Liar Loans an Endangered Species

With foreclosures rising and home prices falling, could something other than supply and demand be moving the real estate market?

That’s a question increasingly being raised in Washington, where a new interest in mortgage fraud is beginning to emerge.

“Mortgage fraud takes many forms,” says Jim Saccacio, Chairman and CEO at, the nation’s largest foreclosure resource. “It typically involves claims of excess income, fictional jobs, hidden debts, disguised sale discounts, tainted appraisals and manipulated credit reports. While it might seem that buyers would be the natural authors of such shams, in at least some cases it’s lenders looking for bigger fees who change the paperwork without the knowledge of unsuspecting borrowers.”

The just-issued eighth annual mortgage fraud study developed by the Mortgage Asset Research Institute found that reports of suspicious mortgage activity rose 33 percent in the first half of 2005 when compared with 2004. In turn, the 2004 report was up 150 percent when compared with 2003.

“If rising interest rates produce a significant reduction in originations for 2006,” says MARI, then “additional cases could surface in the future at a rapid rate as some originators press to maintain high origination levels.”

“Stated income and reduced documentation loans speed up the approval process, but they are open invitations to fraudsters,” according to MARI.

No one knows the extent of mortgage fraud, but MARI says that when one study compared loan applications with IRS records it found that “90 percent of the stated incomes were exaggerated by 5 percent or more. More disturbingly, almost 60 percent of the stated amounts were exaggerated by more than 50 percent. These results suggest that the stated income loan deserves the nickname used by many in the industry, the ‘liar’s loan.’”

With a stated income loan application, a borrower estimates his income. This estimate is generally not verified by lenders except when a loan is audited, something which might happen when a mortgage is sold or a home is foreclosed. Lenders charge a higher rate for stated income loan applications, meaning that stated income loans can be re-sold to mortgage buyers at a higher price.

Speaking of stated income loans applications, John C. Dugan — the Comptroller of the Currency and one of the most important federal regulators — says that “what may be suitable in limited circumstances has now become acceptable as general practice. For subprime loans, stated income has become the rule rather than the exception, and in a very brief span of time. While this practice was relatively rare just a few years ago, last year nearly 50 percent of all subprime loans relied on stated income. How can this be?

“Sound underwriting — and, for that matter, simple common sense — suggests that a mortgage lender would almost always want to verify the income of a riskier subprime borrower to make sure that he or she had the means to make the required monthly payments. Most subprime borrowers are salaried employees for whom verifying income by producing copies of W-2 forms is just not that difficult. So why would these borrowers pay the higher interest rate that lenders charge for stated income loans?”

Why are borrowers paying more? Dugan offers two reasons:

First, “borrowers may not fully understand how much more they are paying for the limited convenience of not producing their W-2s or providing any other form of income verification. That lack of understanding provides a tempting target for brokers who typically have a financial incentive to skip the verification process and get the loan approved at a higher interest rate.”

And the second reason? As Dugan explains, “evidence is mounting that borrowers are frequently inflating their incomes, often substantially, to qualify for larger mortgages.”

Dugan says there are times when a stated income loan applications may make sense.

“The simplest example is a straight refinancing that doesn’t involve a cash take-out, and is underwritten by the same lender who provided the original mortgage: there, the lender has experience with the borrower and knows that the new loan will be more affordable and therefore more secure than the one it replaces. It may also make sense for individuals who are self-employed or who work on commission and have understandable difficulty in documenting income.”

But is Dugan right about stated income loans?

In the first case — the example of a lender offering a lower-cost mortgage to a current borrower — the borrower is not getting the even-lower rate that would be possible with full documentation.

The second case — which concerns the “understandable difficulty” of the self-employed and those working on commission to document their income — would certainly raise eyebrows with another federal agency, the IRS.

All taxpayers must file annual returns and those who are self-employed must pay a portion of their projected tax obligation quarterly. In other words, the self-employed always have both tax returns for prior years plus a need to keep current records. At a time when bank records can be accessed online and easily printed out, the self-employed are able to readily document gross income and to reasonably estimate costs based on past tax returns.

“All of us,” says Dugan, “have been troubled by the recent spike in delinquencies and foreclosures, and it seems clear that one reason for the trend is the increased reliance on stated income in subprime mortgages. It’s true that in many cases it is the borrower who is deliberately inflating his or her income in order to qualify for a loan that he or she can’t really afford. But a lender is responsible for its underwriting standards, and it is fundamental that the institution ensure that it has the information it needs to make a sound judgment on the borrower’s ability to repay the loan.”

In fact, the use of stated income loan applications is not just a problem associated with subprime loans. As the MARI study shows, “for the most part, the states that report difficulty with subprime fraud are the same ones that have problems” with all forms of financing.

Dugan offers three observations which ought to be sobering to borrowers, lenders, investors and regulators

First, “stated income is too great a temptation for misrepresentation and, in its most extreme form, outright fraud. It ought to be a truism that sound underwriting practices minimize this temptation.”

Second, Dugan asks, “how can lenders seriously talk about ‘debt-to-income’ ratios, for example, if the denominator of ‘income’ is really an unknown variable that can be whatever the borrower says it is?”

Dugan’s point is that stated income loan applications have the effect of easing “debt-to-income ratios without disclosing that fact to investors or regulators — or without disclosing how much easing has taken place. If lenders believe that higher debt-to-income ratios can be prudent, then they should be willing to disclose the actual, higher debt-to-income ratios rather than masking them through stated income loans.”

Third, it’s “not a safe and sound underwriting practice to make mortgage loans that substitute future house price appreciation for borrower income as a key source of repayment.”

“I do find it telling,” says Dugan, that “when faced with the new housing market conditions, subprime lenders have responded first by tightening standards on stated income. And I also find it telling that one of the first things that loan servicers do in the current environment, when deciding whether to restructure or foreclose on a delinquent loan, is — you guessed it — seek verification of income. Apparently verified income is viewed as a critical factor in determining whether a loan can be saved, which of course begs the question: if loan verification is such an important predictor of the borrower’s ability to repay in the current environment, why wasn’t it equally important when the loan was first made?”

“Regulators at the federal and state level are expected to issue new mortgage guidelines for lenders in the next few months,” says Saccacio. “The trick will be to keep in place a system which largely works while getting rid of the practices most likely to be abused. Given the growing worries regarding mortgage fraud, there’s little doubt that stated-income loan applications will be greatly restricted in the future, much to the benefit of borrowers, lenders and investors.”

Columnist Peter G. Miller is the author of The Common-Sense Mortgage and is syndicated in more than 100 newspapers.

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