Interest Rate Roundup

Wednesday, April 11, 2007

The Washington Post weighs in on mortgage fraud

The major papers aren't mincing words, it seems. Here's the Washington Post's latest entry on mortgage fraud, headlined "Housing Boom Tied To Sham Mortgages." The MOST noteworthy section echoes what I have said for some time now ...

"Thirty years ago, most Americans got their mortgages at a savings-and-loan association from bankers who obeyed conservative lending rules. But sweeping changes in the finance world have created a far different system. It has helped raise homeownership to record levels, but many real-estate professionals say it also has led to far looser lending standards.

"Nowadays, instead of poring over paperwork for weeks, lenders often verify loans through electronic underwriting programs in which numbers can easily be tweaked. About 70 percent of Americans get their home loans from independent mortgage brokers, many of whom are paid bonuses for pushing higher-interest loans.

"Close to 90,000 brokers have joined the profession since 2000, according to Wholesale Access, a research firm in Columbia. The field is lightly regulated. Eighteen states do not require criminal checks, the Conference of State Bank Supervisors reports. Undoubtedly, most mortgage brokers are honest, but some have played central roles in recent fraud cases.

"The housing boom brought another change. Mortgages are no longer held for long by banks but are packaged together as massive bonds and sold on Wall Street. Propelled in part by demand for these bonds, companies began offering loans that required little or no documentation of borrowers' income.

"These "stated income" loans were designed for a limited purpose: giving self-employed people a crack at homeownership. But during the boom, the number of such loans exploded to the point that they became a running joke in the industry, earning the nickname "liar loans." Estimates vary widely, but research suggests that they made up a significant portion of all mortgages during the boom -- 58 percent in a study by First American LoanPerformance.

"Mortgage lenders in theory have a right to compare loan documents to a buyer's tax returns, but they rarely do. In the few cases where it has been done, results were startling. In a study published by the Mortgage Asset Research Institute, one lender sampled 100 stated-income loan applicants and found that 90 had exaggerated take-home pay by 5 percent or more and that nearly 60 inflated their pay by more than 50 percent.

"Mortgage originators often neglected extensive document verification because it slowed loan approvals. "Everyone in the mortgage industry is trying to approve loans faster than their competitors," said James Croft, founder of MARI in Reston. "They all offer the same basic rates and the same basic mortgage products. But if I can get the loan faster, that gives me a competitive advantage."

This goes to the crux of the matter. The mortgage securitization process was supposed to make it so banks didn't fail and credit didn't tighten excessively in the event mortgage loans started going sour.

But spreading credit risk out over a wide pool of investors also had a perverse impact: Removing the credit risk from loan originators removed a big chunk of the incentive to care about end loan performance. Loans went from being something you originated, held in your portfolio, and earned interest on over time (and lost money on when borrowers defaulted!) to a hot potato -- one designed to be passed from one party to the next, with each party (originator, wholesale lender, securitizer, etc.) earning its fee, then moving on to the next mortgage. In other words, the focus shifted to loan volume rather than loan quality.

Incidentally, I said months and months ago that many of these problems would come home to roost. Here is just one piece from mid-2006. I wasn't alone, either -- many other sane, rational observers also pointed out the housing and mortgage industry's flaws. It's a shame policymakers didn't do anything about it when they had the chance.


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