A look at the subprime mortgage problem

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Tracy L. Coenen

The recent focus on the near-collapse of the subprime mortgage market has raised some interesting issues regarding fraud. Some borrowers are unable to meet their obligations due to legitimate reasons, while other are defaulting because of fraud committed in the process of getting the mortgage.

Either way, the high number of defaults on subprime mortgages is rocking the economy, and no one knows how bad things will get. The first to see the effects of this “crisis” were the large mortgage brokers, but smaller lenders are feeling the pain as well. As the real estate market has cooled, the effect of higher default rates is affecting businesses and individuals who are relying on credit for their survival.

The effects of this problem go far beyond just the housing market. This credit crisis is affecting many industries, and the world economy is feeling the pain as well. What was initially an increasing rate of default on home mortgages has now escalated to a full-scale crisis that is affecting the availability of credit in the world markets.

Setting the Stage

Subprime lending is the practice of loaning money to higher risk borrowers, often at higher interest rates than those available to the rest of the market. People and businesses with no credit, bad credit, or other risky characteristics tend to borrow from subprime lenders. These lenders are offering a “second chance” to those who may not otherwise qualify for financing.

Subprime lenders have often been accused of predatory practices. Some say they prey on those with poor credit, and set up situations in which those borrowers are doomed to fail because of too high interest rates or because of situations in which the borrowers should not even be borrowing at all.

Other say that subprime lenders are merely offering a service to those who might not otherwise qualify for mortgages, credit cards, auto loans, or other loans. There is a greater risk with these borrowers, as shown through a historical analysis of their default rates. Therefore, borrowers in the subprime market generally pay higher interest rates than found via traditional loans or mortgages.

So are subprime lenders just asking for trouble and inviting fraud? I don’t think so. I think they offer a service that is needed. Unfortunately, as with any product or service out there, the possibility of fraud and abuse exists.

Mortgage Fraud or Not?

Mortgage fraud is committed in a number of ways. It can happen with an inflated appraisal, valuing the property at more than what it is really worth. Another possibility is an inflated purchase price, with a portion of the excess later given as a kickback to one or more of the parties involved. Very common in mortgage fraud is the inflation of one’s earnings in order to qualify for a larger mortgage than might otherwise be available.

Default on subprime loans can often be traced to a borrower purchasing “more house” than she or he could afford or a general overuse of available credit. How do such buyers get those houses they can’t afford? It is often accomplished by inflating the borrower’s income, and sometimes with a hidden second mortgage.

“Stated income” mortgages are ripe for abuse. Borrowers do not have to provide documentation which substantiates their income. Rather, they “state” their income and the mortgage company accepts that income as true. This can increase a borrower’s interest rate a little, but may still be worth it to the borrower.

A stated income mortgage can be ideal for a borrower with an unusual earnings situation. Consider a self-employed person. Her or his income may not be reflected on a W-2, the typical document mortgage companies rely upon. Non-traditional earnings may still be available to pay a mortgage, so in this case, a stated income mortgage may be the best option.

On the other hand, unscrupulous borrowers and mortgage brokers can use the stated income mortgage to game the system. Borrowers are sometimes encouraged by an aggressive broker to inflate their earnings in order to qualify for a larger mortgage. Sometimes borrowers do this of their own accord, when their home-buying tastes exceed their borrowing ability.

While the mortgage is paid on time, no one worries about whether or not there was the fraud in the application process. When the borrower pays late or defaults, then the problem is highlighted and fingers are pointed.

Another facet to the subprime mortgage problem is the prevalence of “interest only” mortgages. Borrowers have used them liberally in the past several years, as they were a legitimate way to get more house than they might otherwise be able to afford.

Unfortunately, many borrowers didn’t appreciate the seriousness of a mortgage in which one’s principal is never reduced. The borrower never gets any closer to actually owning the property and there is no equity in the property. A major disruption in life such as an illness or a job loss can wreak havoc on the ability to pay the mortgage.

Picking Up the Pieces

Those who committed fraud or made poor choices during the mortgage process are left with homes and properties they can’t pay for. How does it get resolved? One of the most common ways is foreclosure, yet the cooling of the real estate market isn’t helping this situation at all. Mortgage companies can foreclose and attempt to sell a property, but if there are no buyers or if the market for mortgages is poor, the original mortgage company may not be made whole.

Investment companies are stepping in and offering to help property owners avoid foreclosure. In some cases, this is successful, as the original property owner gets out of the property without loss or damage to her or his credit history, and the investment company has an opportunity to get a property at a bargain.

Unfortunately, there are unscrupulous investment companies that take advantage of troubled homeowners. Some property owners may not understand what they are getting themselves into, especially if they enter into a complicated contract like a sale and lease-back, with the opportunity to repurchase the property at a later date. Often these contracts are complicated and filled with numerous restrictions the original property owner must follow or risk losing money or equity already put into the deal.

Probably the most prevalent response the subprime mortgage crisis is the tighter restrictions now being employed by lenders. The availability of stated income mortgages has been decreased somewhat, and lenders seem to be scrutinizing applications more. It makes one wonder why they haven’t been tougher all along. The “easy money” during the mortgage heyday was tempting for those who wanted to manipulate the system, and lenders seemed unable to say no to anyone.

Consumers must be protected from predatory lending, but borrowers must also take it upon themselves to be responsible with their use of credit and to educate themselves about the process. Consumers should not enter into deals th
at they don’t fully understand, and should not let their desire for bigger and better outweigh their misgivings about the level of debt they’re incurring.

Tracy L. Coenen, CPA, MBA, CFE, is the president of Sequence Inc., a forensic accounting firm with offices in Milwaukee and Chicago. Coenen can be reached at [email protected] or 414-727-2361.