The Washington Post reports Housing and Urban Development Secretary Shaun Donovan will tell the House Financial Services Committee that the agency wants to increase the up-front cash paid by borrowers,  raise minimum credit scores for borrowers, and limit how much money sellers can kick in, including paying closing costs or giving free upgrades.

The proposals for tighter standards come as the FHA handles a much larger share of the mortgage market than in the past, and more of its loans go bad. As we explained, FHA loan volume has quadrupled since 2006, and a rising number of defaults has prompted fears the agency will be the next in line for a government bailout.

From The Post:

In the past, the FHA has resisted raising down payments or insurance premiums for fear of shutting out qualified borrowers and stunting the housing market’s slow but steady recovery.

But Donovan plans to tell the House committee that the exploding volume of loans the FHA is now handling requires stricter risk controls than the previous administration had in place, according to a copy of his prepared testimony. A recent audit shows that the FHA’s financial cushion already has eroded below the level required by law.

It’s important to connect the dots here, from mortgage fraud schemes to the FHA. Investors that commit mortgage fraud while flipping short sales or through other schemes increasingly have been finding ways to fund their deals through the FHA, as we noted. In some cases, they have been evading FHA anti-flipping rules by setting up land trusts to purchase and hold real estate, and to obscure the identity of the actual purchaser.

As Yves Smith at Naked Capitalism explained, the FHA has been put in a difficult position as a result of the financial crisis:

It is really a shame to see what has happened to the FHA. Prior to the subprime bubble, the FHA has a good record with providing low down payment loans to borrowers. Before readers scoff, it had a simple secret: it screened borrowers. And the old-fashioned process was sufficiently time-consuming that the prospective homeowners also had to grapple with whether they could make the payments…But now the FHA has been assigned a role in the “save the housing market” game plan, which means notions of prudence get compromised.

But it’s even more than that. As we reported nearly a year ago, both the FHA and HUD were mostly ignored during the Bush administration — but now are being called on to turn on a dime and play major roles in saving the mortgage and housing markets.

The FHA must turn itself around and operate at its peak, after years of neglect. While the Obama administration tackles the stimulus plan and other urgent problems, government agencies like FHA and HUD, long relegated to the sidelines, are being called on to ramp themselves up and take on greatly expanded tasks. With the financial crisis so severe, the revitalization has to happen immediately – and there’s no Plan B. Getting these agencies back up to speed is an overlooked challenge facing the new White House regime.

Rising fraud in FHA loans is one example of that challenge. The new rules are a step toward addressing the problem. But the administration also needs to make a top priority of providing the FHA with the resources to put in place additional risk controls and other necessary changes to handle its much larger role. Banks that aren’t lending have gotten most of the government’s attention and money, even as rising fraud in FHA loans is threatening the housing market, and the economy, as a whole. It’s long past time to change that.

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With home prices continuing to fall and more foreclosures yet to come, it’s clear that tough times remain for a housing market recovery. And to add to the troubles, another threat to any rebound is emerging: mortgage fraud.

The risk of mortgage fraud in the third quarter of this year on U.S. home loans shot up 11 percent from the previous quarter, according to Interthinx, a firm that provides fraud prevention services to lenders. But unlike the inflated home values and incomes that marked the mortgage fraud common during the housing boom, things are different this time around. Interthinx, which analyzes mortgage fraud nationally, and uses its risk measure to show where it may be increasing the most, found a continuing shift to schemes involving bank-owned foreclosed homes, and short sales, in which an owner sells the house for less than what’s owed on the mortgage and the lender forgives the remaining debt. The firm also reported that real estate agents and other professionals increasingly are involved in the schemes, which are growing in popularity due to the abundant supply of  foreclosures, and the fact that appraisals frequently aren’t required in order to sell distressed properties.

[Economy1]The fraud goes beyond just just ripping off banks. Mortgage fraud leads to more property value declines in hard-hit neighborhoods, leaves homeowners already in distress in even worse shape, and ultimately will end up costing taxpayers, who will be stuck with the costs when loans go bad.

As fraud picks up, a typical scheme increasingly works like this: A homeowner underwater on a mortgage, owing more than the home is worth, arranges a short sale – with a friend or relative as the buyer. The relationship is never disclosed to the lender. The home then gets deeded back or gifted to the troubled borrower shortly after the sale. Or, the bank unwittingly accepts a lowball short sale offer, allowing the new owner to quickly flip the property to a buyer already on standby, willing to pay a higher price. Such schemes amount to fraud because buyers and sellers lie to the bank about the true nature of the transactions. Banks lose more money than they would have, had the short sales occurred at their true market value – the profits go into the pockets of the flippers. Some investors only flip the properties again, saddling the buyer’s lender with a property that’s not worth the mortgage amount.
Flipping foreclosures and short sales is taking off as the latest real estate craze, with numerous web sites popping up to market advice on turning quick profits on distressed properties. And short sales also are expected to only increase as loan modification efforts continue to falter, and borrowers facing foreclosure have few other options. Interthinx expects fraud involving a “straw” borrower – a deceptive stand-in used as cover for a questionable transaction – to also become more frequent as a result.

“Since many large for-profit schemes during the boom were fueled by a steady stream of straw borrowers recruited through ‘investment’ clubs and networks,  the coincidental proliferation of “get rich quick” websites targeting short sale and REO investors and the continuing popularity of “flip this house” programs on TV suggests that there is a significant pool of potentially willing participants, and that left unchecked, the damage could be significant,” Interthinx said.

The problem for neighborhoods with distressed homes is that investors buying them up and flipping them can destabilize a community even further, since some investors may not maintain properties or may walk away from losses. Using relatives for short sale fraud means the bank ends up approving a mortgage that the owner still may not be able to afford, creating more losses, both for the bank and for the neighborhood.

And, increasingly, people involved in fraud schemes are finding ways to finance them through taxpayer-backed Federal Housing Administration loans, an agency already dealing with delinquency problems and and mortgage fraud, said Robert Simpson, president of Investors Mortgage Asset Recovery Co. in Irvine, Calf., a firm that analyzes mortgage fraud. The FHA’s loan volume has quadrupled since 2006, and FHA-backed loans have been beset by rising defaults that some contend put the agency at risk for a taxpayer bailout. Between the FHA, and government-controlled mortgage giants Fannie Mae and Freddie Mac, nearly 90 percent of all mortgages are backed by the U.S. taxpayer. Banks and lenders took the losses, at least initially, the last time around. This time, taxpayers may end up on the hook, he said.

“Anytime there’s money out there, someone will begin trying to figure out a way to get to it,” Simpson said. “Right now, the fraud gets shipped over to the FHA. We’ve got to hope they are being very diligent, because if they are not, the damage will be irreversible.”

Mortgage fraud played a huge role in the mortgage market collapse. Borrowers qualified for loans they couldn’t afford when brokers inflated their incomes, sometimes without their knowledge.These days, fraud revolves less around the origination of the mortgage loan and more with all the different transactions that take place over distressed properties, from sales of Real Estate Owned homes to short sales, said Guy Cecala, publisher of Inside Mortgage Finance, a trade publication that follows the subprime industry. The well-documented proliferation of foreclosure rescue and loan modification scams is a prime example, Cecala said.

Mortgage fraud also is on the rise because former subprime loan officers are out there looking for new jobs, and new ways to make money, he noted.

“Whenever there’s a new transaction, there’s a new way to game they system, and this is exactly what people are trying to do,” he said.

Short sales at first seem an unlikely target for fraud, because they can be a lengthy and difficult process, with banks often taking months to approve sales, if they do at all. For that reason, Cecala said, he believes short sales – at least for now – comprise only a small piece of the mortgage fraud picture. But the Treasury Department is expected to issue guidelines soon on streamlining short sales and offering financial incentives to borrowers and lenders. The push for more short sales, combined with a backlog of foreclosed homes, distressed homeowners, and banks anxious to get foreclosures off their books, will likely make short sale and REO flipping fraud more prevalent.

A recent investigation by the Sarasota Herald-Tribune of sales in two Florida counties, for example, found that banks had lost “untold millions” because of  short sale flippers using questionable appraisals and failing to disclose that a quick sale at a higher price had already been arranged. The report found a small industry of flippers buying distressed properties and reselling them within days. Real estate professionals were a key part of the schemes, participating in both buying and selling properties. All the losses added up, with just the most suspicious sales, where properties were flipped within a day, already costing banks $1.7 million in Sarasota and Manatee counties alone.

Flipping properties isn’t illegal, but it can involved fraud in several ways, explained Ann Fulmer, vice president of business relations for Interthinx. It’s when a seller never mentions higher offers on the table from bona fide purchasers, or fails to disclose that the seller already has a contract with a buyer for a higher price. Red flags sometimes should be raised when borrowers use transactional funding, which means essentially renting someone else’s money for one day, in order to appear in a stronger financial position. Then there’s the the use of land trusts – they’re not illegal, in and of themselves. Land trusts are organizations created to purchase and hold real estate. But short sale gurus are advising investors to set them up to evade FHA anti-flipping rules, and to hide the true borrower’s identity, which can amount to fraud.

“Short sale flips are today’s equivalent of the California gold rush,” Fulmer wrote recently.

She and other mortgage experts noted that banks already are on to some of the schemes. In some cases, banks are requiring everyone involved in a transaction, from the real estate agent to the mortgage broker, to sign affidavits swearing they have aren’t in the flipping business with anyone else involved in the sale. Cecala, of Inside Mortgage Finance, said federal law enforcement agents also are moving more aggressively even on smaller cases of mortgage fraud, unlike during the housing boom, when only major cases drew attention.

But a fraud specialist for a major wholesale lender, who declined to be named, said there’s still plenty of misdeeds going on. Some borrowers are filing amended tax returns showing a much higher income than the borrower’s true income. The borrower pays a penalty to the IRS for unpaid taxes, but uses the higher income figure to qualify for a bigger loan, or for a loan he wouldn’t otherwise have qualified for. In addition, some builders still are offering “silent seconds” to borrowers who can’t afford a home on their own. A silent second refers to a second mortgage, sometimes used for a downpayment, that is not disclosed to the lender of the first mortgage.

Stated income and no documentation loans known as liar loans, may be gone, the fraud specialist said, but some lenders still are seeing borrowers and loan officers still trying to fudge or doctor financial information, a common practice during the pre-liar loan days of the 1980s, he said. “We’re seeing white out again,” he said.

Most striking is that Hope for Homeowners has attracted unexpected backers: Investors who had refused to consider the program’s requirement that they forgive some of a borrower’s mortgage balance if the home is worth less than is owed, known as being underwater, are now trumpeting that provision.

“Institutional investors that own securities backed by mortgages are extremely keen to write down principal in exchange for the borrower refinancing into a Hope for Homeowners loan,” said Tom Deutsch, deputy executive director of the industry group American Securitization Forum.

Investors that were previously unwilling to write down the value of their loans are increasingly on board with the practice — anything to get those loans off the books. A bird in the hand is worth two with a high probability of default, as they say. But there’s something amiss here. If investors believed that they would maximize their return on troubled loans by reducing principle, they would. That is, if they thought that by writing down the principle on a loan they would increase the odds of payment by enough to make the haircut worthwhile, then it would make sense for them to go ahead and do so. And if they were already doing so, then there would be no need for this program.

But clearly there is a need. Investors are only ready to write down principle if that allows them to shed default risk — which means they don’t think that writedowns lead to large reductions in default risk. And they’re probably right. Under this program, there are new borrowers waiting to pick up the loans because Federal Housing Administration is authorized to insure them — up to $300 billion. It kind of looks as though the government is working hard to absorb up to $300 billion in mortgage loan losses from various investors.

Hope for Homeowners seems primarily geared toward providing hope to investors, rather than homeowners. Given the extent to which unemployment is driving defaults in the current climate, a serious effort to stem foreclosures would focus on generous extensions of unemployment benefits, to the exclusion of most everything else.

But his enthusiasm isn’t universal.

Illustration by: Matt Mahurin

Amid the buzz the program has generated over the possibility of jumpstarting the sluggish housing market, some worry that “monetizing” a tax credit – which means providing homebuyers with short-term loans secured by their expected tax refunds, so they can gain quick access to the money – isn’t quite as simple as it sounds.

It could make borrowers vulnerable to the same predatory abuses that plague the Earned Income Tax Credit program, an anti-poverty government effort. That program remains a regular target of tax preparation companies, which partner with banks to aggressively market short-term, high-rate Refund Anticipation Loans secured by the refund. Recipients – the working poor – often fork over as much as one-third of their refunds in charges and fees, in order to get their money a week or two earlier. The loan is repaid when the actual refund arrives.

It’s possible that unscrupulous lenders could launch homebuyer tax-credit programs of their own, profiting from the publicity over HUD’s initiative. It’s not clear if the Federal Housing Administration, which has seen its share of the mortgage market explode from less than three percent to more than 30 percent in the past few years, will have the resources to police the program adequately. And with government the largest source of mortgage money in a tight credit environment, “people are going to try to take advantage of it” through fraud, said Ann Fulmer, of vice president of business relations for Interthinx, a provider to lenders of fraud prevention services.

Beyond all that, some decry the idea of helping people buy homes who can’t come up with downpayment money on their own, calling it the kind of thinking that led to the mortgage crisis in the first place. Congress approved the credit as part of the stimulus package approved in February.

Interest in the downpayment program is so intense that earlier this week, when HUD mistakenly posted a mortgagee letter with guidance for the program on its website, then took the letter down, reports spread in the blogosphere that the program had been killed. A HUD spokesman confirmed the speculation was false and that the program was going ahead as planned.

And so is the controversy.

At Minyanville, a financial information Website, real estate consultant Andrew Jeffery declared that “subprime lending has come roaring back,” noting that a few states already have started similar tax credit programs. Financial recklessness, he said, isn’t coming from Wall Street this time around, but from the government itself. As Jeffery put it, federal and state governments are “in a rush to prop up home prices and delay the ultimate day of reckoning” by insisting on “coercing taxpayers to over-leverage themselves” and take on debt they can’t afford.

Peter Morici, an economist and business professor at the University of Maryland, was equally blunt. “If you can’t save for a downpayment, should you be buying a house? It’s like we’re saying, ‘People who can’t save a cent and who can’t let go of their credit cards should get downpayment assistance.’”

Morici also called the program a “total payoff to builders,” who lobbied heavily for the tax credit.

But others aren’t so quick to criticize. They point out that the government is just trying to balance helping out a housing market desperate for buyers with avoiding the kind of risky lending that created the crisis. Fulmer, of Interthinx, noted that the FHA is working hard to “walk a tightrope” – making sure that moderate income buyers still have a shot at buying homes, given steep new downpayment requirements, while backing responsible and sound lending.

“There are competing goals,” said Brian Chappelle, a former FHA official and founding partner of Potomac Partners, a Washington mortgage industry consulting firm. “They want to stimulate housing and economic activity and they also want the borrower to “have skin in the game.”‘

The downpayment idea has attracted widespread interest, with the Wall Street Journal calling it a possible “game changer” for the moribund housing market. In the end, said Chappelle, “our economic problems trump risk concerns.”

In his speech to the National Association of Realtors, HUD’s Donovan said that “we all want to enable FHA consumers to access the tax credit funds when they close on their home loans so that the cash can be used as a downpayment.” He said the FHA will allow “trusted FHA-approved lenders,” as well as HUD-approved nonprofits, and state and local government entities, to monetize the credit through short-term bridge loans.

HUD spokesman Brian Sullivan said he couldn’t comment further, except to say that the FHA is continuing to work out final details.

The program is expected to mirror efforts already in place in a handful of states, including Missouri, Delaware, New Jersey, Washington, and Pennsylvania. Under those programs, the states offer bridge loans that allow buyers to borrow against their tax credit for down payment and closing costs, then repay it when their tax refunds arrive. If the borrower doesn’t pay, the unpaid loan becomes a lien on the property, at a slightly higher interest rate, which means the borrower faces higher monthly payments over the next decade.

The FHA has run into trouble in the past with down payment programs. Congress last year banned a seller-funded down payment assistance program that led to high default rates on FHA loans. As TWI reported recently, supporters of the banned program, including builders, Realtors, mortgage brokers, and some in Congress, are trying to revive it.

Under the seller funded program, the FHA allowed homeowners to get down payment help from nonprofits or charities funded in part by sellers. But sellers often raised the sales price of a home to cover the cost of the down payment “gift.” The charity or nonprofit that supplied the down payment money was reimbursed by the seller for it, along with service costs and fees, once the deal closed. Borrowers paid for it all, whether they realized it or not. The Internal Revenue Service called the whole thing a scam and revoked the charitable status of seller-funded providers.

Aaron Krowne, founder of the Mortgage Lender Implode-o-Meter, a website that tracks the mortgage industry and is leading a campaign in the blogosphere to block any reinstatement of the seller-funded down payment assistance program, said he doesn’t have the same concerns about the homebuyer tax credit idea.

“It differs significantly from SFDPA (seller funded down payment assistance) in that the seller has no specific inducement to inflate the price, nor is there any third party who earns a fee for laundering a “contribution” from the seller,” he said. “So, in my opinion, it is a bad macroeconomic inducement and is bad policy — but it isn’t criminal and dishonest with likely knock-on effects like SFDPA.”

In addition, the FHA is likely to keep a close watch on the entities it approves to make the short-term loans, and will limit the costs and fees that can be charged, noted Robin Medecke, a researcher at the Mortgage Lender Implode-o-Meter.

Her worries about the program, she said are different.

“Where I would be concerned is the possibility of Fannie and Freddie adopting similar guidelines with limited or no power to dictate or enforce similar restrictions,” she said. “That’s the real as-yet-unopened can of worms, in my opinion, and if it’s further extended to the secondary market, thereby opening up the tax credit advance to private investors, the potential for abuse increases exponentially.”

HUD’s goal in developing the program was to encourage lenders issuing the mortgages to also make the short-term loans to the borrowers, noted Chappelle, the former FHA official. But Chappelle spoke with several small and regional lenders last week, who said they aren’t interested in doing so. Only government agencies and approved nonprofits can issue a lien on the property if the loan goes unpaid, he said.

“While the lender can make the loan, I hear that most won’t do it because it must be unsecured,” Chappelle said. “It can’t be attached to the property. No question some of the tax credit could be abused by entities that will step-in and make these loans.”

Guy Cecala, publisher of Inside Mortgage Finance, which covers the lending industry, agreed, saying an “obvious problem” is that predatory lenders will start marketing similar homebuyer tax refund anticipation programs, “piggy backing on the publicity surrounding the non-profit products authorized by HUD.”

While Donovan referred to “trusted” FHA-approved lenders that will be allowed to participate, Cecala also questioned that assurance. “It gets a little trickier when you bring FHA-approved mortgagees into the mix since that group includes brokers – and probably former subprime lenders,” Cecala said.

Business Week magazine reported last year that subprime lenders with histories of abuses were turning to FHA-backed loans.

The biggest question about the program is whether of the agency has the ability to monitor it for fraud, said Sonia Garrison, a senior researcher with the Center for Responsible Lending. The FHA was downsized over the past decade as it played a smaller role in the mortgage market.

“We’ve got to be able to get the FHA the resources it needs to police the program properly,” she said.

And to draw the fine line between helping the housing market, and keeping a lid on risky lending.

It seemed like a good idea at the time. Last October, the Bush administration unveiled a plan aimed at helping homeowners facing foreclosure called Hope For Homeowners. Earlier this month, there was consternation and disbelief across the political and economic spectrum when it was revealed that the program — initially projected to help up to 400,000 of the most distressed borrowers — had closed exactly 25 loans since its inception.

The logic behind Hope For Homeowners sounded simple enough. It was inspired by a Depression-era entity, the Home Owners’ Loan Corporation, that helped more than a million Americans stay in their homes. Homeowners stuck with ballooning mortgage payments and declining home values could apply for a new, fixed-rate mortgage backed by the Federal Housing Administration. The Department of Housing and Urban Development allocated $29.5 million in start-up costs to cover training and development for the program. To date, a little more than half that amount has actually been spent. What happened?

Illustration by: Matt Mahurin

“Basically, the incentives are wrong for every category of participant,” said Julia Gordon, senior policy counsel at the non-profit Center for Responsible Lending. For starters, it wasn’t cheap to participate. Homeowners had to pay hefty fees and insurance premiums. In addition, a provision designed to discourage house-flipping required homeowners to share, on a sliding scale, between 50 and 100 percent of appreciated equity built up in the home for the first five years. After five years, homeowners would have to turn over 50 percent of that equity, no matter how far into the future they kept the house.

For their part, lenders were required to lower the principle, referred to as “taking a haircut” in industry jargon. Many of these at- or near-default mortgages also had junior liens on them, often in the form of home equity loans. Hope For Homeowners would wipe out those lienholders entirely. Since the plan was wholly voluntary, lenders were under no obligation to take a loss on the loan. As a result, the vast majority took a wait-and-see approach.

The biggest stumbling block, though, was that of securitization. The majority of subprime mortgages were packaged into securities, and the agencies that manage those securities were loathe to enact loan modifications that could lead to lawsuits against them. Technically, a servicing company is free to do what it needs to do to protect investor dollars. However, if the servicer thought taking the HFH “haircut” was the better option while the investor wanted to foreclose and hope for the best, a messy legal battle could ensue, and no one wanted to be the test case.

“What seems to be happening is the servicers are saying ‘I know foreclosure is bad for everybody but my agreement permits it,’ so it’s the default option,” said Alan Mallach, nonresident senior fellow at the Brookings Institution.

Housing policy experts say the program probably wasn’t helped by the decision to put it under the umbrella of the Federal Housing Authority. “The FHA definitely does not move quickly,” said Sharon Price, director of policy for the housing advocacy group National Housing Conference. Marrying HFH to existing FHA programs turned out to be much more complicated than planned, to the extent that the agency ended up having to build the initiative’s infrastructure nearly from scratch.

“What happened was once we got to the details, this program was so different it really forced the FHA folks — who were pretty thinly staffed — to create a whole new infrastructure,” said the Center for Responsible Lending’s Gordon. “It wasn’t as efficient as one might have theoretically surmised.” This alone would have slowed down implementation, but the directive couldn’t have come at a worse time for the FHA.

When the subprime sector took off earlier this decade, the FHA had found itself increasingly on the margins. Formerly the go-to lender for borrowers with tarnished credit histories, the agency found itself competing against behemoths like Countrywide and IndyMac. Its limited menu of fixed-rate loans seemed less attractive to homebuyers than the exotic, interest-only, adjustable or deferred payment plans the private sector offered, and the FHA’s market share slid.

That trend reversed abruptly when the subprime mortgage market imploded. Last year, the FHA suddenly had to juggle a whopping 161.2 percent increase in applications over 2007. “If Hope For Homeowners actually took off, they’d be swamped,” said Alan Mallach.

Last week, House Financial Services Committee chair Rep. Barney Frank (D-Mass.) pledged to figure out what went wrong, and a series of tweaks to the program has been green-lighted by the financial committee and awaits full House approval. This piece of on-deck legislation dials back the required premiums and equity-sharing measures, and decreases the loss-taking required of lenders. Another provision gives legal immunity to loan servicers who modify loans.

Some say it’s not enough. American Enterprise Institute resident fellow Alex Pollock suggests taking HFH out of the FHA and creating a separate entity. “What they did in the 30s and what I would have preferred would have been a stand-alone entity.” Pollock said. “You’d have had a much more energetic program with a higher probability of success if it was set up as a thing in and of itself.”

Alan Mallach takes it a step further, suggesting that this new division could be responsible for all of the mortgage-related programs, infusions and investments the government has become involved — some would say entangled — in over the past several months. “What we need is a single mechanism for whenever the government finds itself controlling a mortgage,” he said.

Both agree that such a plan is politically unpalatable, though, because it requires at the outset an implicit acknowledgement that the current mortgage problems are going to be with us for a long time to come. Even for a government that has gobbled up substantial amounts of soured assets, that admission might be too much to swallow.

Martha C. White is a freelance journalist in New York. She regularly writes about finance and the economy.