BY STANLEY I. FOODMAN
In this article, the author discusses predatory lending practices and mortgage fraud. In addition to much needed legislative initiatives to combat such abuses, the author advises lenders to simply go back to basics and make better lending decisions.
In 2000, the 1990s “dot.com” bubble burst caused markets to retreat significantly.
On March 9, 2000, the NASDAQ closed at 5,046.86, then it see-sawed until the second half of 2002, when it closed at 1,139.90; before beginning a gradual ascent. The Dow Jones Industrial Average (“the Dow”) which had peaked at 11,215.10 during the halcyon dot.com days, sank to 7,591.93 by early 2003. Reflecting the dot.com bust and financial market ripples, the S&P 500 Index peaked at 1,527.46 in early 2000 and dipped to 800.58 in mid-2000.
THE SECURITIES MARKETS AND INTEREST RATES
As the markets fell, so did interest rates. The Federal Reserve funds rate, for example, in March of 2000 was 5.85 percent. By the end of June 2003, the rate had plummeted to 1.22 percent. The rate eventually fell to one percent in the first half of 2004.
Traditionally, as interest rates drop, money flows back into securities markets. However, that did not happen following the dot.com bust. Rather, the capital flowed in significant amounts into the real estate markets in the form of mortgage lending. The amount of money available for mortgage lenders was increasing and lower interest rates lured unprecedented numbers of real estate buyers into the market with the promise of virtually “free” money. These purchasers significantly bid up the prices of properties. The artificially low interest rates created and maintained by the Federal Reserve and its member banks, and the resulting “feeding frenzy” by consumers was the “cover” that created a consequential real estate valuation bubble. As everyone reading this knows, that bubble has burst.
HOME MORTGAGES BY THE NUMBERS
Without the consumers’ enabled “feeding frenzy,” the resulting predatory lending and mortgage fraud explosions could not have been possible.
According to the Mortgage Bankers Association (“MBA”), the total number of all mortgages serviced increased by 15,798,368 between the fourth quarter of 1999 and the third quarter of 2007. During the same period, the number of sub-prime mortgages increased by 5,420,184. According to the Federal Reserve, by the end of 1999 the total dollar value of all outstanding home mortgages was $4.4 trillion. By the end of the third quarter of 2007, the total dollar value of all outstanding home mortgages was $10.4 trillion. In other words, the dollar value of all household mortgages in the U.S. increased by a stunning 236 percent in less than eight years seemingly without regard for ability to repay.
Fast-forward to 2009. With the ongoing credit market meltdown and home foreclosures at historic highs there has been an abundance of media coverage generated about mortgage fraud. Intertwined with mortgage fraud is the debate over how predatory lending practices may have played a role in the continually rising numbers of foreclosures around the United States. An in-depth look at lending industry and U.S. government figures reporting the increases in the dollar amount and numbers of mortgages outstanding during the five year period between 2002 and the end of 2007 is enlightening. The obvious conclusion often drawn is that without the existence of uncontrolled predatory lending practices, the alarming levels of mortgage fraud being investigated and prosecuted would not exist.
HUD notes on its website that even though great progress has been made in expanding access to capital for previously under-served borrowers, there is a growing incidence of abusive practices in a segment of the mortgage lending market. In addition, HUD specifically notes that predatory mortgage lending practices strip borrowers of home equity and threaten families with foreclosure, which destabilizes the very communities that were beginning to enjoy the fruits of the nation’s economic success.1
What is Predatory Lending?
In the United States, there is not one official definition of “predatory lending.” There are, however, laws against many of the practices commonly identified as “predatory,” and various federal agencies use the term as a catch-all for many specific, frowned upon, and prohibited activities in the loan industry.
TheMortgage Bankers Association defines predatory lending as a range of lending practices harmful to borrowers, including equity stripping and lending based solely on the foreclosure value of the property. One other common definition of the term is “the practice of a lender deceptively convincing borrowers to agree to unfair and abusive loan terms, or systematically violating those terms in ways that make it difficult for the borrower to defend against.” A July 15, 2000 report by the Department of Housing and Urban Development (“HUD”) and the Department of the Treasury (“DOT”) titled, “Curbing Predatory Home Mortgage Lending: A Joint Report” (the “HUD/DOT Report”), uses about seven and a half pages and almost 4,000 words in an attempt to define “predatory lending.” The HUD/DOT definition covers, with examples, elements of predatory lending including: loan flipping; excessive fees and “packing;” lending without regard to the borrower’s ability to repay; and outright fraud.
Perhaps predatory lending is in ways like what Justice Stewart said of “hard core” pornography: “I shall not today attempt further to define the kinds of material I understand to be embraced within that shorthand description… But I know it when I see it….”2 However it may be defined, predatory lending has been a problem in search of a legislative solution for many years.
THE ONGOING BATTLE AGAINST PREDATORY LENDING
In addition to attempting to define predatory lending, the HUD/DOT Report made numerous recommendations for Congressional action (discussed further herein) that would stop or slow predatory lending. But, in 2009, the issue is still unresolved. That is not to say that nothing has been done.
As early as June 1997, the Federal Reserve Board (“FRB”) held hearings to assess the effectiveness of the Home Ownership and Equity Protection Act (“HOEPA”) in combating abusive (“predatory”) lending practices. At those hearings, consumer advocates reported continued abusive practices in connection with home-equity loans. They expressed concern that as the total number of sub-prime loans increase, abusive loans will continue to increase in absolute numbers. During the hearings, mortgage industry representatives acknowledged that abusive practices occur, but they asserted that such practices were not widespread in the national mortgage market.
According to HUD, it has been fighting predatory lending since spring 1999 through research, regulation, consumer education, and enforcement actions against lenders, appraisers, real estate brokers, and other companies and individuals that have victimized homebuyers. Apparently, because federal legislation to curb predatory lending practices has not materialized, HUD efforts to stop predatory practices in the mortgage industry have been largely ineffective.
In July 1998, about one year before HUD said it began fighting predatory lending, the Board of Governors of the Federal Reserve System along with HUD issued a Joint Report to the Congress titled “Concerning Reform to the Truth-in-Lending Act and the Real Estate Settlement Procedures Act” (the “1998 HUD/FRB Report”) The 1998 HUD/FRB Report addressed loan flipping, credit insurance, ensuring consumer rights in foreclosures and consumer education and counseling — issues that focus on preventing and helping those who may be victims of predatory lending fight foreclosure actions. Specific references to predatory lending in the 152 page 1998 HUD/FRB Report included a variety of recommendations to Congress. None of the recommendations were implemented.
The need for federal legislation to fight predatory lending was emphasized by Margot Saunders, managing attorney for the National Consumer Law Center, two months after the 1998HUD/FRB Report to Congress was issued.
On September 16, 1998 Saunders testified before the Subcommittees on Housing&CommunityOpportunity and Financial Institutions&Consumer Credit House Committee on Banking and Financial Services regarding the rewrite of the Truth-in-Lending Act (“TILA”) and the Real Estate Settlement Procedures Act (“RESPA”). In addition to representing the National Consumer Law Center, she was also speaking for the Consumer Federation of America, Consumers Union, National Association of Consumer Advocates and the U.S. Public Interest Research Group.
In her testimony, Saunders said: “It is clear that the current system is not working: too many homeowners are losing their homes to foreclosure every year, and too many more are paying more than they should or they can afford for their home. It does not help Americans to tantalize them with the dream of homeownership without providing the support to allow them to maintain that homeownership. A tripling of the foreclosure rate in 17 years is an indication that the mortgage marketplace is working against the maintenance of homeownership. Something is wrong. The mortgage industry may want regulatory reform, but homeowners need help as well.”3 A decade later, the situation is far worse, and Saunders remarks are all the more chilling.
On May 4, 1999, the Clinton Administration proposed legislation that addressed a number of financial industry issues. This proposed legislation included five basic principles, one of which was preventing fraud and abusive practices. A subsequent Housing and Urban Development report referred to this proposed Clinton Administration legislation in great detail. It said that the Clinton-Gore agenda included a call for action against sub-prime lending abuses, including: expanded protections in the home equity lending market; expanded enforcement tools; improved home mortgage lending reporting; and improved regulator guidance on sub-prime lending. The report added that many of the recommendations that formed this part of the Clinton Administration’s agenda were drawn from the 1998 HUD/FRB Report.
On April 12, 2000 Congressman John J. LaFalce (D-NY 1975–2002) introduced H.R. 4250. The bill, co-sponsored by 18 congressmen, popularly known as the “LaFalce–Sarbanes [Senator Paul Sarbanes] Predatory Lending Bill,” was designed to amend the TILA guidelines governing certain credit transactions secured by the consumer’s principal dwelling (high-cost mortgage). Bills with similar titles, such as the “Predatory Lending Consumer Protection Act of 2000” were introduced in the 107th Congressional Session (H.R. 1051 & S. 2438) and the 108th Congressional Session (S. 1928) by Representative LaFalce and Senator Sarbanes, along with numerous Democrat co-sponsors.4 On July 15, 2000 while Congressman LaFalce’s H.R. 4250 was stalled in committee, HUD and the Department of the Treasury issued its 121-page report titled “Curbing Predatory Home Mortgage Lending: A Joint Report” (the “HUD/DOT Report”). The report was the result of a Federal Government Interagency Task Force which held public forums in Atlanta, Baltimore, Los Angeles, and New York. This Task Force included personnel from the U.S. Attorney’s Office, States Attorney’s Offices, Maryland Department of Labor and Licensing, Maryland House of Delegates, Baltimore City Government, HUD Office of Inspector General, Civil Justice Ind., Fannie Mae, Enterprise Foundation, Mortgage Bankers Association, Maryland Bankers Association, Realtor’s Association, Maryland Consumer Rights Coalition, AARP, Offices of Senators Sarbanes and Mikulski and numerous local housing organizations, banks and appraisers.
The HUD/DOT Report included numerous recommendations for “legislative and regulatory action to combat predatory lending, while maintaining access to credit for low- and moderate-income borrowers.”5 The HUD/DOT Report went further than the joint HUD/FRB 1998 report. It addressed specific predatory lending practices, including loan flipping, packing excessive fees into the loan and lending without regard to the borrower’s ability to repay and outright fraud and abuse.”6 In recommendations to minimize or stop predatory lending in prime and sub-prime markets, the HUD/DOT Report made numerous recommendations addressing predatory mortgage lending. These recommendations address four areas of concern: consumer literacy and disclosure; harmful sales practices; abusive terms and conditions; and market structure.7
On March 9, 2005 Representative Bradley Miller (D–NC) introduced H.R. 1182 to amend TILA, impose restrictions and limitation on high-cost mortgages, revise the permissible fees and charges on certain loans made, prohibit unfair or deceptive lending practices, and to provide for public education and counseling about predatory lenders, and for other purposes. Referred to as the “Prohibit Predatory Lending Act,” the bill had 67 cosponsors. On May 13, 2005, the bill was referred to the Subcommittee on Housing and Community Opportunity where it died.
Years later, on November 11, 2007, the House of Representatives passed H.R. 3915:Mortgage Reform and Anti-Predatory Lending Act of 2007 (“H.R. 3915”). The bill moved to the Senate where it was referred to the Committee on Banking, Housing, and Urban Affairs. H.R. 3915 is just one of many bills introduced in the House and Senate over the past decade or so addressing predatory lending. Bills prior to H.R. 3915 failed to clear committee.
It is clear that despite a decade of reports and attempts at legislative solutions, predatory lending is alive and well in the United States. Had Congress successfully addressed the issue a decade ago, it may have mitigated the alarming increase in the number of home foreclosures and the resulting negative ripple effect on the American economy. But the bills died in committee.
PREDATORY LENDING PRACTICES
As previously discussed, defining the practices that make a loan predatory is problematic. The agencies say that any list of predatory practices will be incomplete because bad actors are constantly developing new abusive practices, sometimes to evade new government regulation. In a predatory lending situation, the party that initiates the loan often provides misinformation, manipulates the borrower through aggressive sales tactics, and/or takes unfair advantage of the borrower’s lack of information about the loan terms and their consequences. The results are loans with onerous terms and conditions that the borrower often cannot repay, leading to foreclosure or bankruptcy. In addition to loans with outrageous conditions, one must look to the type of loan being made. For example, the sub-prime mortgage collapse that transpired in the summer of 2007 was a major piece of the economic crisis puzzle that led to the downfall of several lenders. It has many experts asking:
Are Sub-Prime Mortgages to Blame?
In trying to identify the root causes for the collapse of the mortgage market, experts looked to sub-prime mortgages. Sub-prime loans are made to borrowers with lower credit scores, or difficult to document income, and, as such the risk of default and interest rates, are much higher than for conventional loans. Mortgage Bankers Association (“MBA”) statistics show that “conventional sub-prime mortgages” (perhaps itself an oxymoron?) serviced in the United States have increased dramatically between the fourth quarter of 1998 and the third quarter of 2007. The Washington, D.C.-based organization’s statistics show that while conventional prime mortgages have increased at a relatively even pace during that period, the number of conventional sub-prime mortgages have exploded.
The following chart, provided by the Mortgage Bankers Association, is a snapshot of the number of mortgages serviced in each of the calendar quarters as indicated:
The total number of those mortgages that represent some type of predatory lending is the subject of much speculation.
According to the Inside Mortgage Finance MBS Database, the percentage of securitized mortgages with stated income/stated asset or no documentation loans has been increasing in the past two years:
This is strong indication that mortgage lenders have become indifferent to borrowers’ ability to repay loans, as the potential upside of immediate profit grows.
The HUD/Department of the Treasury definition of predatory lending suggests that it is something that can occur in the prime conventional loan market, but generally arises in connection with sub-prime mortgages. HUD and the Department of the Treasury have jointly reported that the sub-prime market, in contrast to the prime mortgage market, provides a much more fertile ground for predatory lending practices because:
- The characteristics of many sub-prime borrowers make them more easily manipulated and misled by unscrupulous actors. Many sub-prime borrowers who have had difficulty obtaining credit in the past may underestimate their ability to obtain new sources of credit, which may make them more likely to accept the first offer of credit they receive, rather than shop for a loan with the best possible terms. In addition, sub-prime borrowers may be more in need of immediate funds due to the heightened challenge of meeting household and emergency expenses on their lower incomes;
- Many sub-prime borrowers live in low-income and minority communities that are comparatively underserved by traditional prime lenders. As a result, many of these communities suffer from insufficient competition among lenders, so that better loan terms may be harder to find, or persons may be unaware of them; and
- The sub-prime mortgage and finance companies that dominate mortgage lending in many low-income and minority communities, while subject to the same consumer protection laws, are not subject to as much federal oversight as their prime market counterparts—who are largely federally-supervised banks, thrifts, and credit unions. The absence of such accountability may create an environment where predatory practices flourish because they are unlikely to be detected.
Sub-prime mortgage practices are therefore one of the major problems in the mortgage market crisis. Thus, it is clear that predatory lending is as much a function of the manner in which the loans are made, such as with sub-prime loans, as the oppressive terms that they contain. Moreover, the predatory nature of many loans typically is not the result of a single loan term or feature, but a series of features that in combination impose substantial hardships on the borrower.8 There are also blatant acts of mortgage fraud occurring in the market everyday.
Fraudulent practices are quite pervasive in the mortgage money markets and predatory lending is an invitation to fraud. Being in a situation in which perceived profitability by the lender leads to perceived opportunities by borrowers and fraudsters to profit from situations in the mortgage application process is a recipe for disaster. The pressures to “close” loans by both borrower and lender are great, and the potential profits, for the lenders and brokers, are very high.
How Pervasive is Mortgage Fraud?
According the Federal Bureau of Investigation’s (“FBI”) May 2005 “Financial Crimes Report to the Public,” the increased reliance by both financial institution and non-financial institution lenders on third-party brokers created opportunities for organized fraud groups, particularly where mortgage industry professionals are involved. Couple this with the fact that a significant portion of the mortgage industry is void of any mandatory fraud reporting, and the situation is even more fraught with peril. In addition, mortgage fraud in the secondary market is often underreported, leaving the true level of mortgage fraud largely unknown. The mortgage industry itself does not provide estimates on total industry fraud. Based on various industry reports and FBI analysis, mortgage fraud is pervasive and growing.
Mortgage Fraud Schemes
The FBI compiles data on mortgage fraud through Suspicious Activity Reports (“SARs”) filed by federally-insured financial institutions and Department of Housing and Urban Development Office of Inspector General (“HUD-OIG”) reports. The FBI also receives complaints from the mortgage industry at large. The FBI reports that each mortgage fraud scheme contains some type of “material misstatement, misrepresentation, or omission relied upon by an underwriter or lender to fund, purchase or insure a loan.”
The FBI investigates mortgage fraud in two distinct areas: “Fraud for Profit” and “Fraud for Housing.” Fraud for Profit is sometimes referred to as “Industry Insider Fraud” and the motive is to revolve equity, falsely inflate the value of the property, or issue loans based on fictitious properties. Based on existing investigations and mortgage fraud reporting, 80 percent of all reported fraud losses involve collaboration or collusion by industry insiders.
Fraud for Housing represents illegal actions perpetrated solely by the borrower. The simple motive behind this fraud is to acquire and maintain ownership of a house under false pretenses. This type of fraud is typified by a borrower who makes misrepresentations regarding his income or employment history to qualify for a loan.
Although there are many mortgage fraud schemes, the FBI is focusing its efforts on those perpetrated by industry insiders. The FBI is engaged with the mortgage industry in identifying fraud trends and educating the public. Some of the current rising mortgage fraud trends include: equity Published in the skimming, property flipping, and mortgage related identity theft.
Equity skimming is a tried and true method of committing mortgage fraud. Today’s common equity skimming schemes involve the use of corporate shell companies, corporate identity theft, and the use or threat of bankruptcy/ foreclosure to dupe homeowners and investors.
Property flipping is best described as purchasing properties and artificially inflating their value through false appraisals. The artificially valued properties are then repurchased several times for a higher price by associates of the “flipper.” After three or four sham sales, the properties are foreclosed on by victim lenders. Often flipped properties are ultimately repurchased for 50-100 percent of their original value. Property flipping is nothing new; however, once again law enforcement is faced with an educated criminal element that is using identity theft, straw borrowers, and shell companies, along with industry insiders, to conceal their methods and override lender controls.
Programs to Combat Fraud
Combating significant fraud is a Federal Bureau of Investigation priority because, as the nation has witnessed with severe consequences, mortgage lending and the housing market have a significant overall effect on the nation’s economy. Since 1999, the FBI has been working to actively investigate mortgage fraud in various cities across the United States. The FBI also focuses on fostering relationships and partnerships with the mortgage industry to promote mortgage fraud awareness. All mortgage fraud programs were recently consolidated within the Financial Institution Fraud Unit of the FBI. This consolidation provides a more effective and efficient management over mortgage fraud investigations, the ability to identify and respond more rapidly to emerging mortgage fraud problems, and a better picture of the overall mortgage fraud problem.
The FBI has also been working to establish broader SAR reporting requirements for mortgage lenders who do not have adequate protection under the current safe harbor provisions. The FBI is collaborating with the mortgage industry and Financial Crimes Enforcement Network (“FinCEN”) to create a more productive reporting requirement for mortgage fraud. The FBI has also been working with the mortgage industry through the MBA to promote a more efficient and effective method of identifying and reporting fraudulent mortgage activity, otherwise known as, the Suspicious Mortgage Activity Report (“SMARt Form”) concept.
The FBI works closely with individual lenders, as well as national associations such as the MBA, the Appraisal Institute, the National Association of Mortgage Brokers, and the National Notary Association, to define and combat the mortgage fraud problem. In addition, on a case-by-case basis, the FBI receives close cooperation from lenders. An example of this is the usage of Real Estate Owned properties from lender inventories to facilitate mortgage fraud undercover operations (“UCO”). In December 2003, for example, the FBI initiated an UCO to address the massive amount of mortgage fraud in the Jacksonville area. On September 16, 2004, as a result of this investigation, seven search warrants were executed and two arrests were made. A mortgage broker and his closing attorney were arrested via complaint, and charged with bank fraud for their role in this alleged scheme.
This UCO was made possible through the close cooperation of a local financial institution. This type of cooperation happens around the country and is a key component in the FBI’s approach to this growing crime problem.9
The dot.com bubble burst, and left a mess in its wake. With investors stung by losses in the tech markets, and looking for a quick way to riches, they set their sites on the money lending markets. Mortgage lenders found themselves flush with cash, and consumers, emboldened by low interest rates and lax lending standards, borrowed more than was good for them. In this fertile environment, fraud and predatory lending practices flourished.
Legislative efforts proved powerless to stem the tide, and the financial markets eventually went bust, requiring a huge infusion of federal funds in order to keep the economy on a stable footing. What can be done to prevent another calamity like this from happening in the future?
Making Better Lending Decisions
In addition to a major legislative initiative designed to curb these practices, quite simply, lenders must make better lending decisions. In the industry’s quest for solutions to predatory lending and mortgage fraud practices, it is often suggested that lenders rely more on credit scores as a driver of lending qualification. This is an incomplete approach, at best. Credit scores are one of several factors in a lending decision. The fact that a borrower has a high credit score is not by itself indicative of future repayment.
The same could be said for relying on perceived property “market value” as justification for loans. Valuing real estate is in many ways an art, the results of which are based on historical information that is not necessarily indicative of future value. At its foundation, real estate lending shares characteristics with venture capital financing and business lending. If real estate, which is the subject of a loan, is the only collateral or source of repayment available to a regulated lender, the regulated lender may be doing a disservice to its depositors whose money is the source of the loan.
As computers and data bases have become ubiquitous, reliance on lender staff training and experience as a basis for making loan decisions has moved from the front line to committee at almost every level. Lending decisions tend to be more overtly dehumanized and “driven by the numbers.”In the last 10 years, regulated lenders have downsized their underwriting staffs in favor of relying on outside conflicted third parties such as mortgage and real estate brokers to do large portions of their underwriting due diligence.
Unless and until regulated lenders return to the “old fashioned” system of character lending that includes: intensive ongoing lender training; analysis of repayment sources; analysis of borrower financial statements; copies of IRS taxpayer transcripts; and title insurance company review of real estate loan collateral, as well as other tried and true techniques, such as knowing one’s customer, predatory lending and mortgage fraud will be very difficult to eliminate and control.
1 See http://www.hud.gov/offices/hsg/sfh/pred/predlend.cfm.
2 Jacobellis v. Ohio, 378 U.S. 184 (1964).
3 See http://www.nclc.org/initiatives/predatory_mortgage/testimony.shtml.
5 Curbing Predatory Home Mortgage Lending: A Joint Report” p. 1.
6 Id. at p. 2.
7 Id. at p.3.
8 Id. Chapter III.
9 U.S. Department of Justice, Federal Bureau of Investigation, Financial Crimes Report to the Public, May 2005.
Published in the March 2009 issue of The Banking Law Journal.
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