On this topic, anyone who likes to read absurdly long posts can check out the following, which I recently submitted as a prospective column to a SoCal newspaper:
Yo ho, yo ho, a pirate’s life for me.
As financial markets reel from the biggest credit contraction in at least a decade, the world is getting a good look at just how buccaneering a business the mortgage industry got to be during the late boom. Amid the general fingerpointing, a basic truth is emerging: The real estate market can handle stated-income loans, or teaser-rate mortgages — but not both.
Stated-income loans, in which the borrower’s income isn’t verified, aren’t called “liar’s loans” for nothing. Until recently, though, financial reality placed a limit on how shameless cheaters could get. Since mortgages generally had to be fully serviced from the beginning, if a borrower’s ability to make the payments was overstated, he tended to default quickly. However, when stated-income loans are married to low initial “teaser” rates, a monster is born. Because only a minimal payment must be made at first, deceptions are masked, and the dishonest borrower can coast along for a year or so before his inability to fully service the loan comes into play. In that time, the originator of the mortgage can sell the loan into investment markets, offloading much of the default risk. The borrower, for his part, expects his property to appreciate rapidly, allowing him to refinance or sell at a profit before the payment adjusts beyond his ability to pay. Everybody’s happy — until appreciation stops. Then things get ugly.
Studies and anecdotal evidence suggest that this kind of activity was widespread during the past boom. Fraud ranged from simple exaggeration of income, either by the borrower or an unscrupulous mortgage broker, to sophisticated collusions between borrowers, brokers, agents, appraisers, and sellers to secretly kick excessive cash back to the buyer upon closing. The result is innumerable loans obtained on false premises, where the expiration of teaser-rate periods is exposing the disparity between what borrowers stated as their income and reality. Real economic destruction looms, as a result of this vast misallocation of credit resources.
Mortgage fraud is a federal crime, punishable by imprisonment. Unfortunately, law enforcement resources are limited, and the authorities can’t investigate a fraction of the offenders. General civil remedies may also be inadequate, since the parties most directly injured may have incentives to avert their eyes from fraud in loans sold to investors, lest contractual duties to buy back tainted loans or mark down their value be triggered.
Interestingly, the government sometimes enlists the help of private citizens to combat some kinds of fraud. The federal False Claims Act provides a procedure for private citizens to bring so-called “qui tam” suits (in which the citizen sues on behalf of the government) against perpetrators of fraud in government contracting. If they prevail, they share in the government’s recovery.
Many states, including California, have enacted similar laws. Intriguingly, California law also allows “qui tam” suits against perpetrators of insurance fraud. Thus, “qui tam” suits are not always limited to cases in which the government is a direct victim. They have also been authorized when private frauds have such a damaging effect on the general economy that the government is willing to essentially “deputize” citizens — and provide them with healthy financial incentives — to assist with enforcement that the government cannot handle alone.
In the golden age of piracy, governments often resorted to issuing Letters of Marque and Reprisal, authorizing privately-owned vessels to cruise as “privateers” against hostile shipping. The recent golden age of mortgage buccaneers calls out for a new birth of privateering. The federal and state governments ought to seriously consider authorizing qui tam suits against participants in mortgage fraud. Downsized employees of mortgage boiler-rooms, honest brokers, Realtors, and appraisers who lost business to corrupt competitors, and sharp-eyed amateur analysts would make excellent qui tam plaintiffs. Turn these citizen privateers loose upon the mortgage pirates, and watch how fast the bad actors shape up.