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Pursuing
the Predators: Regulators’ Response to Mortgage Fraud According
to RealtyTrac, Inc., foreclosure rates nationally rose 27 percent
in the first quarter of 2007 over the previous quarter and were up
35 percent from the same period in 2006. Foreclosure rate increases
in Minnesota were even more startling, reflecting a 35 percent increase
over the previous quarter and as much as a 130 percent increase over
the first quarter of 2006. The spike in foreclosures and a related
downturn in the housing market have sent ripple effects throughout
the national economy, causing regulators and consumer advocacy groups
to stand up and take notice. Everyone is pointing a finger at someone
and asking, “Who is to blame?” No
Single Villain In
actuality there is no single “big bad wolf” who is responsible for
the crisis in the housing market, but rather, many players are involved.
The one thing that regulators all appear to agree upon, however, is
that fixing the problem demands clamping down on predatory lending
practices and ramping up enforcement actions against mortgage fraud.
Mortgage
fraud can take many different forms, and may be perpetrated by a variety
of players. Mortgage fraud investigations frequently target mortgage
brokers, who process mortgage applications, act as intermediaries
between buyers and lenders, and are at the center of many transactions.
Because they are typically paid commissions for their services based
on loan amounts, mortgage brokers are strongly motivated to obtain
lenders’ approval for buyers’ applications. Brokers who become overzealous
in seeking such approval may find themselves on the wrong side of
a civil or even criminal fraud investigation. A typical example is
the broker who is alleged to have intentionally overstated the buyer’s
income or assets on an application in order to dupe the lender into
approving it. This
kind of approval became easier to obtain with the advent of “no-documentation”
or “stated-income” loan transactions. In these transactions, a borrower
pays a higher interest rate and the lender, in exchange, relies on
the income representations made on the application without demanding
supporting documentation or making substantial efforts to verify those
representations. Minnesota Attorney General Lori Swanson argued for
regulations against stated-income loans in testimony before the Board
of Governors of the Federal Reserve System on June 14, 2007. According
to Attorney General Swanson, the intended purpose of stated-income
loans is to provide an avenue of approval for self-employed individuals
and others whose income is not derived from a regular paycheck subject
to verification. Instead, she says, they have become an avenue for
unscrupulous brokers who have falsified applications “to claim that
octogenarians hauled in cash by making bird houses they didn’t make
or cleaning houses they didn’t clean, that a gardener in his early
20s made $6,000 per month as a ‘landscape engineer,’ or that a suburban
couple earned money renting out a nonexistent apartment in their home.” A
mortgage broker who intentionally inflates a buyer’s income may feel
morally justified in doing so, on the ground that he is helping the
buyer obtain a home that otherwise she would not be able to afford.
The broker may point out that many such transactions are successful:
When the buyers are able to meet their obligations everyone wins,
including the lender. Such is not the case, however, when the buyer
finds herself overextended and cannot make the required payments.
Then the buyer loses the home and the lender typically sustains substantial
losses when the outstanding balance is not recovered in the foreclosure
sale. Fraud
Takes Many Forms Although
mortgage brokers are easy political targets for state and federal
regulators attempting to assign blame, it should be acknowledged that
the buyers themselves are often at fault. Buyers may intentionally
inflate their own incomes, with or without the brokers’ knowledge,
and place themselves in the precarious position of assuming obligations
they cannot afford. To view the problem solely as an issue of mortgage
industry opportunists taking advantage of poor, unsophisticated consumers
is to ignore the responsibility that some buyers share for making
their own bad decisions. After all, the moral of the fairy tale is
not simply that wolves are bad, but rather, that smart pigs will not
build their houses out of straw. Buyers
may become embroiled in mortgage fraud investigations in other ways,
as well. Take, for example, the case of Isadore Stewart and Jill Lehn.
In December 2006, Stewart, a real estate buyer, and Lehn, a closing
agent, pleaded guilty in federal court in Minnesota to criminal wire
fraud charges arising from mortgage transactions. According to court
documents filed in the case, Lehn prepared closing documents related
to over 60 real estate transactions that deliberately overstated the
true purchase price for the properties. Lehn allegedly concealed from
lenders the fact that a portion of the loan proceeds would be redistributed
to buyers, such as Stewart, and other parties. The government alleges
that buyers obtained a total of over $3 million in concealed payments
in these transactions, and that Stewart personally derived over $271,000
from three separate real estate purchases. Neither Stewart nor Lehn
has yet been sentenced, but both face maximum potential penalties
of up to 20 years in prison and $250,000 fines. As
the case of Stewart and Lehn suggests, mortgage fraud investigations
tend to focus not on individuals acting alone, but rather, on an alleged
conspiracy of individuals, each of whom may play a different role
in the transactions at issue. Such is the case in a typical “flipping”
scheme. Flipping occurs when a real estate investor purchases a home
and then resells it within a short period of time for a higher price.
Usually there is nothing illegal about these transactions and, when
the buyer makes improvements to the home before reselling it, the
practice can be beneficial to a community by raising property values.
Flipping becomes fraudulent, however, when the investor colludes with
a dishonest appraiser, who intentionally overstates the appraised
value of the home so that the investor can resell it for a grossly
inflated profit. A flipping scheme can take advantage of an unsuspecting
buyer or, when the buyer himself is a participant in the conspiracy,
leave the lender holding substantial losses when the buyer allows
the home to go into foreclosure and the lender is unable to recover
the outstanding balance of the loan. “Equity
stripping” is another practice that has raised concerns among regulators.
Equity stripping typically targets homeowners who are experiencing
financial distress, have fallen behind in their mortgage payments,
and are facing a risk of foreclosure. Usually a homeowner attempts
to refinance and is turned down by the lender. A foreclosure notice
is published in the local newspaper and is read by a “foreclosure
rescue” firm, which approaches the troubled homeowner offering help.
The foreclosure rescuer pays off the balance owed in foreclosure,
acquires title to the home, and agrees to reconvey the property to
the homeowner under the terms of a lease or contract for deed. This
kind of arrangement may be considered predatory if the terms of the
lease or contract are unreasonably high, resulting in the homeowner’s
inability to pay and ultimate eviction from the home, while the “rescue”
firm retains ownership and the homeowner’s equity in it. It becomes
fraudulent if the firm knowingly misleads the homeowner about any
of the terms of the arrangement. In
June of this year, the Minnesota Office of the United States Attorney
led a grand jury to indict a former mortgage broker and his assistant
in an alleged equity-stripping scheme that went a step further. According
to the indictment, they encouraged distressed homeowners to refinance
and then used physical intimidation to force the homeowners to endorse
the equity checks produced in the refinancing process over to themselves.
The two now face charges carrying a maximum potential penalty of 20
years in prison. Such
bold schemes are not uncommon. The United States Attorney’s Office
also had the president of a title and escrow company indicted this
past June. The indictment alleges that she opened an escrow account
to deposit funds from lenders for real estate closings, but then transferred
the money to her own personal account and used it to pay about $2.5
million in personal expenses. Not
all problems in the housing market can be attributed to blatant misconduct.
Commentators are also raising concerns about lending practices that
are not illegal, but nevertheless may be viewed as predatory. They
point to insufficient disclosures to consumers, overly ambitious prepayment
penalties, and exorbitant closing costs. Brokers are not the only
parties implicated by these concerns. Commentators also point to lawyers
who fail to properly advise their clients of the risks associated
with transactions, lenders who fail to apply sufficiently rigorous
underwriting standards, and even secondary market investors — who
some argue should be liable to homebuyers for failing to conduct proper
due diligence before taking assignment of questionable loans. Regulatory Response: Minnesota Concerns
about mortgage fraud and predatory lending practices have led state
and federal lawmakers to push for new legislation targeted at cleaning
up the mortgage industry. On May 14 of this year, Governor Tim Pawlenty
signed a predatory lending practices law (S.F. No. 988) that — for
the first time in Minnesota — specifically defines residential mortgage
fraud as a criminal offense. Under the terms of the new law, which
went into effect on August 1, “residential mortgage fraud” is defined
as knowingly making or using any misstatement, misrepresentation or
omission that is both “deliberate” and “material” during the “mortgage
lending process” with the intent that any party to the mortgage lending
process rely upon it. The “mortgage lending process” includes virtually
every step in a mortgage transaction, including solicitation, application
or origination, negotiation of terms, third-party provider services,
underwriting, signing and closing, and funding of the loan. Documents
involved in this process include required disclosures, loan applications,
appraisal reports, HUD-1 settlement statements, and supporting personal
documentation for income verification, such as W-2 forms, bank statements,
tax returns and payroll stubs. Violating the law can lead to a felony
conviction with a maximum term of imprisonment of two years, and mandatory
restitution to any identified victims. In addition to enacting new
criminal penalties, the law also contains provisions prohibiting prepayment
penalties for subprime loans and creates a private civil right of
action for borrowers injured by violations of the affected statutes
and other state mortgage laws. This
new law joins another new predatory lending practices law approved
by Governor Pawlenty on April 20 (H.F. No. 1004), which also became
effective August 1. Although the new law establishes no new criminal
penalties, H.F. No. 1004 included a number of provisions targeted
at predatory lending practices, including: a prohibition against stated-income
loans; a requirement that mortgage originators verify borrowers’ ability
to make scheduled payments; a prohibition against “churning” (arranging
a refinance that provides no tangible benefit to the buyer); a requirement
that originators make disclosures to buyers about anticipated property
taxes and hazard insurance costs; a prohibition against mortgage repayment
options resulting in negative amortization; and a provision establishing
fiduciary duties owed by mortgage brokers to borrowers as their agents. These
new laws complement Minnesota’s equity-stripping statute, which was
enacted in 2004 and codified at Minn. Stat. ch. 325N. That law imposes
strict disclosure and other requirements on any investor who purchases
a home in foreclosure and subsequently reconveys or promises to reconvey
continuing rights to the homeowner to possess the property. The equity-stripping
statute creates criminal penalties against any such investor who defrauds
a homeowner, including imprisonment of up to one year and fines of
up to $50,000 (Minn. Stat. §325N.18). Regulatory Response - Federal Federal
regulators are similarly working to strengthen legislation against
mortgage fraud and predatory lending practices. On July 12, Rep. Spencer
Bachus and several other representatives introduced a 71-page bill
to establish the “Fair Mortgage Practices Act of 2007” (H.R. 3012).
Many of the provisions of the bill would explicitly preempt state
law on the same subject, including certain applications of Minnesota’s
new predatory lending laws. The proposed legislation addresses mortgage
fraud and predatory lending practices on multiple substantive and
procedural fronts. Its requirements are too voluminous and complex
to describe here in exhaustive detail, but some of its more innovative
provisions are worth noting. The
bill seeks to establish a national registry and licensing system for
residential mortgage originators which would, among other things,
require registrants to undergo background checks and provide fingerprints
and would deny licensure to applicants with felony convictions during
the prior seven-year period. The bill also mandates consumer-counseling
referrals and the use of escrow accounts in connection with subprime
mortgages. The proposed legislation imposes additional duties on the
Department of Housing and Urban Development (HUD), creating a separate
“Office of Housing Counseling” within HUD, and requiring HUD to conduct
a study into the root causes of foreclosures. The proposal places
limits on the assessment of prepayment penalties for certain hybrid
fixed-rate/adjustable-rate mortgages, and contains an antiflipping
provision that mandates a second appraisal for homes resold within
the first six months after purchase. Finally, if this bill is passed,
the federal government will appropriate an additional $20 million
for fiscal years 2008-2012 “for the purpose of enhancing the efforts
of the Department of Justice and the Federal Bureau of Investigation
to prevent, investigate, and prosecute mortgage fraud.” When
law enforcement agencies put an entire industry under the microscope
everyone involved feels the impact, because with increased enforcement
comes a substantial risk of over-enforcement. Wide traps set for the
big, bad wolf are likely to catch a lot of innocent parties, too.
Even honest practitioners may find themselves under investigation
for alleged crimes in which they were no more than unwitting participants.
Although these unfortunate companies and individuals will have strong
defenses to any criminal charges levied against them, the emotional
toll on individuals and the costs of defense — in legal fees, lost
productivity and lost business — may be devastating. For these reasons,
anyone working in the residential mortgage industry should tread very
carefully. It is important to exercise caution and avoid even the
appearance of wrongdoing, so that the propriety of any transaction
under scrutiny is indisputable. DULCE FOSTER is a shareholder in Fredrikson & Byron’s White
Collar & Regulatory Defense and Commercial Litigation groups.
Her practice focuses on white collar criminal defense, administrative,
and regulatory matters. |
