An article in eFinance Directory, citing the FBI 2006 Mortgage Fraud Report, reports that mortgage fraud played a role in as many as 70% of early payment defaults. The type of fraud wasn’t specified, but one assumes it was mainly overstatement of income. As the story notes:
A study of more than 3 million mortgage loans found that between 30 and 70 percent of early payment defaults are directly linked to misrepresentations in mortgage loan applications
Defaults are largely concentrated in ARM loans, but are present in nearly every lending sector.
Of the 10 states with the highest concentration of mortgage fraud, 7 of them rank in the top 10 states with the highest default rates.
Now this would seem to be a rather damning set of facts for those who believe that predatory lending played a significant role in the subprime mess. But as we’ll discuss, these two world views, the one that blames the borrower versus the one that blames the lender for the housing market woes, aren’t necessarily mutually exclusive.
Let’s start with first principles. Why do we need to assign blame at all? There are cases where moral considerations get in the way of efficiency. It’s more efficient to have heroin addicts switch their habit to the less pernicious methadone than cure them. And as Malcolm Gladwell illustrated in a New Yorker article, “Million Dollar Murray,” it’s cheaper to give those homeless who are chronic emergency room users apartments and 24/7 nursing care than have them run up hospital tabs.
But generally speaking, if moral considerations aren’t too much at odds with efficiency, we like to protect innocents and punish perps. That perspective in social policy goes back at least to the English Poor Law in 1832, which distinguished among those who could not work, those able to work but unable to secure employment (these two were the “deserving poor”) and vagrants who refused to work.
But unlike the Poor Law and its successors, it’s hard to put many of the borrowers and lenders in the subprime mess into tidy categories. Yes, there were clearly extremes where the borrowers knew they were pulling a fast one and where the lenders were duplicitous. But in many cases, the borrower and lenders were enmeshed, both aware that they were taking advantage of the liberties that the Brave New World of finance offered them.
Tanta at Calculated Risk has waxed eloquent on this topic. In an earlier post, “Unwinding the Fraud for Bubbles,” she noted:
…..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…
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.
Now back to the FBI’s 30% to 70% fraud estimate above. Given the many shades of grey involved in questionable mortgage practices, that statistic should be read as a starting point. Policymakers need to drill deeper into the data to get a more granular picture of what happened. The problem is, of course, that it isn’t easy (which means it is costly and takes time) and it’s also not clear how well any nuanced findings will be reported in the media. Stories of rapacious lenders, greedy speculators and chump borrowers play better than complicated stories where pretty much everyone bears some cupability.
Consider, for instance, that any case in which the borrower misrepresented his income would be considered fraud. We’ve already seen estimates that that took place in 40 to 60% of the subprime loans, which is consistent with the FBI’s range. Yet we have also read of cases in which the borrowers found that their income has been misrepresented by the mortgage originator. In the eye of the law, they would be the fraudsters, since they signed the mortgage document, but in most people’s eyes, they would be innocent.
Even if the lender was the party responsible for the income misrepresentation in only 5% of the income overstatements, its’ a big enough number to make a difference in policy policy solutions.
In a different post, Tanta made another astute observation about how the shift in liability from lender to borrower enabled borrower recklessness. She contrasts the process for lending to a self-employed person who has trouble verifying income. Number 1 is via a stated income loan; Number 2 is the traditional “full doc” approach, in which the bank notes that the debt-to-income (DTI) is considerably above the bank’s guidelines but is warranted for various good reasons.
…..what happens if it actually goes bad?
Well, with Number 1, it’s “clearly” the borrower’s fault. He or she lied, and we can pursue a deficiency judgment or other measures with a clear conscience, because we were defrauded here. We can show the examiners and auditors how it’s just not our fault….
With Number 2? There is no way the lender can say it did not know the loan carried higher risk. Of course, higher-risk loans do fail from time to time, and no one has to engage in excessive brow-beating over it, if you believed that what you did when you originally made the loan was legit. If you’re thinking better of it now, at least with Number 2 you have an opportunity to see where your underwriting practice or assumptions about small business analysis went wrong….
What the stated income lenders are doing is getting themselves off the hook by encouraging borrowers to make misrepresentations. That is, they’re taking risky loans, but instead of doing so with eyes open and docs on the table, they’re putting their customers at risk of prosecution while producing aggregate data that appears to show that there is minimal risk in what they’re doing. This practice is not only unsafe and unsound, it’s contemptible.
We use the term “bagholder” all the time, and it seems to me we’ve forgotten where that metaphor comes from. It didn’t used to be considered acceptable to find some naive rube you could manipulate into holding the bag when the cops showed up, while the seasoned robbers scampered…. You aren’t getting those stated income loans because lenders like to do business with entrepreneurs, “the backbone of America.” You’re not getting an “exception” from a lender who puts it in writing and takes the responsibility for its own decision. You’re getting stated income loans because you’re willing to be the bagholder.
Unless researchers and analysts get to the bottom of the behavior patterns and incentives that helped feed the explosion in risky mortgage lending, we won’t get the right sort of regulatory reform. There will merely be a few years of wound-licking, but the foundations will still be in place for the same bad practices to come back into play.
The devil lies in the details, but the media’s preference for simple and dramatic stories means that the real profile of the subprime lending problem may never get the airing it warrants.