exchange for not documenting his income. Originally designed for the growing number of self-employed workers in America who don’t have ready documentation from an employer, these mortgages became known as ‘liar loans’ because many people without sufficient income used them to qualify for financing they otherwise couldn’t get. One lender that compared what 100 applicants claimed as income on no-doc loans to what they reported to the IRS on their tax returns found that in 60 percent of cases borrowers were exaggerating their income by as much as half (or lying to the IRS).

Speculators are also part of the problem. As the housing market rose, more people got into the game of betting on higher prices by purchasing homes which they intended to flip quickly without ever occupying. As this became a popular form of investing, applicants starting lying about their intentions. They were trying to fool developers who grew wary of selling too many homes in new developments to people who would never occupy them, since these are the buyers most likely to walk away from a mortgage when the market turns down. BasePoint Analytics has estimated that this form of misrepresentation accounts for 20 percent of mortgage fraud.

Whether they were cheating or not, speculators clearly played a big part in the mortgage mess. According to a report earlier this month by researchers at the Mortgage Bankers Association, the vast majority of delinquent mortgages and homes in foreclosure continue to be in a handful of states where the housing bubble was largest and where speculation was common, led by California and Florida, which together accounted for a whopping 58 percent of all subprime adjustable rate mortgages that went into foreclosure in the second quarter of this year. In fact, so concentrated are the problems that only eight states have foreclosure rates that are above the national average. And while the rate of new foreclosures for subprime ARMs in the quarter was a whopping 6.63 percent, for traditional fixed-rate mortgages, it was only 0.34 percent. “For the quarter, a majority of states saw relatively little change” in their foreclosure numbers, the MBA researchers noted.

Against this background, fraud is not only growing but continues to be concentrated in states where the market meltdown has taken place—again led by Florida and California. In those states, moreover, the fraud reports are most common on properties near the coastlines, that is, in places where there is an enormous amount of speculation and where many purchases are for investment purposes.

The FBI is not so surprised by the trend. It warns that a sinking market is ripe for new types of fraud, as individuals try to get out of a fiscal mess using further misrepresentations, or as scam artists perpetrate fraud under the guise of helping consumers stuck in bad loans escape their troubles. Given that we seem to have had a generation of mortgage borrowers who at the least didn’t understand the types of loans they were taking out, and at the worst were committing fraud themselves, the FBI’s latest warning suggests we won’t see the end of the bad mortgage crisis anytime soon.

On the bright side, there won’t be a lot of investment banks packaging these new bad loans into toxic securities that threaten the world financial system.

Steven Malanga is an editor for RealClearMarkets and a senior fellow at the Manhattan Institute

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