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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.

Illustration by: Matt Mahurin

The time may be ripe for a shift in strategy as the foreclosure machine grinds on, and new foreclosure notices reach the troubling milestone of 10,000 per day.

A weak economy has added job losses and falling home values to the mix of toxic loans that prompted the crisis two years ago, making an already difficult situation even more severe. Government measures from foreclosure freezes to loan modifications have only served, so far, to stall the inevitable – and to create an ominous backlog of millions of pending foreclosures. Plus, more than one in five homeowners now owe more on their mortgages than their homes are worth, according to the real estate website Zillow.com. No one can predict with assurance whether those underwater homeowners will keep paying on their loans, or take a walk.

Illustration by: Matt Mahurin

And as bad as things may seem now, there’s still a long period of pain to come: A steady drumbeat of foreclosures, and a stagnant housing market, for the next several years ahead, at a minimum. Some experts see an even more dire picture: Five to 10 years, in California alone, of record high foreclosures. No significant home prices increases nationwide on the horizon in the next year. Or the year after. Or for as long as the next five years. Some 9 million foreclosures are expected by 2012.

While economists search for signs of green shoots, “no one’s really saying anything about this,” noted Guy Cecala, publisher of Inside Mortgage Finance, a Bethesda, Md. publication that covers the lending industry. “There’s really no good news out there, other than we can’t possibly get in much worse shape than we already are.”

Given this bleak scenario, some say it’s finally time for more forceful action. Congress and the Obama administration need to move boldly to stop foreclosures, requiring lenders to go beyond what Calculated Risk dubs “extend and pretend” repayment plans, and actually write down loan balances. And the Obama administration should move quickly to bring more players to the table to pick up the pace of those loan modifications – including the Internal Revenue Service. Servicers might be more aggressive about writing down loans if they’re sure it won’t create tax liabilities for trusts they represent, an impediment that currently stands in the way of getting more mortgages modified, said Kathleen Engel, a Cleveland State University law professor who studies mortgage securitizations.

There’s more to be done, Engel said: Expand the benefits of the homebuyer tax credit up the income ladder, offering it to move up buyers with existing homes as well as first time purchasers. Even direct government loans to borrowers, to keep them in their homes, shouldn’t be dismissed.

“Now is the time to do something,” Engel said. “There are a lot of things to be very concerned about right now. There are people underwater who aren’t making good on their home equity loans. With job losses increasing, more people aren’t able to make their mortgage payments at all. And REOs (Real Estate Owned properties) are driving down home prices. We really need to be trying some new things.”

Engel’s view was echoed by the Obama administration, which recently chastised lenders for their lack in progress in modifying loans. “We believe there is a general need for servicers to devote substantially more resources to this program for it to fully succeed and achieve the objectives we all share,” Treasury Secretary Timothy Geithner and Housing and Urban Development Secretary Shaun Donovan said in the letter, which was sent to to 25 mortgage-servicing firms.
Only about 270,000 borrowers have been offered loan modifications under Obama’s Making Home Affordable program, the Treasury Department says — a far cry from its much more ambitious goal of helping 4 to 5 million homeowners rework their loans.

Geither and Donovan weren’t the only ones speaking out. As TWI reported, a small band of House Democrats last week urged for more action beyond voluntary loan foreclosures. Senate Finance Committee Chairman Chris Dodd (D-Conn.) and 19 other Senators also petitioned Geithner to adopt a more aggressive strategy for loan modifications specifically for homeowners with option adjustable rate mortgages scheduled to reset to higher payments over the next four years. In addition, the Washington Post reported the Treasury Department also is putting together a “Plan C” – a new strategy – to head off defaults in commercial real estate and to tackle delinquencies tied to job losses.

It seems like a full frontal assault. But it may not be enough.

SLOWING DOWN THE INEVITABLE

In reality, there’s little political will to force lenders to write down loan balances. Congress defeated mortgage “cramdown” legislation, which would have allowed bankruptcy judges to cramdown, or reduce, the terms of a mortgage to keep a borrower in his home. The Obama administration stood by as the measure failed. Only that small group of House Democrats still wants to revive it. Bailing out homeowners still runs smack into the wall of moral hazard, in the public’s mind, and even the worsening crisis hasn’t changed that. “I don’t know why this is still true, but people are willing to roll over and give billions of dollars to banks, and they get pissed off about the idea of their next door neighbor getting a break,” said Sean O’Toole, president and founder of ForeclosureRadar.com,which compiles foreclosure data for the California market.

Instead of pressing for more loan modifications, it may be time to conclude that all the programs thrown at the mortgage problem haven’t done much to fix it. The most infamous, Hope for Homeowners, intended to help 400,000 borrowers, resulted in just 25 loan closings. Various state and voluntary foreclosure freezes only gave a pause to foreclosures. And most foreclosure prevention programs were created two years ago, when subprime loans were the major cause of foreclosures, not unemployment and a faltering economy.

These days, if you can’t afford your mortgage payment because you just lost your job, it really doesn’t matter whether you have a toxic Option ARM or a standard 30-year fixed loan. You’re still in default.

“The bad economy is what’s driving foreclosures right now,” Cecala said. “Even if there were no Pay Option ARMs out there, many homeowners would still be in deep trouble.”

Foreclosure prevention efforts, at this point, are “just slowing down the inevitable,” he added. “You can take a look at any one of these programs and you won’t find a lot of value in it.”

The Obama Administration, for example, recently expanded the refinancing options available under Making Home Affordable, to include borrowers who are more deeply underwater on their loans. It sounds good -  but it’s unlikely to pan out, Cecala said. Borrowers may not qualify for refinancings, under new underwriting guidelines from Fannie Mae or Freddie Mac that are far stricter than when they originally applied for their loans. Or borrowers may have to pay such high fees or rates that it won’t make the refinancing worthwhile. In places like California and Florida, some homeowners are so far underwater they still won’t qualify.

THE NUCLEAR OPTION

The big question, as Cecala notes, is whether foreclosures can be stopped at all. Which brings up the nuclear option: Unleash the pent up foreclosures and get the pain over with. Consider the backlog in California alone. More than 3 million households are expected to end up underwater eventually, according to O’Toole. As of now, some 851,000 households are delinquent on their mortgages. Of those, 264,977 already have received a foreclosure notice – but their properties have yet to be sold at auction. Only 22,245 foreclosures were completed in June, Foreclosure.com said.

Given that possibility that half of the the 3 million underwater homeowners or more also will eventually lose their homes, that means that working through the entire backlog could involve between five to 10 years of record high foreclosure levels, O’Toole said.
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Nationwide, the picture isn’t much better. After hitting a high point of about 900,000 in November 2008, REO inventory, or bank-owned foreclosures, slowly decreased over the last six months, down to about 770,000 in May, according to RealtyTrac, an online foreclosure database.

But don’t get your hopes up just yet.

“We believe the reason for that decline is largely due to the various foreclosure moratoria and state laws extending the foreclosure process that have been in effect in recent months,” said Daren Blomquist, a RealtyTrac spokesman. “As some of those moratoria were lifted in March and April we saw a substantial spike in initial foreclosure notices and we believe that will translate into a spike in REOs as well over the next several months.”

The bad news continues:  “In addition, we believe there is still a pent-up supply of delinquent loans that have not even hit the foreclosure process yet because banks are taking longer to start the foreclosure process after a loan goes delinquent – probably partly because they are overwhelmed with the volume of delinquent loans and partly because they are more aggressively trying to modify or refinance loans rather than foreclose.”

Blomquist added that the “twin threats” of risky loans and high unemployment will ensure a steady drumbeat of high foreclosure activity, for at least the remainder of this year.

The radical approach would be to stop staving all this off, take the pain, push the foreclosures through the system without delay, and get to the bottom. In California, at least, that could clear out the foreclosure backlog in about two years, O’Toole estimated.

“I’m not necessarily advocating that we should simply dump all the foreclosures at once – I actually think that could be disastrous,” he said. “But I think dragging them out over the next 5 to 10 years is an equally bad choice.”

But if there’s little political will to bail out homeowners, there’s even less stomach for announcing a strategy to bail on them entirely. It’s not the sort of thing that can be said in pubic. Even if there’s some logic to it.

AN ENTIRELY NEW DIRECTION

And that opens the door for a third way.

Alan Mallach, a senior fellow at the National Housing Institute and the Brookings Institution, took a close look at the housing market in Phoenix, where prices have declined by as much as 60 percent in the past few years.  Houses that sold for a quarter-million dollars now go for $90,000 or so in the booming REO market. Buyers – both investors and individuals – are realizing that at those prices, they have options, if they are willing to be patient. They can hold on to those homes for six or eight years, rent them out until they earn their money back, and wait until they can possibly sell them at a profit.

Most importantly, the new owners often are more than willing to rent back the homes to their former owners, a situation that benefits both sides. Borrowers can stay in their homes, with rent payments they can afford. The homes don’t sit vacant, abandoned, or vulnerable to vandalism, which can drive down surrounding property values. “You don’t kick the person out,” Mallach said. “And many of the investors say it’s an advantage not to have to look for a new tenant.” The situation, he said, provides evidence of “the beginning of some sort of leveling off that’s going on” in neighborhoods hit with foreclosures, at least in Phoenix.

Based in that experience, Mallach these days reminds local governments and neighborhood development groups not all investors are enemies, despite their reputations. Communities can both encourage investors as partners in buying and fixing up bank-owned houses – and warn them they’ll come down hard if they sink too far into speculation. And there are more encouraging signs at the local level. As Philadelphia, and some other cities have found, mandatory face-to-face foreclosure mediation between borrowers and servicers has proven to help avoid foreclosures, without dragging out the process.

A combination of these kinds of ideas – smaller scale, targeted to the needs of particular markets – may a quicker and more effective blueprint for tackling the crisis, especially in the absence of an aggressive government approach.

“Maybe we’re coming to the realization that we can’t loan mod our way out of this,” Mallach said. “There’s no magic solution. There’s no government riding in on a white horse to buy up all the bad assets.”

THE WILD CARD

Congress and the administration, in fact, haven’t exactly come up with anything “radical and bold” yet to tackle the crisis – and it’s unlikely they will turn around and do so now. Instead, Mallach noted, Realtors, the real estate industry, and some economists are spending unnecessary time and energy trying to declare a bottom to the crisis and look for any evidence of good news. It’s a great time to buy a house, they insist.

But there are still 9 million foreclosures expected by 2012, according to the Center for Responsible Lending. Goldman Sachs estimates 13 million foreclosures on all types of loans by 2014. And a continuing decline in home prices for the majority of housing markets is predicted for at least the next two years, says a report by mortgage insurer PMI.

As Malllach noted, policies to encourage renting are one option to counter all this. Even with all their limitations, loan modifications could be another. It’s “a really crucial time” to jumpstart them right now, said Cleveland State’s Kathleen Engel. Servicers finally have gotten fully staffed and up to speed, after a slow start. Clearing away potential tax liabilities for trusts due to aggressive loan modifications could help, she said. So could ratcheting up the pressure on lenders and servicers alike to complete more of them.

But challenges remain. REOs are driving away other sales, keeping downward pressure on home prices, Mallach noted. Stronger markets that have been immune so far to plunging home prices, such as New York City, New Jersey, and the Philadelphia suburbs, still remain at high risk for a downward spiral. Frustration keeps growing over a lack of progress in anything being done to stem foreclosures, creating anger in neighborhoods, and even a movement to put squatters in vacant homes.

Beyond that, underwater homeowners remain a huge wild card, with the chance that a significant number of them will stop paying their mortgages in the near future clouding any hope for a quick recovery.

When it comes to the foreclosure machine, things are probably even worse than they seem. That’s a starting point for any strategy to challenge a housing crisis isn’t ending anytime soon.