One angle of the mortgage crisis that has been incredibly under-covered by the financial and mainstream press is the adverse role that fraud and speculation played in the crisis. The Prince first began to seriously consider the scale and reach of fraud in obtaining mortgages by single home homeowners, originators, originating mortgage brokers, wholesale originators, and speculators, after a call done by Deutsche Bank (NYSE:DB) on CDOs during the heat of the mortgage crisis. In this call, some anecdotal information was provided by some of the analysts about what kind of color they were hearing from mortgage originators about the actions of the owners of foreclosed properties. Now it is already acknowledged in the industry that many people with negative equity in their homes, who are unable to pay high monthly servicing payments because of resets on their ARMs, are walking away from their houses. They are not stripping the homes or living in them until they are foreclosed; they are simply moving out and beginning to rent or live with family. Sure their credit is taking a hit, but that can always be mended the next time they get a cheap credit for a house purchase, when the cycle swings back the other way. Also, consider that if they are already a borrower of subprime or questionable credit worthiness, even a hit like a foreclosure is not going to knock their FICO score much lower.
What was unique about the Deutsche Bank call was not their description of the empty houses that were about to be foreclosed, but the presentation of anecdotal evidence that many of the homes that were being foreclosed in new subdivisions were owned by speculators who had accumulated 3, 5, or even a dozen homes in one or multiple subdivisions, using stated income loans (aka "liar loans’ as described by many in the industry) or Alt-A loans. Some had used Option ARMs or even subprime fixed rate mortgages. It was suggested by the DB analysts and some questioners on the lines at clients of the firm, that many of these speculators grossly exaggerated their stated incomes to qualify to purchase so many homes. Many of these speculators were clearly reasoning that price appreciation over many houses, even if small, would provide enough income to allow them to resell the house before their case for servicing payments ran out. When prices stopped rising, many of these speculators had to walk away from the homes they had accumulated. In new subdivisions where speculators were active, the downward price pressure exerted on homes is enormous and particularly damaging to homeowners who bought in the subdivision with a mortgage that was responsibly matched to their proven income. Lenders poring over their defaulted mortgages are already learning that the number of people who bought homes as investments (i.e. speculators) is much greater than previously believed. Well, Duh! If you participate in a market where the incentives are so ripe for fraud and speculation, because you, as a lender, don’t say no and allow fraudulent misstating of income, you are going to see more defaults from speculators.
Furthermore, we must take note that many of these speculators used stated income loans or Alt-A loans. The speculators may have had high FICO scores so they qualified for Alt-A loans, but their actual income was usually far lower than the income they stated on their applications. There are even claims among mortgage broker whistle blowers that mortgage brokers colluded with speculators to state high incomes when the originators knew that actual income was much lower. This collusion is to be expected when the brokers and originators incentives give them no reason to say no, since the risk of giving loans dolled out with dubious information was going to be passed onto investors. When we consider that speculators used Alt-A stated income loans, it is no wonder that the derivatives tracking the value of Alt-A CDOs have experienced sharp declines similar to subprime CDOs. Many investors who were short subprime CDOs were, and are, short CDOs predominately composed of Alt-A loans. Some of the pain in Alt-A loans experienced by long investors in the paper and originators that hold the paper in their portfolios (i.e. Countrywide (CFC), IndyMac (IMB), etc.) may be offset by refinancing and workouts, that may allow speculators to keep some or all of their houses from being foreclosed. This is especially the case, since the new stimulus plan raised the limit on GSE guarantees, which will allow many home mortgages that could not be guaranteed originally by GSEs easier to guarantee, which will make refinancing much more attractive. That is attractive in the sense of lower, more affordable payments, as a result of lower interest rates caused by the added credit protection of a GSE guarantee. However, it is doubtful that this relief will be large enough to substantially support the value of Alt-A CDOs in the secondary market, or increase the actual cash flows from the underlying assets.
The speculation numbers reported by the Wall Street Journal are almost beyond belief. About 20% of mortgage fraud involved "occupancy fraud," or borrowers falsely claiming they intended to live in a property, according to an analysis by BasePoint Analytics, a provider of fraud-detection solutions in Carlsbad, Calif. Another study, by Fitch Ratings, looked at 45 subprime loans that defaulted within the first 12 months even though the borrowers had good credit scores. In two-thirds of the cases, borrowers said they intended to live in the property but never moved in. The lenders knew this was happening and did nothing to proactively prevent it. Home builders have reached similar conclusions. Many believe believe that as many as one in four home buyers in some markets were investors during the boom, up from their earlier estimates of one in 10 buyers. Obviously the home builders knew "occupancy fraud" was occurring, because there was no way they could possibly sell all the new houses they were building in subdivisions in hot markets like Southern California without this form of fraud. They too turned a blind eye, to get homes sold at the expense of protecting subsequent investors in the repackaged loans from increased credit risk. Although this isn’t surprising, since no short-term incentives existed for homebuilders to stop the speculators from committing fraud. If you want more numbers to wrap your head around describing how widespread this was, check out this excerpt from the WSJ.
Much of the occupancy fraud was concentrated in markets such as Florida, Nevada and Arizona, where prices were appreciating by double-digit percentages annually, said Kevin Kanouff, president of Denver-based Clayton Fixed-Income Services, a unit of Clayton Holdings Inc. (CLAY) that reviews about seven million loans a month on behalf of investors.
In Las Vegas, as many as 60% of the foreclosures last year involved non-owner-occupied homes, according to Applied Analysis, a real-estate-research firm. The Las Vegas firm compared the addresses of the borrowers with the locations of their homes. Where the addresses didn’t match, [this] likely indicated a speculator.
The temptation to lie can be substantial and may have been encouraged, or at least tolerated, by mortgage brokers and real-estate agents eager to close a home sale. Standards tend to be tougher for borrowers purchasing investment properties, since these loans are considered riskier.
Lenders typically allowed investors to finance no more than 90% of a home’s value, but if borrowers said they planned to live in the property, they could buy a home with no money down, even if they had scuffed credit and didn’t document their income, said Pete Ogilvie, a mortgage broker in Santa Cruz, Calif., and president of the California Association of Mortgage Brokers.
The bottom line is that the incentives in the mortgage industry for the originators and speculators were so skewed, that creative innovations like Alt-A stated income loans were ripe for fraud. The story about this fraud that is not being prominently covered by the financial media with the benefit of time, will be seen as a lesson and warning sign for mortgage market participants once the mortgage credit market rebound. Speculators lied to get more favorable loan terms or just qualify for loans period, and the lenders turned a blind eye. The lenders did this to pursue short-term profit and now the lenders and investors are paying the price. In some cases, speculators failed to provide required proof of income on non-stated income loans, and mortgages were still issued by lenders, which were later resold to investors as loans that had proven income as part of their terms.