WORD ON THE STREET: I was living in Atlanta in the summer of 1996 when I first became aware of mortgage fraud. Houses in my upscale neighborhood that had been sitting on the market for as much as two years finally began to sell, and I heard rumors that the purchasers were leaving the closing table with large amounts of cash.
Neighbors began to complain to the homeowners' association that the new owners of these houses were not maintaining the yards or the properties, and expressed concern because the new occupants were "different": They actively avoided contact with the neighbors, didn't seem to have jobs or furniture, were covering garage windows with paper and had a lot of late-night visitors. Then, a title attorney neighbor told me that he had been working with an IRS agent and an investigator from the state Department of Banking and Finance who were investigating these sales.
Since he had a conflict of interest that prevented him from continuing that work, he asked me to get involved. I began to research the sales history of these properties and discovered that a handful of people were involved in all of the unusual sales in my neighborhood, that they were buying and re-selling these houses on the same day with price increases of up to $300,000, and that they were doing this in communities throughout metropolitan Atlanta.
That's when I discovered illegal flipping.
In a typical illegal flip, the perpetrator enters into a contract to purchase a property at or below the current asking price. Before the perpetrator closes on his purchase, and with no or only cosmetic improvements, he obtains an appraisal that shows a substantially higher value. He then enters into a contract to resell the property to a "straw" buyer.
The straw, whose loan application may misrepresent income, employment, assets and intended use of the property, obtains a loan to purchase the property at the higher price. Both transactions are closed simultaneously or only a short time apart, which enables the proceeds from the straw's mortgage loan to be used by the perpetrator to close his purchase of the property at the lower price. The perpetrator's profit is the difference between the actual purchase price and the inflated price to the straw.
The value of the property securing the lender's loan is its protection against loss. If a property is overvalued at origination, the lender will suffer a loss if it has to foreclose, unless property values have risen enough in the interim to match the overvaluation. But even without an eventual foreclosure, overvaluation can have a significant effect on a metropolitan region.
Fraud's effect on metropolitan housing prices
Since the existence of mortgage fraud was not widely known in the mid-1990s, flip sales were not recognized as illegal transactions, and the inflated values were entered into county deed registries, multiple listings, and appraisal and tax assessment databases and were published in the local paper's weekly real estate section. Once these fraudulent valuesÂ became part of the public record, the perpetrators and complicit (or incompetent or inexperienced) appraisers were able to use them as comparable sales to facilitate additional flips in the immediate area and in ever-widening arcs throughout an entire region.
For example, an investigation conducted by the Sarasota Herald Tribune into real estate sales in Florida between 2000 and 2009 identified more than 50,000 suspicious flips – a number that one expert said wasn't "even close to the bare minimum"- for which lenders granted mortgages worth $10 billion. The Herald Tribune noted that these flips began in urban centers and then "radiated into the suburbs and surrounding communities."
While flipping in single-family neighborhoods was immensely profitable for the crooks, flips involving condominium and condo-conversion projects allowed them to take profits into the stratosphere. Why bother with the hassle of flipping one house at a time when you could buy an entire apartment project, convert it to condos (or just represent that they had been converted), or buy flip-ready units from developers of new projects – and then, through real estate investment clubs and hype, flip 100 units at inflated prices and walk away with millions of dollars? That's what happened in a scheme that ran from 1997 through 2004 in Chicago.
In that case, the perpetrators bought and "converted" at least 32 apartment buildings. They recruited an appraiser to inflate the units' values, recruited straw buyers with promises of cash back at closing and, through their mortgage brokerage companies, prepared and submitted loan applications that materially overstated the buyers' income and assets. The defendants obtained $27 million in loans and were ordered to pay restitution of $8 million. While there is no way to ascertain the magnitude of illegal flipping and price speculation in the condo market, Radian Guaranty, the No. 3 mortgage insurer in the country, quit writing policies for attached condominiums in 2009.
Illegal flipping may have been given a boost in 2002, when HBO's wildly popular series "The Sopranos" featured a storyline based on an actual scheme in Harlem where corrupt Realtors purchased run-down buildings, over-appraised them and ‘flipped" them to local nonprofit groups that were eligible for HUD 203(k) rehabilitation grants. In any event, rising prices, low interest rate and the promise of a fast buck through "no money down and cash back at closing" programs hawked by late-night infomercial gurus attracted the attention of "specuvestors," many of whom, especially those recruited by perpetrators at educational seminars for novice investors, were engaged in illegal flipping.
Flipping became such a phenomenon that in 2005, the Arts and Entertainment channel debuted "Flip This House," which quickly became its most popular show, and TLC introduced "The Property Ladder" to showcase the legal riches to be had through this form of investing. Even a hedge fund got involved. While not all flipping is illegal, the rise in illegal flipping was dramatic and particularly intense in Florida, which the FBI in fiscal year 2009 ranked in the top 10 for same-day, 30-day and 60-day property flips.
The effect of fraudulent flipping on a region's housing prices is magnified by the fact that these illicit sales tend to cluster geographically. Clusters of flipped properties, whether in condo developments or single-family neighborhoods, push legitimate sale prices within a one-quarter mile radius by as much as 4%, and can drive the market for these reasons:
- Real estate agents rely on published listing and sales prices to help them determine the market value of their new listings. If they do not live in the area and do not recognize that the reported values were inflated, the listing prices they suggest to new clients will incorporate the fraudulent inflation.
- Appraisers also rely on published and recorded sales values to help determine the value of the properties they are analyzing. If they do not recognize that these previous sales were collusive and inflated, and they are selected for use as comparable properties, the appraisal will incorporate the fraudulent inflation.
- Lenders rely on published and recorded sales data when evaluating the accuracy of the appraisals submitted in support of a loan application. If the published data supports the value, the price will be accepted, the mortgage will be approved and another sale will be recorded.
- In Georgia, once a certain number of increased prices are recorded, the neighborhood will be reassessed for property-tax purposes. If the assessors do not recognize the existence of a fraud cluster and accept the values as a sign of appreciating values, tax assessments will increase. The difference in growth in tax assessments between areas with fraudulent transactions and those without increases over time.
- Investors and lenders sometimes use tax assessments to help them judge whether a given property is worth the asking price.
The end result is that a fraud premium will be charged to subsequent purchasers and all of the residents within the neighborhood.
While there were many reasons that housing prices rose so dramatically during the boom, years of fraudulently inflated values and their upward pressure on prices was certainly an important factor. Combined with low interest rates, and consumer and property investor demand, markets across the country experienced several years of sequential double-digit – and, in some cities, triple-digit – price appreciation in the early 2000s.
At some point, housing ceased to be viewed by the public primarily as a place of shelter and came to be viewed as an ATM for owners with increasing equity and as a means by which anyone could become wealthy. The latter attitude was reflected in the government's pressure on lenders and Fannie Mae and Freddie Mac to increase their lending to high-risk populations in order to boost their homeownership rates and enable them to achieve financial security. With housing prices apparently going nowhere but up, demand for residential mortgage-backed securities was intense, and trillions of dollars flooded into the market.
Demand from the secondary market drives underwriting standards, because lenders must sell their loans to maintain their capital and reduce reserve requirements. To meet the government's directive to increase lending, meet the demands of consumers and shareholders, and to stay competitive, the secondary market relaxed its underwriting requirements with respect to creditworthiness (as measured by FICO scores) and loan-to-value (LTV) ratios which, in the 1990s, required a down payment of as much as 30% of the purchase price. Unfortunately, the statistics underlying the FICO scores did not have a sufficient history to provide valid statistics of borrower performance in declining economic environments, and few people thought that housing prices would collapse.
Since workers' median total compensation had risen by only 7.2% between 2000 and 2005 – and most of the rise was due to benefits, not wages – housing affordability was a serious issue for millions of potential borrowers. The relaxation of underwriting standards meant that products like stated-income loans, which had been developed for a niche market of high-net-worth and exceptionally creditworthy self-employed borrowers, were now available to W-2 employees.
What no one realized at the time was that mortgage fraud, which was widely perceived to be negligible as a percentage of origination volume, would skyrocket, because fraud moved en masse from the realm of professional criminals and speculative investors who commit "hard fraud" (or fraud for profit) to the realm of "soft fraud" (or fraud for property).
Many lenders, some fraud experts and the Federal Bureau of Investigation (FBI) make a distinction between fraud for profit and fraud for property. The industry makes this distinction because frauds for property are perceived to be "one-offs" that never default because the borrower is trying to buy a home and he fully intends to repay the mortgage.
While fraud for property looks like an isolated incident when viewed at the individual loan level, if you analyze loans involving the same broker, real estate agent or appraiser, you may discover that they are all part of what Chris Swecker, former assistant director of the Criminal Division of the FBI, calls "the malignant network" of professional enablers who encourage borrowers to go along with the lie, or who commit it on their behalf, and who make a commission each time that a misrepresented loan closes. Seen from that perspective, it is all fraud for profit.
When the industry accepts "soft" fraud, so long as the mortgage gets paid, it encourages people to lie. So the mortgage broker tells the borrower that it's OK to exaggerate his income a bit because "the lender doesn't care what goes on the application, so long as you keep the payments current." The borrower fudges his income, the loan closes and the broker gets paid.
But it's clear that the next borrower, who's a delivery guy, can't afford the payments on the house he wants. So, to get his commission, the broker tells the borrower he can afford it, because he can get 100% financing and the interest rate is only 2%. What he doesn't make clear to the borrower is that the 2% rate is only good for the first three months. Then, knowing that investor guidelines prohibit the lender from verifying the borrower's income, he has the borrower sign a blank application and fills in the income for him. But instead of putting down an income that is reasonable given the borrower's employment and experience (which was the requirement for stated-income loans), he puts down "manager" for the borrower's job and puts down whatever income it takes to get him qualified. The loan is fraudulent, and the broker profits because it closes anyway.
It's not just mortgage brokers who facilitate what only appears to be fraud for property. Take the real estate agent who sees that the borrower won't have enough money to bring to the closing table. To keep the deal alive, she asks the seller to give the borrower what he needs and says that if they increase the sale price on the contract, he'll get his money back at closing, because the higher price means a bigger loan. The agent rationalizes that the deal isn't fraud, because nothing's really changed – moving money from column A to column B is just "creative financing," right?
Wrong. Borrowers who make a financial investment in a property are less likely to walk away from their obligations or to let the property go into foreclosure – and this kind of structuring can take a loan from a 95% LTV to an undisclosed 110% LTV. The higher risk posed by this borrower was hidden from the lender, and the lender was deprived of the opportunity to increase the interest rate to account for the higher risk or to decline the loan altogether. That's fraud. And seeing that the agent structured the deal to make sure she'd get her commission, it's clear that it's fraud for profit.
It all worked as long as housing prices kept rising. Borrowers could refinance with cash out if they needed to pay some bills, and if they got into real trouble, they could sell for at least what they owed. When they did go into default, those rising prices shielded lenders from most, if not all, of the loss. People who had lived in their homes for years could tap their accumulated equity to pay for their children's college education or buy a new BMW or take a cruise. Housing drove the national economy, and the "wealth effect" kept its engine running.
But in the second quarter of 2003, interest rates began to climb, and mortgage origination volume peaked. Although new housing starts jumped at a faster rate than at any time since 1986, the growth in households was at its lowest point in 40 years, creating excess supply. By 2005, housing prices were beginning to fall, foreclosure rates began to jump across the country and the subprime mortgage meltdown began. Merit Financial, a large subprime lender, was the first of hundreds of mortgage banks to fail. By August 2007, foreclosures were at record levels, the financial markets had seized up in the liquidity crisis, and the rest, as they say, is history.
Ann Fulmer is vice president of business relations for Interthinx Inc., a Verisk Analytics company. This article is adapted from testimony Fulmer gave Sept. 21 before the Financial Crisis Inquiry Commission. Her full testimony can be found here.