Weak housing markets appear to encourage mortgage fraud. Typically, fraud associated with home purchases requires multiple perpetrators, one of whom is the ringleader. While a lender is always the victim, another lender may be involved as a perpetrator. An appraiser, home seller and home buyer are always involved, perhaps innocently, perhaps not.
Here is a great example provided by one of my readers. He had his house listed for sale for six months with no takers at the list price of $700K, reduced from over $800K, and finally took it off the market. Shortly thereafter, he received a letter offering him $675K, contingent on his getting an appraisal for $750K. (The letter-writer was the ringleader in this case.) The homeowner did get an appraisal for $750K, perhaps because of his high asking price earlier, and the tendency for appraisals to lag the market.
The ringleader explained to the homeowner how the deal would go down. The critical factor was 100 percent financing for the full amount of the appraisal. Of the $750K obtained from the lender, $675K would go to the seller, $20K to settlement costs, $20K to the ringleader, and $35K to help the buyer with the payments.
One major element in the fraud is concealment of the true price, which is $675K. The standard lending rule is that the loan amount is based on appraised value or sale price, whichever is lower. Hence, the sales contract and loan documents have to show a $750K sale price, which makes it a fraud.
The ringleader trolls for buyers with ads that do not mention price or loan amount, only monthly payment. The advertised payment, furthermore, is below the monthly mortgage payment on the $750K loan by the amount of the ringleader’s monthly contributions from the $35K, which has been extracted from the sale price for that purpose.
Who in his right mind would borrow $750K to purchase a house worth $675K? Only those who are payment myopic, meaning that they make purchase decisions based on monthly payment rather than price. There are many, especially among first-time home buyers, most of whom have been paying rent for their housing. In making decisions about renting, it is appropriate to compare the quality of the accommodation with the monthly rent, and many carry that mindset over to home purchase, not realizing that home ownership is a different game altogether.
On the face of it, these borrowers should not qualify. They are putting no cash in the transaction — even the settlement costs are paid for them — and they can afford the payment only with the help of the supplement paid by the ringleader. How does the ringleader find a lender who will qualify them?
I don’t know the answer, but my speculation is that the lenders who originate these loans are co-perpetrators who knowingly accept falsified documents. They don’t hold the loans, and therefore don’t take the risk of default and foreclosure. The risk is passed first to wholesale lenders who buy the loans from the originator, and then to the ultimate holders, which are likely to be investors in mortgage-backed securities and the entities that guarantee the securities.
Loan originators who sell loans in the secondary market can be required to repurchase loans that quickly go into default. Usually these buyback arrangements don’t extend more than six months; however, beyond that the originator is off the hook.
In the case at hand, the ringleader protects the lender against buybacks by selecting borrowers who can carry the payment with the help of the supplement. So long as the supplement lasts, which will be one to two years, the likelihood of default is low. When the supplement stops, the default probability will jump, but that is no longer viewed as the responsibility of the loan originator.
This is a tempting deal for home sellers who are having trouble getting their price. When a sale is consummated, they get their money and are out of it. Because they sign off on falsified documents, however, they are participants in fraud.
It is also tempting for buyers who see an opportunity to acquire more house, perhaps far more, than they could otherwise afford. The down side is that they must also sign off on falsified documents, and they risk defaulting on the mortgage.
Buyers will default after the supplement ends unless either a) their income rises to the point where they can carry the payments on their own, or b) the house appreciates enough that they can sell at a price that covers the mortgage. A default would seriously damage their credit and delay any plans to become homeowners legitimately.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.