Jonathan A. Goodman is a shareholder in the law firm of Frascona Joiner Goodman & Greenstein, P.C., in Boulder, Colo. His practice areas include real estate, real estate finance, and broker representation. He can be reached at firstname.lastname@example.org.
Loan Fraud Land Mines
An upswing in mortgage fraud has prompted lenders to tighten their credit standards, which has kept some buyers shut out of the housing market.
August 1, 2007
In December 2006, REALTOR® Magazine published an article I wrote about loan valuation fraud, “Loan Fraud Alert.” In that article, I talked about some of the many ways in which often-innocent real estate practitioners are becoming parties to mortgage fraud.
Since then, we have seen the collapse of the subprime mortgage market. Lenders have tightened credit standards. And some buyers have been shut out of the housing market.
Nationwide, the number of real estate transactions has declined, falling by some 10 percent between May 2006 and May 2007, according to NAR research. But unfortunately, mortgage fraud is alive and well. These days, it’s not unusual to see the fake sales price of a home set at 120 percent or more of the true sales price, with the puff being offset by a kickback from the seller to the buyer.
Why do we care if valuations are inflated? If the seller’s goal is to net $400,000 from a sale, why do we care if the buyer appears to pay $480,000 for the property, and the seller kicks back $80,000 to the buyer?
Fraud, as well as poor underwriting and overly aggressive borrowing, is a land mine that, if not defused, will prolong the current wave of mortgage defaults and could even derail real estate markets on their natural road to recovery.
When a lender thinks a property is selling for $480,000, it might make what it thinks is an 80 percent loan-to-value first mortgage in the amount of $384,000 and what it thinks is a 20 percent loan-to-value second mortgage in the amount of $96,000.
However, when the true sales price is $400,000 (after the $80,000 kickback to the buyer), the first mortgage actually has a 96 percent loan-to-value ratio, and the second mortgage is undersecured by $80,000.
The first loan is dodgier than it appears, and the second loan is essentially unsecured. Often, the mortgage broker and the underwriter are aware of the fake and the real prices, though making it appear as if no one was being misled. In fact, the paper trail is designed to disguise the property’s true value to the upstream mortgage investors in the secondary market.
In the worst examples of valuation fraud, the buyer makes very few, if any, mortgage payments and then disappears with the kickback. The loan quickly goes into default, and the higher foreclosure rates push down all home prices in the market.
More frequently, the price-puffing buyers have good intentions. They plan to use the kickback as a kitty to fund their mortgage payments until the property appreciates to cover the mortgage debt.
When a market is appreciating, buying property with 120 percent leverage may appear brilliant. When a market stagnates or declines as many have done today, the kitty runs out, and the property often ends up in foreclosure. The loan fraud land mine explodes. Statistics gathered by The Denver Post from January 2005 through April 2006 suggest that price puffing enhances the likelihood of a foreclosure tenfold.
Valuation loan fraud makes the real estate and financial markets more fragile because property owners have less equity than it appears.
Price puffing also creates artificially high sales prices that fool tax assessors, future buyers, and people making decisions to take out home equity loans. More subtly, price manipulation fools other sellers about the relative value of their homes and contributes to pricing stalemates between sellers and buyers.
Because so many of the loan fraud land mines are yet to come to light, the consequences of valuation fraud will be felt for a long time. In the meantime, puffers are emboldened to push the frequency and the amounts of their price inflations still further.
If the lending industry doesn’t regulate itself, legislatures and regulators will be forced to attempt clumsy solutions. Unfortunately, tightening the wrong screws in the credit machine or tightening the right screws too much may reduce mortgage fraud, but it will also unduly restrict access to credit and limit the pursuit of home ownership.
Updated: July 15, 2020