Mortgage Fraud and Predatory Lending: Causes and Regulation

Introduction: The Scale and Nature of Mortgage Fraud

If a rash of armed bank robberies swept across America and criminals absconded with $30 billion, one may be certain that public panic would ensue and the banking system would likely be changed forever. If thousands of armed thugs went rampaging across the nation forcing people out of their homes and then destroying the properties — leaving the occupants homeless — fear would force society to adapt its policies to fight that threat. Yet in many ways this is precisely the situation occurring with the recent rise in mortgage fraud and abuse. Certainly the criminals are armed with paperwork instead of shotguns, but the impact they are having is no less real. Authorities have stated that fraud is involved in $60 billion in loans annually, resulting in $30 billion in losses.

Mortgage fraud is quickly leading to houses being repeatedly "flipped" between conspiring buyers to reach artificially high prices and then fraudulently sold to innocent purchasers for far more than they are worth — leading both to repossessions and to artificially created comparable sales that may skew future appraisals. Such flipping serves to defraud both banks and individual buyers.

However, not only is the mortgage industry being defrauded from outside; elements within the mortgage industry are also — often illegally — defrauding thousands of disadvantaged borrowers out of millions of dollars combined and destroying thousands of lives in the process. The effects of these frauds are particularly felt in inner cities, where predatory lending practices are shattering many communities, leading to homes being repossessed from long-term owners and either left vacant or sold to slumlords. Many independent studies have shown that the majority of consumers targeted by predatory lenders are minorities or lower-income individuals — fraud seems to target those who can least afford to survive it. A startling number of loans made to lower-income or credit-disadvantaged borrowers (the subprime market) are not only unfair in terms of higher interest rates, but are actively deceptive and intended to leach away as much income and equity as possible. The mortgage industry is not only subject to fraud perpetrated upon it — it is also itself riddled with abusive and fraudulent practices.

It is perhaps because fraud is so pervasive in the industry today that less is being done to combat it than one might expect. Mortgage companies frequently fail to report fraud, and when they do, reports are often put on hold by law enforcement. Individual consumers may not realize they have legal protection, or may feel there is no point in fighting the system and risking losing even more. Abuse committed by mortgage companies is even harder to prosecute than fraud committed against them, as the former often walks the thin line between legal — if unethical — and illegal practice. Many grassroots groups are trying to combat lending abuse, while many corporate organizations work to develop ways for mortgage companies to better protect themselves against fraudulent applications. In addition to these non-governmental solutions, federal, state, and local governments have all tried passing regulations to prevent mortgage fraud and abuse. Despite these efforts — and in some cases ironically because of them — fraud and abuse continues to grow year by year, daily reaching new extremes, developing new tactics, and becoming increasingly destructive in the economic and social realms.

The Dead Pledge Heritage: Historical Roots of Mortgage Exploitation

The degree of dishonesty and fraudulence associated with the modern mortgage industry raises an important question: is there some level at which the very nature of the mortgage industry is fraudulent, or at least invites fraud? Looking over the history of mortgages, one can see some indication that there has long been a link between exploitation and the mortgage. This is somewhat indicated in the formation of the word itself. Mort- signifies death, and -gage derives from the same root as "pledge."

Mortgages are, literally, death pledges. This phraseology is descended from the idea that "property rights were said to be 'dead' to the borrower until the due date. Worse yet, if he failed to settle up on the due date, he lost everything — or, as English jurist Sir Edward Coke put it in 1628, if a mortgagor failed to pay, 'then the Land which is put in pledge… is taken from him for ever, and so dead to him.'"

As this brief linguistic lesson suggests, mortgages in the old world were not unrelated to the exploitative systems of feudalism. In fact, many ancient civilizations had agreements akin to mortgages. In ancient Egypt, for example, most private landowners had effectively mortgaged their land to the ruling class, and though they owned it officially, still paid for the right to remain there. This stable Egyptian system gave rise to the longest-lasting civilization known to history and created an enduring and powerful ruling class which, nonetheless, might be considered to have been somewhat exploitative of the peasantry.

The ability to borrow against one's property — to pledge it to death if one failed to pay — was important to the economic development of Egypt, just as it would later be in Europe and America. It was this mortgaging aspect of Egyptian culture against which the Mosaic Laws were reacting when the Jewish scriptures forbade lending money at interest to fellow Jews and ordered that all property be returned to its hereditary owners every seven years. The ancient Hebrew sense that God did not approve of the death pledge of mortgaging carried over to Catholic theory and later Puritan thought as well, both of which considered usury a sin.

Mortgaging of property persisted despite the Christian rejection of usury, and has been credited with helping to fuel the westward expansion of the American frontier, as struggling farmers had one property after another foreclosed on by predatory banks.

Mortgages have historically been linked to the chaining of individuals to the soil, to the transfer of power from peasants to ruling classes, and to other exploitative practices. This history has a certain relevance to today's predatory lending practices and may contain insight on possible solutions to mortgage fraud if fully explored. It may also help explain certain dynamics on the consumer side of mortgage fraud. To fully understand how modern mortgage fraud functions, however, it is necessary to know the history and mechanics of the common modern mortgage.

The New Deal and the Modern Mortgage

It was not until the New Deal fought to pull America out of depression that mortgages as they currently exist — with all their strengths and weaknesses — really came into being. This was when the Federal Housing Administration was established to guarantee 93% of new homeowner mortgages, and when the Federal Savings and Loan Insurance Corporation (FSLIC) and the Federal Deposit Insurance Corporation (FDIC) were created to insure savings and deposits. With the federal government guaranteeing nearly everything, there was almost no risk for lenders. This created an environment in which, for the first time, loans were both federally regulated and actively encouraged. A predictable surge in homeownership followed.

This government move was at least partly a response to the significant problem of predatory lending that already existed in America. Prior to the founding of the FHA, the American mortgage industry had gotten its start not with banks but with insurance companies — institutions motivated not by fees and interest charges but by the hope of gaining ownership of properties if borrowers failed to make payments. Repayment schedules were spread over three to five years and ended with a balloon payment. It was the FHA that introduced the amortization of loans so that indebtedness could decrease over time. They also instituted lending practices based on ability to repay, assessment of property quality before making a loan, and expanded loan terms — seven, fifteen, and thirty years — so that mortgages could be feasibly repaid. For the first time in modern Christian history, carrying significant mortgage debt was equated not with sin but with the proper way of family living, and homeowners went from being a minority to a majority of households.

Yet despite this overwhelming push to improve the financial situation of borrowers, the end result was not an unmitigated good. In the housing rush, houses had often been bought at inflated prices and at high rates of interest. For many people, homeownership was "cost burdened," with mortgage payments taking more than 40% of some households' income. To this burden were added the additional costs of suburban living — the necessity of owning a car for transportation to remote workplaces and the upkeep of suburban lifestyles. Within a few decades, foreclosures began again, and a younger generation watched their parents' dreams seem increasingly remote. Financing changed once more as Fannie Mae began offering more flexible options such as adjustable-rate mortgages and resurrected the balloon payment. Meanwhile, the weight of mortgages served to settle the older generation into political and economic stagnation, something that many young people in the 1960s and 1970s protested as a hidden cost of suburbia.

One can see, therefore, a certain degree to which mortgages are inherently exploitative. A simple analysis of the amount borrowed compared to the total amount repaid over the life of a loan might point to the same conclusion. Some of the fraud perpetuated within the mortgage industry may have its roots in this fundamental inequality — whether from individuals' sense that a certain amount of dishonesty is justified by the high price they will pay for their mortgage, or from companies being willing to overlook certain fraudulent acts that might in the end increase net profits if they do not result in foreclosure. Nonetheless, there is a significant difference between legitimate — if exploitative — loans undertaken with the full and informed consent of all parties, and loan fraud that occurs when one or more parties is lied to about the essential facts of the situation. Lending may be parasitic in all cases, and predatory in many, but it is particularly predatorial when it is based in fraud and misrepresentation.

How the Loan-Approval Process Creates Opportunities for Fraud

Odd as it may sound, the mortgage process may be particularly vulnerable to fraud precisely because it is so complicated. Each step of the process has its own weaknesses, and specific frauds have been designed to exploit each one. Understanding the steps of mortgage approval is necessary to understand the types of fraud, most of which share the goal of securing loans that would not otherwise be granted.

When deciding whether to approve home buyers for specific mortgages, lenders typically look at three central factors: the borrower's ability to repay the loan in all conceivable situations, the borrower's perceived willingness and dedication to repaying the loan, and the likelihood of financial loss should the bank be required to foreclose.

The borrower's ability to repay is based on a number of calculations. One of the most obvious is employment and salary history. Generally speaking, mortgage companies prefer that buyers have been employed at the same place for at least two years, or at least be in the same line of work for a few years. In many cases, employment information is misstated on fraudulent loan applications. Most lenders attempt to verify employment by requesting letters of verification from employers and copies of pay stubs. Fraudulent responses include misreporting employment information, forging letters of verification, and even using modern graphics software and high-quality laser printing to forge pay stubs and W-2 forms. In addition to individuals voluntarily exaggerating or inventing employment history, it is apparently common for unscrupulous mortgage brokers to encourage this behavior in clients whose details might be inconvenient. In worst-case scenarios, brokers may alter this information on their own, without the client's knowledge. Loan fraud carried out for the profit of professional scammers is likely to use entirely false employment information.

Ability-to-repay calculations are also based on the amount of debt a person has already taken on. In order to qualify for a mortgage, most lenders require a debt-to-income ratio of 28/36 — meaning no more than 28% of the borrower's total pre-tax monthly income may go to housing, and no more than 36% to all debt repayment combined, including car loans, student loans, and credit cards. Some fraud cases have been built around hiding true indebtedness — for example, by taking out private loans unreported to credit bureaus to pay off other debts, or by taking out loans immediately before the mortgage process that will take months to appear on credit reports. This calculation may also take into account the amount of money one has available for a down payment, an amount that may be manipulated in various ways.

Apparent willingness to repay is another important aspect of the underwriting process. This calculation considers credit scores and intended use of the home, among other factors. While credit scores are difficult to fraudulently change, many frauds do exploit the role of credit in mortgages. Scammers may claim, for example, that they want to use someone's good credit and income to forge a real-estate partnership and then use that arrangement for fraud. Stated use of the home is an especially prevalent lie, as the lender has no reliable way to be certain whether the buyer intends to live in the home or rent it out, and there do not appear to be effective legal constraints forbidding buyers from "changing their minds" about whether to live in a property or rent it out after purchase.

The final area of concern is whether the property presents a good investment risk. In the worst case, if the bank needed to repossess the house, would the sale of the foreclosed property cover the bank's investment? FHA loans have a significant effect here because they insure the bank against losses, often encouraging lending that might not otherwise occur. All the same, there must be a sense that the property is worth what is being paid for it and that the buyer will put enough equity in immediately to make it a sound risk. This means that down payment size and the home appraisal are significant factors.

Down payment size may be fraudulently inflated by undisclosed financing on the house, such as seller financing or a second mortgage masquerading as a down payment. More common, however, is appraisal fraud. Almost every source on mortgage fraud identifies crooked, inept, or misled appraisers as being on the front lines of fraud schemes. Appraisals are based on several factors: the objective quality and condition of the home, the market prices of comparable properties in the area, the desirability of the property in terms of neighborhood amenities, and the personal judgment of the appraiser. Any of these judgments can skew the appraisal. According to one community report, appraisers in inner-city areas in particular appear very inconsistent — a property one appraiser judges to be worth upward of $80,000 another may value at less than $40,000 because of prejudice against given neighborhoods or different choices of comparable properties.

Because of natural variation in appraiser judgment — not to mention the wide range of values that can exist on a single street — it is very easy for an appraiser to skew appraisals without anyone noticing. Appraisers may skew data out of a good-old-boy-network sentiment, assured of future work because they reliably come back with appraisals that suit the purposes of those who hire them. Such appraisers may even believe they are doing everyone a favor: helping loan officers earn their commissions, assuring that buyers get the homes they have bid on, and that sellers receive their asking prices. These cases may never be noticed or caught. Many other appraisers, however, are thoroughly crooked and participate in schemes where prices are wildly inflated for the purpose of obtaining fraudulent loans from which the appraiser takes a cut. These are the cases where the most damage is done to everyone involved.

In all of these cases, a great deal of individual judgment comes into play on the part of underwriters as to whether a loan presents a good risk. This "best judgment" zone is one area where illegal discrimination or fraudulent activity can take place. Underwriters have on occasion been involved in loan schemes where they were influenced to make unwise decisions — generally overlooking fraudulent information, but potentially approving legitimate though unwise applications as well. Authorities have noted growth in the number of criminal gangs who use romantic relationships with loan processors to work their scams. When their targets are uncooperative, they will often resort to threats of force. Such organized criminals may push loans through underwriting or use underwriters and other processors to gain access to personal information that could be used in future loan frauds involving stolen identities. Most fraud, of course, does not take place at the level of the underwriter — it occurs before the file ever reaches the underwriter's desk, creating fraudulent information that scammers hope will convince the underwriter to approve the loan.

As can be clearly seen, every step of the loan-approval process is fraught with opportunities for deception against the mortgage lender. Abuse against consumers generally takes place at a different stage, though it may include defrauding both borrowers and lenders. Fraudulent forms of predatory lending generally occur in the marketing of loans, in the way the process is presented to borrowers, and in the signing of papers. It is at these stages that unethical lenders may mislead borrowers, fail to present relevant information, or tell outright lies. While it is in screening the application that lenders face their greatest risk of being defrauded, it is in the process of selecting the loan that consumers are most at risk.

Conclusion

Mortgage fraud is a thorny problem, because there are few true innocents involved, and the stain of guilt which infects the system makes judgment and prevention difficult. On the one hand, banks are guilty of exploitative and predatory behaviors that destroy lives, yet they are simultaneously providing what have come to be indispensable financial services. One might say that the victims of predatory lending are innocent, and yet generally their predicament arises from either irresponsibility — having poor credit scores or failing to do adequate research before committing to a large investment — or a failure to carefully read their mortgage documents. In fact, many predatory loans are based on borrowers being pressured into dishonesty, a dishonesty that they themselves ultimately pay for. The system being defrauded in the majority of organized fraud cases is a victim, of course, but it is being victimized partly by its own weaknesses. The predatory lending practices of major banks surely desensitize loan officers, appraisers, and other professionals to the value of integrity — can anyone be surprised that they eventually turn their shady skills against the industry itself?

The degree to which appraisals may be skewed by dishonest actors is directly related to the degree to which appraisals are sensitive to the racial and economic conditions of a neighborhood, just as the degree to which banks may be defrauded against their will is not unrelated to the degree of fraud they tolerate for their own profit. The difficulties in regulating and controlling fraud are legion, in no small part because both victims and perpetrators have so much to hide. Change will only come when systematic reforms are made to the structure of the system itself. Considering how many millennia dishonest lending and borrowing has plagued humankind, it would be overly optimistic to hope for a comprehensive solution within the lifetime of anyone now living.