Monday, March 26, 2007

Unwinding the Fraud for Bubbles

by Tanta on 3/26/2007 08:10:00 AM

There is a tradition in the mortgage business of distinguishing between two major types of mortgage fraud, called “Fraud for Housing” and “Fraud for Profit.” The former is the borrower-initiated fraud—inflating income or assets, lying about employment, etc.—that is motivated by the borrower’s desire to get housing (not the same thing as “real estate”), by means of getting a loan he or she doesn’t actually qualify for. It may require some collusion by the loan originator or appraiser, but it may not. It is usually the least expensive kind of fraud to lenders and investors, since the goal is getting (and keeping) the property, so the borrower is at least usually motivated to make the payments. The problems come about, of course, because these borrowers failed to qualify honestly for a reason. Borrower-initiated fraud loans may be considered “self-underwritten,” and such loans do have a much higher failure rate than the “lender-underwritten” ones. Their only saving grace is that the lender tends to recover more in a foreclosure than in a fraud for profit case. Penalties to the borrower rarely ever come in the form of prosecution; losing the home and becoming a subprime borrower for the next four to seven years—with the credit costs that implies—are the borrower's punishment.

Fraud for profit is simply someone trying to extract cash—not housing—out of the transaction somewhere. If it is borrower-initiated fraud, it’s not a borrower who wants a house; it’s a borrower who wants to flip a piece of real estate or launder money or in some other way grab the cash and leave the lender holding the bag. Most of it, however, is initiated by a seller, real estate broker, lender, or closing agent (or all of them in collusion). It generally requires additional collusion by bribable appraisers, although it can certainly be initiated by a corrupt appraiser looking for a kickback, or can merely take advantage of a trainee or gullible appraiser. This is the flip scam, straw borrower, equity skimming, misappropriation of payoff funds, identity theft kind of fraud. It may not be as common as fraud for housing, at least in some markets, but it’s much, much more expensive to the bagholder. At minimum, the fraud-for-housing borrower wants to take clear, merchantable title to the property and maintain it at an acceptable level. That’s either unnecessary expense or (in the case of title) a hurdle to be gotten over by the fraud-for-profit participant.

The problem with this traditional distinction is that, recently, we seem to have an epidemic of predator meeting predator and forming an alliance: a borrower willing to commit fraud for housing meets up with a seller or lender willing to commit fraud for profit, and the thing gets jacked up to a whole new level of nastiness. Consider the “cash-back purchase” scam we keep hearing about: that’s a perfect example of a borrower who wants a house, a seller who wants an illegitimate profit, and a broker or appraiser or settlement agent who wants a kickback all conspiring to defraud the lender: it’s hard to call it either fraud for housing or fraud for profit because it’s both.

What, in the past, might have kept the two fraud types separate—the fact that a normal borrower would not see it in his or her best interest to borrow more money than necessary to pay more than fair market value for a home—disappeared in the mania of buy-more-borrow-more and pass the “screwing” on to the next sucker who buys it from you. As soon as borrowers became convinced that paying substantially more for the property than the current seller did just a few months ago is always and everywhere a good sign, you could no longer rely on the “rational agent” borrower to at least limit his fraudulent tendencies to lying on the loan application in order to get away from apartment life. You actually see them agreeing to sign “secret” sales contract clauses that will require them to borrow more than the fair market value of the property, and then give the excess loan proceeds to someone who won’t be helping to repay the debt. Or accepting “down payment assistance” from an interested party, in order to buy a property whose price is inflated by the amount of the “assistance.” That this doesn’t seem to strike them as self-defeating tells you a lot about how uninformed or misinformed we are, how far into a true mania we’ve gotten. In the old days, you used to be able to count on RE frauds to display basic self-interest, naked or camouflaged.

Telling the difference between the victims and the victimizers, the predators and the prey, and the fraudulent and the defrauded, is getting a lot harder when you have borrowers not required to make down payments able to lie about their incomes in order to buy a home the seller is overpricing in order to take an illegal kickback. The lender is getting defrauded, but the lender is the one who offered the zero-down stated-income program, delegated the drawing up of the legal documents and the final disbursement of funds to a fee-for-service settlement agent, and didn’t do enough due diligence on the appraisal to see the inflation of the value. Legally, of course, there’s a difference between lender as co-conspirator and lender as mark, utterly failing to exercise reasonable caution, but it’s small comfort when the losses rack up. With tongue only partially in cheek, I’m about to suggest a third category of fraud: Fraud for Bubbles.

Everybody likes to hear lurid or merely entertaining stories from veterans of the Loan File Wars about weird fraud cases.
A recent CNN piece quotes a Clayton analyst as having found a mortgage note signed by “M. Mouse” (hat tip, Andrew!). How did anyone miss that? I have my own war stories, but to be honest with you, I’m still hesitant to share much about them. I realize that in the internet era it’s a losing battle, but still: every time you talk publicly about a fraud scenario, you’re giving someone an idea—either to try to perpetrate the scam, or to evade the tricks people like me use to find their traces in a loan file. I can remember training loan officers to look carefully at a W-2, and to recalculate the withholding taxes, since so many fakers of W-2s would either forget to do that, or wouldn’t do it right. Imagine how distressed I was when one of my loan officers went home and fixed that bug in his fake W-2 template.

What I want to do instead is to make some general observations about why so much fraud is missed by lenders. Obviously, there are lenders who are colluding with borrowers, or who are defrauding investors or borrowers or some other party; that’s either “fraud for housing” or “fraud for profit” or the new hybrid of the two. To me, that’s the least interesting problem (although it’s an important one). I want to talk about the extraordinarily widespread “insufficient caution” problem in this industry: the lenders who are just too easy to defraud. It seems to me that this problem gets to the heart of a lot of the issues we keep talking about here: toxic mortgage products, loose standards, out of control home price bubbles, and the endless chain of “disintermediation,” outsourcing, temping, dumbing down, fragmenting, and otherwise morphing of the business of home mortgage lending into a big fraud magnet. It often seems as if the industry just stopped believing that it could ever really be at risk.

My theory of the Fraud for Bubbles is, in a nutshell, that it isn’t that lenders forgot that there are risks. It is that the miserable dynamic of unsound lending puffing up unsustainable real estate prices, which in turn kept supporting even more unsound lending, simply masked fraud problems sufficiently, and delayed the eventual “feedback” mechanisms sufficiently, that rampant fraud came to seem “affordable.” So many of the business practices that help fraud succeed—thinning backoffice staff, hiring untrained temps to replace retiring (and pricey) veterans, speeding up review processes, cutting back on due diligence sampling, accepting more and more copies, faxes, and phone calls instead of original ink-signed documents—threw off so much money that no one wanted to believe that the eventual cost of the fraud would eat it all up, and possibly more.

On the one hand, everyone does know that you can’t run a mortgage lending business with the same level of anti-fraud measures they use at Domino’s to keep from wasting pizzas on prank calls. On the other hand, we are starting to see—and I predict we will start to see a cascade of—stories of lenders with such lax internal controls that if they did remember the risks, you have to conclude they just tried to repress those memories. Go back and read the Cease and Desist order for Fremont. Does it sound like an operation that believes in the reality of risk? Is everyone still convinced that “hey, we sell the risk to someone else” still means squat when it comes to fraud and misrepresentation?

I said I didn’t want to get into too much detail, but I’ll tell you right now that some kinds of fraud are so easy to spot it’s pathetic. You don’t need to have the borrower sign “M. Mouse” on the note. Asking for income documentation, ordering tax return transcripts prior to closing, requiring settlement agents to fax the final purchase contract to the lender for approval prior to close, enforcing arm’s-length transaction rules: this stuff isn’t hard to do, and it will not catch everything but it will sure catch a lot, and it’ll catch it before you close, which is really the cool part. So what’s the response whenever you suggest these things? It costs too much. It takes too long. It drives up transaction costs and therefore puts a drag on home prices. It “unfairly” takes its bites out of our favorite new borrower segment: first time homebuyers, self-employed entrepreneurs, real estate “investors.” It makes loans harder to sell and securitize instantly and cheaply. It makes it harder for an originator to make those representations and warranties based on the bliss of ignorance. It could bring down the whole secondary market as we know it!

So I’ve heard all that before; you need not hand it to me again in the comments. You need, if you are inclined to find any of that compelling, to tell me in somewhat more detail how your cost/benefit analysis works. You can always find one anecdote of one legit, deserving borrower who wouldn’t get a loan if I controlled for fraud as much as I’d like to. You can’t always get me to believe that it’s worth it to originate or buy 49 fraudulent loans in order to get that one good one. You certainly can’t get me to believe that I’m the one who is risking everyone’s “confidence” in the secondary mortgage market.

I suspect most of us feel, generally, that fraudsters—borrowers, lenders, anyone else—who get burned just got what they deserved. True enough. But lending fraud, like warfare, creates quite a bit of “collateral damage,” in all senses of the term. Those honest homeowners watching their neighborhoods collapse after the fraud-bombs finally detonated are not probably very comforted by the fact that it wasn’t their fault. So when we debate the question of potential “bailouts,” we keep running up against the question of who needs or deserves the bailout. If you want to do something to assist the honest homeowner who bought with an 80% loan but is now upside down because of the neighbors’ fraud, how do you do that without, inevitably, helping out the lender who facilitated that fraud, too? If you want to do something to protect the stability of the honest lenders, how do you do that in a way that doesn’t, inevitably, also protect the scumballs and incompetents?

Getting into a bubble is easy. Getting out?

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