Saturday, December 22, 2007
The Wall Street Journal had a front-page article (here) about a mortgage fraud scheme in Atlanta that implies a substantial portion of the foreclosures occurring around the country involve some type of fraud by an assortment of buyers, appraisers, closing attorneys, mortgage brokers, and assorted scam artists. The title is "Fraud Seen as a Driver in Wave of Foreclosures," as if the record number of foreclosures would be significantly less if there was not any mortgage fraud. The particular scheme in Atlanta seems awfully simple, despite claims by lender Bear Stearns, which suffered over $6 million in losses, that it is quite "sophisticated." The scheme involved falsified loan applications, property appraisals, and financial statements, with people posing as wealth borrowers to purchase homes and divert a portion of the loan. Even better, many of the loans required no documentation of the borrowers' financials or employment, making this type of loan especially ripe for fraud.
Is this really some new form of fraud that somehow crept into the system and caught lenders unaware? Please! For those of us with a memory that stretches back fifteen to twenty years, there was this thing called the S&L crisis in which a number of banks in Texas, New England, Florida, California, and any place else where real estate boomed collapsed due to bad loans for homes, condo developments, and smaller commercial properties. What is going on now is not really much different from what occurred back in the late 1980s that led to many banks having to write off billions of dollars of loans on properties that went into foreclosure. Was the S&L crisis due primarily to fraud? Certainly not, although there was more than enough shady dealings to account for a sizable number of cases.
We are, if you will, experiencing déjà vu all over again, in the words of Yogi Berra. The names and titles are different, but the conditions that led to the increase in mortgage fraud and the types of industry practices that allowed it to flourish are pretty much the same. Let me highlight a few of the similarities I see:
- Loan Documentation: Back then, they were called "No-Doc" loans, and now they are called "Stated Income" loans. Either way, the borrower tells the lender what his/her/its/their assets and income are, and there is no verification by the lender, who simply wants to close the loan and move on to the next transaction. Will people lie to get a loan, or perhaps to steal? If you will allow me to quote a teenager in my house: "DUH!"
- A Rising Tide Lifts All Boats: Have you heard this one: the housing market is booming, prices are skyrocketing almost overnight, with bidding wars breaking out and sellers getting multiple offers, and banks lending freely to take advantage of the high volume of applicants. Welcome to the late 1980s in Boston, Silicon Valley, Washington D.C., Los Angeles, etc. Much like what we've seen in the sub-prime market, increasing home values back then meant no one really paid much attention to whether the borrower could meet the payment schedule because refinancing was just a phone call away . . . until the values started dropping. For those of us who bought houses in the late 1980s, at least in the D.C. suburbs, we didn't get back above water until 1994 or thereabouts.
- Inexperienced Lenders Jump Into the Market and Get Burned: The WSJ story talks about how Bear Stearns' Alt-A mortgage group that it had just acquired got burned on these "Stated Income" loans, and that the firm had no fraud detection measures in place. Well, who cares about a little bit of truth-shading when the loan can be refinanced or the house sold to the next willing purchaser (nee sucker). How did we get an S&L crisis anyway? Well, these sleepy financial institutions had to start competing in areas where they were inexperienced, lending to developers with no history rather than those dull, 30-year fixed rate mortgages to local homeowners who would pay off their mortgage and then retire. There was no "juice" in those loans, so the pressure was on these S&Ls to expand into new areas, just like lenders over the past few years who had to show exponential growth to feed the Wall Street quarterly numbers beast. The only real difference I can see is that the criminal charges back then were mostly under 18 U.S.C. Sec. 1344, the bank fraud statute, while the frauds today involving mortgage companies will probably require charges under the mail and wire fraud statutes -- no biggie to a federal prosecutor.
- Grow Market Share: This plays off the previous point about inexperienced lenders, and the fact that even experienced bankers got caught up in the rush to make more, and riskier, loans so they too could keep Wall Street happy. Washington Mutual has been around a long time, and survived the S&L crisis just fine, but it is now having all sorts of trouble because of its various mortgage products. Ditto banks like First Horizon, Regions Financial, and Sun Trust. Some of their problems are traceable to mortgage securities, which have spread the pain much wider than the more localized issues that triggered the S&L crisis, but many of those institutions are also increasing their loan loss reserves for mortgages they made. No one rewards a conservative lender when it is a boom, and that was certainly the case both in the 1980s and over the past few years. Whoever survives the shakeout will do rather well, but it's too early to declare the winners and the losers. Does anyone remember when Citicorp's stock dropped under $10 back in the early 1990s? Wanna bet whether that will happen again? Don't make the mistake of thinking that banks learn from the past.
- These New-Fangled Loans Were Used to Lure in Gullible Borrowers: For those who think "negative amortization" is a new phenomenon in mortgage loans, that was proclaimed as an example of lender overreaching back in the mid-1980s after interest rates were uncapped by the Garn-St Germain Act. Borrowers have fallen for the siren song of the slick mortgage broker for decades now, and these aggressive loans are nothing more than the adjustable rate mortgages that trapped so many borrowers in the late 1980s and forced them into foreclosure. Does anyone really think mortgage brokers were more ethical twenty years ago? I agree that the pain will be much wider this time because of the larger number of sub-prime borrowers who have little chance of recovering financially, but the fact that more people are being hurt does not really make it any different.
Back in 1990-1992, the Department of Justice formed Task Forces to pursue investigations into bank and mortgage frauds in Texas, New England, and San Diego. I was hired to work in the New England group, and got to spend three years looking at loan documents, financial statements, etc., from loans made by collapsed banks. There were rotten apples in the banking industry then, just as there was more recently, albeit with different names . We have not reached the level of bank closures that was seen in 1991, when S&Ls in Texas and savings banks in New England were closing on what seemed like a weekly basis, and let's hope that doesn't happen this time around.
Fraud always comes to the surface when the housing market collapses, because the acceptable excesses of a boom became the crimes of the bust. Fraud is a crime of opportunity, and the mortgage scams that are coming to light occur when the conditions are right, such as impatient lenders who will lower lending standards to show a growing book of business. The increase in mortgage fraud cases is more a symptom of the rise of the housing market than a cause of the increased foreclosures being seen these days. (ph)