Monday, June 11, 2007

Cash-Back Mortgages

The NY Times has an interesting Freakonomics piece on cash-back mortgages.  An excerpt:

[A]s he interviewed mortgage brokers, real estate agents and bank loan officers, he heard regular mention of a mysterious kind of deal in which the seller gave the buyer a cash rebate without noting this transaction in the mortgage paperwork. (It is illegal for buyers and sellers to transfer cash or assets without properly notifying the lender.) Of course, none of the people that he interviewed copped to this practice. But sometimes the signs of a cash-back transaction were, quite literally, out in the open for all to see, on banners hanging from for-sale properties or in printed real estate ads.

How does this kind of deal work?

Pretend that you want to buy a house that costs $200,000 but don’t have $20,000 to make the 10 percent down payment that would get you a decent mortgage. The seller’s real estate agent offers a solution: let’s make the official purchase price $220,000 instead of $200,000, he says — but in return, the seller will give you $20,000 in cash. This rebate will be a separate transaction, the agent explains, which doesn’t need to be written into the mortgage paperwork. (A seller can legally offer a cash-back incentive, but it would have to be reported to the bank — which would negate the advantage of having the bank think that the buyer already has the cash.)

Voilà! Suddenly you have the $20,000 in cash necessary to get a good mortgage, and the seller still nets his original price of $200,000. The only difference is that the bank records the sale of the house at an inflated $220,000. And, instead of borrowing 90 percent of the value of the house, you have in fact borrowed 100 percent. “In short,” Ben-David writes, “a buyer can purchase the property with no down payment.” . . .

Having isolated the suspicious transactions in the data, Ben-David could now examine the noteworthy traits they shared. He found that a small group of real estate agents were repeatedly involved, in particular when the seller was himself an agent or when there was no second agent in the deal. Ben-David also found that the suspect transactions were more likely to occur when the lending bank, rather than keeping the mortgage, bundled it up with thousands of others and sold them off as mortgage-backed securities. This suggests that the issuing banks treat suspect mortgages with roughly the same care as you might treat a rental car, knowing that you aren’t responsible for its long-term outcome once it is out of your possession.

Ben Barros

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