The meltdown’s Main Street

NEW YORK – Sept. 30, 2008 – Journalists like simple stories with clear-cut villains. So, in the financial crisis, Time magazine tells us that Wall Street “sold out” America, while The New York Times decries “Wall Street’s . . . real-estate bender.”

Such chatter makes it easy to forget that this mess began with a heap of bad mortgages made by consumers who never came within a hundred miles of the cardsharps on Wall Street.

The inability (and in a good deal of cases, the unwillingness) of these ordinary Americans to pay back these loans (many sitting in mortgage-backed securities held by institutions around the world) helped tilt us toward this systemic threat to our financial system.

Even as we focus on bad bets and lousy leverage ratios on Wall Street, these toxic mortgages continue to unwind. As they do, we’re getting a better look at how they were made – and it’s not pretty. It’s clear that speculation and fraud – much of it on the part of borrowers – were rampant.

Indeed, mortgage fraud not only soared in the run-up to this mess, it’s still rising. The FBI says that reports of suspicious mortgage activity jumped tenfold from 2001 through 2007. And the Mortgage Asset Research Institute says it rose another 42 percent in this year’s first quarter.

As more mortgages have gone bad, researchers have looked into troubled portfolios and found startling rates of deception. For instance, the research firm BasePoint Analytics has estimated that 70 percent of subprime loans that default before they reset (exactly the kind that trouble the market right now) contain some kind of misrepresentation by the borrower, lender and/or broker.

One big category of deception: So-called no-doc loans, where the borrower agrees to pay a slightly higher interest rate in exchange for not documenting his income. Originally designed for self-employed workers who don’t have ready documentation from an employer, these mortgages became known as “liar loans,” because many people without sufficient income used them to qualify for financing they otherwise couldn’t get.

One lender compared what 100 applicants claimed as income on no-doc loans to what they reported to the IRS on their tax returns – and found 60 percent of borrowers were exaggerating their income by as much as half (or lying to the IRS).

Speculators are also part of the problem. As the housing market rose, more people got into the game of betting on higher prices by purchasing homes that they intended to flip quickly without ever occupying. As this grew popular, applicants starting lying about their intentions. They wanted to fool developers who’d grown wary of selling too many homes in new developments to people who’d never occupy them, since these are the buyers most likely to walk away from a mortgage when the market turns down. BasePoint Analytics has estimated that this form of misrepresentation accounts for 20 percent of mortgage fraud.

The Mortgage Bankers Association reported recently that the vast majority of delinquent mortgages and homes in foreclosure are in a handful of states (led by California and Florida) where the housing bubble was largest and where speculation was common. Together, these states accounted for a whopping 58 percent of all subprime adjustable-rate mortgages that went into foreclosure in the second quarter of this year.

In fact, so concentrated are the problems that only eight states have foreclosure rates above the national average. While the rate of new foreclosures for subprime ARMs in the quarter was a whopping 6.63 percent, it was just 0.34 percent for traditional fixed-rate mortgages. “For the quarter, a majority of states saw relatively little change” in their foreclosure numbers, notes the MBA report.

The ongoing fraud is still concentrated in the “meltdown” states (again led by Florida and California). In those states, moreover, the fraud reports are most common on properties near the coastlines – that is, in areas where many purchases are for speculation or investment (that is, not for a home to live in).

The FBI warns that a sinking market is ripe for new types of fraud, as individuals try to get out of a fiscal mess using further misrepresentations or as scam artists perpetrate fraud under the guise of helping consumers stuck in bad loans.

Since we seem to have had a generation of mortgage borrowers who at the least didn’t understand the loans they took out, and at the worst were committing fraud, that FBI warning suggests we won’t see the end of the bad-mortgage crisis anytime soon.

On the bright side, there won’t be a lot of investment banks packaging these new bad loans into toxic securities that threaten the world financial system.