Mortgage Fraud - Financial Times - Payback Time

Published in the Financial Times [London], Thursday, August 9, 2007

[Mortgage Fraud]
Payback time

By Brooke Masters and Saskia Scholtes

At the height of the US subprime lending boom, taking out a mortgage could not have been easier. Low credit score and history of bankruptcy? No problem. Income too low to qualify for a mortgage? Inflate what you earn on a "stated income" loan. Nervous that your lender might check up on your "stated income"? Visit www.verifyemployment.net.

For a $55 fee, the operators of this small California company will help you get a loan by employing you as an "independent contractor". They provide payslips as "proof" of income and, for an additional $25, they also man the telephones to give you a glowing reference should your lender need it.

But perhaps the most absurd aspect of the US subprime mortgage market in recent years is that lenders became so generous with credit provision for out-of-pocket borrowers that very few checks were ever made.

That left the system extraordinarily vulnerable to widespread fraud, a possibility that federal and state prosecutors across the US have begun to look into. With the subprime crisis expected to cost investors between $50bn (£24bn, €36bn) and $100bn, according to the US Federal Reserve, these investigations could transform it from a market correction to a full-blown national scandal.

At the root of the subprime problem was easy credit: lenders and their brokers were often rewarded for generating new mortgages on the basis of volume, without being directly exposed to the consequences of borrowers defaulting. During several years of strong capital markets and strong investor appetite for high-yielding securities, lenders became accustomed to easily selling the risky home loans they made to Wall Street banks. The banks in turn packaged them into securities and sold them to investors around the globe.

Such ease of mortgage funding allowed thousands of borrowers to get away with fraudulently mis-stating their incomes, often with the encouragement of their brokers. More ambitious fraudsters appear to have taken out multiple mortgages and walked away with the cash.

Karen Gelernt, a partner at law firm Cadwalader, Wickersham & Taft, says: "The difficulty is getting a handle on the size of the problem, because there is no real mechanism for reporting fraud for most originators in this market. In fact, they had every incentive not to report."

Fraud has been detected up and down the financing chain: just as borrowers have lied to get better rates and larger loans, mortgage brokers and loan officers have lied to borrowers about the terms of their loans and may also have lied to the banks about the qualifications of the borrowers. Appraisers, likewise, have lied about the value of the properties involved.

"The recent rapid expansion of the subprime market was clearly accompanied by deterioration in underwriting standards and, in some cases, by abusive lending practices and outright fraud," Ben Bernanke, Fed chairman, recently told lawmakers. With mortgage rates rising and house prices falling, subprime borrowers have been defaulting at record rates.

The fallout is working its way up from the retail level - forcing people out of their homes and lenders into bankruptcy. Investment banks have lost revenue as investors back away from mortgage securities and a handful of high-profile hedge funds have collapsed - most notably two highly leveraged funds managed by Bear Stearns. The crisis has contributed to turmoil in financial markets in recent weeks and could threaten the health of the US economy as lenders tighten access to credit, putting a drag on consumer spending.

For some, this rapid and dramatic unravelling of the subprime lending industry has echoes of the costly savings and loans crisis of the early 1980s - a meltdown that also had its origins in financial market innovation and inadequate oversight, and which many cite as a contributing factor in the 1990-91 economic recession. That crisis ended with a federal bail-out of $150bn and a handful of high-profile convictions for fraud.

This time around, the major losers have been hedge funds, which in theory are limited to wealthy investors. But some analysts believe the pain could spread - many pension funds and college endowments have turned to hedge funds to heat up their returns and some, including Harvard University, are starting to get their fingers burned. Harvard is estimated to have lost $350m of the $550m it invested in a hedge fund run by Jeffrey Larson, a former Harvard money manager, that collapsed recently as a result of positions related to the subprime market.

If the losses trickle down and end up hurting small investors, pressure may grow for a public bail-out. Rumours swept the market earlier this week that Fannie Mae and Freddie Mac, the government-backed mortgage agencies, might get the authority to make sweeping purchases of underpriced mortgage securities.

"The US mortgage landscape has become a top-of-mind political talking point, and we would not be surprised to see the usual 'flow like mud' legislative process fast-tracked with respect to items offering relief to the -troubled mortgage market," says Louise Purtle, strategist at -CreditSights, a research firm.

Most fraud in subprime lending appears to have been so-called "fraud for purchase" - lying about income so as to win a mortgage approval. In reviewing a sample of "no doc" loans that relied on borrowers' statements, the Mortgage Asset Research Institute recently found that almost all would-be home owners had exaggerated their income, with almost 60 per cent inflating it by more than 50 per cent.

These fraudulent borrowers are often difficult to uncover, says Ms Gelernt, because they often stretch to meet their minimum payments for some time before they eventually default. The time lag between initial fraud and default also makes a conviction hard to obtain, she adds, while mortgage investors also have little chance of recovering their losses from individual borrowers in these circumstances.

Many of the originators to blame for poor quality control standards may not be held to account either - with several such lenders already in bankruptcy. "There's a real problem in finding fraud after the fact because the money is already out the door and you won't get the recovery," says Ms Gelernt.

Loose lending standards also facilitated fraud for profit. US prosecutors around the country have broken up at least a dozen mortgage fraud rings and more cases are expected.

In one New York case, the FBI charged 26 people who used stolen identities, invented purchasers and inflated appraisals to obtain subprime loans on more than $200m of property. In an Ohio case, 49 per cent of the mortgages processed by a -single broker never made even a first payment.

The fate of a series of North Carolina neighbourhoods built by Beazer Homes may offer a foretaste of the looming problem. Low income home-buyers around Charlotte have sued the builder alleging that its lending arm steered them into mortgages they could not afford, leading to widespread foreclosures.

The homeowners allege that sales agents misrepresented their personal data, including assets and income, to help them qualify for government-insured mortgages starting in 2002. By the beginning of this year, 10 Beazer subdivisions in Charlotte had foreclosure rates of 20 per cent or higher, compared with 3 per cent state-wide, according to a local newspaper analysis.

The FBI is probing Beazer for possible fraud and the US Housing and Urban Development is examining whether its sales practices violated government-insured mortgage rules. Beazer has defended its sales practices and says it has a "commitment to managing and conducting business in an honest, ethical and lawful manner". In June it announced that it had fired its chief accounting officer for allegedly attempting to destroy documents. The company's shares have lost 75 per cent of their value since the probes began.

Several state attorneys-general are also on the trail. Andrew Cuomo of New York state made headlines this spring with a series of subpoenas to property appraisal companies and has said publicly that he is probing the entire industry. Sources familiar with the office's work say the investigation is still at a relatively early stage.

Marc Dann, the Ohio attorney- general, is looking further up the funding chain. He has been outspoken in his criticism of the role the financial services industry may have played in the large numbers of foreclosures in his state. "There's a whole series of people that knew or should have known that there was fraud in the acquisition of these mortgages," Mr Dann told the Financial Times. "We're looking at ways to hold everybody who aided and abetted that fraud."

Mr Dann's office is looking at brokers, appraisers, rating agencies and securitisers and plans to use several legal methods to hold bad actors accountable. The Ohio attorney-general not only has criminal enforcement powers, but also represents the third-largest set of public pensions in the country and can thus file civil lawsuits on behalf of investors.

"But for the mechanism of packaging these loans, the fraud never would have existed," Mr Dann says. "We're following this trail from homeowner to bondholder." He says his investigation could take six months to a year to bear fruit.

The Securities and Exchange Commission, for its part, is investigating whether Bear Stearns and other hedge fund managers were forthright about disclosing the rapidly declining value of their holdings.

Many of the mortgage-related securities bought by the hedge funds are rarely traded and difficult to value accurately. They are often valued in portfolios according to complex mathematical models because real market prices are not available, making it possible to disguise underperformance if models are not updated.

The SEC has not brought a case in the area so far, but current and former regulators note that it has previously won settlements from several mutual funds and banks that failed to revise the prices of illiquid assets during a falling market.

Private securities lawyers are also starting to file securities fraud lawsuits on behalf of investors who have lost out because of the subprime meltdown.

Jake Zamansky, a lawyer who negotiated an early settlement from Merrill Lynch in the scandal over skewed investment bank research, has filed an arbitration claim against Bear Stearns alleging the firm misled investors about its exposure to the mortgage-backed securities market.

The class action law firm of Bernstein Litowitz is also preparing a claim against Bear Stearns, alleging the firm made material mis-statements in the offering documents for its now defunct hedge funds.

"This was simply about a hedge fund strategy that failed," said a Bear Stearns spokesman. "We plan on defending ourselves vigorously against the allegations in these complaints."

Other hedge funds may also come under political or legal pressure over their role in the loan crisis.

Richard Carnell, a professor at Fordham law school, says it may be possible to hold the investment banks that securitised the mortgages at least partially responsible in the case of a major collapse of the market. "There are two things you can object to in the securitisers' conduct: failing to disclose material facts about the credit quality of the mortgages; and you can also criticise them for acting as an enabler for someone they know is a bad actor," he says.

But putting together a case will not be easy because the hedge funds and other investors who bought such securities are presumed to be sophisticated about financial matters. This means it will be harder for them to prove they were not properly warned about the risks involved.

In the case of the Bear Stearns funds, investors may face new hurdles to recovering any money through US lawsuits. Though the funds operated mostly in New York, they were incorporated in the Cayman Islands and that is where they have filed for bankruptcy. In what could be a test case for international bankruptcy laws, the liquidators have applied to the US courts asking them to block US lawsuits during the liquidation process.

Bear Stearns said in a statement: "Because the two funds are incorporated in the Cayman Islands, the funds' boards filed for liquidation there . . . The return to creditors and investors will be based on the underlying assets and liabilities of the funds not on the location of the filing."

Even if the US lawsuits do go forward, a case pending before the Supreme Court could also prove crucial to investors who hope to make a case that hedge funds and rating agencies enabled widespread fraud.

In Stoneridge Investment Partners v Scientific Atlanta, the court is considering whether investors can recover from firms - including accountants, lawyers and bankers - that help a public company commit fraud by participating in a "scheme to defraud". If the high court rules against "scheme liability", investors who lost money in the subprime market will have very few places to turn to try to get some of it back.

William Poole of the Federal Reserve Bank of St. Louis thinks that this may be what investors who lose money on subprime-linked securities deserve for not looking at them closely enough.

Criticising Wall Street underwriting standards recently, he said: "The punishment has been meted out to those who have done misdeeds and made bad judgments. We are getting good evidence that the companies and hedge funds that are being hit are the ones who deserve it.''

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