More Home Buyers Stretch Truth, Budgets to Get Loans

As Southland housing cools off, reports of fraud grow, raising fears of a wave of foreclosures.

By David Streitfeld
Times Staff Writer

September 29, 2006

Mortgage fraud continues to escalate in Southern California, FBI figures show, raising concerns of increased defaults and foreclosures as the housing market cools down.

Lenders filed 4,228 reports of suspicious activity in the region during the first 11 months of the government's fiscal year, which ends Saturday, the FBI said. That puts 2006 on track to nearly double last year's total.

The jump in reports of suspicious activity even as home sales have declined may stem in part from a lag in reporting. But the FBI and industry experts say the trend also reflects growing deceit by average borrowers who overstated their income, exaggerated their assets or hid their debts simply to qualify for a mortgage in the region's sky-high housing market.

"There's more of the little guy running around — people committing fraud for housing," said Ronda Heilig, the bureau's mortgage fraud program manager.

A seven-county region from Orange County to San Luis Obispo County has seen a fourfold increase in suspicious loan activity since 2003, largely coinciding with sharp run-ups in housing prices and lending activity. But with home sales slowing and prices leveling off, the explosion in small-scale duplicity could have serious consequences, industry experts believe.

During the boom, people who lied about their income to get a loan — and then struggled to make the payments — had the option of making ends meet by tapping their newfound equity through refinancing or by selling the property for a profit.

But now, with prices flattening out or declining, those without sufficient equity could be forced to sell for a loss or even default on payments. That could accelerate any downturn in the market by swamping it with foreclosed and bargain-priced properties.

"This is the calm before the storm," said Steve Smith, a Redlands appraiser who lectures frequently about real estate fraud to industry groups.

When home prices in California began to throttle up in the early years of the decade, people needed bigger loans but sometimes couldn't prove they could handle the debt. To accommodate them, lenders started to offer loans that required little or no documentation.

For example, in a so-called low-doc loan, also known as a stated-income loan, the lender doesn't verify the borrower's income. With a "no-doc" mortgage, the lender doesn't check income, assets or employment.

Such loans, which carry higher interest rates than traditional loans do, were originally designed for people whose income swung widely, like the self-employed, or high-wage earners in unusual circumstances — a doctor who had just moved to a new community and hadn't set up a practice yet, for instance.

As the state's boom went on, the mortgages became so popular that they now account for a third of new loans, according to data tracking firm First American LoanPerformance.

Industry insiders have a nickname for low-doc and no-doc mortgages: liar's loans. The phrase reflects the suspicion that many of the borrowers who get such loans don't have the income or assets to qualify the old-fashioned way.

One lender recently compared 100 stated-income loans with the borrowers' tax returns and found that only 10 of the borrowers were telling the truth about their wages, according to Mortgage Asset Research Institute, a division of data firm ChoicePoint Inc.

Sixty of the borrowers had exaggerated their incomes by more than 50%, according to the institute, which didn't identify the lender.

The loans first gained popularity in the 1980s, but many lenders got burned by them when property values turned down in the early 1990s, said the institute's founder, James Croft. "We're seeing some of the same loans today, and so we'll go through an 'Oh, whoops' realization and a tightening up."

The recent boom in such loans also has been driven by people who bought homes in hopes of "flipping" them for a quick profit, industry experts say.

"I saw a lot of people stretching their income to get into investment properties, and not disclosing the purchase of multiple concurrent investment properties," said Rachel Dollar, a Santa Rosa, Calif., attorney who runs a blog documenting mortgage fraud cases. "They were buying more than they could afford, believing the increased equity was going to bail them out."

In what might be a sign of trouble ahead, the U.S. Department of Housing and Urban Development's Office of Inspector General said in July that it had audited 41 loans that had gone into default. All of the loans had been made by National City Corp., a Cleveland-based bank that is one of the biggest lenders in the country, and had been insured by HUD. The location of the borrowers was not identified.

In 20 of the loans, or just about half, the inspector general found "errors and documentation omissions clearly contrary to prudent lending practices."

On one loan, for example, the borrower's previous address turned out to be nonexistent. On another, the borrower submitted two bank statements. The first month's closing balance didn't match the second month's opening balance, an indication that the documents might have been faked. A third borrower overstated his income, a fourth his assets.

National City acknowledged errors in seven loans but said its default rate was below the industry average.

Suspicious-activity reports can be triggered in a variety of ways. Fraud is sometimes uncovered by lenders in quality-control spot checks or by an inquiry that comes after a borrower quits making payments.

If the lender can identify a suspect, it is required to report fraud of as little as $5,000. If no suspect can be identified, the floor is $25,000.

But only lenders that also operate as banks are required to file suspicious-activity reports with the FBI. That's a growing number of lenders — another reason reports might be increasing — but banks still account for fewer than half of all mortgage loans. Independent mortgage brokers, which arrange loans but do not fund them, are not required to file reports.

The FBI's Los Angeles region includes reports of suspicious activity in the counties of Los Angeles, Orange, Riverside, San Bernardino, San Luis Obispo, Santa Barbara and Ventura. But prosecutors here say few cases are referred to them, and even fewer are pursued.

The FBI, preoccupied with counterterrorism, says such cases generally aren't worth pursuing.

"We act on the ones that are the most egregious and involve the most loss to the lender," said supervisory special agent Peter Norell, who coordinates the FBI's white-collar-crime program in Los Angeles.

The tiny minority of cases that do result in arrests and trials tend to involve rings of professional criminals.

In one popular scheme to defraud lenders, one ring member acquires a property, gets it appraised by a confederate for twice its value, and then sells it to a third accomplice at the inflated price.

The accomplice immediately defaults on the loan — netting the ring a quick payday on the sale and leaving the bank stuck with more debt than equity.

Then there are cases of outright theft. Kenneth C. Ketner, who ran a Newport Beach mortgage company, pleaded guilty last month to diverting about $9 million in borrowers' funds. Prosecutors said he used some of his loot for a $244,000 Ferrari.

FBI statistics show that Southern California has the most reports of mortgage fraud in the country, topping those of the Atlanta, Chicago and Miami regions. But the number of cases investigated by the FBI here has been falling relative to those of other urban areas.

In 2004, the bureau said, the Southern California region was tied for second in the number of cases opened. Last year it fell to a tie for seventh.

"Resources are doled out based on priority," said the FBI's Heilig. "White-collar crime is ranked No. 7." Shortly after she was interviewed, Heilig herself switched from mortgage fraud to the FBI's No. 1 priority, counterterrorism.