Research

Ties that bind: The connection between fraud and foreclosures in the mortgage market

The public perception is that foreclosures mainly affect hardworking families who are hit with a payment reset or a trigger event such as a job loss. But Anthony Sanders, a professor of finance and real estate at the W. P. Carey School of Business, also sees evidence of "rampant fraud."

2007-09-26

"There is a presumption in the media (and thus, by default, Congress) that every foreclosure has a family that invested its life savings in a home and that it is 'mean lenders' who refuse to work with these very hardworking, honest Americans and only want to take their homes away." That's real estate expert Anthony Sanders' take on the public perception of the current foreclosure problem.

Many foreclosures do affect hardworking families who are hit with a payment reset or a trigger event (such as a job loss). But Sanders, who is a professor of finance and real estate at the W. P. Carey School, also sees evidence of "rampant fraud." Data gathered by the FBI support Sanders' view.

Between 2002 and 2007, as the number of foreclosures rose, the number of mortgage fraud cases under investigation by the FBI increased 237 percent. According to the FBI's 2006 Mortgage Fraud Report, issued in May, 2007, "mortgage loans based on fraudulent information usually result in delinquency, default, or foreclosure" once the housing market has cooled.

The taxonomy of fraud

Broadly, there are two types of mortgage fraud. One is fraud for property, which involves a borrower misrepresenting information in order to get a loan for a home to live in. According to the FBI report, even though fraudulent borrowers "may embellish income and conceal debt, their intent is to repay the loan." They may get into trouble, though, if they engaged in fraud to get a loan that they really couldn't afford.

"In one group you have borrowers getting loans with no down payment at a very low adjustable rate, thinking that they can sell or refinance the house before the interest rate adjusts," said Gary Birnbaum, associate dean for graduate studies and program development at the Sandra Day O'Connor College of Law.

But when housing prices stop rising like they had been, those borrowers can't sell or refinance, their interest rate adjusts, and they can no longer make their monthly mortgage payment. "They just bought too much house," said Birnbaum. The second type of mortgage fraud is fraud for profit, which the FBI says "often involves multiple loans and elaborate schemes perpetrated to gain illicit proceeds from property sales."

Sanders thinks that much of the fraud that has occurred in the last few years is borrower fraud — both fraud for property and fraud for profit. "Unfortunately, borrowers who engage in fraud on behalf of themselves or 'investors' are getting more sophisticated," he said. Most mortgage broker and lender fraud, on the other hand, is "misrepresentation of information," Sanders said.

Mortgage fraud schemes

To understand why rising rates of mortgage fraud are so strongly related to increasing numbers of foreclosures, it's important to look at the most common mortgage fraud schemes. "Fraud has many faces," said Sanders, "ranging from borrowers who simply want to 'get in on the action' when housing prices are rising to document fraud to 'clever games.'" But, Sanders said, "it's difficult to put numbers down for these groups."

The "clever games" Sanders referred to include an Ohio case in which a group of foreigners took out no-money-down mortgages to buy homes in high-end central Ohio neighborhoods, paying $250,000 or more above the homes' asking prices. The sellers refunded the buyers' extra money in order for the buyers to make repairs to the home. But instead of making repairs, the buyers funneled the extra money into sham remodeling companies, and then into their own pockets.

They then walked away with the money, not making a single payment on the loans. But that's only one example of the types of mortgage fraud that exist. "There's no single model for mortgage fraud," Birnbaum said. "Mortgage frauds can take a variety of forms." Birnbaum said that "at least some cases involve artificially inflated appraisals.

These appraisals may result in purchases of homes by people who cannot easily service the mortgage debt — and certainly not after an adjustment in the rate of their adjustable rate mortgages. This, in turn, contributes to the rate of default and foreclosure." Or the inflated appraisals may allow a fraudster to buy a house for market value and then sell it, based on the inflated appraisal, for a much higher price (sometimes 100 percent more) and pocket the difference.

The buyer, often a victim of the housing frenzy, is left holding a huge mortgage on a house that isn't really worth what he thought it was. "At some point, someone has to pay the piper," Birnbaum said. "That may be the last buyer in the series of fraudulent transactions, left with an unaffordable mortgage and an unmarketable house when the loan rate adjusts."

Birnbaum said that in his experience, the purpose of the fraud is often to sell to an unknowing victim and pocket the profit, or to use the artificially valued house to inflate the value of other houses in the area (which the fraudsters will then sell for a profit). Another mortgage fraud scheme, Birnbaum said, is particularly common in wealthy neighborhoods. "A fraudulent buyer will take out a no-down-payment loan to purchase a home, say for $2 million.

He'll then make minimal repairs — investing, say, $100,000 to make the home appear more expensive, get an artificially inflated appraisal, and resell the home for $4 million. Then he pockets the $1.9 million profit." Flipping — the process of buying a home, fixing it up, and reselling it for a profit — is not illegal. But the line between flipping a property legally and engaging in fraud is a thin one.

"What makes property flipping illegal is that the appraisal information is fraudulent," the FBI report says. A number of high-profile scams involved fraudsters conning lower- and middle-income individuals into "lending" their names and social security numbers — sometimes in exchange for a stake in an "investment club" and other times in exchange for a cash payment, usually between $300 and $1,000.

The common denominator, as in many fraud cases, is that the duped individuals are left holding mortgages they can't afford, sometimes on properties for which they do not even have the keys. Mortgage fraud is often "like a Ponzi scheme" Birnbaum said, with one buyer profiting off of the investment of the next buyer. The last buyer is then left holding the mortgage, typically much larger than the property is actually worth.

Whether mortgage fraud schemes involve borrowers who could never afford to make payments on the mortgages in their names or borrowers who never intended to make the payments, it's no surprise that the homes fall into foreclosure. Either way, the mortgage lender — or the institutional investor who purchased the mortgage — is a victim, too.

It's the economy

What was so different about the market since 2002 that mortgage fraud cases have risen so dramatically? "To paraphrase former President Bill Clinton," Sanders said, "it's the economy." "Fraud is not causing foreclosures; it's the downturn in the housing market that's causing foreclosures," Sanders said. "Fraud simply increased the number of borrowers who shouldn't have had mortgages in the first place."

Those are the borrowers whose homes fall into foreclosure when the housing market cools. According to the FBI report, "higher housing prices tempted borrowers to commit fraud for property in order to qualify for a mortgage loan. Also, mortgage fraud perpetrators likely seized the opportunity to take advantage of the relaxed lending practices to commit fraud for profit." Why did that happen?

The hot housing market upped the demand for mortgages. "Some lenders were processing loans very quickly," Sanders said. "Anytime this happens, underwriting standards (and even common sense) can fall by the wayside in the mortgage market." But, he said, "fraudsters are becoming quite sophisticated and it could be that no amount of underwriting can prevent it."

What to do

Events like rapidly rising rates of foreclosure often spur lawmakers to create new legislation to prevent a repeat occurrence — or to bail out the victims, such as recent actions by Congress. But Sanders hopes that the increases in mortgage fraud don't spur another bout of government intervention. "I certainly hope that legislators do not 'better regulate' the market. Government intervention often yields unintended consequences, such as the end to subprime lending altogether," he said.

Instead, Sanders thinks the market will find its own remedies. "First, mortgage brokers and lenders should be required to post capital to cover expected losses on any mortgage sold into the private label market," Sanders said. Mortgages sold into the private label market are loans that are pooled into securities called asset-backed securities, or ABS (sometimes also called mortgage-backed securities), and sold on the secondary market to investors.

When loans in these pools go into foreclosure, the investors in the ABS lose. Second, Sanders said, mortgage brokers and lenders should be required to assume some of the risk inherent in mortgage lending. He recommends that mortgage brokers and lenders hold the riskiest of the ABS bonds, called first-loss bonds (when a borrower defaults, the losses on the default are first taken away from the principle that was to be received by the first-loss bonds).

"That way," Sanders said, "mortgage brokers and lenders will be more careful about finding borrowers and lending to them." In the end, the largest cause of defaults and foreclosures is the fact that the housing boom allowed many borrowers to take out mortgages that they couldn't realistically afford in the long term.

But the evidence showing a connection between defaults and foreclosures and fraud is clear. While fraud doesn't cause foreclosures, the same market conditions that allowed borrowers to buy too much house also allowed fraudsters to profit on the backs of innocent — or at least unwitting — buyers and unknowing investors in asset-backed securities.

"I think that we will find a large, perhaps even majority (though not vast), of borrowers who are defaulting are either fraudulent in some way or simply had no business being in real estate, or at least not with that expensive of a property," Sanders concluded.

Bottom Line:

• The public perception is that foreclosures usually affect hardworking families down on their luck, but experts see a connection between foreclosures and mortgage fraud.
• Since 2002, as foreclosure rates have risen, the number of mortgage fraud cases under investigation by the FBI increased 237 percent.
• Mortgage fraud includes fraud for property, which involves a borrower misrepresenting information in order to get a loan for a home to live in; and fraud for profit, which "often involves multiple loans and elaborate schemes perpetrated to gain illicit proceeds from property sales."
• Mortgage fraud schemes include buyers and sellers artificially inflating appraisals; buyers taking large seller refunds and then walking away; and investment club schemes that borrow or buy individuals' names and social security numbers to take out loans.
• The hot housing market made it easier to commit fraud. Now, we're seeing the inevitable end-result of that fraud: high rates of foreclosure.
• Experts suggest that the market will self-regulate to curb fraud in the future, and that legislative intervention could have unintended negative consequences.

Finance Real Estate