Fraud and the Subprime Mortgage Crisis [1 ed.] 9781593326661, 9781593324537

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Criminal Justice Recent Scholarship

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Edited by Marilyn McShane and Frank P. Williams III

A Series from LFB Scholarly

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Fraud and the Subprime Mortgage Crisis

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Tomson H. Nguyen

LFB Scholarly Publishing LLC El Paso 2011

Copyright © 2011 by LFB Scholarly Publishing LLC All rights reserved. Library of Congress Cataloging-in-Publication Data

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Nguyen, Tomson H. (Tomson Hoang), 1976Fraud and the subprime mortgage crisis / Tomson H. Nguyen. p. cm. -- (Criminal justice) Includes bibliographical references and index. ISBN 978-1-59332-453-7 (hardcover : alk. paper) 1. Subprime mortgage loans--Corrupt practices--United States. 2. Mortgage loans--Corrupt practices--United States. 3. Fraud--United States. I. Title. HG2040.5.U5N47 2011 364.16'3--dc22 2010051342

ISBN 978-1-59332-453-7 Printed on acid-free 250-year-life paper. Manufactured in the United States of America.

Table of Contents

List of Tables............................................................................. ix List of Figures ........................................................................... xi Chapter 1: Mortgage Fraud: An Introduction ....................... 1 Research Questions.............................................................. 6 Defining Mortgage Fraud .................................................... 8 Predatory Lending vs. Mortgage Fraud ............................... 9 Conceptual Definitions ...................................................... 10 What is Subprime Lending/Subprime Loans? ................... 14 Origins of Subprime Lending – Deregulation of the Financial Industry.................................................... 17 Related Influential Legislation .......................................... 19 The Growth of Subprime Lending..................................... 21 Wall Street and Mortgage-Backed Securities.................... 22 Conclusion ......................................................................... 25

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Chapter 2: Research on Mortgage Fraud and the Law ....... 27 Mortgage Fraud and the Law............................................. 27 Mail and Wire Fraud Statutes ............................................ 28 Statutes on the Transportation of Stolen Goods ................ 29 Federal Statues Regarding Federally Charted v

vi

Table of Contents and Insured Financial Institutions...................................... 29 Mortgage Fraud ................................................................. 32 The Role of White-Collar Crime in Financial Disasters ............................................................................ 39 Types of Fraud in the Financial Debacles ......................... 41 The Orange County Bankruptcy........................................ 44 Corporate Scandals ............................................................ 44 White-Collar Crime as Organized Crime .......................... 45 The Role of Organizations in White-Collar Crime............ 47 Theoretical Underpinnings ................................................ 49

Chapter 3: Data and Methods................................................ 57 Interviews .......................................................................... 59 Sample Questions Regarding Work and Work Experience ........................................................ 63 Sample Questions Regarding Work Environment and Management.......................................... 64 Sample Questions Regarding Specific Loan Origination Practices ................................................ 65 Research Subjects .............................................................. 67 Secondary Data Sources .................................................... 69 Strengths and Limitations of Interviews............................ 71 Inside Interviewing ............................................................ 72 Research Concerns ............................................................ 73 Limitations of the Study .................................................... 75

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Chapter 4: Mortgage Origination Fraud .............................. 77 Traditional & Contemporary Forms of Mortgage Fraud Compared................................................ 77 Contemporary Mortgage Fraud ......................................... 88 Patterns of Contemporary Mortgage Fraud (Mortgage Broker, Loan Officer, and Loan Processor) ................................................................. 97 Mortgage-backed Securities, Alternative Loan Products and Fraud .............................. 103

Table of Contents

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Revisiting Mortgage Fraud.............................................. 110 Chapter 5: The Social and Economic Implications of Fraud............................................................ 115 Discrimination in the Mortgage Industry ........................ 118 Predatory Lending ........................................................... 121 Towards Economic Equality ........................................... 123 Fraud in the Context of Economic Inequality.................. 126 “You Call This Equality?”............................................... 130 The Illusion of Affordability ........................................... 139 Discussion........................................................................ 142 Chapter 6: Now What? Final Thoughts and Recommendations ................................................................. 147 Responses to the Crisis .................................................... 149 Policy Implications .......................................................... 152 Tightening Qualification Guidelines and Underwriting Standards................................................... 153 Increase Regulatory Oversight and Accountability ......... 154 Revisiting the Industry’s Approach to Compensation: An Alternative to Volume-Based Commission and Bonuses....................... 156 Increasing Education Standards for Loan Agents ........... 158 Recommendations ........................................................... 158 References .............................................................................. 161

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Index ....................................................................................... 181

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List of Tables

Table 1. Percentage of Fraud Cases as Classified by the Mortgage Asset Institute .......................................... 35 Table 2: Research Subjects and their Industry Positions.......... 67 Table 3: Comparison between Various Subprime Loans the Traditional Prime 30-year Fixed Rate Mortgage ... 134

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Table 4: Illusion of Affordability. Loan type: Negative Amortization Loan ................................................. 140

ix

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List of Figures

Figure 1: Flow Chart of the Loan Origination Process/Stages (Primary Subprime Mortgage Market) .................... 15 Figure 2: Typology of Contemporary Mortgage fraud.............. 90 Figure 3: Unaltered Bank Statement Used in a Mortgage Loan 92 Figure 4: Altered Bank Statement Used in a Mortgage Loan .. 94

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Figure 5: The Link between Mortgage Fraud and the Subprime Mortgage Crisis...................................................... 109

xi

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CHAPTER 1

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Mortgage Fraud: An Introduction

On March 16, 2008, the Associated Press reported that Bear Stearns, one of the world’s largest investment banks, was the latest victim of the subprime mortgage crisis (Bruno, & Read, 2008). Three months later, federal authorities announced the criminal indictments of Ralph Cioffi and Matthew Tannin, two former Bear Stearns executives (Hamilton, 2008). In early 2008, former Federal Reserve Board Chairman Greenspan (2008) wrote that “the current financial crisis in the U.S. is likely to be judged in retrospect as the most wrenching since the end of the Second World War” (p. n.p.). By the end of the year, the financial losses from the global economic meltdown had outgrown that of the savings and loans bailout in the 1980s and 1990s. According to “some estimates, it has made that costly debacle look like chump change” (Schmitt, 2008). In a report by compiled for the 2007 U.S. Conference of Mayors and the Council for the New American City, it was stated that “the wave of foreclosures that has rippled across the U.S. has already battered some of our largest financial institutions, created ghost towns of once vibrant neighborhoods—and it’s not over yet” (Global Insight, 2007: 6). In September 2007, subprime adjustable-rate mortgages (ARMs) accounted for “6.8 percent of the loans outstanding in the U.S., yet they represent 43 percent of the foreclosures” (Mortgage Bankers Association, 2007). RealtyTrac (2008) reported the number of foreclosure filings increased by as much 1

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Fraud and the Subprime Mortgage Crisis

as 75 percent from 2006 to 2007. While the rise of foreclosures has been attributed to several factors, the leading industryaccepted culprits are the inception of adjustable-rate hybrid mortgages and deteriorating home values. In 2007, $450 billion worth of mortgages that contained an adjustable-rate clause were reset into ARMs. In 2008, this number increased to $500 billion. Reset activity peaked in March 2008 at nearly $100 billion before declining (Schumer, 2007). Throughout 2008, an average of 450,000 subprime ARMs was reset each fiscal quarter. Of these, half of the homeowners lost their homes due to foreclosures (Ivry, 2007). Once mortgages are reset, borrowers commonly experience difficult financial problems directly related to the increase in the interest rate and mortgage payments. According to a 2007 Congressional economic report, on average, homeowners faced increases of 30-50 percent in monthly mortgage payments after their mortgages were reset (Schumer, 2007). By 2009, the United States (U.S.) and global economies were suffering from the effects of the subprime meltdown. According to Reuters, European banks from Switzerland, Britain, and France suffered billions of dollars in related subprime mortgage write-downs (Slater, 2008). Northern Rock, Britain’s fifth largest mortgage lender, also suffered major losses as depositors, uncertain of the bank’s stability, withdrew as much as they could, which required a government bailout to avoid collapse (Peston, 2007). Investors from across the world completely lost confidence in the ability of the U.S. economy to deal with the surmounting losses and engaged in global dumping of U.S. - related investments. One important question that has both theoretical and practical ramifications is whether the subprime mortgage crisis entails significant amounts of fraud at various institutional levels. For example, as noted by some white-collar criminologists regarding earlier financial debacles, material fraud built into financial markets could remain virtually undetected until its consequences reached epic proportions (Black, 2005; Rosoff, Pontell, & Tillman, 2010). This was a difficult and seemingly yet-to-be-learned lesson of the savings and loan crisis in the 1980s. In the current case, economists and

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Mortgage Fraud: An Introduction

3

other financial experts have failed to observe or accept the reality that there is significant potential for mortgage fraud in the modern economic crisis, which underscores the importance and urgency of the present study. As news of the housing industry’s collapse unraveled, the number of reports of mortgage fraud investigations and indictments relating to the financial crisis increased. For example, in January 2008, the Federal Bureau of Investigation (FBI) stated they were investigating 14 corporations involved in subprime lending as part of their Subprime Mortgage Industry Fraud Initiative launched the previous year. On June 19, 2008, the FBI reported that over 400 individuals were charged in a nationwide investigation that included the arrest of the two Bear Stearns fund managers (Schmitt, Christensen, & Reckard, 2008). The report noted that lending fraud crimes involved “mortgage transactions based on gross fraudulent misrepresentations about the borrowers’ financial status, such as overstating income or assets, using false or fictitious employment records or inflating property values” (Department of Justice, 2008). In recent years, mortgage fraud has been steadily emerging as a major problem in the United States. In 2006 alone, mortgage fraud cost the mortgage industry between $946 million and $4.2 billion (Mortgage Bankers Association, 2007). The federal Financial Crimes Enforcement Network (FinCEN) has reported similar findings regarding the number of mortgage-related SARs. According to the FinCEN, the number of SARs filed in “2006 rose 44 percent over the same period in 2005. This follows a 29 percent increase from 2004 to 2005, and an almost 100 percent increase from 2003 to 2004” (FinCEN, 2006). Before the global economic meltdown occurred which undoubtedly has accrued a far greater loss, an FBI briefing on mortgage fraud and subprime loans stated that mortgage-related frauds cost the nation tens of billions of dollars. For example, New Century Financial Corporation, once the second-biggest U.S. subprime-mortgage lender, was found to have “engaged in a significant number of highly improper and imprudent practices related to its loan originations, operations, accounting and financial reporting processes” (Kary, 2008). Smaller mortgage broker offices were also under criminal suspicion by the FBI. “The question of fraud

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Fraud and the Subprime Mortgage Crisis

goes to the entire process – where the loans were created, whether there was fraud in their creation, or misrepresentation as to the quality of the loans in the sales process” (Sasseen, 2008). The savings and loan crisis of the 1980s and the corporate scandals of 2002 have one thing in common—powerful individuals who abused their position of authority to collectively loot billions, of dollars. The face of white-collar crime is synonymous with names such as Bernard Madoff, Robert Citron, Kenneth Lay, and Charles Keating. While powerful criminal executives continue to represent a major social problem of severe fiscal consequence, they were not the focus of this study. In Confessions of a Subprime Lender: An Insider’s Tale of Greed, Fraud, and Ignorance, Richard Bitner (2008), president and cofounder of a multimillion dollar subprime lending company, stated that:

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The problem is huge in part because so many things went wrong. First, unlike most business disasters driven by the malfeasance of a few leaders sitting at the top of the food chain, the current crisis is a result of systemic problems that extended from one end of the industry to the other. (p. xii) The growth of mortgage fraud and its role in the subprime mortgage crisis meltdown has been a major topic of concern of social scientists and economists since the beginning of the crisis. Economist James Galbraith (2009), for example, has been an outspoken critic of the government’s response to the banking credit and liquidity crisis, a direct result of the tremendous losses from home foreclosures. Galbraith has noted, on numerous occasions, a need for the government to “review loan tapes” before blindly buying these toxics assets, arguing that such inspections would “reveal a very high proportion of missing documentation, inflated appraisals, and other evidence of fraud” (Galbraith, 2009). Bill Black, a professor of law and economics at the University of Missouri, Kansas City, has brought to the forefront similar concerns regarding the role of mortgage fraud in the context of the global crisis. Financial lenders have a large stake in addressing the problem of mortgage fraud, yet according

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Mortgage Fraud: An Introduction

5

to Black, they weren’t the principal filer’s of suspicious fraudulent complaints. The underreporting of fraudulent subprime mortgage frauds by financial institutions doesn’t come as a surprise since those culpable include lenders themselves. “One only spots mortgage fraud if one conducts underwriting (and accounting control frauds abhor it), and the last thing a control fraud wants is to invite the FBI's attention” (Black, 2008). He noted that fraud incidences found in file reviews indicate that the amount of loans originated that contain fraud in fiscal year 2007 was one million loans, a much higher estimate than the actual mortgage fraud suspicious activities incidences filed by federally regulated lenders. (Black, 2008). What role does mortgage fraud play in the overall global economic crisis? The criminological literature on white-collar crime provides a robust theoretical backdrop in addressing this question. The purpose of this study is to historically trace, sociologically explore, and criminologically detail the various forms of mortgage fraud and their relation to the factors associated with the growth of the subprime industry (e.g., introduction of alternative loan products, growth of subprime securitization, and inadequate regulation and enforcement). The criminological literature (e.g., Calavita, & Pontell, 1990; Pontell, & Calavita, 1993; Black, Calavita, & Pontell 1995; Tillman & Pontell 1995) on white-collar crime in major financial debacles, particularly the savings and loan crisis, clearly identified industry and organizational factors linked to white-collar crime. These studies examined the criminological impact that competition unleashed by financial deregulation in the 1980s, inadequate regulations and weak regulatory enforcement had on the prevalence, and forms of commission of white-collar crime. The current study conducts a similar case analysis of the subprime mortgage industry. It connects the growth of mortgage fraud to the structural factors and lending practices of the primary subprime mortgage industry, with a particular emphasis on the social organization of mortgage origination and funding. This study examines how together, various organizational sectors (lenders, mortgage brokers, and appraisers) of the primary subprime industry all played a role in creating a “crimefacilitative environment (Needleman and Needleman, 1979)

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Fraud and the Subprime Mortgage Crisis

which provided the means and opportunities for white-collar crime. This analysis will be guided by the body of criminological literature on white-collar crime. Such examination will require an in-depth review of the factors in which finance capitalism has created new opportunities for fraud, and the deregulatory and lending policies that have multiplied opportunities for criminal activity in the subprime lending industry. Understanding the complex problem of mortgage fraud and its relationship to the subprime lending crisis, especially since there is very little research background, will require a thorough analysis of governmental policies and lending practices that make up the subprime mortgage industry. Research Questions

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This research project involves several research questions that address how various forms of mortgage fraud have developed and grown as a result of the structural policies and lending practices of the subprime mortgage industry. This study explored the problem by answering five primary research questions that relate to the foregoing discussion. 1. How do alternative loan products impact the growth, type, and patterns of mortgage-related fraud? The development of the subprime lending industry is characterized by the growth of exotic loan products such as stated-income, 100 percent financing, and negative amortization loans. These mortgage products are the result of deregulatory policies and competitive lending practices of the lending industry, and such products have completely altered the qualification guidelines and underwriting standards of the industry. The subprime lending industry is synonymous with the proliferation of such lending products, and recognizing how these loan products impact the growth, type, and patterns of mortgage-related fraud is an important part of understanding the problem. 2. How do mortgage-backed securities impact the growth, type, and patterns of mortgage-related fraud? The securitization of subprime mortgages had a tremendous impact on the lending

Mortgage Fraud: An Introduction

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industry; in particular, it greatly contributed to the growth of third party originators such as mortgage brokers and wholesale lenders. Mortgage assets are no longer kept on the mortgage originators’ financial portfolio, but are rather sold immediately after origination and funding. With relation to fraud, such developments have reduced liability, accountability, as well as the quality of underwriting since banks no longer have a stake in the quality of loans they underwrite. And similar to alternative loan products, the growth of the subprime lending industry during the last decade has been intricately tied to the growth of subprime mortgage-backed securities. It is important to note that the issuing of securitized mortgage products by originators occur outside of the primary lending market and this study only focuses on the impact that mortgage-backed securities have on the primary market.

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3. How does the growth of the subprime mortgage industry impact our understanding of mortgage fraud, more generally? Mortgage fraud has been traditionally viewed by law enforcement and the lending industry as either fraud for profit or fraud for property. The tremendous changes in governmental policy and the lending guidelines and practices that have resulted from intense competitive pressures in the industry have completely altered our understanding of mortgage fraud and white-collar crime, more generally. An important aspect of this study is to examine what these changes are, and analyze what impact these changes will have on our overall understanding of mortgage fraud. 4. What role, if any, do the industry players that constitute the primary subprime mortgage market (Brokers, Lenders, Appraisers, and Escrow) have on the growth, type, and patterns of fraud? The aforementioned research questions broadly address structural, organizational, and institutional factors that may lead greater opportunities for crime. It is equally important to understand the role each of these actors play as such analysis will help provide a theoretical model for understanding mortgage fraud and white-collar crime more generally.

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Fraud and the Subprime Mortgage Crisis

5. And lastly, how have previous criminological research on white-collar crime in major financial debacles (savings and loans, Orange County bankruptcy, and the corporate scandals) shed light into the current subprime mortgage crisis? In other words, what have we learned from our previous mistakes? The body of literature on fraud has led to various theoretical models that help explain the emergence of crime as a result of governmental policies and capitalistic qualities in institutional and organizational settings. An important part of this study will be to examine how these theoretical models help shed light into our understanding of the current crisis. For example, it will be important to relate our understanding of various forms of accounting and control frauds (e.g. collective embezzlement, unlawful-risk taking, and covering up) to the crimes of the subprime mortgage industry to determine the similarities and differences, which would altogether shed light into our overall understanding of white-collar crime. Defining Mortgage Fraud

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According to the FBI (2007), “mortgage fraud is defined as the intentional misstatement, misrepresentation, or omission by an applicant or other interested parties, relied on by a lender or underwriter to provide funding for, to purchase, or to insure a mortgage loan.” Mortgage fraud has been traditionally viewed by researchers, government authorities, and industry organizations as either fraud for property or fraud for profit. According to a report by the FBI, Fraud for property/housing entails minor misrepresentations by the applicant solely for the purpose of purchasing a property for a primary residence. This scheme usually involves a single loan. Although applicants may embellish income and conceal debt, their intent is to repay the loan. Fraud for profit, however, often involves multiple loans and elaborate schemes perpetrated to gain illicit proceeds from property sales. Gross misrepresentations concerning appraisals and loan documents are common in fraud for

Mortgage Fraud: An Introduction

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profit schemes and participants are frequently paid for their participation. (FBI, 2007, p. 2) Between the two forms of mortgage fraud, fraud for profit schemes “is of most concern to law enforcement and the mortgage industry” (ibid). These schemes are usually made up of fraudsters who are mortgage professionals and have extensive knowledge or experience in the mortgage/real estate industry. The problem, according to the FBI (2007), was that fraud for profit schemes could be so damaging as to have devastating implications for the entire U.S. economy. There are various types of mortgage fraud, that include overinflated appraisals, fictitious financial statements, schemes that involve straw buyers, and foreclosure prevention fraud. This study will utilize this general definition of mortgage fraud as a base point to analyze the changes, if any, that various structural and sociological factors have on our understanding of mortgage fraud. The primary concern of this analysis is not on the exact definition, per se, but rather, the social and legal implications of the definition. It will be important to know, for example, how the law enforcement sectors’ narrow perception of mortgage fraud has limited its ability to detect and enforce criminal frauds.

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Predatory Lending vs. Mortgage Fraud The thin line between predatory lending and criminal fraud can be very difficult to distinguish. Various acts of predatory lending can easily cross the line into outright criminal conduct and as a result, it is an important part of our analysis. With regard to mortgage fraud, “a lending institution is deliberately deceived by an actor in the real estate purchase or mortgage origination process” — such as a borrower, broker, appraiser or one of its own employees — into funding a mortgage it would not otherwise have funded, had all the facts been known (p. 3). Predatory lending on the other hand, according to the Mortgage Bankers Association (MBA) (2007), refers to unethical and detrimental lending practices to borrowers, “including equity stripping and lending based solely on the

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Fraud and the Subprime Mortgage Crisis

foreclosure value of the property. Some of these practices can be fraudulent, but defining an exact set of predatory lending practices has been difficult” (p. 3). A joint study by the South Carolina Appleseed Legal Justice Center and the Center for Responsible Lending (2003) found that, while predatory lending was not considered illegal in many states, the practice could be extremely harmful to the borrower since predatory lenders rarely ever considered the ability of their client to repay the loan. Predatory lending practices can be financially or racially motivated and can be very costly to an unsuspecting borrower. For example, borrowers may unknowingly be steered into a subprime mortgage when they qualify for a prime mortgage. Mortgage lenders, for example, may convince borrowers to obtain mortgages with attractive introductory terms and conditions under the guise that such conditions are fixed throughout the term of the loan. Predatory lending also involves deliberate deception by mortgage professionals. Only a few states require that loan agents act in a fiduciary manner toward their clients. In general, predatory lending includes charging excessive fees, steering borrowers into bad loans, which net higher profits, and abusing yield-spread premiums. In Why the Poor Pay More: How to Stop Predatory Lending, Squires (2004) argued that minorities, working families, and the elderly were commonly victimized and exploited by financial institutions that ensnared vulnerable segments of society into high-cost predatory loans. While predatory lending is harmful and widespread, it is mostly legal (Center for Responsible Lending, 2006). Yet, under certain circumstances, the commission of predatory lending practices may easily cross the legal threshold and become criminal conduct. A mortgage broker who steers his client into a higher cost mortgage loan may at the time same time intentionally overstate financial information in order to qualify the client. Conceptual Definitions In order to understand mortgage fraud within the complicated nexus of the mortgage lending structure, it will be important to be familiar with the common language of the industry. There are

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many concepts that are part of the mortgage industry lingo and it is important to understand these terms for the purposes of this study. Account Manager (AM): A person (employed by a lending institution) who works with borrowers(retail lenders) or brokers (wholesale lenders) to conduct in-depth interviews, interpret, and explain program guidelines and regulations to clients, review preliminary determinations of eligibility for participation in housing assistance programs, assemble loan packages, and perform clerical work of moderate difficulty in support of assigned programs. Loan processors usually collect documents on behalf of the borrower or brokers as requested by the lender during the loan origination process. Appraisal/Appraiser: A licensed individual authorized to apply industry techniques to establish a document that estimates a property’s fair market value; an appraisal is generally required by a lender before loan approval to ensure that the mortgage loan amount is not more than the value of the property.

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Adjustable Rate Mortgage (ARM): A mortgage loan subject to changes in interest rates; when rates change, monthly payments increase or decrease at intervals determined by the lender and market interest rate. The change in monthly payment amounts, however, is usually subject to a legal cap. Borrower: A person who has been approved to receive a loan and is obligated to repay it plus any additional fees according to the loan terms. Debt-to-income ratio (DTI): A comparison of gross income to housing and non-housing expenses. With Federal Housing Administration, the monthly mortgage payment should be no more than 29 percent of a

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person’s monthly gross income (before taxes) and the mortgage payment combined with non-housing debts should not exceed 41 percent of the total income. FICO (Fair Isaac Corporation): A score that takes into account one’s credit history and worthiness. The score ranges from 300-800. Foreclosure: A legal process through which mortgaged property is sold to pay the loan of the defaulting borrower. The foreclosure process begins when the homeowners fail to make their mortgage payments. After the owner fails to comply with the terms and conditions of the mortgage agreement or deed of trust, such as failing to make the mortgage payments, the financial lender, bank, or creditor can chose to sell or repossess the parcel of property.

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Loan Officer (LO): A person who is considered the sales arm of mortgage lending. Loan officers are responsible for seeking and generating sales of mortgage loans. They help individuals obtain loans, answer questions regarding loan terms and conditions, and generate income for their employers, which can be a financial lender or a broker. Loan Processor: A person (usually employed by a mortgage broker or a lending institution) who works with borrowers to conduct in-depth interviews, interprets and explains program guidelines and regulations to clients, reviews preliminary determinations of eligibility for participation in housing assistance programs, assembles loan packages, and performs clerical work of moderate difficulty in support of assigned programs. Loan processors usually collect documents on behalf of the borrower as requested by the lender during the loan origination process.

Mortgage Fraud: An Introduction

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Loan-to-value (LTV) ratio: A percentage calculated by dividing the amount borrowed by the price or appraised value of the home to be purchased; the higher the LTV, the smaller amount a borrower is required to pay as a down payment. Mortgage Broker: A licensed individual or firm, owned and operated by a licensed broker authorized to originate and process loans for a number of lenders. A broker/broker office works with borrowers and lenders as an intermediary to find a mortgage that best suits the borrower’s needs. Primary Mortgage Market: The market where borrowers and mortgage originators come together to negotiate terms and effectuate mortgage transactions. Mortgage brokers, loan officers, mortgage bankers, mortgage lenders, banks, borrowers, and credit unions are part of the primary mortgage market.

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Secondary Mortgage Market: The securities market, which primarily involves the transfer and sales of mortgage securities and or bonds, backed by the value of mortgage loans. (U.S. Department of Housing and Urban Development, 2007) The majority of mortgage loans are originated by third party brokers and financial lenders. Once mortgages are originated and funded, financial lenders quickly package the mortgages and sell them to the secondary mortgage market where they are turned into securities and sold worldwide. The old days of a single bank owning, originating, funding, and serving a mortgage are long gone. The process of a obtaining a mortgage, which starts with the application of the loan and ends with the funding of the loan, has thus become much more complicated and involves many different agents and agencies. Breaking down the major actors, components, and stages of the loan origination process allows for a more precise understanding of the complicated and convoluted nature of the mortgage industry. The process of qualifying a

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borrower to obtain and complete a mortgage transaction involves many different stages. To understand this process, the following flow chart (Figure 1) details the general stages of the loan origination process, beginning with a borrower purchasing or refinancing a mortgage loan to the subsequent recording and completion of the loan origination process. The following illustration provides a graphic presentation of the general stages of the loan process; it is not a fully comprehensive and complete depiction of all nuanced procedures. The flow chart illustrates the complexity of the operational aspects of the mortgage industry. It is important to note that the illustration depicts only the loan origination processes involved in the primary market and does not include the secondary mortgage market.

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What is Subprime Lending/Subprime Loans? There are major differences between subprime and prime lending and understanding the concept and practice of subprime lending is an important aspect of this study. The practice of providing credit to borrowers with less than par or lower than average credit worthiness is known as subprime lending. Subprime lending involves various forms of credit including credit cards, auto loans, and mortgages. Several defining factors delineate a prime loan versus a subprime loan. The first is the credit risk of the borrower. Borrowers of subprime loans tend to have a higher risk of default. According to Agarwal and Ho (2007), the delinquency rate for borrowers of prime mortgages, fixed and adjustable-rate, is between 2 to 4 percent. The delinquency rate for subprime borrowers tends to be much higher. For example, “[I]n December 2006, over 13 percent of subprime loans were delinquent in the U.S., and more than 14 percent of subprime ARMs were delinquent” (Agarwal, & Ho, 2007, p. 3). This is not surprising considering that borrowers of subprime mortgages usually have credit scores (FICO) lower than 620.

Mortgage Fraud: An Introduction

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Figure 1: Flow Chart of the Loan Origination Process/Stages (Primary Subprime Mortgage Market) STEP 1: Borrowers Initiate Residential Mortgage Loan

STEP 2: Broker or Loan Officer takes initial loan application from borrower

STEP 3: Loan Processor (employed by broker) orders escrow, title and appraisal

STEP 4

Escrow

Title

STEP 5: Upon receipt of loan package, lenders underwrite application, and generate conditional loan approval. Loan approval is sent back to the processor

STEP 4: Processor submits loan package (loan application, escrow instruction, title commitment and appraisal) to the lender.

STEP 6: Processor obtains all conditions and sends to lender.

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STEP 10: Lender reviews loan docs and set loan for Funding.

Appraisal

STEP 7: Lender verifies all conditions/borrowers information. Appraisal review dept. verifies appraisal. Once approved, loan documents including disclosures are generated. Loan docs are then sent to escrow STEP 8: Escrow receives loan documents, verifies its contents and schedules a Notary Public to meet with Borrower for signing.

STEP 9: Borrower and Notary Public signs loan documents. Loan docs return to Escrow for review and upon approval, docs go back to Lender.

STEP 11: Title Records New Mortgage. Loan is Complete.

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Fraud and the Subprime Mortgage Crisis

The high credit risks posed by borrowers of subprime loans usually translate into higher fees and interest rates charged by the lender, which is the second delineating factor between prime and subprime loans. The fees and interest rates charged by the lender usually equate to higher monthly payments and upfront costs. Since the 1990s, interest rates on subprime loans have been approximately 2 percent higher than the average prime rate. Despite the higher costs associated with obtaining a subprime loan, borrowers usually have no other option. Compared to the prime mortgage industry, subprime lending is characterized as having low standards of underwriting. The unprecedented growth of the subprime lending industry since the 1990s and the intense competition that ensued resulted in mortgage products for which anyone could qualify. If the borrower had a bankruptcy, a judgment, a foreclosure, or bad credit history, there would be a subprime loan available. The costs the borrower would have to pay for the mortgage, however, would be much higher in terms of fees and interest related charges. As the number of new financial lenders grew, so did the level of competition; banks were offering more non-traditional and exotic loans to subprime borrowers (Kirchhoff, & Keen, 2007). There was a general push by the federal government, private organizations, and the banking industry to increase the homeownership rate among minority families. Coupled with low interest rates and the introduction of new alternative mortgage products that contained attractive introductory incentives, the housing industry experienced tremendous growth, especially among the subprime lending sector. Between 1994 and 2006, subprime mortgage originations grew from 5 percent of the originations in the U.S. to approximately 20 percent of originations (Holmes, 1999; Arnold, 2007; Bernanke, 2008). The competitive environment of the subprime lending industry also led to the decline in qualification standards. Loans were handed out like candy on Halloween. When a financial lender offered a new promotional loan product primarily based on no proof of income required, a competitive lender would immediately introduce a loan that was easier to qualify, such as a no proof of income and employment history required. In order to

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stay competitive, lenders had to offer more attractive financial products for that were easier to qualify for. A popular mortgage product, for example, was the combo loan, which allowed borrowers to avoid purchasing mortgage insurance. The combo loan product offered the borrower two mortgages that combined, was 100 percent of the home’s value. Borrowers could purchase a home without putting a penny as down payment. By 2005, the average down payment of first time homebuyers dropped to 2 percent, and almost half of all first-time borrowers (43 percent) put nothing down at all (Knox, 2006). As long as home prices rose, subprime lenders made money and continued reducing qualifications and underwriting standards. Subprime lending is a very recent phenomenon. Three decades ago, individuals with poor credit histories would have been denied credit but a several major federal deregulatory moves, beginning in the 1980s, changed all of this and set the stage for what we now know as subprime lending. At the same time, these deregulatory moves also opened the door to creative financing and intense competition in the lending industry, which altogether, created ripe conditions for irresponsible lending and outright fraud. The following section consists of a historical review of these banking deregulations and related legislation.

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Origins of Subprime Lending – Deregulation of the Financial Industry The process of financial deregulation that loosened banking and commerce restrictions and regulations began in the early 1980s. The deregulation fervor of the early Reagan administration was contagious and “gained widespread political acceptance as a solution to the rapidly escalating savings and loan crisis” (Pontell, & Calavita, 1993, p. 207). However, the financial legislation that was to follow would completely dismantle the regulatory infrastructure that kept the thrift industry under control for four decades prior (Mayer, 1990). With several strokes of a pen, the financial industry completely changed. New and innovative products and lending practices grew from increased market competition and the desire to increase profits. Deregulation was seen by the Reagan administration and by

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Fraud and the Subprime Mortgage Crisis

many economists as the panacea to large government. However, Mayer (2002) argued that:

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After a generation of expanded retail banking services, the United States has been moving backwards …The Fed's untroubled supercilious tolerance of these developments reminds us that there are people in high places who still believe government should not interfere with the freedom of contract between the loan shark and the needy. (p. 298) In 1980, the Depository Institutions Deregulatory and Monetary Control Act (DIDMCA) profoundly altered the rules of the banking industry. One of the major changes included the creation of the Depository Institutions Deregulation Committee. The primary task of this committee was to phase out all usury controls, or caps on interest rates. Prior to that time, individuals with poor credit would have been denied credit but the DIDMCA “eliminated all interest rate caps on first-lien mortgage rates, permitting lenders to charge higher interest rates to borrowers who pose elevated credit risks, including those with weaker or less certain credit histories” (Gramlich, 2004). This deregulatory move also invited loosely regulated or unregulated institutions into the loan industry, which targeted borrowers who had credit problems. Subprime borrowers became unfortunate victims of the unregulated free enterprise system and became the prey of financial institutions who charged exorbitant fees and interest rates for basic loans. Similar to the Community and Reinvestment Act (CRA), the passage of the DIDMCA involved political motives, which subsequently resulted in disastrous consequences. For example, Calavita and Pontell (1990) stated that deregulatory moves, such as the DIDMCA, “triggered an even more pronounced negative rate spread. When the DIDMCA failed, Congress prescribed more of the same” (p. 313), referring to the 1982 Garn-St. Germain Depository Institutions Act. The 1982 Garn-St. Germain Depository Institutions Act, passed by Congress, was considered by many to be a primary cause of the savings and loans crisis. This legislation further loosened lending restrictions by preempting state law that

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restricted financial institutions from lending only conventional loans. It gave banks the authority to lend non-conventional mortgages, which greatly altered the landscape of the lending industry. Title VIII of the Garn-St Germain Act, cited as The Alternative Mortgage Transactions Parity Act of 1982 (AMPTA), provided authority to lending institutions to offer exotic mortgages that included: • Interest-only mortgages • Balloon-payment mortgages • Negative-Amortization mortgage • No documentation/low documentation or “stated” mortgages

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• No down payment/100 percent financing mortgages The Garn-St Germain Depository Institutions Act also gave banks the ability to charge their borrowers adjustable interest rates. Bank sanctioned ARM’s were intended to address the problem of asset-liability mismatches, a financial problem banks encountered when their liabilities did not correspond with profits earned from long term, low-interest rate mortgages (Black 2005; Calavita, Tillman, & Pontell, 1997) . This major piece of deregulation was intended to strengthen the financial industry by reducing its susceptibility to changes in the financial market. The purpose of the act was “to revitalize the housing industry by strengthening the financial stability of home mortgage lending institutions and ensuring the availability of home mortgage loans” (Reagan, 1982). Related Influential Legislation Other instrumental legislation included the 1977 Community and Reinvestment Act (CRA), which was signed into law by

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Fraud and the Subprime Mortgage Crisis

President Jimmy Carter. The CRA was intended to address a growing concern regarding the deterioration of urban cities, particularly low-income and minority cities in the U.S. Prior to the passage of the CRA, minority communities were often denied access to credit based on discriminatory practices such as redlining and steering. The passage of the act was intended to reduce discrimination in the credit and housing industry by giving financial institutions incentives to “make loans to lowand moderate-income borrowers or areas, an unknown but possibly significant portion of which were subprime loans” (DiLorenzo, 1997). The purpose of this legislation was to ensure that banks and thrifts would expand credit opportunities to a wider population, including homeownership and business opportunities to non-wealthy populations from lower income communities. The CRA was a product of a grassroots effort to provide affordable housing to minority communities. The law has been modified twice in order to meet the increased monitoring requirements and needs of communities (Canner, & Passmore, 1997). It is important to note that the CRA set in motion the practice of subprime lending, but only among financial institutions that are federally regulated. The subprime mortgage lending industry that later emerged from the financial deregulations that took place during the 1980s (DIDMCA and the Garn-St Germain Depository Institutions Act) was not subject to the regulations of the CRA (Avery, Bostic, Calem, & Canner, 2007). While these legislative plans set the stage for subprime lending, it was not until 1986 that real estate became widely viewed as a great investment. The demand for mortgage debt greatly increased after the passage of the Tax Reform Act of 1986 (100 Stat. 2085, 26 U.S.C.A. §§ 47, 1042), which prohibited tax deductions of interest on consumer loans, but allowed interest deductions on mortgages for primary residences as well as one additional home. The passage of this law gave consumers an incentive to obtain real estate to borrow against rather than using consumer credit. The combination of low interest rates in the mid 1990s and rising home values led to

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record rates of equity borrowing – subprime mortgage cash-out refinances were a popular loan product and a common method homeowners used to access the cash from their home equity. In a report released in 2006, slightly over one-half of subprime loan originations were for cash-out refinancing (Chomsisengphet, & Pennington-Cross, 2006). The Growth of Subprime Lending

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Bank-allowed subprime lending originated from these legislations, yet a decade later, the mortgage industry still resembled its pre-legislative era. As recently as 1990, financial lenders offered loan products that were simplistic and uniform in nature. Most loan products contained fixed interest rates and standard underwriting guidelines, such as low loan-to-value and debt-to-income ratios. In other words, most loans were 30-year fixed mortgages with a minimum down payment of 20 percent. Further, mortgages were offered primarily by traditional banking institutions. However, in the early 1990s, the face of the mortgage industry began to change. The Alternative Mortgage Transactions Parity Act had opened the door for non-traditional mortgages that allowed borrowers who otherwise would have not qualified to obtain a loan. Referring to the AMPTA Birger (2008) wrote that “neither the expansion of the subprime market nor the proliferation of exotic interest-only or option-ARM mortgages would have been possible without federal laws passed in the 1980s” (p. n.p.). The proliferation of alternative and innovative mortgage products, low interest rates, and the continual pressure to reform discriminatory lending practices led to greater access to credit by the population (Essene, & Apgar, 2007). As rates declined, mortgage lenders also loosened their requirements and invented new types of loans based on the fallacious supposition that people would be able to pay more in the future, since real estate and wages would continue to increase indefinitely …With an adjustable rate mortgage starting at 3 percent, for example, the

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Fraud and the Subprime Mortgage Crisis monthly payment on a $400,000 mortgage is only $1,686 per month, $712.00 less than the $2,398 required at a 6 percent rate. (Lifflander, 2008, p. 4)

The exponential growth of the housing market was also a result of the increased demand for homes due to the larger pool of qualified homebuyers and the limited number of available homes, which drove home values through the ceiling. Rising home values furthered the growth of the subprime industry since homeowners found themselves with equity they could leverage. These factors combined with depressed interest rates, lax underwriting standards, and easy access contributed to the unprecedented growth of the industry. As the industry and competition among financial lenders grew, so did the reduction in underwriting standards and wider availability of alternative loan products. In 2007, the dollar amount of outstanding subprime loans was $1.3 trillion, or 7.2 million separate subprime mortgages (Bernanke,2007). The growth of the subprime mortgage industry and the real estate industry in general had a tremendous impact on the housing market. Between 1994 and 2002, the national homeownership rate rose from approximately 64 percent to 69.7 percent, a national high (U.S. Census, 2000). The value of real estate also experienced tremendous growth. Between 1997 and 2006, the value of real estate increased by an average of 124 percent (The Economists, 2007). Some communities in southern California, Las Vegas, Nevada, and Phoenix, Arizona, saw even greater increases.

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Wall Street and Mortgage-Backed Securities Starting in the 1980s, financial institutions began lending credit to subpar creditworthy borrowers, but it was not until the early mid 1990s that subprime lending began to expand at an exponential rate. While many factors contributed to the growth of subprime lending, more than any other reason for the growth was Wall Street investors’ growing interest in subprime securities backed by loans from U.S. homeowners (Ip, Whitehouse, & Lucchetti, 2007). Subprime mortgage, according

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Mortgage Fraud: An Introduction

23

to Bitner (2008), was still in its infancy when Lehman Brothers became the first Wall Street bank aggressively to enter the business of selling subprime securities. The subprime loan securitization rate has grown from less than 30 percent in 1995 to over 58 percent in 2003. The securitization rate for conventional and jumbo loans has also increased over the same time period. For example, conventional securitization rates have increased from close to 50 percent in 1995-97 to more than 75 percent in 2003. (Chomsisengphet, & Pennington-Cross, 2006, p. 41) Considered by many to be one of the greatest innovations in mortgage lending, the securitization of mortgages into mortgagebacked securities dramatically changed the mortgage lending industry. Rather than one single bank supplying the money to fund a mortgage, securitization made it possible for multiple investors to fund mortgages. The banks simply supplied access to credit (mortgages, consumer loans, and auto loans), then sold the assets to investors through the securitization markets, allowing them to replenish their cash reserves. Over time, traditional financial institutions such as retail banks became loan originators. Wall Street’s involvement in subprime lending through the secondary market changed the face of the primary lending industry in several ways. First, the underwriting standards deteriorated as financial institutions no longer had a stake in the loans they originated. As long as the loans originated by mortgage lenders fell within the guidelines set forth by their investors, they were considered good loans. The banks made money from fees they charged the investors for originating, underwriting, and funding the loan. Second, Wall Street’s involvement led to the growing number of mortgage brokers in the industry. According to Bitner (2008), there were approximately 37,000 new registered broker companies in 2001 and, by 2006, the number increased to 56,000. The share of mortgage originations by brokers compared to banks also increased. By 2003, mortgage brokers originated 25 percent of all prime loans and over 50 percent of subprime loans (Bitner, 2009). The National Association of Mortgage Brokers reported “that as many as two-thirds of mortgage loans are now originated

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Fraud and the Subprime Mortgage Crisis

by mortgage brokers” (FinCEN, 2006, p. 6). Third, Wall Street’s involvement infused a tremendous amount of cash into the mortgage industry, which helped fuel the growth of subprime lending. Prior to the mid- 1990s, most banks kept their mortgage assets for the full term of the loan. This limited how much profit a bank could earn on their money. Securitization drastically eliminated this problem by freeing up the money once a mortgage was sold. The rise of home foreclosures that led to the collapse of the subprime mortgage industry in late 2007 eventually caught up with the secondary mortgage market; in fact, the subprime crisis, in essence, shut down the credit markets. In February 2009, Bernanke, Chairman of the Board of Governors of the United States Federal Reserve, announced that the securitization markets had to remain closed, with certain exceptions (Bernanke, 2009). Prior to the collapse of the subprime mortgage industry, subprime securities were considered attractive and lucrative. After the collapse, the value of the subprime mortgage-backed securities plummeted and many financial institutions that retained a significant number of securities on their portfolio were closed. By 2007, over two trillion dollars worth of securities had been marketed by Wall Street. This move, in essence, shifted liability from banks and mortgage lenders to the securities market, which further exacerbated the situation worldwide (Ip, Whitehouse, & Lucchetti, 2007). The securitization of mortgages was once considered a safe bet since risks and liabilities were spread out. The notion that packaging loans and turning them into securities sold worldwide would make the global economy more resilient turned out to be a mirage. Worldwide distribution of mortgage-backed securities served only to spread the impact of the crisis or allow “toxic assets” to become intertwined in the global financial system. The effect that Wall Street had on the primary subprime lending market was dramatic. Rather than by one entity, a single mortgage was originated by many individuals and companies (broker, appraiser, lender, title, and escrow), which diffused accountability. The banks and lenders no longer kept the mortgage assets; “they merely delivered the product that

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investors wanted to buy” (Bitner, 2009, p. 107). The fragmented system that made up the primary subprime mortgage market produced an environment that lacked accountability, underwriting standards, and regulatory oversight. The growth of the mortgage broker system and the lending practices that emerged from the broker office comprised a large part of this complex system. Currently there are no national standards for licensing and oversight of mortgage brokers. Some states license mortgage brokerage offices, but not individuals; 24 states have no specific educational or experience requirements for mortgage brokers; and only a few states require criminal background checks on mortgage brokers making it possible for unethical individuals to move from one mortgage brokerage firm to another. (FinCEN, 2006, p. 6)

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Conclusion The current study explores the ways in which alternative mortgage products, unleashed by deregulation, poor regulation and regulatory oversight over loan agents, and the lending practices that emerged due deregulation and Wall Street’s involvement impacted the growth, type, and pattern of mortgagerelated fraud in the primary mortgage market. As part of this study, a comparative criminological analysis was conducted using the contemporary subprime mortgage crisis and the savings and loan crisis of the 1980s. Prior research on the role of white-collar crime in major financial debacles provides a theoretical framework within which to examine the prevalence and commission of fraud. The subprime mortgage industry shared these similar risk factors. Last, this study explores the role that industry actors (brokers, loan officers, etc.) had on the growth of mortgage fraud.

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CHAPTER 2

Research on Mortgage Fraud and the Law

This chapter will examine the body of white-collar crime literature, beginning with a brief review of the federal statutes that have been applicable in enforcing mortgage related crimes. The literature review will also include a discussion of the role of white-collar crimes in major financial debacles. It will draw upon several bodies of work: the role of fraud in the savings and loans debacle, the Orange County bankruptcy, and the corporate scandals. Examining the factors that contributed to the growth of fraud in these financial debacles will help shed light into our understanding mortgage fraud in the contemporary U.S. economic crisis. This review will include an examination of the various types and patterns of financials crimes that have emerged from these crises. The chapter then concludes with a theoretical review of the criminology literature on white-collar crime.

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Mortgage Fraud and the Law A report issued on mortgage fraud by the Mortgage Bankers Association in 2007 noted considerable attention focused on the need to enact new federal legislation despite the plethora of existing laws that provided law enforcement authorities with substantial legal authority to enforce and prosecute all instances 27

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Fraud and the Subprime Mortgage Crisis

of fraud. The broad and all-encompassing breadth of federal statutes enabled perpetrators of mortgage fraud to be prosecuted under various laws that included: 1) mail and wire fraud statutes; 2) interstate transfer or transportation of goods statutes; and 3) federally chartered and insured financial institution statutes. The statutes listed below review a 2007 report by the Mortgage Bankers Association, which summarize the federal statutes applicable in federal prosecution of mortgage related crimes, for example: United States v. Hitchens, 2002; McElroy v. United States, 1982; United States v. Bond, 1990; and United States v. Jack, 2007. Mail and Wire Fraud Statutes 18 U.S.C. §1341 The mail fraud statute makes it illegal to devise or intend to devise any “scheme or artifice to defraud” anyone and to place in the mail (or a private carrier), cause to be deposited in the mail, take or receive from the mail, or knowingly cause to be delivered any material for the purpose of carrying out the scheme or artifice to defraud. A violation is punishable by fine or up to 20 years imprisonment. Additionally, if the violation affects a federally chartered or federally insured financial institution, a violation is punishable by up to a $1 million fine and up to 30 years imprisonment.

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18 U.S.C. §1343 The wire fraud statute18 similarly makes it illegal to devise or intend to devise any “scheme or artifice to defraud” anyone and to transmit or cause to transmit by wire, radio or television any materials for executing such scheme. Penalties for a violation of the wire fraud statute are the same as for a violation of the mail fraud statute.

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Statutes on the Transportation of Stolen Goods 18 U.S.C. §2314 Whoever transports, transmits, or transfers in interstate or foreign commerce any goods, wares, merchandise, securities or money, of the value of $5,000 or more, knowing the same to have been stolen, converted or taken by fraud; or Whoever, having devised or intending to devise any scheme or artifice to defraud, or for obtaining money or property by means of false or fraudulent pretenses, representations, or promises, transports or causes to be transported, or induces any person or persons to travel in, or to be transported in interstate or foreign commerce in the execution or concealment of a scheme or artifice to defraud that person or those persons of money or property having a value of $5,000 or more; Shall be fined under this title or imprisoned not more than 10 years, or both. Federal Statues Regarding Federally Charted and Insured Financial Institutions 18 U.S.C. § 1014

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Makes illegal the making of “any false statement or report, or willfully overvalue[ing] any land, property or security, for the purpose of influencing in any way the action of” the United States, federal agencies, and Section 20 financial institutions in connection with a mortgage loan. The punishment for a violation is a fine of not more than $1 million and/or imprisonment of not more than 30 years. 18 U.S.C. §§ 1344 Makes illegal the defrauding of a Section 20 financial institution. The punishment for a violation is a fine of not more than $1 million and/or imprisonment of not more than 30 years.

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Fraud and the Subprime Mortgage Crisis

18 U.S.C. §§ 1010 and 1012 Make illegal any false statements for purposes of influencing the Department of Housing and Urban Development (HUD) or getting a HUD-insured loan. The punishment for a violation is a fine and/or imprisonment of not more than two years. 18 U.S.C. § 1348 Prohibits “defraud[ing] any person with any security of an issuer with a class of securities registered under section 12” of the Securities Exchange Act of 1934; 18 U.S.C. § 1001 Prohibits fraud “in any matter within the jurisdiction of the executive, legislative, or judicial branch of the Government of the United States” 18 U.S.C. § 1028 Prohibits the presentation or use of a falsified identification document or other identifying information that appears to have been issued by the United States; • 18 U.S.C. § 1342, which creates an additional offense for the use of a fictitious name or address in connection with mail fraud;

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• 42 U.S.C. § 408(a)(7), which prohibits the use of false social security numbers; • 18 U.S.C. § 1964, which provides for civil remedies for Racketeer Influenced and Corrupt Organizations (RICO) violations; • 18 U.S.C. § 1503, which prohibits the obstruction of justice; and

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• 18 U.S.C. §§ 1956-57, which prohibits money laundering. The report also provides several recommendations to help law enforcement and prosecutors combat and prevent mortgage fraud. Some of these recommendations include: • Extra funding for existing law enforcement agencies. • Establishing specialized government agencies to focus only on mortgage- related crimes. • Greater communication between separate entities involved in the investigation and prosecution of mortgage fraud.

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• Increased punishment for mortgage-related offenses. (Mortgage Bankers Association of America, 2007, pp. 6-8) On May 2005, Georgia became the first state to criminalize mortgage fraud. The passage of the Georgia Residential Mortgage Fraud Act served as an example to other states seeking to introduce similar legislation. Within two years, seventeen states followed suit and introduced similar legislation (Mortgage Bankers Association of America, 2007). On May 20, 2009, the Fraud Enforcement and Recovery Act (FERA) was signed into law by President Barack Obama, which increased the amount of support that the government would provide federal enforcement agencies responsible for investigating mortgage fraud. The legislation, authored by Senator Patrick Leahy, overwhelmingly passed in the Senate and became part of a larger federal effort to strengthen the nation’s capacity to investigate and prosecute mortgage-related fraud. The passage of the FERA was considered an extremely important and timely measure due to the economic crisis, and the major growth of mortgage fraud. In his closing statement at the senate hearing, Leahy (2009) stated:

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Fraud and the Subprime Mortgage Crisis Our bill will strengthen the Federal Government’s capacity to investigate and prosecute the kinds of financial frauds that have so severely undermined our economy and hurt so many hard working people in this country… Mortgage fraud has reached near epidemic levels in this country. Reports of mortgage fraud are up 682 percent over the past five years, and more than 2800 percent in the past decade. And massive, new corporate frauds, like the $65 billion ponzi scheme perpetrated by Bernard Madoff, are being uncovered as the economy has turned worse, exposing many investors to massive losses.

The Fraud Enforcement and Recovery Act drastically improved the enforcement of mortgage fraud investigations and prosecutions in several ways. These included: • Providing and allocating $245 million per year for the following two years to hire federal law enforcement agents, legal prosecutors, and fraud analysts. • Strengthening agencies involved in the investigation and prosecution of mortgage fraud. These agencies included the Federal Bureau of Investigation, the U.S. Postal Inspection Service, the Department of Justice, the U.S. Secret Service, and the Inspector General for the Department of Housing and Urban Development.

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• Strengthening the ‘False Claims Act’ which simplifies the civil prosecution and recovery of funds due to fraud. Mortgage Fraud On November 2006, the Financial Crimes Enforcement Network (FinCEN) Office of Regulatory Analysis extracted a sample from 82,851 reports of suspicious fraudulent activity to ascertain

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contemporary trends and patterns in emerging financial crimes. (SARs), numbering 1,054 and filed between 1997 and 2005, were randomly sampled from the Bank Security Act database. According to the report, mortgage-related fraudulent suspicious activities increased by 1,411 percent between 1997 and 2005. The Federal Financial Institutions Examination Council revealed that the greatest increase of suspicious frauds occurred in 2003, which coincided with an equally large increase in refinancing activity (41 percent compared to 2002). The report also noted that brokers, loan officers, and employees of lenders were the most common suspects associated with reported mortgage fraud. There were several important findings in the FinCEN report. First, the report noted that 65.78 percent of the sample involved material misrepresentation or false documents. The misrepresentations identified in the study included: 1) altered bank statements, W-2’s, credit scores, and tax returns; 2) fabricated letters of gift and letters of credit; 3) invalid social security numbers; and 4) false employment. “The most commonly reported misrepresentation (80.62 percent) was occupancy fraud” (FinCEN 2006). Contemporary forms of mortgage fraud commonly were for both fraud for property and profit, and the perpetrators became increasingly difficult to identify. Second, the study found that reports of SARs among mortgage broker originated loans, which accounts for more than two-thirds of loans as of 2006, greatly increased between 1996 and 2006. This might coincide with the unprecedented growth of mortgage brokers in the U.S. since the 1990s. The study also reported that appraisal fraud and property flipping consisted of approximately 10 percent of the sample. Other notable types of mortgage fraud reported in the study included straw buyers, identity theft, and forged documents (FinCEN, 2006). In April 2006, the Mortgage Asset Research Institute (MARI) released the Eighth Periodic Mortgage Fraud Case Report to the Mortgage Bankers Association, which examined the “current composition of residential mortgage fraud and misrepresentation in the United States” (Sharick, Omba, Larson, & Croft, 2006, p. 1). The report presented data on the geographic

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Fraud and the Subprime Mortgage Crisis

distribution of fraud found in both prime and subprime loans. Data for this report were collected through a central database, MARI’s Mortgage Industry Data Exchange (MIDEX), to which major mortgage lenders, agencies, and insurers provided information with regard to incidents of alleged fraud and material misrepresentation. The database also collected monthly mortgage payment information on over 40 million active loans, including early payment defaults and those with payment problems occurring (Sharick et al., 2006, p. 3). According to data collected by MARI between 2001 and 2005, Florida, Utah, Missouri, Illinois, and Georgia reported the highest number of mortgage fraud incidents among subprime loan originations. Florida had the highest fraud index score; however, California was surprisingly absent from the list. Of the top states that reported high rates of mortgage fraud, California came in at number eight. The report had trouble pinpointing the underlying factors behind California’s low score, but noted that there were unknown forces that the study failed to incorporate. The report also provided data on types of mortgage fraud. Mortgage fraud, according to the MIDEX system, was classified as fraud in applications, tax and financial statements, verifications of deposits (VODs), appraisals/valuations, verifications of employment (VOE), escrow/closing, and credit reports (Sharick et al., 2006). Incidents of fraud reported among mortgage applications were the most common type, followed by tax and financial statements. The table below details the various types of fraud that was reported to MARI by its cooperative lenders between the years 2002-2005. The numbers represent the amount of each type of fraud that was reported as a percentage of the all fraud; and common with the grouping of financial crimes, the total percentages for each year exceed 100 percent because one type of fraud can fall under two or more categories.

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Table 1. Percentage of Fraud Cases as Classified by the Mortgage Asset Institute Mortgage Fraud Types Mortgage Origination Year

Fraud Classification 2005

2004

2003

2002

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Applications 59% 61% 63% 60% Tax and Financial 22% 27% 22% 18% Statements Verifications of 16% 17% 18% 15% Deposit Appraisals/ 14% 16% 26% 40% Valuations Verifications of 13% 14% 15% 13% Employment Escrow/Closing 7% 7% 14% 18% Credit Reports 4% 8% 7% 5% Mortgage Asset Institute. Case submissions to the MIDEX system

The findings in the report (as illustrated in the table above) provide an excellent picture of the types of mortgage fraud that are reported, such as the amount of fraud that occur during the application process. Of the six identified frauds, four of the fraud types, or over 80 percent of the frauds, involve information gathering and verification which take place during the application process. The growth of frauds that involve the intentional misstatement and omission of financial information can be attributed to the growth of “giveaway loans,” or loans in which anyone can qualify for. Loan qualification guidelines were so loose that a borrower with a poor credit history, insufficient assets, and even a bankruptcy could qualify. The report also examined early serious delinquencies as an indicator of possible fraud. If a loan became delinquent within the first 6 to 18 months after origination, it was flagged by

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Fraud and the Subprime Mortgage Crisis

lenders and reported to the database. While early payment defaults (EPDs) do not necessarily mean fraud, studies have found a strong correlation (Sharick et al., 2006). Similar to the findings from the aforementioned studies, a recent California study reported common instances of fraudulent misrepresentations during the mortgage origination process. BasePoint Analytics (2007), a corporation which helps banks and lenders identify fraudulent transactions, conducted the study which examined over 16,000 loans to ascertain the causes of early payment defaults found that "as much as 70 percent of recent early payment defaults had fraudulent misrepresentations on their original loan applications; applications that contained misrepresentations were also five times as likely to go into default” (p. 1-2). According to Tim Grace, CEO of BasePoint Analytics, “there is a direct correlation between early payment defaults and mortgage fraud” (p. 1). The study also found that frauds included income inflated by as much as 500 percent, appraisals that overvalued the property by 50 percent or more, fictitious employers, and falsified tax returns (BasePoint Analytics, 2007, p. 2). The MARI report presented similar findings. According to the report, material misrepresentation was common among loan products that required little scrutiny of the borrowers’ financial disposition. In particular, the growth of alternative loan products, such as no documentation/low documentation loans, allowed unscrupulous activities to flourish. These loans were also known as stated income loans, or “liar loans,” and were much more likely to be open invitations to fraudsters. “When the stated incomes were compared to the IRS figures, the resulting differences were dramatic. 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. (Sharick et al., 2006, p. 12) These loans have become known as “liar loans” since it allows borrowers to simply lie about the qualification requirements. In an interview with Bill Moyers, Black (2009) noted that,

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Liar loans mean that we don't check. You tell us what your income is. You tell us what your job is. You tell us what your assets are, and we agree to believe you. We won't check on any of those things. And by the way, you get a better deal if you inflate your income and your job history and your assets. To understand the link between mortgage fraud and other financial crimes, the Financial Crimes Enforcement Network (2009) conducted a study that examined 156,000 mortgage loan fraud (MLF) subjects over a five-year span. The study identified the various financial crimes associated with the commission of mortgage fraud, as identified and reported by depository institutions. In particular, the study reported on the ways in which the “mortgage loan fraud subjects and associated subjects reportedly hid, moved, or disposed of large sums of cash. They also provided information about other suspected financial crimes, such as stock manipulation, insurance fraud, check fraud, and fraudulent casino transactions” (FinCEN, 2009, p. iv). The study first identified suspects of MLF as reported by depository institutions and then evaluated the activities of reported MLF subjects, the suspicious activities reports (SARs) of non-depository institutions, such as money services businesses (SARs-MSBs) , securities brokers, security dealers, insurance companies (SARs-SF), casinos, and card clubs (SARs-Cs) (FinCEN, 2009). Several important findings included the following: 1. Money laundering and transactions intended to avoid reporting requirements accounted for:

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• • •

85 percent of activities reported by money services business, 47 percent of activities reported by casinos and card clubs, and 28 percent of activities reported by securities dealers and brokers.

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Fraud and the Subprime Mortgage Crisis 2. 17 percent of reports submitted by casinos and card clubs were identified as check fraud. 3. Money services business reported that 23 percent of MLF subjects attempted to conceal or alter their identities. 4. Approximately 70 percent of money services businesses reported suspicious wire transfers; 34 percent reported wire transfers to other countries 5. In total, 23 percent of the reports submitted by securities brokers, dealers and insurance companies involved securities fraud, which represented a 7 percent increase in the same 5 year period 6. Suspected perpetrators included real estate and financial services professionals. 7. The number of SARs filed by depository institutions has increased from 2006 to 2008.

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(Financial Crimes Enforcement Network, 2009, pp. v-vi) The relationship between mortgage related crimes and other financial crimes is an important aspect of understanding whitecollar crime as it allows for an understanding of “ways in which financial crime extends through multiple financial industries” (Financial Crimes Enforcement Network, 2009, p. iv). Financial crimes often fall under more than one category of a particular type of fraud; perpetrators of mortgage fraud oftentimes also commit identity theft and money laundering as part of their commission of mortgage fraud, as the previous study has identified. Unfortunately, the mortgage lending industry is a very large sector of the overall financial industry and is intricately tied to many other financial sectors such as banking, credit, real estate, investments, and insurance. The strong relationship between mortgage fraud and various financial crimes and its

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permeation throughout the financial industry make it an important part of this study. In order to better understand the relationship between mortgage fraud and the global economic crisis, it will be important to review the role of white-collar crime in major financial debacles, such as the savings and loan crisis, the Orange County bankruptcy, and the corporate scandals. A review of these financial debacles may provide great insight into the factors the led up to the current crisis.

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The Role of White-Collar Crime in Financial Disasters The limited body of scholarly work (e.g., Calavita, & Pontell 1990; Hagan, & Benekos, 1991; Pontell, & Calavita 1993; Pontell, Calavita, & Tillman 1994; Will, Pontell, & Cheung, 1998; Pontell, 2004; Black, 2005; Pontell, 2005; Pontell, & Geis, 2007) on the role of fraud in major financial debacles (e.g., savings and loan crises, the Orange County, California bankruptcy, and the corporate and accounting scandals of 2002) revealed complex dynamics underlying the causes and implications of crime in corporate organizations. These researchers posited that while little debate existed “regarding various forms of white-collar crime and its detrimental impact, there is much contention regarding the role of fraud in major financial debacles” (p. 310). Contrasting claims stemmed from the fraud minimalist perspective (made up mostly of economists) and white-collar and corporate crime research spanning over 50 years (Pontell, 2005). Influenced by corporate governance theory beginning in the 1930s, corporations were believed to work best unhindered by government regulations. The free market or corporate governance law and economic movement, influenced by the work of Easterbook and Fischel (1991), trivialized the notion of fraud. This model attributed major financial meltdowns “to larger structural disorders, mismanagement and incompetence, government and regulatory interference, overzealous enforcement efforts, and risky business” (Easterbook, & Fischel, 1991). In regard to the savings and loan debacle for example, economists believed that the crisis was brought about as a result

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of economic conditions (rise in interest rates, unemployment, recession, etc.) and government policies that created a moral hazard, which led thrift owners to take risks that were necessary but legal to save their company (Barth, Bartholomew, & Labich, 1989; Rubinovitz, 1990). Economists contend that fraud played only a minimal role, if any, and had nothing to do with the failure of thrifts. This perspective stood directly opposed to the primary tenets of criminological research on white-collar and corporate crime (e.g., Coleman, 1987; Erman, & Rabe, 1997; Geis, 1967; Finney, & Lesieur, 1982; Brathwaite, & Fisse, 1990; Simpson & Piquero, 2002) spanning over 50 years and focusing on factors, such as organizational environments that produced high incentives and opportunities for fraud, inadequate regulatory oversight and enforcement, systems capacity, and regulatory regimes as the primary causes of financial debacles (Pontell, 2004). These competing perspectives underscored the importance of examining what role, if any, fraud plays in major financial debacles. Pontell’s (2004) study compared two opposing models, the minimal fraud model and the material fraud model, as explanations for the catastrophic financial losses experienced in the savings and loans crisis, the Orange County, California bankruptcy, and the U.S. corporate and accounting scandals. The study examined each of the financial debacles and attempted to answer questions relating to the significance of fraud by applying the major tenets of both explanatory models. Unfortunately, there was a very thin line between risky business and criminal fraud, which was not surprising considering that “the aim of the more sophisticated fraudster is to manufacture the appearance of an ordinary business loss, or worst, of the ‘slippery slope’ rather than deliberate fraud” (Levi, 1984, p. 322). In his analysis, Pontell (2004) found that a clear pattern of control fraud was present in each of three financial disasters. In each, there were clear and deliberate instances of misstatements, misrepresentations, and manipulation of various financial documentations. For example, in the savings and loan crisis, it was reported by the General Accounting Office (1989) that control frauds were central in as many as 80 percent of all thrift

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failures. The debate however, focused on how much impact the role of fraud actually had. Hagan and Benekos (1991) argued that up to half of the total losses were due to fraud. A study conducted by Pontell and Calavita (1993) found that massive control frauds were central factors in the savings and loan crisis. Crimes, such as embezzlement and looting, were common practices among thrift executives; one way that fraudsters made money was to go on shopping sprees with company funds (Pizzo, Fricker, & Muolo, 1989). In the Orange County bankruptcy, there were massive cases of financial manipulation and intentional misrepresentation to investors (Will, Pontell, & Cheung, 1998). Criminal activities in the corporate scandals were evident and included accounting frauds, cooked books, and falsified profit reports. In all of these financial disasters, the argument that free markets would naturally spot fraud and selfcorrect simply did not suffice. The question as to what role white-collar crime played in the thrift failures, however, continued to be debated. On the other hand, the major types of financial crimes documented in these financial crises were clear and evident.

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Types of Fraud in the Financial Debacles A review of the types and patterns of fraud that emerged from the major financial debacles of the last three decade was essential for the current study. Calavita and Pontell (1990) provided great insight into the criminological impact of financial deregulation, the competitive pressures that resulted, the lack of regulatory oversight and enforcement, and the constrained enforcement of financial fraud. Following in the same tradition, this study traced the financial frauds that emerged from the structure of the subprime mortgage industry. A primary aim of this study was to understand the types and patterns of mortgage fraud and to compare the results to the findings of prior studies. Many types of criminal fraud took place during the savings and loan debacle. In 1987, a hearing before the House Subcommittee of the Committee on Government Operations reviewed the misconduct and criminal fraud that were uncovered

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in the investigations of the California thrift failures (U.S. Congress, 1987). The findings of the investigations provided clear cases of property flipping, investment fraud, and a host of other criminal activities. Using data collected from interviews with regulators and FBI investigators, news reports, government hearings, and Thrift Information Management System data provided by the Resolution Trust Corporation, Calavita and Pontell (1997) compiled a long list of financial crimes that included what they described as daisy chains and land flips. “Daisy chains comprised a network (chain) of associates who accommodate each other’s phony transactions; land flips involved selling a property back and forth among two or more partners until its ‘value’ has increased many times over” (Calavita, Pontell, & Tillman, 1997, p. 68). Crimes such as these fell under three primary categories of thrift fraud: 1) illegal risk taking; 2) covering up; and 3) collective embezzlement. Illegal Risk-Taking Similar to gambling, this category of crime included financial investments by thrifts that were so risky, that they violated laws, regulations, and constituted unsafe practices (U.S. General Accounting Office, 1989). In the savings and loan crisis, the most popular type of excessive risk taking strategy was the use of deposits for Acquisition, Development, and Construction loans (Calavita, Pontell, & Tillman, 1997). The major financial deregulation that took place in the 1980s loosened banking restrictions and gave banks the power to invest a significant portion (up to 40 percent) of thrift assets, which were derived primarily from brokered deposits. Considering that the federal government insured these deposits, the developers simply had little to risk. As a result, thrift operators invested millions of dollars into commercial development projects that were completely unmarketable and profitable. The fiercely competitive financial environments provided the incentives for fraud (Calavita, & Pontell, 1990) and in the midst of these highly imprudent ventures, thrift operators were commonly found to have misappropriated bank funds and violated federal law (Pizzo, Fricker, & Muolo, 1989).

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Covering-up Arguably the most common and widespread form of criminal fraud (Calavita, & Pontell, 1990) that occurred during the savings and loan crisis was covering-up. Covering-up was found in approximately 23 percent of the violations of criminal fraud (U.S. General Accounting Office, 1989). Covering-up involved the intentional concealment of information, usually financial information, to prevent knowledge of wrongdoing from authorities. The common cover-up schemes among thrifts during the savings and loans debacle included fabricated documents and cooked financial books. For example, after the government takeover of Lincoln Savings, examiners found evidence of doctored board meeting minutes, forged signatures, falsified reports, and stuffed files (Pizzo, Fricker, & Muolo, 1989). Collective Embezzlement Also known as looting, this form of fraud was considered the most costly category of crime in the thrift industry. Collective embezzlement was unlike the low-level lone embezzler, who engaged in criminal acts against his organization by stealing money, for example. Rather, collective embezzlement was a cooperative effort by members of an organization who, together, commit a crime using the organization as a weapon or tool (Sherman, 1978; Wheeler, & Rothman, 1982; Calavita, & Pontell, 1990; Calavita, Pontell, & Tillman, 1997; Pontell, & Calavita, 1993). During the savings and loan crisis, thrift executives created falsified bills, fictitious escrows, and phony commercial development projects from which they siphoned funds used to purchase lavish cars, homes, and private jets (Murphy, 1989). Approximately a decade after the savings and loan debacle occurred, the Orange County bankruptcy took place, and while it wasn’t a case of endemic fraud, it was a blatant case of illegal and excessive risk-taking that was fraudulent. Mortgage frauds also entail excessive risk-taking during the loan origination process and similar to the bankruptcy case, the thin line between risky legal financial ventures and criminal conduct is often crossed.

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The Orange County Bankruptcy The bankruptcy of Orange County was considered one of the largest government failures in U.S. history, with losses approximated at $1.7 billion. At the center was Robert Citron, who eventually pleaded guilty to six felony counts of defrauding and misappropriating public funds, was sentenced to a year in county jail and fined $100,000 (Ex-Treasurer freed, 1997). In addition to massive cover-ups and misappropriation of funds (Will et al., 1998), the crimes included the sale of securities using false and misleading financial documents and the illegal transfer of public funds. For example, between April 1993 and February 1994, Robert Citron and Matthew Raabe misappropriated over $80 million dollars of public funds that belonged to the Orange Country Treasury Pool, according to court documents. The abuse of positions of power by these individuals is a very common theme in major financial frauds. Black (2008) noted that CEO’s and senior executives can use their power and influence, bringing to the table financial tools such as accounting to perversely reward themselves, usually at the degradation of their firm. These powerful individuals commit control frauds in complex manner that the risk of detection is minimal. This was especially the case in the following corporate scandals.

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Corporate Scandals The names Kenneth Lay and Jeffery Skilling became synonymous with white-collar crime after the collapse of Enron, once the seventh largest US Fortune 500 Corporation, in December 2001. What followed the bankruptcy announcement was a major investigatory effort by the federal government that uncovered tax evasion, accounting fraud, abusive use of tax shelters, and a host of other criminal activity (U.S. Senate Committee on Finance, 2003). As the investigation continued, the scale of unreported debts and restatement of accounts mounted; Enron had “not only wiped out $70 billion of shareholder value but also defaulted on tens of billions of dollars

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of debts” (Partnoy, 2002, p. 1). In the end, 34 prosecutions resulted, leading to the indictments of several top executives at both Enron and its auditing firm, Arthur Anderson (Birnbaum, 2004). In total, there were 17 guilty pleas, most of which were plea bargains in exchange for cooperation in other court cases (McBarnet, 2006). Several months after Enron’s bankruptcy, WorldCom filed for bankruptcy, at the time considered the largest in U.S. history. Similar to Enron, WorldCom engaged in accounting fraud to the tune of $11 billion dollars that literally toppled the company (ExWorldCom CEO, 2006). Behind the scam was the Chief Financial Officer Scott Sullivan, ex-controller David Myers, and Bernard Ebbers. WorldCom specifically overstated its financials by “classifying payments for using other companies’ communications networks as capital expenditures” (Lyke & Jickling, 2002, p. 1). On August 8, the company announced that it had also manipulated its reserve accounts in recent years, affecting an additional $3.8 billion (U.S. House, 2008). In addition to these corporate scandals, a host of other corporations (e.g., Tyco International, Adelphia Communications, Xerox Corp.) faced charges of accounting irregularities and criminal fraud.

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White-Collar Crime as Organized Crime Researchers who have examined the parallels between organized crime and white-collar crime have suggested, for example, that the line between the two has increasingly blurred as organized crime groups entered legitimate businesses (Meeker & Dombrink, 1984; Meeker et al., 1987). Others, such as Smith (1980), suggested “eliminating altogether the notion of organized crime as a distinct phenomenon and replacing it with a ‘spectrum’ of entrepreneurial activities ranging from criminal enterprises to legitimate businesses” (as cited in Calavita, & Pontell, 1993, p. 524). In examining the tie between organized crime and white-collar crime, Calavita and Pontell (1993) analyzed savings and loan frauds to determine whether thrift

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Fraud and the Subprime Mortgage Crisis

crime could be classified as organized crime. The goal of the study is to analyze whether the organized crime model or traditional understanding of organized crime share similarities with corporate crime. The authors noted that, when the nature of the crime (methods and motives) rather than the background of the individual was the focus of analysis, “certain forms of fraud by corporate offenders are, for all intents and purposes, organized crime” (p. 539). The framework of organized crime, according to the authors, involved several dimensions: 1) conspiracy, 2) organized, 2) premeditation, 3) continuous, and 4) connections with public officials. Within this framework, the authors found that the “fundamental types of illegal transactions found repeatedly in the savings and loan crisis fit well with their working definition of organized crime” (p. 533). The level of threat to society that organized crime presents is usually not questioned by anyone. Studies that analyzed crime seriousness (Rossi et al., 1974; Cullen et al., 1982; McCleary et al., 1981; Gray, & O’Connor, 1991) generally found that whitecollar crime that did not result in personal injury ranked “considerably lower than crimes involving personal violence or individual property crime with serious loss of property” (Meeker, Dombrink, & Pontell 1987, p. 75). Testing the perceptions of crime seriousness of white-collar crimes among occupations within the criminal justice system (defense attorneys, prosecutors, judges, and criminal justice professionals), Meeker et al.(1987) found supporting results from prior studies (e.g., Rossi et al., 1974; McCleary, 1981; Pontell et al., 1983) of a normative consensus regarding crime seriousness. In light of the savings and loan debacle and the major corporate scandals that made national headlines, the perceived level of seriousness between traditional criminal activities and white-collar crime had tremendous similarities (Rebovich, & Layne, 2000). A 2008 study conducted by Isenring examined the perceptions of white-collar crime among Swiss bank employees and found that bank employees classified white-collar crimes as serious offenses, regardless of whether the acts resulted in physical harm. These findings indicated there was growing awareness regarding the detrimental impact that white-collar

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crime had on society. The researchers also found that subjects took white-collar crimes very seriously and were supportive of harsher punitive sentences for such offenses, much in line with the perspective shared by prosecutors, judges, and investigators (Meeker et al., 1987; Isenring, 2008).

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The Role of Organizations in White-Collar Crime In recent years, researchers increasingly focused their attention on the role of organizations in the prevalence and commission of financial crime. Rather than focusing on individuals, researchers investigated the criminogenic factors of the organization. The primary focus in this area of research was on the ways in which organizations created opportunities and incentives for fraud coupled with low risks of detection and punishment. Several studies, beginning in the 1970s, provide a starting point for this discussion. In his analysis of the alcoholic beverage industry, Denzin (1977) found that larger structural conditions within the industry were central factors in the documented violations of the law by industry players. In a similar vein, Needleman and Needleman (1979) identified several factors (limited liability of actors, opportunities for economic success, and low risks associated with the means to obtain the success) that, together, created a criminogenic environment. Using the securities industry as a point of reference, they argued these criminogenic features of the organizational structure played an important role in compelling its members to engage in criminal activity. The structural conditions – high incentives and low risk – served as a motivator for the organizational member as well as outside members to utilize the system for their advantage (Needleman, & Needleman, 1979). Organizational crime could be defined as illegal behavior "committed by executives and managers acting as representatives of their institutions on behalf of those institutions" (Calavita, & Pontell, 1994, p. 300; see also Hagan, 1985; Schrager, & Short, 1978; Wheeler, & Rothman, 1982;

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Glasberg, & Skidmore, 1998). The difficultly came in distinguishing whether the crime served to benefit the individual or the corporation since both usually garnered the reward of the crime. Wheeler and Rothman (1982) addressed this by proposing an alternative perspective: white-collar crimes were not only beneficial to the organization and its members but were also tools or weapons in the commission of those crimes. Similar to a gun used in a robbery or a real estate appraiser in a fraud scheme, an organization could serve as a weapon in the commission of a white-collar crime (Tillman, & Pontell, 1995). This viewpoint considered an organization’s features as instrumental rather than contextual; for example, the reputation of an organization may determine its ability successfully to commit massive frauds undetected. Arthur Anderson, for example, once one of the world’s largest accounting firms, was able to cook the books for Enron for years before any irregularities were detected. Tillman and Pontell (1995) suggested several features of an organization that should be considered when examining the commission of white-collar crime. These included: 1) organizational size, 2) growth, 3) ownership structure, and 4) regulatory environment. In a study conducted by Tillman and Pontell (1995), 686 insolvent thrifts from the savings and loan crisis were analyzed to determine the organizational correlates of fraud. The researchers were particularly interested in how an organization’s ownership structure and behavior were related to the prevalence and commission of white-collar crime. The study presented several important findings, which were consistent with previous research. It was found that when financial institutions departed from traditional financial practices and embarked on high risk, high growth strategies, they were more likely to become vehicles for fraud. The researchers also noted that insiders who engaged in fraudulent acts were usually well aware of their actions and consequences; “for these actors, the long term survival of their organization was often unimportant, as it simply functioned as a tool, or a weapon, in the commission of their crimes” (Tillman, & Pontell, 1995, p. 1458).

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Theoretical Underpinnings As can be seen, understanding the complexity of white-collar crime required recognizing factors often difficult to grasp and intellectually challenging. The nature of white-collar crimes involves issues related to law, organizational processes, criminal justice, and criminology. While the criminological literature might offer tremendous insight into the theoretical explanations of street crimes and the characteristics of those who commit them (e.g., Rosoff et al., 2003), by comparison, the literature on the underlying causes of white-collar crime and criminals is tenuous (Shover and Hochstetler, 2006). It is much more difficult to explain and understand the factors that compel whitecollar criminals since they usually do not display traditional criminogenic characteristics associated with street level criminals. The difficulties of understanding white-collar crimes and criminals requires one to draw on various perspectives that include cultural, interpersonal, and institutional mechanisms that produce opportunities and motives for white-collar crime. The nature of white-collar criminals is described as ironic – they did not exist on the fringe of society and did not experience many social characteristics as a youth such as poverty, marginalization, and discrimination but, rather, were part of mainstream culture. In fact, many corporate criminals are considered extremely successful members of society. They not only conformed to accepted societal values that include hard work, education, and the attainment of wealth, but they achieved their success through culturally accepted means. According to Rosoff, Pontell, and Tilman (2003), the ironic nature of whitecollar criminals could be better understood through the lens of the cultural mechanisms that produced strain on individuals. Introduced over a century ago in his study, Suicide, Durkheim(1897) viewed societal values and norms as an inescapable force that might break down under certain conditions, such as rapid social change (e.g., from feudalism to capitalism). According to Durkheim,

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The limits are unknown between the possible and the impossible, what are just and unjust, legitimate hopes and claims and those which are immoderate. Consequently, there is no restraint upon aspirations...A condition of anomie results from passions being less disciplined, precisely when they need more disciplining. (p. 246) It is during this loss of norms and values that individuals experience a state of normlessness. Simply stated, anomie could be defined as a social condition characterized by instability, the breakdown of social norms, institutional disorganization, and disconnect between socially valid goals and available means for achieving them. Merton (1957) later elaborated on Durkheim’s view of anomie to describe social-structural conditions that led to deviant behavior. Unlike Durkheim, Merton rejected the notion that individuals were naturally driven by anarchic tendencies. Rather, he posited that individuals wanted to succeed and were socially sanctioned if they failed to achieve wealth. Individuals were brought up and trained to accept the cultural goal of wealth and the methods to attain it. Criminals differed in that they did not value the culturally prescribed means and it was this disjuncture which led to delinquency (Merton, 1957; Short, & Strodtbeck, 1965). In this vein, the social structure was dynamic and active in producing fresh motivations with one underlying reason, the subjective definition of wealth. The thrift operators and executives who were involved in the savings and loan debacle and the corporate scandals were extremely affluent. Despite their six and seven figure salaries, they engaged in fraudulent activities to produce more wealth. A broker who earns a sixfigure income or a corporate CEO who earns millions annually, for example, might still a certain level of social and economic inadequacy, thus, resort to innovative means, including criminality, to overcome these frustrations. Studies of incarcerated youth reliably showed that individuals differed significantly in their relative definition of cultural values,

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education, and wealth (Landis, Dinitz, & Reckless, 1963; Landis, & Scarpitti, 1965). An individual may earn millions of dollars and still feel dissatisfied with the income amount. Applying the theoretical premises of strain, social disorganization, and differential association, Cloward and Ohlin (1960), similar to Merton and Cohen (1955), argued that the strain an individual experienced resulted from the disjuncture between culturally prescribed goals and the means to obtain them. Cloward (1959) earlier theorized that blocked access to illegitimate as well as legitimate opportunities would be a logical extension of Mertonian strain theory. “Our hypothesis can be summarized as follows: the disparity between what lower class youth are led to want and what is actually available to them is the source of a major problem of adjustment" (Cloward, & Ohlin, 1960, p. 86). Differential opportunity theory, as they called it, added an additional element to traditional strain theory. In order for a criminal act to occur, it must be predicated upon an opportunity structure. Criminals needed to have access or associations that allowed them to learn the modes, values, actions, and motivations necessary to be criminal. Vaughan (1983), in her case study of organizational misconduct by a drugstore chain, noted that organizations found support for this perspective. She argued that, like individuals, organizations seek illegal means to achieve economic success when legitimate avenues were blocked and when opportunities were available to attain resources unlawfully. In Vaughan's schema, the interplay between structurally induced strain and the availability of opportunities was the key to determining the likelihood of whitecollar criminality in any organizational setting. The absence of oversight combined with the social and financial rewards associated with funding a high volume of loans, and the low risk of detection and punishment made the organization susceptible to significant levels of fraud (Denzin, 1977). Fraudulent activities, such as changing a borrower’s income, debt-to-income ratio, establishing false employment, creating false reserves, modifying w-2’s, giving kickbacks to appraisers to falsify value and the rest, were rarely ever

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discovered. Further, if questionable documents or practices were exposed by a financial lender, a broker office would get off with a verbal warning or, in a worst-case scenario they would simply cease to do business with the broker. Brokers who submitted fraudulent information to financial lenders were rarely ever prosecuted because wholesale lenders completely relied on the business provided by independent brokers and sanctioning brokers could be detrimental to the company. In the mortgage industry, the rewards and reinforcements for funding the loan far outweighed the costs associated with the sanctions or lack thereof for engaging in fraud to get the loan funded. Sutherland’s (1945) study, White-Collar Criminality, concluded that the ideas and beliefs learned in association with other people had a direct causal impact on criminal behaviors. Focusing on interpersonal interaction as a cause of criminality, Sutherland asserted that white-collar crime could be understood through the learning processes underlying the causes of traditional crimes. Sutherland posited that criminality was the result of a learning process that occurred through direct and indirect interaction with criminals, and whether the interaction led to criminality was largely determined by the nature and intensity of the interaction. Akers and Khron (1979) later modified differential association theory by incorporating modern learning principles into the social learning perspective. The view that learning was limited to interpersonal interactions was discounted by modern social learning theory. The process of learning, as argued by Akers and Khron, also involved experiences and reinforcements that an individual received from the environment. Differential associations, definitions, imitations, and social reinforcements affected the individual’s initial and possible continual involvement in criminal behavior (Akers, & Khron, 1979; Burgess, & Akers, 1996; Wilson, & Herrnstein, 1985). According to Braithwaite (1999), such an approach resulted in impressive empirical support. For example, Akers and Khron (1979) were able to explain 60 percent of the variance in marijuana use with questionnaire measures of differential

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association, differential reinforcement (e.g., praise for not using, perceived probability of punishment), definitions favorable or unfavorable to use (e.g., techniques of neutralization), and imitation (‘admired’ models who used marijuana). Together, social learning principles of association and reinforcement are largely influenced the by an organizational environment, and has become the basis of numerous social programs in the U.S. Despite the theory’s wide application to traditional criminals, or lower-class subcultures, Sutherland (1945) argued that the learning process was essentially the same with white-collar criminals. Other theoretical models emphasized the institutional structure of the industry under question as an area of interest for understanding the causes of white-collar crime. Needleman and Needleman (1979) described a criminogenic industry as an economic, legal, organizational, and normative internal structure, which played a role in generating criminal activity within the system. Many industries (e.g., music and automobile) were afflicted by fraud (Rosoff, Pontell, & Tillman, 2004) but the mortgage industry may rank as one of the worse cases since a significant number of those involved in the loan process greatly profited from the opportunities and incentives the industry provided during the housing boom. Further, Wall Street’s complicit role in the matter – its continual purchase of securitized mortgages without investigating the true value of these assets and the rating agencies lackluster approach to assessing the quality of the financial instruments – along with government deregulation of the financial industry contributed to a crime-facilitative environment in which frauds flourished. Many borrowers who later foreclosed on their homes also profited since they often refinanced the full value of their home, a property that they never could have afforded to purchase or own in the first place. In the last decade or so of subprime prosperity, the simple qualification guidelines established by financial lenders, along with the industry-wide loose underwriting standards, made it possible for a broker office to qualify anyone and everyone who wanted a mortgage. If a

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borrower lacked the required assets or job to qualify, it would be falsely established. The practices of cutting, pasting, and recopying or using simple Photoshop techniques to create false documentations were simple. In the American classic movie, “Catch Me If You Can,” Frank Abagnale, played by Leonardo DeCaprio, illustrated how simple it was to defraud banks. The check forgery scams were committed by a kid, and it is an illustration that all one needs to commit fraud is a will to do it. Most loan agents were aware of superior methods that reduced detection by underwriters. There were few consequences of detection as lenders would generally respond to a submission of questionable documents with a verbal warning. Considering that profit margins for an average loan transaction could easily exceed $10,000.00, even the most ethical loan agents succumbed to the practices in some form or another. More recent theories pointed to capitalism as the culprit, arguing that a culture of competition was embedded in the mentality of individuals (Coleman, 1994). The win at any cost mentality and the intense motivation and pressure to stay ahead of the game, even if it meant bending the rules or engaging in outright fraud and deception, is a natural byproduct of capitalist economies (Rosoff, Pontell, & Tillman, 2004). This is more evident in the subprime lending industry as the competition between lenders was considered fierce. Consequently, these competitive pressures led individuals and organizations to engage in criminal activities just to “get ahead.” As we will find in the following chapter, the culture of competition is an important aspect of understanding the etiology of various criminal activities. The criminological literature on white-collar crime offers various models with which to understand the causes of mortgage fraud. Prior research on the savings and loan crisis, for example, has identified links between various types of financial crimes and the structural policies and practices that characterized the thrift industry in the 1980s, and allows for a general understanding of fraud and the current subprime mortgage crisis because both financial crises involved deregulatory policies that

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loosened financial restrictions, provided inadequate oversight, and required no accountability (Nguyen and Pontell, 2010, p. 594). The study detailed here follows in the theoretical traditions of those studies (e.g., Calavita, and Pontell, 1990; Calavita, Tillman, and Pontell, 1997; Pontell and Calavita, 1993; Tillman and Pontell, 1995), by examining detailed accounts by insiders concerning various types of mortgage frauds and the underlying motivations behind their crimes in the context of structural policies and lending practices of the subprime industry (p. 594). The findings outlined in chapter 4 provide an analysis of detailed accounts by white-collar offenders in the mortgage industry using Sykes and Matza’s theoretical model. Sykes and Matza’s (1957) theory of “neutralization” or a priori rationalizations, provides a framework for understanding how certain criminals engage in deviant acts and still maintain positive self-images. The notable work on the decision making of white-collar offenders conducted by Benson (1985) demonstrated the various decision-making processes criminals use to redefine to alleviate or eliminate culpability. Subsequent studies on white-collar crime have found consistent evidence that white-collar criminals explain their actions within the context of both legal and ordinary occupational activities, which makes identifying the illegal activities difficult (Coleman, 2002; Conklin, 2004; Jesilow, Pontell, and Geis, 1993; Shover and Hunter, 2010). The findings will also be informed by e rationalchoice theory. While this theory has been predominately used for understanding traditional criminal activities, recent research on the “crime-as-choice” theory for understanding and controlling white-collar crimes has provided a useful framework from which to understand subprime mortgage fraud (Nguyen and Pontell, 2008, p. 595). Shover and Hochstetler’s (2006: xvi) model of “lure, oversight, and the supply of tempted and predisposed, concepts at the heart of crime-as-choice theory,” will be a useful paradigm for understanding the factors that lead to the criminal decision making described in Chapter 4.

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CHAPTER 3

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Data and Methods

This study utilized both traditional and non-traditional methods to access data from industry insiders. From the perspective of a social scientist, the difficulties associated with obtaining access to sensitive populations can often determine the success of the study. My previous study on the social structure of a Vietnamese café offering illegal gambling, for example, depended solely on my ability to obtain written consent from the owner of business. Seldom are individuals willing to share personal information, especially when such information is criminal in nature. From the perspective of a social scientist and a criminologist, gaining access to mortgage industry practitioners willing to share personal and often incriminating information posed a potential logistical nightmare. Mortgage businesses in California were selected out of convenience as well as utility. Compared to the rest of the country, California ranks among the top states in terms of the real estate market. Homes in California experienced the greatest rate of appreciation, depreciation, foreclosures, and lending activity. California is also home to the largest number of subprime mortgage lenders and is considered the headquarters of the global economic meltdown. A recent study that analyzed $1.38 trillion worth of subprime mortgages originated between 2005 and 2007 found that approximately 56 percent of the loans were originated by 15 lenders from California (Abate, 2009). 57

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Fraud and the Subprime Mortgage Crisis

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Before the research subjects were located and selected, a review of the literature was undertaken that examined various aspects of mortgage fraud and white-collar crime, such as the factors that led large organizations (i.e. thrifts of the savings and loans) to engage in crime. The literature review also included a categorization of financial crimes common in financial organizations. For example, researchers have explored and categorized the types of crimes that emerged out of the savings and loan crisis. While these studies provided tremendous insight into the criminogenic culture of the thrift industry and particular corporations, the findings have limited relevance to the mortgage industry, and particularly, the subprime lending industry in California. Toward this end, it was necessary to use the literature as a foundation for exploration into the problem of subprime mortgage frauds in California. The research then supplemented the literature with face-toface interviews with various actors within the primary subprime mortgage market. Based on the review of the literature and on preliminary discussions with industry professionals and borrowers, the decision was made to use interviews as the primary method of inquiry. Altogether, data for the study were derived from four primary sources: interviews, government reports, media, and industry studies. The primary goal was to locate and identify a pool of potential subjects who; 1) have working experience in the subprime lending industry, and 2) are willing to share their experiences. This step of the process was made much more manageable as a result of my previous involvement in the mortgage industry as a mortgage broker.1 In addition, I was able

1

Between March 2005 and the end of 2007, I worked in the mortgage industry and while my short tenure in the industry in no way qualifies me as an expert on the topic of fraud, my exposure to the mortgage business allowed me to generate business relationships with many industry practitioners that included other brokers, loan officers, underwriters, and account executives. Thus, my past business relationships served as a means of locating and targeting potential

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to obtain several lender lists from mortgage brokers from southern California. These lender lists contain information on subprime mortgage lenders and the account executive that is the contact for the lender. A list can contain as much as 100 lenders and was also a source of contact information which I mined for potential research subjects. Using business solicitation emails, business cards, existing loan applications, and lender lists, I attempted to contact approximately 56 industry agents that included brokers, account executives, underwriters, and appraisers. Of the 56 loan agents, I was successful in reaching 37, 17 of which offered verbal consent over the phone to participate in the study. The first 17 subjects were thus non-probable samples and selected out of convenience. The problem with such an approach is that an unknown portion of the population has been excluded from the sample. Despite the size of the sample, it can never be known whether it will actually represent the entire population. Despite these concerns, it was determined that the exploratory nature of this study warranted this method as the most appropriate methodology.

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Interviews Interviews were all conducted in person and face-to-face with a total of twenty-three (n=23) subjects from 2008 to 2009. A large portion of the interviews took place in a one-on-one context; however, two interviews were conducted in a group setting with two interviewees in a private location. The two group interviews involved research subjects who had an established a relationship with each other and proposed to do the interview together. The researcher was experienced with interviewing based on considerable experience gained from a master’s thesis project and a recent study of youth gangs (Nguyen, 2004; Vigil,

research subjects. I began by attempting to contact all of the individuals with whom I had a relationship

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Nguyen, & Cheng, 2006). Both studies employed a qualitative research design that involved interviews and observations. These studies and other research experience provided requisite research skills necessary to secure and extrapolate sensitive data from subjects through conversation. A decision not to use a digital voice recorder for the interviews eliminated concern among interviewees about voice recognition. Instead, written notes were taken on a notepad, which led to a more comfort for the research subjects. The subjects were advised to avoid using any identifiers (names, dates, locations, and times) verbally; however, it was common for subjects to speak openly and, in the process, possibly to reveal names of persons and places. In such instances, a pseudonym replaced the identifier. No one was allowed to enter or leave the research location during the interview. Once the interview was completed, the data were placed in a locked container. The protection of research subject identity was of utmost importance for this study. The success of the study depended on clearly established rules that ensured the greatest possible protection and the least amount of risk. It was extremely important to convey this to the subjects. As a criminologist, I was not new to research involving collecting information that, if compromised, could result in catastrophic consequences. Knowledge of the subjects’ identity and their actions required the use of substitute identifiers, such as pseudo-names, assigned numbers, or nicknames, with research notes about actual subjects, locations, and actions. 2 Interviewees were asked to

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2

All confidential information required the use of cryptic notes as opposed to the straightforward note-taking style (Nguyen, 2004). This method was necessary to reduce the potential for a breach of identity but could be problematic when collecting a great deal of information without the accuracy of a recording device. However, writing cryptic notes during the interview was useful for remembering key words, phrases, and sequences of events (Berg, 1989). All cryptic notes from the study were immediately stored in a secured and locked container and will be maintained safely for a period of three years as required by federal law. Subsequently, all materials pertaining to this study,

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avoid using real names, locations, and any other identifiers that could lead to a breach of identity. The research subjects were aware of potential risks and concerns that were part of their involvement in the study. Confidentiality was of great concern in any criminological research (McSkimming, 1996). The interviews were conducted using the elite interview method (Dexter, 1970; Lofland, 1971), which allowed the subjects with specialized knowledge of mortgage lending practices and procedures to teach the interviewer during our meetings. Pontell, Calavita, & Tillman (1994) have suggested that “the best way to conduct elite interviews is to understand the situation and make full use of the opportunity to extract information from the research situation” (p. 387). The interviews were primarily semi-structured, which allowed capturing the emotions and viewpoints of the subjects. This approach also allowed the subjects to provide information and insight into certain situations and circumstances that might have been completely overlooked if a pre-designed series of questions were asked. While structured interviews might benefit the less skilled researcher because they employ a set series of fixed questions, they also narrowed conversations and might omit valuable data that was not included in the interview. Unstructured interviews, however, allowed for open-ended, organic conversations from which to pull data. Additionally, open-ended questions netted the deepest and broadest responses, but resulted in data that were difficult to decode. Furthermore, conversational exchanges, especially among sensitive populations, seemed less imposing than structured interviews. The rich data that can be obtained from qualitative work allowed works from researchers such as Chambliss (1964) and Vigil, Nguyen, and Cheng (2006) to

including those that contain any identifying information, will be destroyed. The primary concern was reducing possible risks to the dignity, reputation, rights, health, welfare, or well-being of all participants.

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document and detail the complexity of their subjects' experiences. The discussion with interviewees included topics that included day-to-day mortgage practices and sensitive information, such as illegitimate loan origination acts, corporate pressures, and incentives and motivations for fraud. The research questions focused on several broad as well as specific themes. The broad themes included personal background and demographic information, employment background and experience in the mortgage industry, understanding of company policies and practices, and employee training. More specific themes focused on actual work environment, duties, and responsibilities of the subjects, including but not limited to common loan origination practices (legal or illegal), organizational pressures, priorities, expectations, financial incentives, and business relationships. It was more difficult to get subjects to share certain sensitive information, such as their knowledge of criminal practices of coworkers. Knowledge of the subjects’ identity and their actions required extra precautionary measures to ensure that identifiers were not recorded. Subjects were offered the option of giving written consent or waiving written consent. Once the research subjects were provided detailed study information, verbal consent was obtained. Confidentiality was of great concern in any criminological research, including the current study (McSkimming, 1996). All confidential information, such as company names, locations, and other possible identifiers, stated by subjects during the interviews required the use of cryptic notes as opposed to a straightforward note-taking style (Nguyen, 2004). Extreme vigilance was taken to minimize possible risks to the dignity, reputation, rights, health, welfare, or well-being of all participants. Interviews with each subject lasted between one and two hours. None required follow-up interviews. Notes were written on a notepad during the interview and transcribed into an electronic file the following day. The rich data that can be obtained from interviews can allow the detailed documentation of the complexity of the subjects’ experiences (Vigil, 1988; Vigil, & Yun, 1990; Vigil, 2002; Vigil, Yun, & Cheny 2004).

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Again, the research questions were semi-structured, and covered a broad array of organization, institutional, and cultural factors of the lending industry. Questions also focused on specific day-to-day lending practices. Examples of general questions included: Sample Questions Regarding Work and Work Experience Can you please tell me about your employer? How did you get into the mortgage industry? Tell me about your specific job? What were your duties and responsibilities? What was your salary range? How was your salary determined? Commission? Bonuses? Base salary? A combination of one or more? Did you have any financial skills prior to the mortgage industry? Describe in detail your prior experience before entering the mortgage industry? How much training, if any, did you have for the position? E.g., what did it include? (Ethics? Law? Legal procedure? Fiduciary responsibilities? Fraud? Sexual Harassment? Etc.)

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If you had training, please describe your training. Do you feel you had adequate training for your position? Why or why not? How do you feel about the overall recruiting and training procedure of the company? About trainers? Managers? Is

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Fraud and the Subprime Mortgage Crisis there anything else you would like to add regarding this topic? Does your employer work directly with borrowers? In other words, is it a retail or wholesale mortgage company? If not, with who? Brokers? Retail banks? Etc. Please tell me about your business relationships? For example, did you work with directly with borrowers or through wholesale channels? What do you think the goal(s) of your position/team/company were? Monetary? Customer service? Explain your answer. Is there anything else you would like to add regarding this topic? How much of your employers business is prime loans? Subprime loans? Seconds? Refinance? Purchase? Etc. What was the target of your business? How familiar are you with the loan products offered by your company? For example, stated loans, fixed interested loans, ARMS, balloon payment, NINA, seconds, HELOC, full doc loans, etc. (** ask the subject to explain each of their loan products).

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Tell me about the loan products your company offered? If broker, what was the focus of the company? For example, real estate, mortgages, or both? Sample Questions Regarding Work Environment and Management Tell me about the management structure? How is it structured?

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If you worked in a team, how is it organized? (e.g., part of four person team that consist of an underwriter, account manager, funder, and account representative). Tell me about the working environment? Was it: Competitive? Relaxed? Professional? Strict? Pressure to perform? Please explain your answer. Please detail why you think the working environment is structured in such a way? (Effective? Efficient? Poor? Lacking oversight? Etc.) If your position is a sales position, was there a lot of pressure in your workplace? Sample Questions Regarding Specific Loan Origination Practices Are you familiar with mortgage fraud? What is your take on fraud in your position as a …? What types of frauds, if any, have you encountered? What types of frauds, if any, do you find within your organization? Where does it come from? How does management react to fraud when they discover it?

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What types of questionable lending practices have you engaged in, if any? How much do you think exists of fraudulent lending practices in your office? Your type of business? In the mortgage industry? Why?

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Fraud and the Subprime Mortgage Crisis In your experience, do you find that borrowers’ background information regarding loan qualifications is exaggerated, false, etc.? Please explain your answer. If yes, A. Why type of information (financial, credit, etc.)? B. Tell me what you know regarding this? 1. Who? What? Where? When? And How? What is company policy regarding exaggeration or falsification? What are the consequences? How is it viewed upon by your co-workers? Please detail. What happens if you become aware of such information? What are you expected to do? Have you ever exaggerated/falsified/overlook questionable or knowingly false information? If yes, can you tell me about it? Is there anything about this you want to add?

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Tell me what you know regarding how coworkers feel about this? Can you tell me what you know regarding other employees without including any identification information? (e.g., in your experience, what do you know about processors? Underwriters? Management? Etc.). Tell me what you think about stated loan products? With regard to the overstating of financial information – what is your position and your employer’s position regarding this?

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Is there anything you would like to add that I have not asked? These are examples of the various semi-structured questions that were asked to subjects. The answers from research subjects resulted in consistent patterns and similarities, which suggest that the questions were not only appropriate but valid. The similarities among answers from various actors also suggest that experiences within the industry from related actors overlap on several dimensions. Data for this study originated from interviews with loan agents who were employed at the time of the study or previously employed in the subprime mortgage industry and had extensive experience with subprime lending. In addition to interviews, a variety of secondary sources of information (media reports, industry studies, and government reports) was utilized to supplement data from subjects. Research Subjects

The breakdown of research subjects and their industry positions are as follows:

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Table 2: Research Subjects and their Industry Positions Broker Office

The Lender

3 mortgage brokers 2 loan processors 4 loan officers

2 underwriters 2 loan representative 3 account managers

Borrowers

Escrow and Title

3 borrowers

2 escrow officers

Appraisal office 2 appraisers

Total: 23 Subjects

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Fraud and the Subprime Mortgage Crisis

To supplement information provided by loan agents, interviewees included 3 borrowers who obtained a subprime mortgage. It is important to note that of the 3 borrowers, 2 have lost their home through foreclosure. These borrowers provided invaluable input about their experiences in obtaining a subprime loan and knowledge, or lack thereof, of questionable practices during the loan origination process. Access was available to loan practitioners who represented a wide spectrum of mortgage industry players. For example, 2 of the 3 account managers and both loan representatives in the study were employed by 3 of the top 10 largest subprime mortgage lenders in the United States. Of the 4 loan officers interviewed, 2 were employed by small mortgage brokers with 10 or fewer employees. In fact, of the 20 loan agents interviewed, 16 worked in a company of 25 or fewer. It is important to note that in this study, the subjects recruited were are primarily based convenience sample and do not necessarily constitute a representative sample of loan agents in the industry. However, while all research subjects resided in Southern California, the loan practitioners originated loans both inside and outside of the state. The backgrounds of the research subjects varied considerably. The ages ranged from 20 to 46 with a mean age of 28. 14 subjects were male and nine were female. Of the 23 subjects, all had completed high school, 14 had an educational background that included some college, and 6 had completed a bachelor’s degree. None of the subjects had a graduate level education. Regarding training and experience, the majority (19) had no prior experience or training before entering the mortgage industry. Most of the subjects were trained by their employer. 6 of the subjects entered the mortgage industry with related financial background experience and all had experience in the banking industry. In particular, they all worked in retail banks. The loan agents interviewed for this study were compensated by their employers with combined base salary, commission, or bonus. While 7 employment positions were classified as sales positions, a significant portion of all of research subjects’ (excluding borrowers) compensation were based on a bonus and/or commission structure; the higher the number or volume

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of files (loans, appraisals, titles, and escrows) they closed each month, the higher their salary. For example, the 3 account managers (non-sales) were paid a base salary between $30,000$50,000 per year plus bonuses. The financial compensation structure of bonuses differed among financial lenders; however, all were based on the monthly volume that an account manager was able to produce. For example, if the account manager closed more than 50 loans per month, he or she would receive a bonus of $2000. If the account manager closed eighty loans per month, he or she would receive a bonus of $3500. Secondary Data Sources

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The Media This research project began in April of 2008, approximately 6 months into the contemporary subprime mortgage crisis. Daily, new media accounts, reports, and coverage related to the mortgage crisis. The media were thus an invaluable source of data for this study. Information from various media outlets could be informative, providing “primary sources of information about the world outside our immediate surroundings” (Larson, 2005). As the financial crisis unraveled, it was imperative to utilize data sources such as the Wall Street Journal, Bloomberg, and the Financial Times, to provide the latest information on the subprime fallout and the actions taken by local and federal agencies to address it. Government Reports Another crucial source of data for this study included government reports, such as Senate and Congressional hearings, which addressed mortgage-related fraud or problems relating to the housing crisis. Various reports by agencies, such as the U.S. General Accounting Office, the U.S. Federal Housing Administration, and the U.S. Department of Housing and Urban Development, were mined to determine the government’s role and response to mortgage-related crimes. Other government

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sources of data included the Joint Hearings by the U.S. Senate on Predatory Lending and the Congressional Hearing on Mortgage Fraud and its Impact on Mortgage Lenders. State and federal law enforcement information was another source for this study. The Department of Justice and the Federal Bureau of Investigation disseminated information on mortgage fraud, such as current investigations, mortgage-related crime rates, and trends. Similar to the media, information disseminated by the government was a valuable way to stay updated on the government response and role in the crisis.

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Industry Studies Industry organizations, such as the National Association of Realtors, the Center for Responsible Lending, the Mortgage Bankers Association, and the National Association of Mortgage Brokers, were invaluable sources of data for this study. These agencies collected and disseminated housing data, such as real estate values, homeownership rates, and sales projections. The real estate and finance organizations also conducted studies and disseminated data on mortgage fraud. Many organizations played a crucial role in real estate and lending laws and practices that become codified. These organizations could be both partisan and bipartisan; therefore, it was important to be cautious with the information. Other Sources The examination of lending programs and guidelines were also important to provide a detailed picture of the evolution of subprime mortgage programs. A review of lender rate sheets or a daily industry publication of loan programs and rates offered by various prospective subprime lenders to their business contacts, were examined in order to evaluate ways in which the industry eased the ability to obtain a mortgage. Published and provided only to loan agents by financial lenders, rate sheets offered different subprime loan programs, correspondent interest rates, fees, and qualification requirements. This part of the analysis provided a picture of the subprime mortgage industry

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and covered changes in loan programs, underwriting guidelines, rates, and qualification requirements.

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Strengths and Limitations of Interviews Lofland and Lofland (1984) noted that intensive and unstructured interviewing could lead to information rich in detail. The information extracted offered access to intimate levels of knowledge and understanding. The differences between field research and other methods, such as the gathering, focusing, and analyzing of data, were numerous and the strengths did not come without cost. One benefit of qualitative research was that the subjects defined the terms of the study; therefore, researchers could be confident they were testing what they were studying. The rich data obtained from these interviews allowed documentation of the complexity of the subjects’ experiences in the mortgage industry (Vigil, 1988; Vigil, & Yun, 1990; Vigil, 2002; Vigil, Yun, & Cheny 2004). Interviewees discussed subjects in detail that included dayto-day mortgage practices and sensitive information, such as illegitimate loan origination acts, corporate pressures, and incentives and motivations for fraud. The researcher had an established business relationship with seventeen of the 23 subjects, which greatly eliminated the need to develop a certain level of trust and rapport necessary to extract sensitive information during an interview. However, this did not mean there was complete trust or that care was not taken regarding the order and the line of questioning. In addition, research subjects’ comfort had to be assured and vigilance maintained about their expressions, body language, and openness with their involvement in the study. The strict protocol procedures and assurances of confidentiality that were a part of this research project in addition to established relationships made the research subjects feel comfortable about sharing information; however, the information still required a certain sensitivity in interviewing approach. Research subjects were informed that their identities were kept anonymous, and informed of the strict procedures detailed above to prevent information from accidentally

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becoming leaked. Despite these measures, the researcher still needed to approach questions of a sensitive nature with a strategy. For example, questions relating to criminal activity, especially regarding those committed by the subject were asked in a measured and careful manner. Questions regarding fraud were intermixed with normal questions, and the body language and comfort level of interviewees were constantly observed during questioning. The researcher asked probing questions to ascertain the subjects’ level of openness, and their body language, voice, and mannerisms, provided indications of their comfort level. There were numerous occasions where I failed to read my research subjects’ comfort level and body language, and was unable to illicit an open or detailed response to a question. Overall, the interviews revealed that most involvement in or actions of mortgage fraud were considered normal and minor by loan agents. It was, therefore, not very difficult to discuss sensitive topics and to shed light on insightful information regarding illegal loan practices, including ways in which such activities were carried out.

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Inside Interviewing My previous 2 years of experience in the mortgage industry as a mortgage broker provided tremendous insight and knowledge regarding numerous aspects of the mortgage industry which I was able to leverage for this study. For example, I experienced and observed the day to day activities within a broker office, the types of relationship that emerged between various employed actors within the industry, and the nuanced procedures of loan origination. During my work as a broker, I established numerous business relationships with various types of loan agents. This experience gave me a better understanding of the social dynamics within lending organizations, the ways in which loans were negotiated, and the ways in which bonuses and commissions were handled. These experiences usually occur under the purview of industry practitioners and such experiences provided me with definite advantages during various stages of this research project (e.g., knowing what questions to ask and

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whom to ask certain questions). Also, it was very common for subjects to use industry lingo during the interviews, which I understood and thus did not require additional clarification. The research subjects also shared insight about working with mortgage brokers, a major player in the loan origination process. Various researchers similarly argued that individuals who conducted scholarly studies within their own social group or community had special knowledge and insight, which could greatly benefit qualitative investigations (Davis, 1997; Gwaltney, 1981; Hayano, 1979; Rhodes 1994). For example, insider researchers tended to have knowledge regarding where to obtain subjects in a certain community, what questions to ask, and how to empathize with subjects, a skill necessary for effective interviewing (Hayano, 1979; LaSala, 1998, 2001; Rhodes, 1994).

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Research Concerns Issues regarding validity, such as reproducing subject’s biases or perspectives through questions or the line of questioning, had to be scrutinized. Extreme caution was taken during the research design phase to ensure that the line of questioning did not represent or enforce stereotypes, perspectives, or beliefs (Cooke, & Campbell, 1964). This concern was especially magnified because of personal involvement in the industry as a mortgage broker, which caused critical examination of personal perspectives and values throughout the research project. According to Kanuha (2000), complex challenges of being an indigenous or inside researcher had to be overcome when researching a population with which one was involved or shared identity. The true benefits of interviews also required constant awareness of situations, which could take advantage of interviewee’s willingness to open-up. In this particular study, it was important to gauge each subject’s point of discomfort. As I noted earlier, it was important to gauge the research subject’s body language and mannerisms throughout the interview. The most uncomfortable questions had to do with the subject’s involvement in fraud or the discussion that their actions were

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Fraud and the Subprime Mortgage Crisis

criminal. For example, research subjects commonly stated that their clients’ income was calculated by determining the amount required to qualify and making sure that the amount fell within particular guidelines. In order words, if their clients’ actual monthly gross income is $4000, but it the amount required by the lender is $10,000 per month the loan agent would state the latter. These liar loans, as they later became known as, are essentially an open door opportunity for fraud and when our discussions make it clear that the research subjects actions amounted to fraud, they often became defensive. Nevertheless, it didn’t prevent or limit my line of questioning. More than not, the subjects were completely open with their answers and anxious to share all of their knowing of the subject. As with any qualitative approach, there are general concerns such as the possibility of stress, sympathy for the subjects resulting in a loss of objectivity, loathing of subjects, withdrawal, the compromising of one’s situation, and ethical issues (Berg, 1998; Chambliss, 1964; Cooke, & Campbell, 1984; Lofland, & Lofland, 1984; Matthew, & Huberman, 1984; Vigil, Nguyen, &Cheng, 2006). Similar to utilizing multiple questions and tests that match against responses in quantitative designs, qualitative research can employ a variety of means to assess the accuracy or truthfulness of subject responses. One important tenet of qualitative research is the use of triangulation. Participants might not be truthful either because they do not know the truth or because they wish to keep it from public knowledge. To address this concern, it was extremely important to cross-reference participant information with other non-connected participants and research data (loan applications, rate sheets, and literature). For example, subject’s answers regarding their salary and pay scale, job duties and responsibilities, and loan origination practices could be cross referenced with other subjects’ answers, the industry disseminated information on employment positions, and literature.

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Limitations of the Study The ability of a social science researcher to gain access to sensitive data can make or break a research project. A major benefit of this study was the business relationships previously developed in the mortgage industry, which was mined for research subjects. While many may consider this knowledge and information immensely important, there were some shortcomings. First, the selection of subjects was based on convenience, in other words, almost anyone who was either currently employed or previously employed in the mortgage industry, had experience in subprime lending, and agreed to be part of the study. There was no access to a high-ranking individual, such as a CEO or a CFO of a subprime lending company. Access and insight from a high-ranking loan practitioner could have significantly influenced the results of the data and formulation of the model. Second, the research subjects were primarily limited to those who worked in Southern California. The six research subjects who were referred from the initial pool of subjects also resided in Southern California. While the majority originated loans throughout the United States, it would have been highly beneficial to recruit loan agents who resided in different areas of the U.S. Southern California is a unique location, particularly with regard to the real estate market. The common loan origination practices, lending culture, and organizational experiences could be geographically situated; thus, the experiences of these subjects might be different from loan agents who resided in a different geographic location. Another limitation of this study was its scope. The study examined only the primary mortgage lending market, including the borrower, broker, lender, appraiser, escrow, and title, where loans are originated, underwritten, and funded. Once the loan is funded, it is packaged and sold to investors in the secondary mortgage market, which consists primarily of investment firms and rating agencies. To capture the problem of fraud and its role in the subprime mortgage crisis, it would be important to

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Fraud and the Subprime Mortgage Crisis

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incorporate the secondary mortgage market in the analysis. As news of the subprime mortgage crisis continued to unravel, so too was the number of reports of fraud in the secondary mortgage market. The high profile Wall Street arrest of two Bear Stearns executives in 2008 was an example of the problem of fraud in the secondary market and such examinations were omitted from this study.

CHAPTER 4

Mortgage Origination Fraud

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In chapter 2, a review of the literature pointed to the various structural and organization factors that created perverse environments for frauds to flourish. This chapter will apply these theoretical foundations as a guide to understanding mortgage frauds in the subprime mortgage industry. First, a comparative analysis will be made of the new types and patterns of mortgage frauds found in this study. This will involve a thorough discussion of three diverging areas: the criminal act, the perpetrator, and the criminogenic industry. This chapter then analyzes the various aspects of contemporary forms of mortgage fraud, which includes a discussion of the typology of subprime mortgage crimes, and the patterns of fraud among the range of organizations that make up the primary mortgage market. The chapter then concludes with a discussion of our need to reexamine our understanding of mortgage fraud. Our understanding, definition, and categorization of mortgage related crimes is a first step for providing positive impacts on enforcement focus, policies, and preventative priorities. Traditional & Contemporary Forms of Mortgage Fraud Compared The massive changes that took place in the mortgage industry during the early 1990s, such as alternative mortgage products, underwriting practices, mortgage-backed securities, and lack of 77

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accountability, completely transformed the face of mortgagerelated frauds. Contemporary mortgage frauds differ from its traditional mortgage fraud counterpart. The following discussion details three distinctions that differentiate modern forms of mortgage fraud from traditional forms: (1) the criminal act, (2) the perpetrator, and (3) and the criminogenic industry.

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The Criminal Act Unlike mortgage fraud, which classifies fraud as either for property or for profit, contemporary mortgage fraud contains elements of both. A significant number of financial misrepresentations on loan applications are not committed by organized criminal groups whose sole intention is to defraud financial lenders; rather, they come from omissions, misstatements, and misrepresentations perpetrated by legitimate businesses or corporations whose goal is to qualify a borrower for a loan with the intention of their client to obtain a primary residence and repay the loan. The criminal act is simply a part of accepted loan origination practices for a legitimate loan; the profit that results from the transaction is the byproduct of the legal financial transaction. Borrowers and their loan agents in this study were aware of the financial misrepresentation(s) necessary to qualify them for a particular loan product. A common scenario of loan agents was a client who might meet the qualifications of most loan conditions, such as income, employment, and credit requirements, but might not meet the sufficient asset requirements a lender requested. The following statement was from a loan processor regarding a file that needed some tweaking. If we are doing a stated loan and their credit is good but they don’t have enough money in the bank, then I would tweak it to make it work. I would just request a verification of deposit from my client’s bank and just Photoshop the average balance. Sometimes all I need to do is add a 1 in front of the average balance. Before, lenders were really lenient. They would not ever call the bank for verification. They would just check off the condition. Lenders slowly caught on to that and started

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calling in the bank. After the lender caught on, we had to go stated and just overstate the balance. This is a clear example of the type of blatant criminal fraud and the ambivalence that many loan agents have regarding these types of lending practices. This subject was well aware of the legality of his actions, yet felt that it was normal part of the business. Lenders were really lenient before. They do not ever call the bank for verification of what we submit if it looked reasonable. The view that such behaviors within the industry are common and accepted was a commonly described by subjects. The following statement not only illustrates this theme, but also demonstrates a neutralization technique in which the responsibility was not that of the agent, but the authority figure – the broker.

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The subject noted that: When I get an A paper (good credit) client who wants a 30 year fixed loan but does not make enough, all my brokers told me to put them in stated loan where I can just state whatever is needed to get the loan. Everyone in the offices I have worked in would try and give their client a stated loan if the client didn’t make enough money or have enough money in the bank. I have had brokers tell me to state the income much higher on an application just to make sure we get the loan, since we can’t restate the income. I have been at many broker offices – this type of stuff is normal in the mortgage industry. The lack of control mechanisms and oversight that exist within an organization has been noted by researchers as a contributing factor to crime (Denzin, 1977). When a culture of an organization fails to assert controls over actions that result in

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perverted financial rewards, and at times encourage it, frauds committed by organizations’ own employees as described above will very likely occur. Borrowers in this study also noted they were aware they did not meet a particular loan condition, such as the income or asset requirement. For example, a borrower who wanted to obtain a mortgage would find out very early in the process what they qualified for, whether they made sufficient income and had an adequate amount of assets. One borrower stated for example that:

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I tried getting a loan but was unable to for like 2 months. Then my broker told me that I was rejected for a loan and so we needed to go to different lenders. I don’t remember exactly but I think it was because I didn’t make enough or that my credit wasn’t that great. He had to submit my loan to several banks and on the loan application we had to put that I made $14,000 a month, which was obviously not true but he got me the refinance I wanted so I was happy. If a borrower wanted a refinance but did not have sufficient income, they would rely on their broker to get them qualified. The only thing that matters to most borrowers is getting the loan, and they depend on the loan agent to qualify them. It is important to note that the majority of the mortgage transactions during the last decade were refinances, where borrowers wanted to obtain cash from the equity of their homes. This was especially fueled by the year after year appreciation of the housing prices and low interest rates. The initial loan application or Uniform Residential Loan Application signed by the borrower/s contains detailed financial information of the borrower/s. In other words, it was described that borrowers are well aware that their income and/or asset is inflated on the loan application. The important question among various loan originators is how much money is required to get a particular client approved. Loan originators (brokers, processors, and loan officers) have the experience and knowledge necessary to determine the exact requirements of lenders and tailor the loan

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application and required documents to meet qualification requirements. The following statement by a loan officer illustrated the previous point.

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When my clients do not make enough money to get a certain loan or a certain rate they want, I get them a stated loan. You can put down anything for their income or assets as long as it sounds reasonable to the lender. They want the loan so even though they know that my client can’t possibly make what I put down, it’s a stated loan. My lenders don’t really make an issue about the income I state unless it doesn’t make sense at all. So I just work the employment title and that’s it. Borrowers are usually grateful that I got them the loan. They don’t care that I stated in the application that they make this amount of money when they really didn’t. They are just happy I got them the loan. In this instance, the perpetrator used the classic neutralization technique – denial of victim. Since everyone in this transaction benefited (the borrower gets the loan and the remaining parties (loan officer, broker, and lender makes a profit), it is easy to not see a victim. It wasn’t until the housing crash that countless victims of fraud became apparent. The primary question concerning this type of behavior is how can ordinary law abiding citizens of a working class background engage in criminal activity? First, it should be noted that this particular subject very likely did not perceive the action as criminal. Still, it can be ascertained that his actions were questionable in nature. Understanding this type of behavior will require an examination of how ordinary individuals commit crimes. As previously noted, Sykes and Matza (1957) have argued such individuals adopt various neutralization techniques, or rationalizations of their behavior. In this case, the subject simply rationalized his actions by believing that he was truly acting in the benefit of his client; “they want the loan and they are just happy I got it for them.” The subject also rationalizes his actions by noting the lender “didn’t care.” Borrowers and their loan agents share the same goal, which is to obtain a mortgage

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successfully. Lenders (e.g., underwriters, account managers, and representatives) commonly ignore questionable financial claims or documentations submitted by brokers if the information seems reasonable. The following statement was by a loan officer describing his working relationship with his account manager. My account manager for Lender A was really cool. I sent a lot of work her way so she would take care of me. Say, when she calls to verify employment for my client and the employer says that person doesn’t work here, she would call me and let me know. I will tell her to just call again and tell the person she calls to say that my client does work there. My account manager would call again. Or, say my account manager finds out I put down a cell phone number as my client’s employee number; she would just sign off on the condition. Other account managers that I do business with would not be as easy so I will only go through them if I need to.

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Surprisingly, this type of practice is commonly described in the lending industry. A broker may be approved with 30 different lenders, but will primarily use only a handful of lenders who are “willing to work with them.” Alternative mortgage products and low underwriting standards created conditions ripe for crime in legal institutions that might perceive blatant intentional misrepresentations, misstatements, and omissions as nothing more than creative or risky financing. The Perpetrator: Professional, Criminal, or the Professional Criminal? Despite the egregiousness of certain forms of misrepresentation, a significant number of contemporary mortgage frauds were considered minor and acceptable by industry practitioners. In fact, subjects in this study commonly referred to certain fraudulent acts (e.g., overstating income and assets, postdating documents, file stuffing, altering employment title, and others) as a financial skill, describing the actions as risky or creative

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financing. The following description from a loan officer was an example of this viewpoint.

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You can get anyone a loan if you are good. You have to work with what your client has. If he has a crappy job, change his title so you can state a higher income. If the income is still not enough, give him another job. There is a lot you can do to qualify someone. Go stated, make him pay off debts, change the loan amount, change his job title, add someone to the loan. If he doesn’t have enough money in the bank, for example, put his name on another person’s account and get a VOD of that account. These unethical and criminal types of behaviors have been discussed by Clinard and Yeager (1980) in their examination of large manufacturing corporations. In order for a loan agent to learn how to “make a loan work,” there must be some sort of learning mechanism which emerges out of social interactions within an organization from which an individual learns the skills. It is from these intimate interactions that definitions of unethical conduct or fraud, learning, and reinforcement of illegitimate lending practices are transpired (Akers, & Khron, 1979; Burgess, & Akers, 1996; Wilson, & Herrnstein, 1985). In these organizational environments a culture of corruption can emerge in which a company is proactive with its criminal conduct. Studies on criminogenic organizations have found tremendous support for the existence of criminal cultures and have found that the ethical tone of a corporation is usually set by those at the top, in management and executive positions. Alternative mortgage products, such as the popular low doc or no doc loans, commonly known in the industry as stated loans or liar loans, require crafty manipulation on the part of loan agents to qualify borrowers who do not meet lender requirements. The thin line between creative financing and outright criminal fraud is commonly crossed by loan agents who perceive their actions as acceptable in the industry. This is evidenced by many lenders’ circumvention of their

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responsibilities to thoroughly underwrite a loan when a stated loan is involved. There are various ways to get a client to qualify for a loan – many of which may be creative and led to fraud. For example, a loan agent may claim that funds from a refinance will be used to pay existing debts, and therefore reduce the client’s debt-to-income ratio of the loan. However, once a loan funds, a loan agent may instruct the escrow officer, whom he has an established relationship with, to not pay off the debts and establish falsified payoffs. Another example of the thin line between creative financing and criminality is the line between amounts that is inputted as income on a stated or a liar loan. Many loan agents in the industry presume that they can state any income amount on a loan application, as long as it “makes sense.” As such, loan agents will approach a stated loan by first determining the amount required to qualify and then figuring out ways to make sense of it to the lender. This often involves misrepresentations, falsifications, and fraud. Instead, loan agents should first determine their client’s income and present it to the lender in an honest and truthful manner. When such practices are condoned within the working environment, and even promoted by their clients, colleagues, and superiors, questions of ethics and legality are easily suppressed. Referring to overstating a client’s income on a loan application, a mortgage broker remarked:

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It’s a stated loan. You can state whatever as long as it is realistic and the lender believes it. That’s why it’s a stated loan; if my client made enough money, I would go full doc and get a lower rate. No or low documentation loans, or stated loans, do not mean state whatever is realistic and whatever the lender will accept. Loan agents are bound by professionalism, ethical conduct, and fiduciary duties to their client to practice responsible financing. In this case, the client should have been instructed by the broker to reduce the loan amount to better suit his or her ability to repay. Whether the loan agent rationalized the act as accepted

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within the organizational structure by colleagues or superiors, misrepresentations, such as overstating income or assets, was a crime. The borrowers obtained the home or credit they desired; loan practitioners profited from their tractions; and lenders, along with their investors, got their loans. The perpetrators in this study did not resemble an organized criminal group, such as a fraud-for-profit scheme, nor did the subjects in this study view themselves as criminal. They were working professionals who were part of a highly profitable industry that lacked competent financial regulation, legal oversight, and ethical standards. Unfortunately, many of these professionals used their knowledge and skill set as a criminal tool to make perverse amounts of money. Subjects often spoke about financial targets and how much money they were able to make, and one important topic that was disturbingly absent throughout the interviews was what is in the best interest of the borrower. Unfortunately, loan agents were described as too often focusing on which deal netted the greatest return and what type of loan the borrowers wanted rather than what they could afford. In the end, it really makes no difference whether or not loans agents were aware that their actions were criminal or whether such practices are accepted within the loan industry; it is simply a crime and they are simply criminals. The Criminogenic Industry Referring to the three major financial debacles of the last three decades, Levi (1984) stated “it is extraordinary difficult to distinguish white-collar crime from ordinary business transactions” (p. 322). The complex nature of financial transactions made it “difficult to disentangle victim from criminal and crime from business as usual” (Lloyd, 2006, p. k-2). In the mortgage industry, an intricate collaboration must exist among loan agents, borrowers, and lenders (account managers, reps, underwriters, and funders) to originate a loan and get it funded. Information on a loan application must undergo numerous levels of scrutiny and verification by different parties for a loan to be approved. The problem, however, was the

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widespread culture of maximizing profit margins and achieving financial targets over ethical practices. Subprime lending companies greatly rewarded employees who had high funding volumes. My first job after college was at Fremont Investment and Loan where my salary started at $40,000 a year and it also included bonuses. I made a little over $80,000 my first year there because I closed between 80-100 files a month. After working there for a year and a half, I was offered a higher paying job at Encore Credit Corp. where I made over $100,000 a year.

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Most employment positions offered by mortgage lenders were either sales or commission/bonus-based that hugely rewarded employees on how many loans they were able to fund each month. To my knowledge, not a single mortgage lender rewarded their employees based on the quality of underwriting or on the performance of the loan. The compensation for mortgage employees was perversely unusual and uncommon in the financial industry. An individual with no previous experience, like the preceding example, who just graduated out of college, or high school for that matter, could earn a six figure salary as an account manager or underwriter. It is thus not surprising that a tremendous amount of fraud can emerge from organizations which promote financial targets over ethics, and have a high financial incentive to get the deals funded. When these factors are coupled with absent or poor control mechanisms and low risks of detection for fraud, the likelihood of fraud greatly increases. In a statement by loan processor recalling her first act of fraud, she stated: The first time I ever did something I thought was bad and got really nervous about was because I needed to hit my funding volume target. A client gave me a payoff and I forgot to submit it to the underwriter. It was no longer valid when it got to the funding stage. If I

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requested a new payoff, it would have taken some time and kept the loan from funding so I took the payoff home and had the date Photoshopped. More disturbing was the illusion of legitimacy that existed in the industry. Mortgage practitioners straddled a very thin line between risky business and crime. Quite often, what practitioners perceived as risky business was actually criminal deception. For example, if a broker submitted a loan application to a lender and the borrower’s income were insufficient for a particular loan program, the lender would deny the application. Instead, account managers or underwriters working for the lender often advised the broker to resubmit the loan with adequate income, ignoring the previous submission. An underwriter in this study noted that to play it safe, he would tell his brokers to resubmit the same loan application with the corrected income after a period of time had expired. He stated:

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Lenders have a pipeline that is backed up. We are not supposed to accept applications that are submitted twice, but after a month or so, the original denied application is out of the pipeline. After that, I just tell them to submit the application again and the lender has no record of the original denial. Stressful organizational environments can place a lot of pressure on management and leaders to succumb to criminal behavior, especially in environments that contain poor ethical commitments and the rewards of ethical and law violations greatly surpass the consequences. Mortgage representatives and loan managers profit from the high volume of loans that their team produces, a team that commonly consists of underwriters, account managers, processors, and funders. Combined with inadequate regulations, oversight, and accountability, it is not surprising that the industry has become contaminated with fraud.

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Contemporary Mortgage Fraud The acts that comprise modern forms of mortgage fraud are much broader and encompassing than traditional forms of mortgage fraud. This fraud permeates all areas of the subprime industry (retail, lending, appraisal, and escrow), and despite the egregiousness of misrepresentations, most acts of contemporary mortgage fraud are considered minor and accepted. Most of the misrepresentations serve only to qualify a borrower, to approve an applicant for a loan who otherwise would not be approved, and to assist applicants with obtaining the loan they desire. Many acts of contemporary mortgage fraud are viewed as inseparable from common legitimate practices and that those involved are legitimate businesses assisting legitimate borrowers. In a significant number of these mortgage transactions, only minor forms of misrepresentations exist, usually to address disqualifying factor(s) of the loan. For example, the borrower may meet all of the qualifications of the loan except for the minimum asset requirements, which are usually 2 months cash reserves of principle + interest + property taxes + and insurance (PITI). In this case, fictitious reserves are established (12 months bank statements or VOD). Contemporary mortgage fraud can be simple or complicated. Many subprime borrowers are well aware that they lack certain qualifications for a loan and depend on the loan agent to qualify them. In discussing the role of fraud among loan originators and borrowers, Black (2008) noted that “Mortgage origination personnel, not borrowers, overwhelmingly took the lead in mortgage fraud – even when the borrowers shared culpability because they knew that the representations that the lender recommended were false (p.6). It is extremely difficult to determine the not only the true incidence of frauds but the true number of borrowers that obtain loans with the knowledge that their financial representations were false. The initial loan application or Uniform Residential Loan Application signed by the borrower contains detailed financial information. Loan originators (brokers, processors, and loan officers) have the experience and knowledge necessary to determine the exact requirements of lenders and to tailor the loan

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application and required documents to meet qualification requirements. Originators work with borrowers and bank employees (account managers, reps, underwriters, and funders) to ensure the loan is funded. In most circumstances, the involved parties never talk about fraudulent actions and rarely ever conspire to engage in fraud. For example, if the borrower’s income in the loan application is insufficient, the policy of financial lenders is to deny the application. Instead, account managers or underwriters working for the lender responsible for the file will often advise the loan originator to resubmit the file and make corrections. The subtleness and complexity of the industry made it difficult to disentangle victim from criminal and crime from business as usual (Lloyd, 2006, p. k-2).

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Typology of Contemporary Mortgage Fraud Similar to the fraud categories created by Calavita and Pontell (1990) of the different types of savings and loans crime (collective embezzlement, unlawful risk-taking, and covering up), the categories of fraud (see Figure 2) often overlap “because one individuals may commit several types of fraud and because the same business transaction may involved more than one type” (Rosoff, Pontell, & Tilman, 2003, p. 254). A single act of contemporary mortgage fraud can fall into 2 different categories. For example, a loan officer may manipulate the assets of a borrower by adding a zero or completely fabricating deposits, transfers, or the balance of the borrowers’ bank statements. The complicated nature of mortgage fraud can be simplified and better understood by following the typology on the following page.

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Figure 2: Typology of Contemporary Mortgage fraud

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Origination Fraud

Data Manipulation

Data Fabrication

- Overstate income - Overstate assets - Inflate value of property - Change info on bank statements - Change info. on paystubs - Change employment title - Change info. on W2’s - Falsify payoffs to lower DTI

- W2’s - Paystubs - Bank Statements - VOD - VOR - Rental agreement - CPA Letters - 401 K - Establishing false employment - Signing/forge borrower signature - Fictitious letter of explanation

Concerted Ignorance - Ignore appraisal review - Sign off on fraudulent loan conditions - Accept known fraud documents - Accept known false information on loan applications

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Data Manipulation. In the mortgage industry, the manipulation of borrower information in order to meet the qualifications of a mortgage loan is the most common type of fraud. Most of the time, the acts are very simple in nature and include adjustments to the financial information that the loan agent (a superficial term that applies to all official parties involved in the loan origination process) submits on behalf of the borrower. This may include adjusting income to fit the minimum requirements of the lender, despite being aware that the income is false, or having the appraiser inflate the value of the property, although industry practitioners, brokers, loan officers, and processors, are well aware of lending guidelines and requirements. More importantly, loan originators know exactly what will fly or pass with lenders. For instance, loan agents are well aware of actions that may raise eyebrows and may manipulate information accordingly. A stated income loan application submitted on behalf of a custodian claiming an annual salary of $100K would raise suspicion. Therefore, to avoid suspicion, loan agents simply manipulate the employment title and income such as changing custodian to senior waste/recycling management officer and restating the income as $80-90K, annually. To compensate for the additional required income, the loan agent may simply create an additional income source by fabricating a fictitious job, such as a part-time homeoffice income source. A mortgage broker who was operating a loan business at the time of the study offered an opportunity to examine at a doctored bank statement that the broker maintained. A copy of the bank statement provided an excellent example of data manipulation. The illustration below is an actual altered Wells Fargo bank statement that was used as part of a mortgage application.

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Figure 3: Unaltered Bank Statement Used in a Mortgage Loan

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Figure 4: Altered Bank Statement Used in a Mortgage Loan

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Mortgage Origination Fraud 95

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Data Fabrication. Data fabrication involves the creation of false documentation in order to establish source(s) of income and assets. This type of fraud includes creating financial documents, such as W2’s, Verification of Deposits (VOD), Verification of Rent (VOR), or Certified Public Accountant (CPA) letters. Under many circumstances, the loan agent will establish bank statements from an existing account or create false rental income (VOD) from a home the borrower supposedly owns. Another example of this type of fraud includes generating a Letter of Explanation (LOE) to explain information submitted to lenders. One actual refinance application involved a single borrower who was employed as an agent for a valet company that served local restaurants. The loan application stated a monthly income of $8,000 (the required income for his loan), which raised questions from the lender. In this case, the loan officer submitted a LOE and noted that the “borrower worked for a valet company which tailored to high-end restaurants in Newport Beach, CA and large tips were a normal part of his employment.” The LOE stated the man’s tips constituted 90 percent of his salary. The loan application manipulated the title of his employment from Valet Agent to District Valet Manager. The verification process from the lender consisted of only a phone call and verification of length of employment and title. The employee phone number listed on the application was the borrower’s friend who worked at the company. The loan was approved without question. Concerted Ignorance. First coined by Katz (1979) in his article “Concerted Ignorance: the Social Construction of the Cover-up,” concerted ignorance refers to the strategic and intentional lack of knowledge over a topic or subject and respond accordingly. One primary reason why humans intentionally act ignorant is to escape, avoid, or “cover-up culpability” (Katz, 1979, p. 299). With regard to mortgage fraud, concerted ignorance involves the intentional oversight of fraudulent documents, mostly by employees for lenders, and other factors that might disqualify a borrower. An underwriter who works for a lender would greatly benefit from approving and signing off on loan conditions that they know would have disqualified a borrower. When a loan agent is working with several hundred

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files, the majority of which are stated loans, it pays high dividends to be a loose underwriter. A recent study by Fitch Ratings (2007) examined 45 subprime loans and found that there was an appearance of fraud and misrepresentation in almost every file. “The files indicated that fraud was not only present, but, in most cases, could have been identified with adequate underwriting, quality control and fraud prevention tools prior to the loan funding.” Despite the small size of the sample, the researcher felt that such targeted sampling of files was adequate to “determine that inadequate underwriting controls” (Fitch, 2007, p. n.p.). Examples of concerted oversight include the appraisal review department intentionally passing an appraisal of questionable value as a favor for a broker or an account manager signing off on a condition that is false (e.g., signing an employment verification condition), or accepting known false information from borrowers on loan applications. Taking a blind eye approach to loan origination is also very common and problematic in the industry. Most, if not all, acts of intentional oversight by either the retail or wholesale area involve decisions that would raise suspicion or disqualify the borrower. Among all types of mortgage fraud, the most common practice is overstating a borrower/applicant income. The emergence of limited documentation or stated-income loans has made it simple to exaggerate a borrower’s income. Financial lenders that offer stated loan products simply overlook and approve submitted applications that contain questionable income amounts. One study found that it was common for a borrowers’ income to be overstated by 500 percent (Basepoint Analytics, 2007). As noted earlier, the problem with mortgage fraud (more obvious in light of the financial crisis) is that the growing number of foreclosures is due to bad loans extended to borrowers who cannot afford the property. Patterns of Contemporary Mortgage Fraud (Mortgage Broker, Loan Officer, and Loan Processor) According to a report from FinCEN, “[F]inance-related occupations, including accountants, mortgage brokers, and lenders, were the most common suspect occupations associated

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with reported mortgage fraud in the mortgage industry” (FinCEN, 2007). Mortgage brokers, loan officers, and processors (altogether loan originators), those with the most experience and knowledge regarding lending requirements and guidelines and are responsible for collecting, preparing, and submitting documents to the lender on behalf of the borrower, engage in the most incidences of mortgage fraud. The acts that constitute mortgage fraud most often take place within the broker’s office. Loan originators are more involved in the origination of a mortgage than any other individuals are. They are responsible for collecting all relevant background information from the borrowers, which is part of the initial loan application. After shopping for the loan (a term that refers to searching for a suitable financial lender), loan agents generally have a good idea of the factors that may disqualify their particular borrower (e.g., inadequate income, assets, and credit ranking). At that point, a number of possible scenarios may take place. The data that was provided from all the interviews were pieced together to provide a detail of the general or common process that borrowers go through to get a loan is described below. It is important to note that the following description is generic and not the experiences of all borrowers.

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1. Loan agents inform their borrower they can get the loan, but it will require that their income and/or assets be stated as a particular amount. 2. Borrowers are informed that they qualify or not. If they do not qualify, they are either turned away (unlikely) or explained that certain actions will be necessary by either the loan agent or the borrower to get them “qualified.” For example, if borrowers lack the required assets, they are advised to have a friend or family member deposit a specified amount of funds into the bank and leave it for 2 months, or the loan agent has to establish a false verification of deposit (VOD). 3. It is common for borrowers to be unaware of the fraudulent acts committed by their loan agents. In certain circumstances, loan agents will not inform their borrower of the

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disqualifier(s) and questionable act(s) made by the loan agent. This occurs when the disqualifier and the corresponding act to get the loan approved is considered minor.

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In most circumstances, loan originators are completely knowledgeable about the accuracy and credibility of the information they submit on behalf of their clients. There are cases where borrowers intentionally submit falsified information to their loan agents to misrepresent both their agent and their lender; however, fraud for profit, as defined in the industry and by the FBI, is uncommon. Loan agents and borrowers both stipulate that it is in their interest to be fully informed of anything important in a loan. Borrowers are required to sign and approve loan applications and documents and loan originators commonly express the importance of being straightforward and honest with their clients. Honesty between loan originators and their clients is good for business. Further, inconsistency of information by either party can raise red flags to a lender and result in a denial of a loan. Thus, working together and being consistent is generally necessary for a successful outcome. One loan officer interviewed commented: On a stated loan, my clients knew I had to state a higher income on their application in order for them to qualify. I tell them right from the start that they need to go into a stated loan, which usually has a higher interest rate. They don’t like it but all they care about is getting the money (referring to a refinance loan) . I took care of my borrowers and gave them what they wanted. They all knew that they can get a loan anywhere so I have to take good care of them if I want to make money. A lot of my business is repeat business. I have borrowers who have refinanced their one home with me three times. Being straightforward with their borrowers was good for business. Second, it is evident that loan approval generally requires parties to work together and remain consistent regarding information submitted to the lender. Inconsistent or questionable

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documentation would raise red flags, and lead to disqualification or denial of a loan.

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Financial Lender The job of the broker office is to gather the required information for a loan application and submit it to the lender on behalf of the borrower. Thus, crimes involving intentional misrepresentation and misstatement are much more common in the broker’s office. Lenders, on the other hand, are responsible for underwriting the application materials in accordance with the law and guidelines set by their investors. A major part of the duties and responsibilities of lenders include looking over application documents and verifying the information. It was not surprising that intentional oversight or acts of concerted ignorance were described as the most common forms of mortgage fraud among employees of financial lenders. Once the loan file has been submitted to a prospective lender, it is overseen by an account manager or an underwriter. These loan agents are critical to the successful outcome or funding of a loan. Account managers and underwriters account for the majority of work involved in the origination process of the lending phase. Their duties and responsibilities include establishing loan approval conditions and ensuring that prospective loans adhere to lending guidelines. Account managers and underwriters work directly with their brokers, loan officers, and processors on a regular basis, and commonly coach them in structuring a loan or document to make the loan work. They are extremely knowledgeable about their employers’ guidelines and requirements, which makes them a valuable asset to brokers. Each of the 3 account managers interviewed for this study spoke about their relationship with brokers. Most of my brokers were good. They knew what they were doing but some brokers came into the industry and didn’t know the difference between a 1003 (Uniform Residential Loan Application) and a 1008 (Transmittal Summary). When my bad brokers submitted a loan that obviously didn’t work, I would send it back and tell them what to change. Many times, they still wouldn’t get

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it and I have to go back and forth several times with them. Sometimes, I just tell them to submit the loan somewhere else because it got too fishy. My good brokers knew better. They made sure everything was clean by the time I got the file. More importantly, account managers and underwriters are responsible for approving loan conditions once they have verified the information. For example, a loan approval may be predicated on verification of conditions such as an applicant’s employment and assets. It is common for these loan agents to overlook questionable information or sign off a condition(s) without verification. Funders and appraisal reviewers also commonly overlook questionable information, such as an appraisal that lacks the required comparisons to justify the value of the property in question.

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Escrow and Title Company The subjects interviewed stipulated that fraudulent acts were uncommon among escrow and title company agents. While rare, acts of intentional oversight do occasionally occur among escrow agents, such as intentionally leaving out the yield spread premium on the final HUD-1 statement, which is in violation of the Real Estate and Settlement Procedures Act. Another common fraud includes avoiding an escrow instruction to pay off borrowers’ debts from the proceeds of a refinance transaction. Since escrow and title are important phases of the loan origination process, it was included in this investigation. Borrower(s) The borrower is significantly involved in the origination process and the funding outcome of the loan. As noted earlier, borrowers commonly become aware of their qualifications or lack thereof at the initiation of the loan process. It is common for borrowers knowingly to sign an initial loan application that contains false or inflated information regarding their financial background. The loan application is commonly viewed as too complex for the layperson to understand. This may be true about industry

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terminology and other loan documents, such as legal disclosures. The initial loan application, however, is structured to be clear and simple so a layperson can understand it. Since most borrowers lack the knowledge and expertise to fabricate or manipulate financial information and documents, their involvement is limited to overseeing and approving information that has been fabricated or manipulated on their behalf by their loan agents. For example, borrowers in this study were aware that approval of their loan, or a lower interest rate, was predicated on falsification of their income or assets. Generally, borrowers were found to be complicit in the questionable actions of their loan agent and even grateful because their loan would not have been approved otherwise Appraiser Having an appraiser willing to work with you is extremely important to a mortgage brokerage office. Most loan transactions are predicated on the value of the property. Appraisers who are conservative valuators can have a difficult time finding business, taking a conservative approach can be disastrous for an appraiser’s career. Interviewees commonly expressed that, during the real estate boom, it was simple to justify appraisal values that exceeded the actual value of a property. For example, appraisers could avoid taking pictures that showed damage to the property, or use nearby properties with greater appreciation as comparables. One interviewee expressed all that had to be done was “not reveal anything that would reduce the value of the property.” For example, if a garage were converted into a bedroom without a permit, the appraiser would include only an outside picture of the garage. Another common method with which appraisers inflate values is using comps, or comparables, that do not accurately reflect the value of the target property. In the 1990s, the extraordinary increase in real estate values made the practice of inflating values simple and very lucrative for appraisers.

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Mortgage-backed Securities, Alternative Loan Products and Fraud As discussed in Chapter 1, the involvement of Wall Street had a tremendous impact on the primary subprime mortgage industry. Prior to the mid 1990s, most banks kept all of their mortgage assets until maturation. However, during the 1990s, Wall Street began to purchase and fund subprime mortgages. Such involvement of investment banks grew from $18.5 billion in 1997 to $56 billion in 2000 (ACORN, 2002). As a result, mortgage loans were sold by banks soon after funding and the quality of loan underwriting by banks deteriorated. Banks were concerned only with meeting the standards and qualifications set by their investors. The ability of the borrower to repay the loan was considered only within the context of their investor’s guidelines. An investor may set various underwriting and qualification guidelines for particular types of loan and loan amounts. These guidelines may include a minimum fico scores, income, assets, employment history and loan-to-value for a particular loan. The lender will use these guidelines to originate mortgages and the investor will purchase these assets once they have been originated and funded, as long as the loans fall within the guidelines of the investor. Subprime mortgage lenders will commonly originate hundreds of loans according to these guidelines and then package them for sale in the secondary market. Subprime lenders only serve to originate loans and profit from the fee they charge for origination; they have no stake in the quality of borrower or the ability of the borrower to repay. Oftentimes, subprime lenders will fund loans in which the borrower barely qualifies, or truly does not qualify, but have been given credit fraudulently. These fraudulent loans would be packaged in a bundle with quality loans, which makes the poor notes difficult to discern. The growth of Wall Street’s role greatly reduced the number of banks who kept mortgages on their financial portfolio and thus greatly reduced the banks stake in each mortgage product. As the industry grew, so too did the number of wholesale lenders who only operated to originate and sell loans. Overtime, the standards of underwriting within the industry greatly depreciated.

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The easy qualification standards combined with endless capital from investors to fund the loans allowed lenders to approve as many loans as they could handle. The business culture among loan agents, whether they were working for a lender, broker office, appraiser, title, or escrow company, was to fund as many loans as possible. The majority of loan agents were paid on a commission or bonus schedule based on how many loans they closed each month. It was thus not surprising that account representatives with no prior mortgage experience were able to make a six to seven figure-a-year income. The industry focus on funding volume over the best interest of their borrowers and the low underwriting standards were factors that contributed to fraud. Referring to a purchase loan that took a long time to fund, one loan processor stated: There were times when I got calls from my borrowers and they told me they were staying in a hotel while I was working on their loan. I don’t really care but you do feel a little bad for them.

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A loan processor who worked for a retail financial lender stated: The first time I did something shady (fraudulent) started by accident. The loan took a long time and by the time it got to funding, I realized that the payoff letter was overdue [and] I couldn’t use it. My company’s policy is that if a payoff is over three months old, I need to request a new payoff. The only option was to call the lender and request a new payoff letter, but that would have changed everything on the file and I needed to fund this loan to make my bonus target. If I didn’t get this loan funded, I would have fallen in a lower bonus bracket so I just took the payoff home and had my cousin Photoshop the date of the payoff. And plus, my rep would have gotten pissed off if she found out. Actions such as the one described exemplify corporations that exert too much pressure on their loan agents to perform and a culture that rewards financial targets over ethical practices. As

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noted earlier, the absence of professional ethics within a corporation is a common theme in the criminological literature on corporate crime. Only about 20 percent of the 1000 largest corporations have on staff ethics officers (Rosoff, Pontell, and Tillman, 2003). The reasoning behind the unethical practices of corporations is obvious: those who act unethically may perceive that such actions net greater profits and thus rationalize their unethical behavior as good business practice. The practice of originating and selling the loan in the secondary market greatly reduces the accountability in the fragmented loan origination process. Account managers and underwriters who approve loan conditions with the knowledge that documents are suspicious in nature or fraudulent are no longer concerned after the loan is sold. In fact, the easier the account managers or underwriters are in their examination of submitted loan documents, the more they are appreciated in the industry and the more business they receive.

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My brokers all love me. If they had a hard loan, I would make it work. I was good at making bad loans work and my brokers knew that. Anyone can get a good loan through, but its how you make the bad loans work that makes you good. Aside from lender buybacks, which require the lender to repurchase the loan from the issuer or investor under certain circumstances (e.g., the borrower defaults on the mortgage during the first 3 to 6 months, fraud is discovered within the loan), financial lenders are rarely concerned about funding a bad loan or a loan containing questionable information. In fact, mortgage lenders commonly sell their loans to investors in packages or bundles, which can include hundreds of loans, and loan representatives, describe the packaging system as easily susceptible to fraud. The account representatives stated that it was common to throw in the bad loans with the good loans. Our investors provided us with the guidelines and the way we got our bad loans off our books was to package the bad loans together with the good loans. Sometimes a

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loan would get kicked by the investor but most of the time, our investors were more than happy to take our loans. They were buying as fast as we were funding. Wall Street’s involvement also greatly increased the amount of capital available for the lending industry, which fueled the growing demand for loans. The growth of Mortgage-backed securities (MBS) led to greater capital, and the number of wholesale mortgage lenders (over 100 subprime lenders by 2003) contributed to the unprecedented number of mortgage brokers, which by 2000 amounted to over 250,000 brokerage companies in the United States (Bitner, 2008). What is more troubling is the poorly regulated compensation system that exists between brokers and lenders, which conflicts with the benefits to the borrower. For example, if a broker charged a higher interest rate than that which the borrower actually qualified, the broker would be paid extra; if brokers sold a mortgage that contained a prepayment penalty, they would receive higher compensation from the lender. The same was true for other terms and conditions of the loan. So while fiduciary responsibility exists for borrowers, brokers are often placed in a Catch-22. If they act in the best interest of their borrower, they will make less money; if they do not act in the best interest of their borrower, they will make much more money. In fact, brokers adopted the same work ethic of loan agents who worked for lenders; it was all about how many loans they can fund, and how much money they can possibly make on a loan. Depending on the state in which the mortgage brokers operate, they can earn as much as 10 percent on a loan, up to $50,000.00 for a $500k loan. The conflicting financial incentive structure contributed to the problem of fraud. Brokers, for example, pushed borrowers into alternative loan products that had lower teaser interest rates or alternative loan programs that offered a lower monthly payment, despite the fact that the borrower qualified for a better loan. While this was an example of predatory lending and not fraud, some brokers committed fraud in the process. In one, a broker convinced her borrowers to refinance into a negative amortization, or option-arm loan, which usually required a minimum 10 percent down payment. She then offered the

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borrower a personal loan to cover the down payment and asked the borrower to repay the loan once the refinance was completed. While it might seem like a generous gesture on behalf of the broker, she made a tremendous amount of money on the loan. A borrower interviewed for this study detailed how her broker fraudulently financed the down payments for four of her properties refinanced through option-arm loans. What exacerbated the problem of crime was the lack of consequences that brokers faced for committing fraud. If a broker submitted a loan to a lender that was found to contain fraudulent information, the broker would generally receive a verbal warning. Under extreme cases, the broker’s relationship with the lender would be terminated. The high incentives and the lack of consequences also contributed to the problem of fraud. As a broker stated: A couple of times my account manager sent back the file because the bank statements looked bad (poorly doctored). This was at the time when lenders were starting to catch on to bank statements. She told me that if it was me, to make sure I don’t do it again and if not, then tell my borrowers the same.

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In several ways, Wall Street’s involvement in the subprime industry affected the growth, type, and pattern of mortgage fraud. The loose underwriting standards adopted by originationand-sell lenders made fraud easier and the reduced accountability of loan agents worked for the lenders. The growth fragmented loan origination process (mortgage broker system) produced conditions susceptible to fraud. As Bitner (2008) stated: Eventually more than 70 percent of all brokered loan applications submitted to us at Kellner were somehow deceptive, so everything a broker said or did needed to be doubled-checked and re-verified. I have had several colleagues who owned subprime mortgage companies tell me this estimate is conservative compared to their own experience (p. 45).

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These factors (hybrid loans, inadequate underwriting standards for qualifying borrowers, a market structure and incentives that encouraged originators to make loans with little regard for how those loans would perform, and insufficient legal and regulatory standards to ensure that loans were sustainable) contributed to the growth, type, and patterns of mortgage fraud of the subprime mortgage crisis (see Figure 5). Securitization was argued by economists as less risky to the lending industry since it shifted the liabilities of banks and mortgage lenders to the global securities market. But the collapse of the subprime mortgage industry, revealed several disturbing realities: 1) like a ponzi scheme, the growth of the subprime lending industry, which was based a flawed foundation of lending regulations and practices, was unsustainable; 2) rather than deflate, the tremendous growth the industry led to an economic explosion; 3) and what emerged from the crisis was a revelation that a significant amount of fraud was intricate in the growth of the bubble. It became obvious soon after the crisis that the securitization logic was not only flawed but completely erroneous. Factors such as risky hybrid mortgages (interest-only, low doc/no doc, adjustable-rate, piggyback, option-arm, and balloon payment mortgages), loose underwriting standards and an inadequate regulatory structure were direct causes of the foreclosure crisis. However, at the time of this study, industry experts, economists, and policymakers had failed to observe the role of fraud in the equation. While there was a direct relationship between the aforementioned factors and the subprime crisis, a significant number of foreclosures were due to fraud. In other words, the emergence of hybrid mortgages led to common fraudulent practices that qualified borrowers for homes they could not afford, thus resulting in foreclosures. The foreclosure crisis was not only due to qualified subprime borrowers with bad loans, but also to subprime borrowers who were approved for subprime loans they were not able to afford. It may be difficult to grasp the exact role of fraud in the major picture, especially considering all the factors that have been discussed in this study. The following illustration simply details the various factors addressed in this study and the role of fraud.

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Figure 5: The Link between Mortgage Fraud and the Subprime Mortgage Crisis Hybrid Loans

Loose Underwriting Standards Inadequate Enforcement

FORECLOSURES

High Opportunities

No Accountability

Little to No Risk

Third Party Origination (Broker System)

F R A U D

High Incentives

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Inadequate Regulatory Oversight

LEGEND Current Understanding of the Crisis Context of Origination Fraud in the Subprime Crisis

MORTGAGE DEFAULTS

SUBPRIME MORTGAGE CRISIS

MARKET COLLAPSE

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Revisiting Mortgage Fraud Similar to the crimes that emerged from the previous major financial debacles since the 1970s (savings and loans, Orange County bankruptcy, and the corporate scandals), mortgage frauds can be convoluted and involve many players, including industry professionals who take advantage of the trust that clients place in them. Lloyd (2006) noted that the nature of mortgage fraud was: .

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Complex and explicitly criminal, typically involving a number of professionals in a conspiracy to defraud financial institutions. These criminal rings and/or schemes usually involves a dirty appraiser, a mortgage broker, an outside investor and a straw buyer – that is, someone who lends identity and good credit for the sake of the sale with the promise of a cut of the profit. Some groups also include a notary, real estate brokers, and insiders at the title companies and even at the lenders being defrauded. (p. k-2) These criminal activities commonly take the form of Ponzi schemes, pumping and dumping, organized con games, and corporate giants who abuse their positions and authority to loot millions (if not billions) from unknowing individuals (Black, 2005; Pontell, 2005; Rosoff, Pontell, & Tillman, 2007). Examples of fraud schemes or rings of this sort included the indictment of two high profile Beverly Hills real estate agents and two real estate appraisers accused of allegedly defrauding lenders out of $40 million in fraudulent loans (Haddad, & Wedner, 2007) and the December 2007 scheme involving a mortgage broker and a Senior Loan Coordinator, John Ngo, at Long Beach Mortgage. In the case of Long Beach Mortgage, the Senior Loan Coordinator, who was responsible for validating and verifying financially related documentation, plead guilty of perjury in connection with a federal mortgage fraud investigation. The scheme involved several account representatives and a mortgage broker who colluded to push through numerous loans that were fraudulent. Ngo had either signed off conditions or had his operations team at Long Beach

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Mortgage sign off of loan conditions without verification, and with the knowledge that the information submitted by the broker was fraudulent. The investigation revealed that Ngo had been paid approximately $100,000 in checks and bank transfers over a four year period, which he admitted was for “pushing fraudulent loan applications through the funding process…and taking steps to ‘fix’ the loan applications by creating false documents or adding false information to the applications or the loan file” (Department of Justice, 2008, p.4). This case provides insight into the perverse criminogenic culture that can be part of a lending organization. In this extreme case, the Senior Loan Coordinator and various account representatives pushed through loans that contain blatant frauds. The frauds examined in this study, while very much similar, is much more discreet, and whose practices operate within the gray area that distinguished legal from illegal financial practices. For example, if an underwriter fraudulently signed off 1 or 2 conditions out of 20, it would be much harder to detect. The resulting losses as a result will be extremely difficult to assess since they will never be discovered. The direct losses experienced by financial institutions will be in the form of foreclosures, where borrowers were fraudulently qualified for loans they could not afford. We may never know how many foreclosures, of the millions that have already occurred and the significant amount predicted to come, will be due to fraud. Equally important in our analysis is how well these new forms of frauds fit with our current model of mortgage fraud. Using several measures, these types of mortgage fraud do not fit well under the traditional classification of mortgage fraud at all. As noted in chapter 1, types of mortgage frauds are viewed by researchers, government authorities, and industry organizations as either fraud for property or fraud for profit. According to a report by the Federal Bureau of Investigations (2007), Fraud for property/housing entails minor misrepresentations by the applicant solely for purchasing a property for a primary residence. This scheme usually involves a single loan. Although applicants may embellish income and conceal debt, their intent is to

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repay the loan. Fraud for profit, however, often involves multiple loans and elaborate schemes perpetrated to gain illicit proceeds from property sales. (p. 2) Since the 1990s, mortgage industry development altered the face of mortgage fraud and completely rendered the common understanding and the FBI’s categorization of mortgage fraud inaccurate and outdated. The newer face of mortgage fraud manifested as both fraud for property and fraud for profit. No longer can the categories of fraud viewed as mutually exclusive. The most commonly described form of mortgage fraud in this study involved loans in which the borrower not only intended to reside on the property but also to repay the loan. However, unlike the fraud for property schemes described by the FBI, the borrower/applicant was not the sole culprit and the misrepresentations were not minor. The gross misrepresentation of loan documents previously common in fraud for profit schemes were also committed by borrowers and their loan agents, who profited from the transactions but did not resemble any criminal or criminal organization. According to the FBI, the number of mortgage fraud convictions doubled between 2006 and 2007 and the number of open cases (1,210) more than tripled in the fiscal year of 2007 compared to 2003 (Leinwand, 2008). The FBI’s data on mortgage fraud generally consisted of major fraud rings, scams, and ponzi schemes and generally did not include the insidious, yet subtle types of crimes, such as overstating income and assets, the manipulation of debts to be paid off by borrowers to reduce DTI, or the overvaluation of property. These types of fraud were rarely discovered by financial lenders and, thus, never reported. In fact, even when cases of fraud were referred to state enforcement agencies, they were slow to respond (Sichelman, 2006). This is not very surprising considering the limited capacity of the enforcement agencies. In 2007 alone, financial institutions filed approximately 45,000 Suspicious Activity Reports of possible mortgage frauds and there are only 200 FBI agents assigned to mortgage fraud investigations. The troubling reality is that the scale of the mortgage fraud “epidemic” is so great, the FBI’s resources devoted to investigating the epidemic

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so small, and federal agencies’ support for the FBI’s efforts against mortgage fraud so minimal that the epidemic has overwhelmed the FBI” (Black, 2008, pp. 8-9). System’s capacity limitations have allowed frauds to flourish unabated without being investigated and adequately addressed. The savings and loan crisis for example revealed how deeply entrenched criminal fraud could become – it was not until the situation had reached true crisis proportions that criminal implications and causes behind the debacle emerged (Rosoff, Pontell, & Tilman, 2003).

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CHAPTER 5

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The Social and Economic Implications of Fraud

In the previous chapter, various emerging types and forms of mortgage related frauds were analyzed as a product of the structural and organizational makeup of the subprime lending industry. In this chapter, the collective findings will be used to suggest that such frauds have contributed to the discriminatory practices of the lending industry. First, a brief review will take place of discrimination in the lending industry and the major federal legislation that has emerged to bring equality in the lending industry. Next, an analysis will be made of the new forms of discrimination in mortgage lending and how deregulation undermined the ability of federal policies, as such as the Community Reinvestment Act, to control and prevent discrimination against minorities in the financial industry. As part of this analysis, an examination will also be made of the role that fraud plays in perpetuating racial and economic inequality. Finally, the illusion of affordability approach to equality will be explored in detail and the implications of modern forms of racism in the industry will be discussed. Homeownership is the cornerstone of the proverbial American Dream. Owning a home and having a mortgage produces great pride and are typically a symbol of success and wealth. Moreover, homes, in the long term, are viewed as solid investments. Prior to the subprime mortgage crisis, which began 115

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in October 2007, most Americans believed that the value of residential real estate would never fall nationwide. The contemporary subprime mortgage disaster was a rude awakening that completely subverted such widely accepted real estate dogmas (Ip, Whitehouse, & Lucchetti, 2007). In the wake of the crisis, the pride associated with homeownership for many has been replaced with anxiety, insecurity, fear, and humiliation. As the crisis unfolded, a significant number of families either lost their homes or were financially trapped in their current mortgages and simply waiting for their homes to be taken from them. This was particularly true for minority homeowners according to a 2008 report by several research and advocacy organizations.

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High-risk loans made up 20 percent of all loans in predominantly minority communities, compared with 4 percent of total loans in mostly white areas. This concentration means these minority communities will shoulder most of the negative impacts of the subprime crisis – foreclosures, sinking property values, lower tax bases, abandoned homes and higher crime. (Barbassa, 2008, p. 2) For example, a report by the Center for Responsible Lending (2007) estimated that subprime loan originations in 2005 led to over 98,000 foreclosures on African-American homeowners. Progress toward economic equality in the financial industry was fraught with turbulence reminiscent of The Civil Rights Movement. Despite achievements gained in the Civil Rights Movement that greatly reduced forms of overt racism, commentators noted the pervasiveness of a more subtle, yet pernicious form of intentional discrimination, called the new racism (Wilson, 1980; McDonald, & Powell, 1993; Silva, 2006). The intentional discriminatory motivations that underscored actions disguised as objectivity or rational decision-making made it difficult to address. Wilson (1980) described this new racism as manifesting as economic inequality. To address discriminatory practices in the financial industry that kept minorities from obtaining credit, civil rights activists

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and U.S. Presidents nobly pushed for expansion of credit opportunities to a wider population, including homeownership and business opportunities for non-wealthy populations from lower income communities. For example, in June 2002 President George W. Bush proposed an initiative called Blueprint to the American Dream to increase minority homeownership by 5.5 million by 2010. As part of this initiative, various government programs became available for homeowners such as down payment assistance, the availability of more affordable housing, and loan programs such as hybrid ARMs which allowed many homeowners who gain access to real estate (HUD, 2002). Until the early 1990s, the mission to provide access to the American Dream was based on a primary premise – rather than denying mortgage applicants with credit problems, financial institutions should increase opportunities to borrowers with problematic credit histories, a disproportionate number of whom were African American and Hispanic. Greater access to credit was considered the panacea against economic inequality, specifically the rampant problem of discriminatory lending practices that excluded minority groups from obtaining mortgage loans. While the move to expand homeownership to a wider population began in the mid-1970s, it was not until the early 1990s that the number of minority homeowners skyrocketed. Between 1994 and 2001, the rate of homeownership among minorities increased by as much as 5.8 percent, or from 9.5 million to 13.3 million homeowners (HUD, 2002). In fact, the growth of the real estate industry during the last decade was fueled in large part by homeownership among blacks and Hispanics, accounting for 49 percent of the increase between 1995 and 2005 (Kirchhoff and Keen, 2007). The problem, however, is that the growth of minority homeownership occurred primarily among the subprime industry, where lenders were not subjected to regulation. Reports (see, for example, Hizel, Kamasaki, & Schafer, 2002; HUD, 2002; Kirchhoff and Keen, 2007; Pasha, 2005) have found that minorities were given and steered into subprime mortgages at a much higher rate than whites. For example, “About 46 percent of Hispanics and 55 percent of blacks who took out purchase mortgages in 2005 got higher-cost loans, compared with about

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17 percent of whites and Asians, according to Federal Reserve data” (Kirchhoff, & Keen, 2007, p. np.). Unfortunately, a significant number of minorities were given higher cost subprime loans when they qualified for prime loans. In the same report, it was noted that in the minority areas of Boston, for example, “73% of high-income black buyers (those making $92,000 to $152,000) and 70% of high-income Hispanics had subprime loans in 2005, compared with 17% of whites” (Kirchhoff, & Keen, 2007, p. np.). Minorities have, without question, been targeted and victimized in the mortgage industry – the question is whole role fraud plays in the overall equation?

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Discrimination in the Mortgage Industry According to Wilson (1980), the new racism manifested itself as economic or class discrimination. In modern society, inequality is no longer assessed by racial factors alone; rather, it included social conditions, allowing for discreet manifestations and reproduction of stereotypes and prejudices. Modern forms of racism took the form of nonracial dynamics, such as market dynamics, cultural limitations, and economic status. Rather than outright denying service in a business establishment or denying credit solely on the basis of race, modern forms of racism take on the form of racial profiling and differential treatment. With regard to this study, while minorities have been provided additional access to credit through government policies and alternative lending programs, they are still targets of discreet and egregious forms a economic discrimination and fraud. In April 2008, the federal government celebrated the 40th anniversary of the Federal Fair Housing Act (FHA) of 1968 (U.S. Department of Housing and Urban Development), which “prohibited discrimination concerning the sale, rental, and financing of housing based on race, religion, national origin, sex, (and as amended) handicap and family status” (HUD, 2007). The Federal Fair Housing Act was part of the Civil Rights Act of 1968. The FHA eliminated blatantly racial discrimination in real estate, such as racially restrictive covenants (RRC), which are contractual agreements imposed on the buyer of a property by the seller of the property. While most contractual housing

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agreements are simple in nature, such as maintaining the front yard, racially based legal conditions prohibited the occupancy, sale, or rental of the property to black persons. (Monchow, 1928; Dean, 1947; Stach, 1988). RRCs were intended to maintain the racial homogeneity of a community. In other words, it was a way for Caucasians to keep minorities out of their neighborhoods. The fight for equality over the legitimacy of RRC’s often led to violent clashes between whites and blacks. About a decade after the FHA Act, Congress passed the Community and Reinvestment Act (CRA-1) in 1977. The CRA1 served two primary purposes: 1) to address discriminatory lending practices, such as redlining, and to encourage local community investment in which the bank was situated; and 2) to address economic inequality in the banking industry by increasing access to credit opportunities. With respect to these objectives, many would argue that the CRA-1’s level of success is questionable. While the CRA-1 has been credited with generating almost $2 trillion in loans for low and moderate income neighborhoods, the majority, or two-thirds of all loans, that have been originated during the last decade occurred among independent financial institutions not regulated by the federal legislation (Avery, 2007; Squires, 2004). According to Squires (2004), the growth of independent financial institutions has been due to “the restructuring of financial companies and financial deregulation by legislation such as the Financial Services Modernization Act of 1999, which made it far easier for financial services to enter into the market” (p. 9). Researchers from the Federal Reserve Board have reported the same –the majority of subprime loans have been made by independent mortgage lending companies excluded from CRA oversight (Avery, Bostic, & Canner, 2007). These companies are not regularly examined for their compliance with consumer protection laws such as the Truth in Lending Act and the Equal Credit Opportunity Act (Laderman& Reid, 2008). The growth of subprime lending grew tremendously during the last decade, a period in which these legislations were paramount. The authority and oversight of the CRA over the parallel lending industry, if it not had been circumvented by further deregulation of the financial industry, would have greatly

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prevented a significant amount of predatory and discriminatory lending practices that transpired in the subprime industry. This is yet another example of the need to increase regulation in the lending industry. Economists and historians have pointed to redlining as a significant cause of urban decay and disinvestment. Despite the passage of landmark legislation, discrimination-based lending still remained a major problem in the industry. The practice of redlining involved the refusal to extend credit to certain geographical locations, which were predominately black. In his Pulitzer Prize award winning work, The Color of Money, Dedman (1989) found that, between 1981 and 1986, banks and thrifts in metropolitan Atlanta favored lending for real estate in white areas by a margin of five to one.

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Among stable neighborhoods of the same income, white neighborhoods always received the most bank loans per 1,000 single family loans. Racially integrated neighborhoods received fewer loans and black neighborhoods always received the fewest. The report notes ‘that race – not home value or household income – consistently determine lending patterns of metro Atlanta’s largest financial institutions (Dedman, 1989, p. 1). It became clear that overcoming emerging manifestations of the new racism in the banking industry required more than ineffectual regulatory standards and inadequate oversight. The government’s lackluster scrutiny of banks to determine compliance with the CRA is an example; Dedman (1989) referred to the federal government’s annual exams of banks to ensure compliance, noting “tests that few banks fail – in the federal eyes. Since the passage of the law in 1977, regulators have denied eight out of 50,000 special applications by banks due to unfair lending” (Dedman, 1989, p. 21). To strengthen the federal law and improve communities and homeownership opportunities, the Clinton administration led the charge to modify the CRA-1. The 1995 modifications to CRA-1 increased: 1) federal regulators’ authority to monitor banking

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activities, 2) pressure on banks to provide loans within their communities, and 3) the number of subprime mortgage and small business loans substantially (Canner, & Passmore, 1997). The revisions were aimed at making the CRA more performancebased, and to make examinations more consistent, clarify performance standards, and reduce cost and compliance burden” (Braunstein, 2008, p. np.). The modified law (CRA-2) led to the emergence of a secondary market for CRA subprime loans. In 1997, the first CRA mortgage-backed securities were offered on Wall Street (Wachovia, 1997). Since 1995, several additional regulatory and legislative changes have been made to the CRA-2. Despite the noble intentions behind the passage and subsequent changes in the CRA, the law was harshly criticized by Right -economists and the banking industry, who charged that subprime loans posed greater risks to their financial stability despite the higher profitability associated with such financial products. Banks however flourished pre-mid 1990s and there is no evidence that highly regulated and scrutinized lending of subprime loans can led to financial instability of banks. Others have contended that the CRA contributed to the subprime crisis (Liebowitz, 2008) by placing pressure on banks to give out risky mortgages. This argument is extremely problematic since the subprime crisis is, in large part, due to loans that were primarily originated in the non-CRA regulated subprime lending industry. The CRA has resulted in significant positive changes to the banking industry and prior to the mid 1990’s, was responsible for helping rebuild some of the nation’s most desolate urban communities by forcing financial institutions to provide loans to minorities and minority communities (Apgar and Duda, 2003). Unfortunately, a latent function of financial deregulation was the subsequent growth of discrimination and fraud in an industry that existing federal legislation had no jurisdiction over. Predatory Lending According to Berkowitz (2003), predatory loans are a “subset of subprime loans, which include terms that are designed to strip home equity and trap borrowers in high cost terms. While most subprime loans are not predatory, Berkowitz argued that “almost

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all predatory loans are subprime” (p. 4). The growth of the subprime industry, the growth of lending to minorities, and the low requirements and underwriting standards associated with subprime spawned an increase in predatory loan practices that took advantage of the disadvantaged. Predatory lending was not illegal in many states; however, the practice can be extremely detrimental to the borrower. Families can lose their homes within a couple of years after the loan due to lost equity, exorbitant loan fees, and unfair loan terms (Berkowitz, 2003). Predatory lending includes charging excessive fees, steering borrowers into bad loans which net higher profits for the loan originator and lender, and abusing yield-spread premiums. Berkowitz noted that African-Americans had a history of credit denial, and the new opportunities created by wider credit access offered predatory lenders more opportunities to prey on African Americans. According to Berkowitz (2003) subprime loans were “three times more likely in low income neighborhoods; five times more likely in African American neighborhoods; and two times more likely in high income black neighborhoods than in low-income white neighborhoods (p. 5). According to a study by the Center for Community Change (2002),

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Lower income African-Americans receive 2.4 times as many subprime loans than lower income whites, while upper income African-Americans receive 3 times more than do whites with comparable incomes. Compared to whites, lower income Hispanics receive 1.4 times the number of subprime loans. In every metropolitan area included in the study, high concentrations of racial disparities in subprime lending were found among African-Americans and Hispanics. (pp. vii-viii) The CCC study included over 300 metropolitan areas in the United States and “ranked the areas using a variety of subprime lending measures. It found that El Paso, Texas, is the nation's leader in subprime lending, where 47.3 percent of loans made were subprime, well above the average of 25.3 percent” (CNN, 2002, p. n.p.).

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Towards Economic Equality Racial discrimination in the financial industry kept minorities from access to credit. Thus, the move towards economic equality began as a measure to ensure that deposit-taking financial institutions insured by the Federal Reserve increased access to credit by underserved populations (Center for Community Change, 2002). Overcoming the deep history of social, political, and economic inequalities would entail much more than access to credit. The failures of social and economic justice initiatives since the Civil Rights Era instilled among the African-American population, “a common and pervasive sense of inadequacy of remedies pursued to remedy the legacy of racism” (Jackson, 1994, p. 7). The traditional mortgage loans that banks primarily offered until the early 1990s, excluded many minorities from qualifying for a mortgage loan. Mortgages were usually 30-year fixed interest rates mortgages, and underwriting standards were stringent, such as full documentation, low loan-to-value, and low debt-to-income ratios (Essene & Apgar, 2007). The economically disadvantaged backgrounds of many AfricanAmericans and Latinos transcended low credit scores. The legal, political, and economic structure of the U.S. was contaminated with deep-seated racism, which economically marginalized minorities. Expanding homeownership among minorities, it was believed, would entail innovative industry approaches that would address the problem of affordability. In the early 1990s, the subprime mortgage industry experienced dramatic changes in lending practices and products, which increased affordability and, thus, minority homeownership. The proliferation of alternative and innovative mortgage products, low interest rates, and the continual pressure to reform discriminatory lending practices all led to greater access to credit by the population (Essene, & Apgar, 2007). Alternative loan products include all, but were not limited to partial documentation, interest-only, adjustable-rate, and optionarm loans. Financial institutions that are regulated by the government were required by law to provide opportunities for credit to low

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and moderate income families, while independent banks were motivated by perverse amounts of profit. Independent financial institutions realized the potential for making tremendous amounts of profit from alternative loan products since they were able to charge higher fees and interest rates. Banks did not all of a sudden hop on the equal opportunity lending bandwagon because it was the right thing to do, but rather, because it was extremely profitable. And since the majority of independent financial institutions sell their loans immediately after origination, they had very little to lose. Alternative mortgages, the majority of which were adjustable-rate mortgages (ARMs), were almost “exclusively underwritten in the subprime market” (Joint Economic Committee, 2007). For the most part, hybrid loans simply resolved the problem of affordability that most minorities faced with traditional subprime mortgages. Despite the higher fees and interest rates associated with hybrid loans, the loan structure equated to lower monthly mortgage payments in contrast to the traditional 30-year fixed loan. Further, the low qualification requirements and underwriting standards set by the subprime mortgage industry allowed almost anyone who wanted a mortgage to qualify. The stated mortgage product for example, did not require documentation to verify income or assets. Prospective borrowers only had to state their income or assets, and banks simply took their word. Many loan agents took advantage of the loose underwriting standards and easy qualifications and committed fraud in the process. The results of the current study, for example, showed that the stated loan product was commonly given to borrowers who did not meet the income requirements. These liar loans, as they are known as, make it possible for a borrower and loan originator to completely fabricate financial information to obtain credit. Subprime mortgages were also extended to borrowers who had previous judgments, foreclosures, repossessions, or bankruptcies. If the borrower lacked money for a down payment, this was not an obstacle because financial lenders offered 100 percent financing. If borrowers could not afford to pay the traditional principle + interest on a mortgage, they could opt for an interest-only loan. These loans exuded an illusion of affordability since it allowed

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borrowers to obtain a large mortgage with low monthly payments. The problem however is that these loans will eventually reset, and the payments dramatically increase beyond the ability of the borrower to repay. This troubling fact did not have a large affect on many borrowers’ decisions to obtain the loan since many felt they would be able to later refinance once the value of their home increased. Like a ponzi scheme, the exorbitant growth of the housing market would eventually collapse due to the millions of outstanding subprime loans that would eventually led to foreclosure. The unfortunate fallout of the crisis will be paid or by U.S. taxpayers. Hybrid mortgages contained creative financing terms, structured to increase the number of qualified borrowers, particularly minority borrowers. Countless private organizations, former President Bill Clinton, and Federal Reserve Chair Alan Greenspan campaigned for the expansion of alternative loan products to meet the needs of minorities and minority communities. In 2004, former Federal Reserve Chair Alan Greenspan stated that financial institutions should offer a greater variety of mortgage product alternatives other than traditional fixed-rate mortgages (Greenspan, 2004). Between 1995 and 2006, the subprime mortgage industry grew exponentially. During this period, the number of minorities obtaining a piece of the American dream was more than at any other time in U.S. history. The growth of the subprime mortgage industry occurred predominately among African American and Latino families (Fernandez, 2007). According to a 2007 study by the Center for Responsible Lending (CRL), the proportion of subprime home-purchase loans originated to African American families was over 50 percent. Approximately 40 percent of subprime loans originated in 2006 went to Hispanic and Latino families. The growth of the subprime industry increased the demand for homes, which drove home values through the ceiling. Between 1997 and 2006, American home prices increased by 124 percent (The Economist, 2007). The rise of real estate values during this period gave homeowners equity they could leverage, further fueling the growth of the subprime industry. And as the industry and competition among financial lenders grew, so too

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did the further reduction in underwriting standards and wider availability of alternative loan products, which further expanded the access or pool of qualified home buyers. As rates declined, mortgage lenders also loosened their requirements and invented new types of loans based on the fallacious supposition that people would be able to pay more in the future, since real estate and wages would continue to increase indefinitely. (Lifflander, 2008, p. 4) The dollar amount of outstanding subprime loans as of 2007 is placed at $1.3 trillion, or 7.2 million separate subprime mortgages (Bernanke, 2007).

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Fraud in the Context of Economic Inequality The growth of the subprime mortgage industry, which provided the majority of loans to minority families, falls outside the legal and regulatory oversight of the CRA. The growth of the subprime mortgage industry completely subverted the pursuit and goal of economic equality that is symbolized by the FHA and the CRA. According to Thiruvengadam (2009), by 2008 only 6 percent of subprime loans in targeted neighborhoods were covered by the CRA. In a testimony before the United States House Committee on Financial Services, Barr (2008) stated that approximately half of subprime loans were originated by nonCRA covered institutions and another 30 percent came from partially regulated financial institutions. The problem is clear – the legal legislation that is primarily responsible for preventing and enforcing discriminatory lending practices, and ensuring that loans are extended to low-income neighborhoods and minorities became sidelined with the growth of the subprime mortgage industry. The problem is that the subprime industry is unregulated, which meant that predatory and fraudulent lending practices would be unchecked. And while the homeownership rate among minorities grew alongside the subprime mortgage industry, so too were the number of subtle egregious discriminatory lending practices.

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The growth and eventual collapse of the subprime industry has been perceived to be due to poor federal legislation, deteriorating home values, hybrid mortgages, and loose underwriting standards. However, these factors in and of themselves were not simply causes; in fact, given the data presented here, it could reasonably be argued that they were symptoms or in some cases mere effects of various fraudulent practices that preceded them. Various commentators have failed to pinpoint mortgage fraud as a significant culprit of the financial meltdown. Their lenient analyses of the events that transpired fail to account for the significant role of fraud in the current financial debacle. They fail to recognize that unlike traditional forms of mortgage fraud, contemporary forms of mortgage fraud have completely changed the function and goal of the subprime mortgage industry. Toward this end, no longer did the industry function to provide bad loans to bad credit borrowers, but bad loans to bad credit borrowers who never had the ability to repay the loan. This pervasive industry practice that is documented in the evidence brought to bear in this study clearly indicates that criminal fraud was deeply embedded in the lending practices of the subprime mortgage industry and is significantly tied to the foreclosure explosion that is the underlying cause of the current crisis. Factors such as risky hybrid mortgages (e.g., limiteddocumentation loan products and adjustable-rate loans), loose underwriting standards, and an inadequate regulatory structure have been argued to be the direct causes of the foreclosure crisis; industry experts, economists, and policymakers have failed to observe the mediating role of fraud (see chart 2 in chapter 4). While a direct relationship exists between the aforementioned factors and the high rate of foreclosures, the results of this study indicate that the role of fraud needs to be taken into consideration, as such fraudulent practices have qualified borrowers for homes they could not afford, thus resulting in foreclosures. The results are fully in line with those found in previous debacles including the savings and loans, corporate and accounting meltdowns, and the Orange County Bankruptcy (Calavita & Pontell, 1990). Ignoring the significant role of fraud in these instances leads to misguided and incomplete policies,

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which can only provide virtual blueprints for future economic crises. The current study revealed the significance of fraud in the contemporary subprime mortgage crisis. The simple loan qualifications and guidelines established by subprime lenders during the last decade of “lenient lending,” along with the industry-wide loose underwriting standards, have created rampant criminogenic opportunities for mortgage fraud, which functioned to qualify borrowers, the most of which are minorities, for mortgages they cannot afford. If a borrower did not qualify for a loan, due to a lack of assets or adequate income for example, loan agents would have simply created falsified assets and a fictitious employment. The practice of “cut, pasting, and recopying” or using simple Photoshop techniques to create altered and/or false documentations were found to be common among individuals interviewed for this study. The deeply embedded pernicious criminal acts of mortgage fraud by loan agents have been found to be pervasive among mortgage businesses that produce conditions in which there are high incentives for fraud and low risks of detection and punishment. In fact, many subjects have expressed their casualness regarding certain acts of criminal fraud (e.g., overstating income, assets, backdating), positing that such acts are completely common in the industry and accepted by their peers as acceptable business practice. Many loan agents in this study consider such acts as inseparable from legitimate loan origination procedures. Unfortunately, these types of frauds have been found to be common among subprime loans or alternative mortgage products, where the majority of which are extended to minority families. The subprime mortgage crisis led to the greatest erosion of homeownership among African-American and Hispanic families. The gains made in minority homeownership experienced between 1994 and 2004 have been primarily due to the proliferation of subprime loans, in which predatory lending practices and frauds were common. These loan products have been used as the tools by the powerful to exploit minorities in the financial industry; those at the top have perversely profited from the sale of an illusion to the American Dream.

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The growth of minority homeownership has also been driven by fraudulent practices which have placed many minorities in precarious financial situations - many families were steered into high cost loans that contained difficult terms and conditions. For example, minorities were often steered into subprime products or Alt-A loans when they qualified for a traditional prime loan. African-Americans and Hispanics have been especially targeted by predatory lenders since they have a history of credit denial and most have very little understanding of mortgage terms and conditions (Berkowitz, 2003). These mortgages end up being financially disastrous for many minority families, especially in the midst of an economic crisis. It is thus not surprising that after years of predatory practices and financial victimization, minority families have experienced the highest rate of foreclosures. These fraudulent practices have also allowed many minority homeowners who did not qualify for loans, but who built up equity during the housing boom, to refinance the equity from their homes as a source of income, which not only stripped away their safety net during a housing crisis, but place them into riskier loans. Home equity is considered a large portion of wealth and economic stability for many African American homeowners and for many non-minorities as well. According to the Berkowitz (2002), 63 percent of wealth that African American’s own is in home equity (p. 5). During the real estate boom, the American culture of consumerism was more marked than ever among minority homeowners as countless refinanced most, if not all of the newfound equity from their home. Increasing home values, low interest rates, and heavy marketing convinced homeowners to refinance, which placed them in an extremely vulnerable financial situation when the real estate bubble exploded. Between 1993 and 1998, the number of subprime refinance loans increased ten-fold compared to the previous decade, and of all loans originated during the same period, as much as 80 percent of all subprime loans were refinances (Berkowitz 2003, p. 5). In chapter 4, a mortgage refinance case was discussed that involved a valet employee who worked in Newport Beach, CA. In this case, the loan officer submitted a fraudulent Letter of Explanation (LOE) to the lender and noted that the “borrower

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worked for a valet company which tailored to high-end restaurants in Newport Beach, CA and that large tips were a normal part of his employment.” The LOE stated that his tips consisted of 90 percent of his salary, which is a gross exaggeration. The loan application was manipulated and the employment title was altered to justify a higher income. This loan exemplifies a major pattern of fraud underlying the current crisis that played out time and time again in qualifying borrowers for loans which they never had the ability to repay. As most subprime loans originated since the mid 1990s, they were not covered by the CRA. The lack of regulatory oversight over subprime lenders, and the poor under underwriting standards along with exploitable qualification guidelines greatly contributed to the growth of fraud. Moreover, since a significant number of loans were 100 percent loan-to-value, the deterioration of home values due to the housing crisis has placed many homeowners in a negative equity situation. In a recent study by Deutsche Bank (2009), it was found that an estimated “25 million borrowers, representing 48% of all Americans with mortgage loans, will plunge underwater before home prices are expected to stabilize in the beginning of 2011” (Christie, 2009, p. np.). It was only due to fraud that these borrowers were able to obtain the loan in the first place.

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“You Call This Equality?” In their article, “Heads I win, tails you lose: Deregulation, Crime, and Crisis in the Savings and Loan Industry,” Calavita and Pontell (1990) examined the structural conditions brought about from deregulation of savings and loan institutions which placed limitations on the enforcement process and which allowed a virtual explosion of fraudulent practices to take place in the thrift industry . They also posit that different various forms of frauds are inherent to the distinctive qualities of finance capitalism, versus those under industrial capitalism. Calavita and Pontell (1990) argue the profits within a finance capitalist economy “derived from speculative ventures designed to produce tremendous amounts of profits from carefully hedged

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bets” while industrial capitalism produce profit from the tangible production of goods and services (p. 335). In finance capitalist economies, nothing is actually produced and those who are involved, “casino capitalist,” do not have a stake in the long term stability and health of the industry. The goal of these casino capitalists is to get in and out making as much as possible. Such involvement by casino capitalists combined with the poor regulatory oversight of the government has led these researchers to contend that finance capitalist economies have much greater opportunities and incentives for fraud. Extending on that argument, it may be argued that racial inequalities are also inherent in the structure of finance capitalism since access to the industry been traditionally limited to affluent members of society. As noted earlier regarding the “new racism,” progress toward liberalism can produce novel forms of racial inequality. The subprime mortgage industry has greatly disadvantaged African-American, Hispanic and Latino homeowners. The terms and conditions of subprime mortgage products that have been extended to minorities contain excessive fees, interest rates, and difficult terms which make it hard for any borrower to adhere to. The growth of minority homeownership in the last decade is an illusion produced by a multitude of alternative loan products that made homes seemingly affordable. The reality is that while these alternative loans are easy to obtain, the terms and conditions usually led to higher costs and higher payments, which can be problematic for most borrowers. In the end, these homes will be foreclosed on and a significant number of minorities will find themselves in a far worse financial disposition than before. The subprime lending industry has been touted as a major panacea for access to credit among minority populations; however, various aspects of the industry have created an overall illusion of affordability and allowed for the continuous exploitation and victimization of minority groups. In the following sections, a range of subprime mortgage industry related factors (alternative mortgage products, higher fees and penalties, higher interest rates, and unreasonable terms and conditions) will analyzed in

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relation to the economic victimization of minorities. These discussions will reveal how the subprime lending industry has perpetuated a history of discriminatory practices by selling an illusion of the American Dream. Alternative Mortgage Products (AMP) One of the most dramatic changes to the landscape of the financial industry during the past decade has been the proliferation of alternative mortgage products (AMPs). While AMPs have expanded opportunities for credit towards historically marginalized populations, the question is whether such products actually result in more affordable homeownership. In this section, the latent and manifest functions of AMPs will be analyzed to better understand its impact in the lending industry, and how such products have allowed for the continual manifestation of new forms of racism. According to a report by the U.S. General Accounting Office (GAO), AMPs grew from 10 percent of total mortgage originations in 2003 to 30 percent in 2005. There are many AMPs that are offered in the mortgage industry, however, the two most common are interest-only loans and adjustable-rate mortgages.

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In recent years, however, AMPs have been marketed as an “affordability” product to allow borrowers to purchase homes they otherwise might not be able to afford with a conventional fixed-rate mortgage. Because AMP borrowers can defer repayment of principal, and sometimes part of the interest, for several years, they may eventually face payment increases large enough to be described as “payment shock.” (U.S. General Accounting Office 2006, p. 2) Have AMPs helped minorities and made homes more affordable? The manifest functions of AMPs are clear – to create greater access to credit by allowing individuals with unique and questionable credit histories to qualify. The latent functions, are much more sinister and can be described as a

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product that is a mirage - the reality is that AMPs only possess the illusion of affordability. Financial lenders tie financial consequences to borrowers who obtain alternative products. Rather than making loans more affordable, AMPs have been used as a tool to exploit lower income families; most of whom are African-American, Hispanic and Latinos. Access to credit by borrowers with spotty credit histories equate to higher fees and interest loans. The subsequent move to address affordability by offering AMPs is no different. Instead of helping minorities achieve the American dream, financial lenders created imaginative ways to steal from the disadvantaged. “Lenders have increasingly qualified borrowers for AMPs under “low documentation” standards, which allow for less detailed proof of income or assets than lenders traditionally required” (U.S. General Accounting Office, 2006, p. 8). Qualifying for these mortgages, however, come with consequences to the borrower. The following illustration details the alternative loans available to subprime borrowers and the corresponding consequences associated with the mortgage product. It is important to remember that when controlling for income, loan amount, and property value, African-Americans and Hispanics are more often likely to receive these types of loans (Dedman, 1989). This chart provides a juxtaposition of benefits and consequences of four primary AMPs. For each alternative loan, the number of consequences to the borrower outnumbers the benefits. Most borrowers are only concerned with one thing when obtaining a mortgage – what is the mortgage payment? They fail to consider the long term consequences and the terms and conditions which may be potentially disastrous. For example, despite the fact that interest-only loans contain higher fees, interest rates, and penalties as well as an adjustable-rate clause, they are extremely popular simply because the payment is lower than a conventional mortgage. The question is whether AMPs are really more affordable? The answer: only in the short term.

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Table 3: Comparison between Various Subprime Loans the Traditional Prime 30-year Fixed Rate Mortgage

LOAN TYPE

BENEFIT(S) TO BORROWER 1. Lower monthly payments

1. Higher fees. 2. Higher interest rate 3. Interest rate fixed for a limited time 4. Higher penalties 5.Riskier terms and conditions 6. Contains adjustable rate

1. Lower monthly payment 2. Avoid paying PMI

1. Excessive interest rates 2. Balloon payments 3. Higher fees and penalties

1. Lower monthly payments 2. Payment options each month.

1. Growing principle 2. Higher interest rate on alternative payment options 3. Higher fees 4. Adjustable rate interest 5. Riskier terms and conditions

1. Little or no down payment 2. Do not have to prove income or assets

1. Higher interest rate 2. Higher Fees 3. Riskier Terms and Conditions

Interest Only Mortgage

Combo Mortgage

Negative Amortization Loan (Option Arm, NegAM, or Pick-a-Payment)

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Limited Documentation and High Low-toValue

CONSEQUENCES TO BORROWER

In addition to increasing opportunities and incentives for frauds and predatory lending practices, as discussed in the preceding chapter, AMPs have completely opened the door to new forms of racism. The loose underwriting and deceptive illusion of affordability made these loan products particularly

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popular among minority borrowers. Within the lending industry, AMPs that have been harshly criticized for being historically extended to minorities and minority communities, which lend additional credence to the notion that free markets work to further disadvantage the disadvantaged. These loan products are essentially financial traps, and increased regulation, oversight, and education by independent lenders will be necessary if these loan products are to be successfully integrated into the subprime lending industry. AMPs are only part of the subprime lending industry. Minority borrowers often face additional obstacles when obtaining a subprime loan – higher fees, penalties, and interest rates. High Fees, Penalties, and Interest Rate Subprime mortgages were established to provide access to credit among low income populations, so why do these loan products contain higher fees when controlling for loan amount, loan purpose, and household income (Dedman, 1989; Berson, 2006; Duncan, 2007)? A joint study by the U.S. Department of Housing and Urban Development and U.S. Treasury found that:

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Subprime loans were issued five times more frequently to households in predominantly black neighborhoods as they were to households in predominantly white neighborhoods Moreover, many of these minority borrowers were steered into subprime loans when they may have qualified for less expensive, prime loans. (Joint Economic Committee, 2007, p. 4) Compared to prime loans, subprime loans were assessed higher fees with some charging origination fees up to four times the average fee of prime loans (Berkowitz, 2002; Dedman, 1989). In a report by the Center for Responsible Lending, it was noted that “when income and credit risk are equal to white borrowers, black borrowers are 31 to 34 percent more likely to receive higher rate subprime loans than whites” (Sanders, 2007). Subprime loans also have higher built-in penalties compared to their prime mortgage counterparts. Several studies examined the disparities in prepayment penalties among prime and

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subprime loans (Mortgage Bankers Association, 2006; Center for Responsible Lending, 2007). According to Berkowitz (2002), an estimated 80 percent of subprime loans contained prepayment penalties (fines charged to the borrower for paying off the loan prior to a contractual period) compared to 2 percent of conventional loans. Fees assessed by brokers could also come in yield-spread premiums, bank kickbacks or rewards to mortgage brokers for:

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Placing borrowers in loans at a higher interest rate than the lender would have given with their par rate. Yieldspread premiums create an obvious incentive for brokers to make loans at the highest interest rates and fees possible … the broker is even paid a higher bonus if they lock the borrower in a prepayment penalty. (Berkowitz, 2002, p. 9) For an average loan of $400,000, the prepayment penalties could exceed $25,000. Oftentimes, these fees are built into the loan and many borrowers are unaware of the actual implications, such as trapping them in a mortgage. While it is legal for lenders and brokers to charge the high fees, it is an additional element of the overall predatory practices that minorities faced when obtaining a loan. The perverse financial incentive system of the subprime industry resulted in the looting of many vulnerable borrowers, who mostly did not understand the dangers associated with the fees. In many instances, the predatory practices of steering borrowers into costlier mortgages can cross the line into criminal activity. For example, brokers who steered borrowers into a high interest loans are known to cover the amount paid to them by the lenders. This is done by making an arrangement with the escrow company to exclude the “yield-spread premium” on the final HUD settlement statement, a legal disclosure provided to every borrower that details every single fee charged on a loan. Compared to prime mortgages, subprime loans also had higher interest rates. Banks justified charging subprime borrowers higher interest rates because of the higher risks of default associated with subprime borrowers (Schloemer et al., 2006). Subprime loans were riskier, “not only because borrowers

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may have weaker credit histories but also because the loans, in and of themselves, are associated with a higher risk of default” (Schloemer et al., 2006, p. 21). In addition, the loan-to-value ratio of subprime loans was usually greater because subprime borrowers usually lacked the funds for a down payment and thus, borrowed up to 100 percent of the value of the home. Most banks required that borrowers purchase private mortgage insurance (PMI) to protect the lender in case of default if their mortgage loan exceeded 80 percent (LTV) of the property value. To avoid purchasing PMI, the mortgage industry offered combo loans, which allowed borrowers to fully finance or refinance the property without putting a penny down. For example, if a borrower had only 5 percent down payment for a mortgage, the borrower would have two options: 1) a 95 percent LTV loan with PMI to cover the remaining 5 percent of the loan or 2) a combo loan, commonly referred to in the industry as an 80/20. Combo loans consist of two loans: the primary and secondary loan. The first loan amount is usually 80 percent of the combined loan value and the second loan, commonly referred to in the industry as a piggyback loan, usually 10 to 20 percent of the remaining balance covered the remaining value of the property. Studies have found that a primary factor or barrier to homeownership among African Americans and Hispanics is the lack of capital for a down payment or closing costs (HUD, 2003). As a result, minority homeowners usually have to obtain a second mortgage which had much higher interest rates, often reaching as high as 12 percent. Combo loans were disproportionately given to minority borrowers. The General Accounting Office (2006) found that: Besides permitting lower credit scores, lenders increasingly qualified borrowers with fewer financial resources. For example, lenders allowed higher DTI ratios for some borrowers and began combining AMPs with “piggyback” mortgages—that is, second mortgages that allow borrowers with limited or no down payments to finance a down payment. (p. 16)

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Expanding access of credit to low income families by offering higher-cost mortgages to borrowers fails in many regard to fit the goal of economic equality. In fact, a significant number of minority borrowers were victims of predatory lending practices and fraud as a result of the perverse incentives tied to originating subprime loans, the loose regulatory oversight over the industry, and the lack of many minority borrowers’ ability to understand the complexity associated with home loans. The advent of the subprime mortgage industry was intended to address the historical problem of access to credit by making loans more obtainable and affordable, particularly to minority groups. Unfortunately, the factors associated with subprime loans seem to do the opposite – rather than allowing historically marginalized borrowers obtain credit, these loans have resulted in the systematic corrosion of wealth from minorities. In the midst of the economic crisis, minorities are losing their homes and financial livelihoods at rate highly disproportionate to whites. “Lower income families tend to pay more for the exact same consumer product than families with higher incomes” (Brookings Institute, 2006, p. n.p.). Unreasonable Loan Terms and Conditions According to Berkowitz (2002), a researcher with the South Carolina Appleseed Legal Justice Center, minorities, lowerincome families, and the elderly were particular targets for loan practices that included harmful loan terms (balloon payment loans, high LTV loans, and single premium insurance payments) and deceptive marketing schemes. Mortgage brokers rarely ever factored in the ability of the borrowers to repay the loan. Borrowers commonly indicated the amount of loan, type of home, or monthly payment amount they desired and the broker or loan officer worked to obtain the loan, even when the terms or the amount exceeded the borrower’s ability to repay. Subprime borrowers commonly gained high-cost loans they could not afford. According to the Center for Community Change (2002), Lenders may exploit borrowers by imposing credit terms that are not justified by the risk posed by the borrower. Typically, this is done by charging higher interest rates

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and/or charging higher fees than can be justified by the risk posed by the loan …often in schemes designed to take away the property. Lenders may also mislead or deceive borrowers as to the costs and conditions of the loan. In many cases, these practices are challenged as involving fraud and misrepresentation. (p.1) In Why the Poor Pay More: How to Stop Predatory Lending, Squires (2004) detailed ways in which minorities, working families, and the elderly were victimized and exploited by financial institutions who ensnared vulnerable segments of society into high-cost predatory loans. These discriminatory practices have stripped many homeowners of their equity and established wealth. Squires (2004) found that high cost lenders had an “extraordinary large shares of the refinance market in minority neighborhoods” (p. 27). The National Community Reinvestment Coalition (NCRC) have found similar results, that minority and elderly communities receive a higher level of high cost loans that is justified. The American Dream of homeownership was highly enticing for many low-income families. The author posited that predatory practices went beyond insidious discriminatory practices. The lending practices of the subprime industry represented a financial-political system that undermined the poor and served the needs of the wealthy.

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The Illusion of Affordability Altogether, subprime loans give the illusion of affordability to the borrower. After several years, borrowers find themselves in a financial nightmare when their mortgage payments suddenly skyrocket and they find themselves facing the possibility of losing their home. In this section, a very popular loan known as a negative amortization, or option ARM loan, is dissected to demonstrate the concept of illusion of affordability. These loans, compared to other mortgages, are “considered the worst performing loan product of them all (Christie, 2009, p. np.). Despite the higher interest rates, fees, and penalties associated with subprime mortgages, borrowers were mostly concerned with their monthly mortgage amount. Interest-only

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Table 4: Illusion of Affordability. Loan type: Negative Amortization Loan

Estimated Value $400,000.00 Term 360 Months Min. Pay Rate: 1%

First Payment: $1,286 Fully Indexed Rate: 8% Margin 3.5%

Options: A: Minimum Payment

C: 15-Year Balloon Payment

B: Interest Only Payment

D: 30-Year Payment

Year 1

Monthly Deferred Amount

Option A: $1,286.56

$1,649

Option B: $2,666.67

Annual Principle Growth

Option C: $2,666.67

$19,782

Option D: $3,822.60

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The minimum payment option for NegAM loans is limited to five years. The Borrower can choose which payment option they want to make each month (A,B,C,or D). Total Principle Growth (5 years) $86,429.51 Deferred Interest (5 Years) $70,326.0

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loans, for example, charged higher interest rates but since the borrower was paying only the interest, the monthly amount was still lower than a traditional principle + interest mortgage. The following table illustrates how a negative amortization (NegAM) loan could easily give borrowers an illusion of affordability and the inherent dangers in that premise. Negative Amortization (NegAM) loans offered the borrower the flexibility of picking a monthly mortgage payment calculated from four payment options (minimum payment, interest only, 30-year fixed and a 15-year balloon) (Berkowitz, 2002). The minimum payment on a NegAM loan ranged between 1 and 2 percent, respectively. Borrowers obtained NegAM loans simply for the minimum payment feature, allowing them to save thousands of dollars each month. The unpaid monthly amount (difference between the 30-year fixed and minimum payment amount) was added to the outstanding balance of the loan. The example above shows that borrowers could assume an illusion of affordability with a NegAM compared to a traditional mortgage. On a $400,000 loan, a borrower could avoid paying as much as $1649 monthly or $19,788 annually. For borrowers, the logic behind obtaining a NegAM loan was simple and based on the belief that home values would continue to increase, and the rate of appreciation would outpace the growth of deferment. Prospective borrowers who assumed a NegAM mortgage did so under the belief they could refinance out of their extremely risky mortgage later. Near the end of 2007, home values stagnated and began to decline leaving some homeowners with mortgage balances higher than their home was worth. Homeowners with NegAM loans faced extreme risks for default as they dealt with declining values compounded by a growing loan balance. Borrowers who obtained a negative amortization loan during the last ten years have a 77 percent chance of being underwater on their mortgage, or owe more than what their home is worth by 2009 (Christie, 2009).

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Discussion In 2006, the U.S. rate of homeownership reached 69.2 percent, the highest ever in U.S. history (Bernanke, 2007). While the growth of homeownership was broadly based, “minority households and households in lower-income census tracts have recorded some of the largest gains in percentage terms” (Bernanke, 2007, p. n.p.). The subprime mortgage crisis revealed a number of troubling factors. First, the collapse of the industry greatly affected minority families. Dahler (2008) reported that the housing crisis has greatly affected a significant number of minority family’s economic stability, and at times even costing them their homes and life savings. Second, minority communities were also disproportionately impacted by the tide of foreclosures. Neighborhoods that were previously beautiful have been replaced with abandoned and destroyed homes, which could lead to increased crime rates (Kelling, Cole, 1996). The struggle for economic equality stopped overt forms of racism in the financial industry. Minorities will unlikely experience denial of credit simply based on race alone. Progress towards economic equality has also led to industry changes (e.g., alternative loan products, loose underwriting, and qualification standards), which made it possible for lower-income borrowers, most of whom are minorities, to get into a home. Federal laws (e.g., the Fair Housing Act and the Community and Reinvestment Act) and lending policies and practices, such as alternative mortgage products and loose underwriting standards have greatly increased the rate of minority homeownership. These legislations have become symbols of economic equality in finance capitalism in the U.S and the growth in minority homeownership since the 1990s was touted as proof that these legal measures worked. The truth, however, is more sinister. It is not surprising that the measures intended to reduce economic inequality failed to address many contemporary forms of inequality created by a deregulated parallel industry. Minorities who were previously denied credit were being extended credit but at the cost of their financial livelihoods. As a result, more African-American and Hispanic families lost their homes than any other time in U.S. history because of the subprime crisis.

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Many of these homeowners invested all of their savings into their high cost mortgage and might lose everything. These families might have been better off if they avoided the pursuit of homeownership altogether. The fight for economic equality through greater access to the American Dream by increasing opportunities for credit, and the implementation of measures that increased affordability were social and cultural messages that economic class and minority populations previously excluded from access to credit should have equal opportunity to own property. There were, however, contradictions in the implementation of policies intended to increase minority homeownership. On one hand, the measures taken in the industry to increase affordability acknowledged the legitimacy of income differentials that stemmed from a legacy of structural inequality inherent in finance capitalism. While these policies reflected discriminatory cultural perceptions (Lewis, 1966), they failed to emphasize the role social and institutional policies played in legitimating, justifying, and perpetuating this inequality (Piven, 1972; Galper, 1975; Sigelman, & Tuch, 1997; Keiser, Mueser, & Choi, 2004). The Community Reinvestment Act played an important role in U.S. history. It was part of a larger move to expand credit to lower income minority households and communities and to address the problem of racially based economic inequality. While the noble law legislation led to increased minority homeownership, the deregulation of the financial industry has led to a major tumbling block in our overall pursue of equality. The goals of the CRA was ultimately subverted by the same noble goals and intentions that led to the growth of a parallel subprime lending industry that were responsible for the discriminatory lending practices the CRA aimed to prevent. It was clear there were inherent contradictions between measures to increase economic equality and the goals of finance capitalism. Government regulation of the financial industry, according to economic theory, was counterproductive and imposed an unfair handicap on the competitive process. In this perspective, free markets worked best if left alone, “unhampered by perhaps well-meaning but ultimately counterproductive government regulations” (Calavita, & Pontell, 1990, p. 312).

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Government regulations caused asset-liability mismatch problems faced by the savings and loan (S&L) industry, for example, and deregulation was considered the solution (Calavita, & Pontell, 1990). In reality, deregulation led to a tremendous host of additional problems in the savings and loan crisis, including the perverse growth of documented frauds. Decades later, the problem of poor and loose regulation in the financial industry would again emerge as a major contributing factor of the largest financial disaster since the great depression. The goal of the government should be to increase regulation of the financial industry, with a careful balance that ensures accountability and oversight, and at the same time promote innovation and growth. Further, deregulatory moves should be mindful of existing laws and statues (e.g., CRA), as not to undermine or weaken its authority. President Obama and economists has harshly criticized the Financial Services Modernization Act of 1999, saying that it has subverted the goals of the CRA by 1) “failing to require banks seeking to conduct new financial services to maintain a CRA record, and 2) creating a "safe harbor" provision that would amend current law to effectively shield financial institutions from public comment on banking applications that they file with Federal regulators” (whitehouse.gov, 2009). After being elected, President Obama proposed a comprehensive reform of the financial industry by greatly increasing regulation. The American culture of consumerism in the past decade was marked by countless homeowners refinancing most, if not all, of the equity in their homes. During the 2001 economic recession and after the September 11 terrorist attacks, former President Bill Clinton advised U.S. citizens to go out and shop as one way to combat the terrorists attempt to destroy our way of life (Regnier, 2008). The American culture of spending and living on credit was a major source of the crisis. The former administrations’ policy to encourage spending through tax rebates as one solution to address a crisis exacerbated by spending was indeed ironic. Our social and economic pursuit of equality has taken a backseat to corporate targets and monetary outcomes, and this is a stark reminder that we need to reassess our priorities. In reference to the landmark Supreme Court

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decision in Brown v. Board of Education of Topeka, Kluger (2004) noted that “if it is a sin to aspire to conduct of a higher order than one may at the moment be capable of, then Americans surely sinned in professing that all men or created equal then acting otherwise” (p. xi).

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CHAPTER 6

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Now What? Final Thoughts and Recommendations

The results of this study provided a clear indication that a significant number of mortgage loans originated during the years of lenient lending in the subprime industry, which are currently held by banks as part of their financial portfolio or packaged and sold as securities, had a high likelihood of containing some form of fraudulent misrepresentation. Unfortunately, a significant number of these fraudulent loans will never be discovered. Government legislation, industry competition, and unregulated lending guidelines made the qualifying of borrowers almost fail proof. A marginally experienced loan officer or broker could find a loan for any borrower, regardless of credit worthiness and financial disposition. The process requires a bit of crafty manipulation of certain borrower(s)’ information, such as cash reserves, income, employment data, debt-to-income ratio, and other lending requirements that were part of the origination stage of the loan. What made this practice of mortgage fraud so common is the variety of factors that include, 1) an absence of checks and balances within the financial industry to verify the accuracy of information presented on behalf of borrowers; 2) perverse financial incentives to commit frauds; 3) loose regulatory oversight; 4) low risks of detection and punishment; and 5) a culture that emphasizes profit and financial targets over ethical 147

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practices. Still, this is not to say that mortgage frauds were common in other sectors of the mortgage industry. The prime lending sector, for example, was not included and examined in this study. It would be interesting to examine the role of fraud in more traditional lending organizations. Additionally, while various types of frauds were described as common within the industry, the true number of frauds will never be known since the goal of such crimes is to avoid detection. Various studies and reports which have attempted to examine the amount of fraud that exists have found that as much as 70 percent of mortgages contain some sort of misrepresentation, misstatement, and/or omission. The primary purpose of this study is the exploration of the criminological underpinnings of the subprime mortgage crisis. The goal is to give the academic and mortgage industry a better understanding of the problem, prevalence, and implications of mortgage fraud, especially with regard to the failure of the industry to identify, regulate, and enforce lending guidelines that set the stage for the troubling growth of mortgage lending crimes. During the study, the mortgage industry was undergoing a foreclosure crisis on such a massive scale that the country was brought to its economic knees. On the brink of recession, the subprime crisis caused industry experts, including the federal government, to scramble in the hopes of trying to avert the disaster or minimize the damages. To date, their analysis of the problem and policy recommendations failed to include fraud as another culprit of the mess. Guided by previous studies that examined the role of fraud in major financial debacles, this study was able to trace the growth of various types and patterns of fraud to alternative mortgage products, mortgage-backed securities, institutional and organizational structures that made up the subprime lending industry. The results of this study provided concrete evidence that the legal and organizational structure, as well as lending practices of the subprime mortgage industry produced conditions that were ripe for various types of mortgage fraud. The results also supported evidence found in previous studies, which traced various forms of fraud to legal and structural conditions of the financial industry.

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The evolution of the subprime mortgage industry completely altered mortgage related crimes. Contemporary forms of mortgage fraud not only fell under the FBI’s category of fraud for profit and fraud for property, but also commonly incorporated both models. The borrower was not always a victim. The perpetrators were not always fraudsters. The major forms of misrepresentations, misstatements, and omissions were not always perpetrated by major fraud schemes. And, unlike the FBI’s mortgage fraud categorization, contemporary forms of fraud were much more subtle and detrimental to mortgage lenders because most of the incidents were undetected. Modern forms of fraud depart from the traditional understanding of mortgage fraud, and encompass elements found in predatory lending practices, fraud for profit, and fraud for property schemes. In the end, a significant number of borrowers who were given credit undeservingly, fraudulently, and/or irresponsibly ended up in foreclosure and lenders lost much more than in traditional fraud for profit schemes.

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Responses to the Crisis The subprime crisis caused a global credit crunch as financial institutions that experienced tremendous losses became more reluctant to extend credit to borrowers (Financial Times, 2008). To address this liquidity issue, the Federal Reserve cut interest rates several times - slashing interest rates from 5.25 percent in September 2007 to 2.25 percent in March 2008 (Federal Reserve, 2008). The federal government held a number of private bank auctions to extend billions of dollars to financial institutions. Both interest rate cuts and auctions were intended to increase bank liquidity in the hope they would ease lending restrictions and extend credit to consumers (Federal Reserve, 2008). To address foreclosures directly, the government and financial institutions established Hope Now Alliance, an organization to help homeowners avoid foreclosure through loan medication and the reduction of interest rates (White House, 2008). The organization’s goal is to work with the nation’s largest financial lenders to assuage, for a limited time, the financial pressure homeowners face because of the housing

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crisis. While the Hope Now Alliance assists troubled borrowers by working with them and their financial lenders to help restructure mortgages (e.g., such as reducing interest rates, loan principle amount, and changing the mortgage program), the solution still falls short of addressing the significant problem detailed in this study – homeowners will still be in mortgages they cannot afford. Simply reducing the interest rate and extending the term of the loan will not be an adequate solution and industry practitioners and community leaders have begun to recognize the programs’ failures. According to the Homeowners Preservation Foundation, only 4 percent of those who called HOPE NOW actually spoke with a mortgage counselor (Mortgage News Daily, 2008). Michael Shea, the executive director of the Acorn Housing Corporation, an organization part of HOPE NOW, called the program a failure (Mortgage News Daily, 2008). The President of Acorn, Maude Hurde, stated:

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HOPE NOW estimates of 950,000 mortgage modifications in 2008 is a pathetic failure when stacked up next to the 2 million Americans who lost their homes. Further, we don't know how many of these modifications actually resulted in reduced monthly payments that are affordable to homeowners, the driving reason behind high re-default rates. (ACORN, 2008) In a survey conducted by the California Reinvestment Coalition (CRC) of 33 of California’s more than eighty “mortgage counseling agencies that offer assistance to financially strained borrowers, it was found that most lenders sent defaulting homeowners packing with a foreclosure or short sale” (Perkins, 2008). In an attempt to reduce the rising number of home foreclosures, the FDIC, after taking over Indymac Bank offered homeowners the option of modifying their mortgages. Under the proposed plan, the borrower’s principle plus interest payments could not be over 38 percent DTI, and their interest rate would be reduced to approximately 6.5 percent. Again, this program failed to address the problem of affordability. First, borrowers had to show documentation of income. This proved difficult since many borrowers who obtained a stated-income loan did so

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because they were not required to demonstrate proof of income and, thus, were able to overstate their financial status. Also, financial lenders were not serious about resolving foreclosures if they were allowing only interest rate reductions and extending the terms of the loan. Homeowners were not only in homes they cannot afford but also discovered they owed much more than their house was worth. According to the Wall Street Journal, the major depreciation of housing values resulted in one in six homeowners, or nearly twelve million homeowners, that were underwater on their mortgages (Hagerty, & Simon, 2008). While the FDIC’s plan could help some borrowers, it would most likely fail since many borrowers needed major, not minor, restructuring of their mortgages that addressed the problem of affordability. On June 30, 2008, the Housing and Economic Recovery Act was enacted by former President George Bush to address the subprime mortgage crisis. The Act authorized the Federal Housing Authority to guarantee $300 billion in 30-year fixedrate mortgages to qualified subprime borrowers. If financial lenders agreed to write the subprime loans of their borrowers to 96.5 percent of the appraised value, the FHA would guarantee qualified borrowers a refinanced mortgage under the provision that borrowers must share 50 percent of future appreciation with the government (Pub.L. 110-289, 122 Stat. 2654). The Hope for Homeowners program, as it was called, failed to address affordability. Again, homeowners were required to document their income in order to qualify. Second, participation in the program by financial lenders was voluntary. Financial lenders must be willing to accept a loss. As of February 2009, there had only been a total of 451 applications and, of that, only 25 loans had closed (Naylor, 2009). On February 18, 2009, President Barack Obama announced the Homeowners Affordability and Stability Plan. This plan allocates $75 billion to assist an estimated seven to nine million homeowners in avoiding foreclosure by helping them refinance or restructure their home loan. The program allows homeowners who have loans with Fannie Mae or Freddie Mac to refinance into a low interest loan (approximately 5.16 percent). The plan will also target distressed homeowners who are currently behind, or will be behind, in their mortgage payment to restructure their

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mortgages. Unlike previous measures, this plan provides monetary incentives for financial lenders to modify loans. While it was too early to tell at the time of this research, the plan falls short in addressing major principle reductions, which is an important element of ensuring affordability.

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Policy Implications The federal government, economists, and industry insiders failed to observe fraud as a significant underlying contributor to the crisis. As a result, little attention was placed on policy responses that addressed poor regulatory oversight and enforcement, loose lending policies, lack of accountability, and underwriting standards that allowed fraud to flourish. The legal and organizational structure combined with the guidelines and lending practices that characterized the subprime mortgage industry clearly created new opportunities for fraud. The economic structure of the subprime lending industry also contributed to the growth of fraud by failing to discourage it. Whenever information in a loan application was misleading, misrepresented, or misstated, rarely were there consequences for the perpetrator. According to those interviewed, the acts were rarely reported to authorities and, in most cases, incidences of suspected fraud were addressed only verbally and informally. A common theme among research subjects was the lack of seriousness regarding many acts of mortgage fraud. Consequently, it was common for loan agents to become apathetic regarding guidelines, policies, and laws in the face of high monetary returns, minimum risks, and little accountability. To address the problem and ensure that fraud of this nature, and potentially a crisis of this magnitude do not reoccur, we must address the issues that are contributors to fraud. As part of the solution, we must also consider policies that will address problematic lending policies and practices in general. For example, our current lending system monetarily rewards mortgage brokers for placing borrowers in higher cost loans, which is contradictory to a loan agent’s fiduciary responsibilities, making the lender-broker reward system somewhat of a fiduciary conundrum. A holistic approach to

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addressing the problem of fraud requires a consideration of policies that not only directly address fraud, but also improve the lending system in general.

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Tightening Qualification Guidelines and Underwriting Standards First, we will need to tighten the easy qualification guidelines and the poor underwriting standards inherent in the subprime lending industry. Alternative mortgage products are a way to extend credit to those who cannot afford the traditional 30-year fixed-rate loan; however, the low qualification and loose underwriting standards need to be addressed if we want to reduce the problem of fraud. Low-documentation and no documentation loans have shown that they are invitations to fraud. Zero down payments or 100 percent financing programs do not place borrowers in a situation where they have a stake in the loan, and are clear indications the borrowers cannot afford the loan since they have no capital to invest. If a borrower cannot meet the required guidelines set forth for a particular loan but is able to obtain one, the likelihood that the loan was obtained through fraud is obvious. When the guidelines of a loan are set so low that they invite fraud, there must be mechanisms in place to discover and eliminate it. Stated (“liar”) loans should be either eliminated altogether or modified to produce a hybrid program or an amalgam of stated and verified. Completely stated loan programs need to be eliminated. Such hybrid loan programs should be combined with strict underwriting standards that check and cross reference financial information submitted on behalf of borrowers not only to ensure the accuracy and authenticity of the information that is submitted, but also to verify that they can afford the loan. Financial lenders need to add additional layers of oversight on each loan. For example, a separate entity or department can be established by every lender to scrutinize the loans in the process of origination. Lenders may also consider the option of an offsite and unbiased independent reviewer. The passage of Bill H.R. 1728, the Mortgage Reform and Anti-Predatory Lending Act of 2009, in the House of

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Representatives signifies a major step in the right direction by the federal government. The new law, if passed in the Senate, will mandate new restrictions on lending activities and increased standards regarding consumer protection notification and disclosure in the loan origination process. According to the Bill, mortgage originators, creditors, and lenders will be prohibited from charging certain prepayment penalties, must make a goodfaith determination regarding their clients’ reasonable ability to repay a loan, and must establish that a concrete net benefit to the borrower exists for all mortgage refinances. The rationale behind these reforms is to ensure that the creditor is acting in the best interest of the borrower. The Bill also improves on existing regulatory inadequacies that have allowed loan originators or creditors to escape accountability for their actions. Under the proposed Bill, creditors will maintain a portion of the risk on subprime loans that they sell to investors, and consumers will be allowed to “obtain redress directly from firms involved in securitizing mortgages” (House Committee on Financial Services, 2009).

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Increase Regulatory Oversight and Accountability The fragmented mortgage origination system that has become the dominant lending system in the U.S. has greatly reduced the accountability of loan agents involved in the process. The process of mortgage origination, may involve as many as six entities (mortgage broker, appraiser, escrow, title, lender, and borrower). Each of these entities is contracted to work together on a single loan and their involvement in the process is limited by their specialization. While there are benefits to the broker system (e.g., the convenience of shopping multiple lenders), problems occur because the independent contractors have their own self-interest in mind. For example, all appraisers want to maximize profits but if their valuation approach of properties is too conservative, they will not receive much business. Thus, appraisers likely bend the rules and over inflate their appraisals just to please their brokers and maintain their clients. While over inflated appraisals benefit the borrower, they can be devastating to financial lenders. With brokers, for example, the more money

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they can squeeze out of a borrower through the sale of mortgage that contains upfront and hidden fees, costly terms and conditions, the more money the broker will make. The problem with this system is that the borrowers’ best interests are neglected and once the work is done (loan is funded and sold), it is out of the loan agent’s hands. The dominant fragmented lending system is extremely problematic. Once a mortgage is funded, loan agents are no longer held liable for inconsistencies or misrepresentations on a loan. In addition, if a lender terminates the relationship with a broker due to fraudulent practices, the broker simply uses another lender. Considering that there were over 200 subprime mortgage lenders, brokers had very little to lose if they were caught committing fraud and their relationship with their lender was terminated. While some financial lenders may require that a broker repurchase a loan if the borrower defaults within the first three months or if there is obvious fraud, this policy is rarely ever enforced. Financial lenders also did very little to share information regarding fraudulent mortgage brokers, appraisers, escrow, and title companies, which exacerbated the problem of fraud in the lending industry. Bitner (2008) noted that his subprime mortgage company “encountered fraud on a daily basis but had no mechanism for sharing information with other lenders” (p. 165), which would have reduced the ability of a broker to jump from one company to another. Aside from having a black list of appraisers with which lenders will not do business, no system allows for sharing pertinent information of criminal fraudsters. The key to reducing the prevalence of fraud in a fragmented loan origination system is to increase regulatory oversight over independent agents and increase accountability over their actions. The main problem with the subprime mortgage industry is the lack of consequences for those who commit fraud. Unfortunately, poor regulatory oversight and absent accountability can be contagious, creating a culture of highly profitable illegal loan origination practices that, if not enforced, can quickly spread within organizations and industries. Of the five mortgage sectors, the mortgage broker office is the most problematic. Mortgage brokers are poorly regulated and have a tremendous amount of authority and discretion regarding

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information on loan applications. The results of this study indicated that a significant portion of mortgage fraud emerged from the mortgage broker office. No legal apparatus or regulatory system is in place that scrutinizes loans originated by real estate or mortgage brokers. This is surprising considering that brokers originate approximately 70 percent of residential loans in the U.S. While there are several state and federal laws (e.g., Real Estate Settlement and Procedures Act, Truth in Lending Act, Home Ownership and Equity Protection Act, Fair Credit Reporting Act, and the Equal Credit Opportunity Act) by which brokers must abide, rarely is their work scrutinized unless they have been reported to authorities. Little fraud is actually reported and even when a broker, or those who are working for a one, is caught committing fraud, it is unlikely that authorities will have knowledge of it.

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Revisiting the Industry’s Approach to Compensation: An Alternative to Volume-Based Commission and Bonuses Most, if not all, loan agents in the subprime mortgage industry are paid based on a salary, commission, and bonus structure. This compensation structure rewards employees for producing the highest number of loans possible during a pay period. The problem arises when the clients’ best interest is in direct conflict with the system. In fact, an employee compensation system that rewards high funding or closing volume can never be good for the client. It does not take a genius to figure out that the more time a loan agent spends on a single loan, the fewer number of loans can be made. This is especially the case for lenders. Account managers, underwriters, account representatives, and funders focus on how much volume they can clear each month. Of those interviewed, for example, a funder stated that she was able to fund over 200 loans per month and an account manager and underwriter both claimed to fund over 100 files a month. Their priority is rarely whether a loan is best suited for a particular borrower. Instead, most loan agents who work for lenders focus on making sure that their borrowers qualify.

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Mortgage brokers make money in quite a different manner than employees of a lender. They are usually compensated by both borrowers and lenders for their services. Borrowers commonly pay their broker in the form of fees, which vary depending on the loan amount, and financial lenders usually pay brokers in the form of yield spread premiums (YSP) based on selling a higher interest rate or prepayment penalty. For example, if a borrower qualifies for a 6 percent loan, and the broker sells the loan for 6.5 percent to the borrower, the broker would earn an extra point (1 percent of the loan amount) in YSP; if the broker sells the loan for 7 percent, the earnings are 2 points YSP. The problem with this reward system is that it also fails to consider the best interest of the borrower. In fact, the higher the interest rate on a loan that the broker sells, the more money he or she will make. This contradicts the fiduciary responsibilities that loan agents should have toward their clients. This employee compensation system has made many in the mortgage industry money, while placing numerous borrowers in difficult financial situations. The mortgage industry needs to reconsider this compensation system and, instead, take a commission/bonus-forquality approach to rewarding their employees. Employees who are rewarded based on loans that are performing will likely to take into account the ability of their client to repay. One approach, for example, is a bonus system that rewards quality screening of applicants. Lenders need to consider rewarding their employees once a loan has been in good standing for six months to one year rather that immediately after the loan is funded. If, for example, a lender provided a bonus of $50 per file to their underwriter and account manager, $25 could be paid after six consecutive payments by the borrower and the remaining $25 at the one-year mark. Concerning mortgage brokers, financial lenders should adopt compensating brokers a flat fee for each loan. This would eliminate the need for brokers to place borrowers in loans that contain hidden interest rate charges and fees. While these recommendations do not directly address the problem of fraud, they address the poor lending practices that contribute to the overall problems (e.g., loose regulatory oversight, organizational culture that focuses on financial targets

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over ethical standards) that characterize the subprime lending industry. Increasing Education Standards for Loan Agents While most states require mortgage brokers to meet educational and licensing requirements, many do not require loan officers to be licensed at all. This can be especially problematic since the process of loan origination is complex and the information difficult to understand. Even when individuals are licensed, there is no guarantee they are competent loan originators. Further, a loan officer, for example, will commonly work with many different lenders, policies, guidelines, and requirements. The poor educational requirements and lack of a national educational standard for loan officers have resulted in an industry with a negative reputation. The subprime mortgage industry and the lending industry in general should consider raising its own standards (Bitner, 2008). Some general recommendations include: 1) requiring loan officers to be either licensed or educated (e.g., taking a 4-unit college-level course in mortgage lending), 2) developing a national licensing and training system for all loan practitioners, and 3) requiring mandatory continuous education for all loan practitioners.

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Recommendations Modern forms of mortgage fraud are complex; it must also incorporate understanding of predatory lending practices, as well as employee abuse of authority and power. This is the first study to examine the complex nature of mortgage fraud and its role in the subprime mortgage crisis; much more needs to be done in order to understand the social and legal implications of contemporary forms of mortgage fraud. In addition to examining the role of fraud in the secondary mortgage market, it will be important to continue investigating the racial and economic implications of mortgage fraud. As well, future studies should continue to examine mortgage fraud more generally. It will be important to consider, for example, the role of technology in contemporary forms of mortgage fraud, and ways in which the

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growth of the fragmented mortgage origination system affected the growth of mortgage related frauds. This book serves as a continuation of our overall academic investigation into whitecollar crime in the post-industrial era. The findings lend additional support to past studies that have focused on various aspects of white-collar crimes, including the role of frauds in major financial debacles, the organizational and institutional role in the commission of frauds, and the theoretical nature of whitecollar crime. Similarly, the study also provides fresh insight into the types and patterns of mortgage frauds, and how such crimes have been a product of regulatory policies, and organizational cultures and practices. The deregulation that took place during the early 1980s led to intense competition in the lending industry and as lenders of became hungrier for economic growth, their lending standards and ethical practices gave way to financial targets. A significant number of loans originated during the last decade of subprime prosperity have thus gone into foreclosure and the number of these loans that contained fraud might never be known. One interesting tale that emerged from mortgage crisis is the growth of forensic loan audit businesses. The business of forensic loan audit or loan compliance is now one of the newest and fasting growing areas of the mortgage lending industry. The service of loan auditing is an examination of mortgage documents for fraud and other related violations of law committed by a lender or broker during the origination of the loan. Borrowers are paying thousands of dollars to have an expert cross reference their loan documents with various local, state, and federal laws to determine whether the lender or broker charged excessive fees, or if there were deceptive predatory lending practices and fraudulent abusive mortgage related violations. If it is found that the broker or lender charged excessive fees for a loan, for example, borrowers may file a legal demand for a refund of fees; borrowers may also use the findings as leverage against their lender to restructure their mortgage With loan compliance, the tale of mortgage fraud in this mortgage crisis has come full circle – fraud that was used to qualify a borrower for a loan is later used as a leveraging tool against lenders. A borrower who knowingly allows his income and assets to be overstated can

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now use that specific information as leverage against a lender to reduce their interest rate or balance, or extend the terms of loan. Without adequate regulatory intervention, oversight, and enforcement, frauds of this nature will almost certainly continue.

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Statutes Cited. 18 U.S.C. § 1014 18 U.S.C. § 1344 18 U.S.C. § 1010 18 U.S.C. § 1012 18 U.S.C. § 1348 18 U.S.C. § 1001 18 U.S.C. § 1028 18 U.S.C. § 1342 42 U.S.C. § 408(a) 18 U.S.C. § 1964 18 U.S.C. §§ 1961-1965

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18 U.S.C. § 1503 18 U.S.C. §§ 1956 18 U.S.C. §§ 1957 Pub.L. 110-289, 122 Stat. 2654 100 Stat. 2085, 26 U.S.C.A. §§ 47, 1042 Community Reinvestment Act, 12 U.S.C. § 2901 (1977). Mortgage Reform and Anti-Predatory Lending Act, 15 U.S.C. § 1641 (2009). Real Estate and Settlement Procedures Act, 12 U.S.C. § 2601 (1974). Cases Cited. 1.

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2. 3. 4. 5.

United States v. Hitchens, 2002 WL 31898234 (3d Cir. Nov. 19, 2002). McElroy v. United States, 455 U.S. 642, 653-54 (1982) United States v. Bond, 231 F.3d 1075 (7th Cir. 1990) United States v. Jack, 2007 WL 329838 (11th Cir. Feb. 6, 2007) SEC v. Robert Lafee Citron, SACV 96-0074 GLT (EEx) (C.D.Cal.)

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Index

Bear Stearns, 1, 3, 74, 168 Broker, 13, 65, 95 Bush, Georges, 115, 149 Carter, Jimmy, 20 Community and Reinvestment Act, 113, 117, 119, 141 Concerted ignorance, 94, 169 Corporate Scandals, 43 Criminal act, 40 Criminogenic, 48 Culture, 56, 109 Envrionment, 46 Industry, 52, 75, 76, 83 Opportunity, 126 Organization, 46, 81 Data fabrication, 94 Depository Institutions Deregulatory and Monetary Control Act See, DIDMCA, 18 Deregulatory policy, 6 DIDMCA, 18 Failure, 18 Discrimination Mortgage, 116

Affordability, 138 Illusion, 137 Stability Plan, 149 African-American, 115, 120, 121, 127, 131, 135, 140 Credit score, 121 Disadvantaged, 129 Homeowners, 114, 127 Homeownership, 126 Alternative Fraud, 126 Lending program, 116 Mortgage, 19, 21, 22, 25, 35, 75, 80, 81, 101, 104, 121, 122, 124, 129, 130, 140, 146, 151 Perspective, 47 American dream, 113, 115, 123, 126, 130, 131, 137, 141 AMP, 130, 131 Minorities, 130, 131, 133 Appraiser, 11, 100 Backed security, 7, 22, 23, 24, 75, 101, 104, 146 Bankruptcy, 26, 43, 125 181

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182 Enforcement and Recovery Act (FERA), 30 Equality, 121, 128 Escrow, 7, 34, 65, 99 Fair Housing Act, 116, 140 Fannie Mae, 149 FICO (Fair Isaac Corporation), 12 Financial crime, 36, 37 FinCEN, 3, 24, 25, 31, 32, 36, 95 Foreclosure, 9, 12 Fraud, 2, 3, 34 California, 33 Categories, 87 Cost, 3, 42 Criminal, 9 Definition, 8 Financial crisis, 38 Financial debacles, 26, 38, 40, 125, 157 Global crisis, 4 Housing crisis, 67 Model, 39 Types, 40 Fraudulent practices, 106, 125, 127, 128, 153 Georgia Residential Mortgage Fraud Act, 30 Governmental policy, 7 High-risk loans, 114 Hispanics, 115, 120, 127, 131, 135 Disadvantaged, 129 Hybrid loan, 106, 122, 151 Identity theft, 32, 37 Inequality, 115, 124 Racial, 129 Loan Officer, 12, 95

Index Loan Processor, 12, 95 Madoff, Bernard, 4, 31 MBS See Backed security, 104 McElroy v. United States, 27, 178 MIDEX system, 33, 34 Minorities Credit, 114 Denial of credit, 140 Discrimination, 113, 116, 121 Financial industry, 126 Home crisis, 136 Homeownership, 115 Loan products, 123 Mortgage, 129 Subprime, 116 Victimization, 10, 116, 130 Mortgage Bankers Association, 1, 3, 9, 26, 30, 32, 68, 134 Mortgage Broker, 13, 23, 68, 95 Mortgage Reform and AntiPredatory Lending Act of 2009, 151 New Century Financial, 3 Obama, Barack, 30, 142, 149 Organized Crime, 44 Predatory Lending, 9, 10, 68, 119, 137, 178 Predatory practices, 10, 104, 118, 120, 124, 126, 127, 132, 134, 136, 147, 151, 156, 157 Primary Mortgage Market, 13 Racial discrimination, 121 Reagan administration, 17

Index

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Real Estate and Settlement Procedures Act, 99, 178 Refinance, 21, 52, 78, 82, 94, 97, 99, 104, 127, 135, 139, 149, 152 Minorities, 137 SAR, 32 SEC v. Robert Lafee Citron, 178 Secondary mortgage market, 13, 74, 156 Subprime, 4, 14, 15, 17, 18, 21, 22, 62, 84, 101, 107, 122, 132, 133, 134, 136, 163, 165, 168 Crisis, 1, 2, 4, 8, 25, 53, 67, 73, 75, 106, 113, 126, 140, 146 Disaster, 114 Fraud, 5, 54, 56, 75, 153

183 Industry, 5, 6, 7, 8, 20, 22, 24, 40, 65, 68, 101, 106, 121, 123, 129, 136, 146, 147, 150 Lenders, 57, 66 Market, 7, 56, 122 Mortgage, 2, 3, 6, 10, 14, 22, 66, 115, 119, 123, 124, 129 Organization, 16 United States v. Bond, 27, 178 United States v. Jack, 27, 178 Wall Street, 22, 23, 24, 25, 52, 67, 74, 101, 104, 105, 149, 176 Mortgage-backed securities, 119 White-collar crime, 4, 5, 6, 7, 8, 25, 38, 40, 43, 44, 45, 47, 56, 83, 157 Wire Fraud, 27