In various ways, 2008 feels like a distant memory. But something in the air feels eerily familiar to the run-up to the mortgage meltdown that year.
Today, increased pricing combined with rising interest rates is ushering in a climate in which demand for refinances and purchases is limited. As we know from the last crisis, when the mortgage industry gets squeezed, we see a spike in “creative” financing. These unusual instruments helped turn the American dream of homeownership into a terrifying financial situation and played a key role in bursting one of the largest bubbles in recent economic history.
Opportunistic lending houses and financial institutions wagered that American consumers would do anything and everything possible to make mortgage payments, and therefore “eased” their underwriting guidelines to grant borrowers nearly any sum toward a real estate purchase, provided that property could pass appraisals. Borrowers with little or no experience in the real-estate market were lured in by the promise of low payments and low interest rates on properties they once thought were completely out of reach. In some of the worst cases of fraud, forged documents, fraudulently reported (inflated) income and even stand-in “straw” buyers worked hand-in-hand with mortgage originators and even lenders themselves to process what were essentially fictional borrowers with minimal oversight or due diligence.
With more “money” to spend, property prices in major markets skyrocketed due to a competitive sellers’ market and ever-increasing bids for properties that could not sustain such prices. This created a tremendous secondary market for existing homeowners who were tempted by the opportunity to take out thousands and thousands of dollars in property equity for any number of purposes ranging from debt payoff, to property improvements, to vacations and more.
Unfortunately for lenders and borrowers alike, the continuous cycle of irresponsible lending never had any chance of being sustainable long term. As markets settled back down, many homeowners now found themselves “underwater” and owing more in mortgage payments than their property values were worth. For some, large balloon payments from variable interest rate loans hit borrowers with massive cash payments due for which they were uninformed and/or ill-prepared to fulfill. But borrowers weren’t the only targets. Investors were also encouraged to lie about intent to occupy purchased properties since lenders preferred the lower rates of default typically associated with owner-occupied real estate. In truth, many of these properties ended up as “flips” — a renovated property that is renovated and then resold for a profit. Investors took advantage of owner-occupied status as a work around for capital gains taxes, and further inflated prices in hot real estate markets, thus starting the cycle all over again with new borrowers asking for money that they did not have the means to repay. Knowing this was potentially the case, mortgage originators and “non-banks” would package real estate holdings into mixed securities and then re-sell them to other financial institutions as elements within that institution’s investment funds. When the bubble eventually did burst, everyone left with attachments to failing mortgages or securities were left holding the bag to the tune of millions of dollars in financial losses.
To prevent another nightmare for unwitting borrowers and the financial markets, the government went to great lengths to regulate the mortgage industry. In response, the U.S. mortgage industry splintered into origination by highly regulated banks and far less regulated nonbank mortgage originators. While in 2007 nonbanks accounted for 20% of originations, by 2016 these nonbanks accounted for half of all mortgage originations.
Yet there are signs in the nonbank mortgage market that now indicate there may be serious issues ahead.
Without a robust refinance market, new homeownership must significantly grow to sustain the mortgage market, but it is also not a buyer’s market. The median price of a home has risen from just under $150,000 in 2016 to approximately 200,000 in 2018. This median house price is now roughly the same as it was in 2007. As of May 2018, in the capital of mortgage fraud — aka Miami — the median price rose 7.7% year over year to $350,000 while the demand for homes decreased 8.5% year over year.
With decreased demand comes a situation that is ripe for mortgage fraud. After all, brokers and originators can only earn a living if people are buying homes or refinancing. So, pushing a product like no-prime loans offers a way for these businesses to stay afloat. While some believe that pricing and inflation are to blame for a shortage of qualified buyers, others point toward signs of the market being at a saturation point as opposed to inventory.
Historically, outside of the great financial crisis, the homeownership rate in America fluctuates between 62% and 65%. Over the past several years, the homeownership rate has been steadily increasing to its current level of 64.2% — on the high end of the historical “healthy” homeownership rate. As this number rises, the number of unqualified homeowners typically gets significantly larger, driven by competition among buyers/borrowers. Often, the first indications of an influx of unqualified buyers can be seen in the disparity between mean reported income and earnings as listed on state and federal income tax statements, and the mean incomes being used to justify mortgage applications in the same geographic regions.
Other signs that mortgage professionals may be engaging in fraudulent activity include: significant adjustments to sales prices that are not supported by comparable market data (comps), notes that MLS listings are being changed to reflect “appraised” value, required use of a specific appraiser and the prevalence and/or expansion in down-payment assistance programs that charge excessive fees to buyers and borrowers while also “concealing” their involvement on contracts and loan documentation.
When one, some or all of these factors are in play, the rise of unqualified homeowners creates a marketplace ripe for fraud (again). Subprime mortgages have made a comeback and have been rebranded as “no-prime loans.” In fact, $4.1 billion of securities backed by subprime loans were issued in 2017 and $1.3 billion of these kinds of securities were issued in the first quarter of 2018 (more than double the first quarter of 2017). Cleverly marketed as a “second chance” for less-than-perfect borrowers, subprime and no-prime loans can be easily manipulated to prey on less experienced or otherwise challenged borrowers. Those who fail to meet underwriting requirements for debt-to-income ratios or who have credit scores at or below 640 can find it nearly impossible to qualify for the best possible/lowest interest rates for mortgages. Prime in this case simply means, the lowest rate available on the market. Sub-prime, no-prime and near-prime loans are all ways to say “anything that’s not the best/prime rate.” Borrowers who pursue no-prime loans are very often convinced that unfair rates, punitive terms and excessive fees are par for the course for “that kind of borrower.” As such, they end up paying far more to borrow money on top of an over-inflated real estate asking price. Interest-only loans and adjustable-rate mortgages should be carefully looked at, with projected amortization schedules that reflect the highest possible increases and decrease to the rate.
In as little as 18 months, borrowers may indeed be looking back and asking: How did I end up with a mortgage that I can’t afford for a house that is not worth the price? Correspondingly, lenders will wonder as to how they are inundated with borrowers who are unable to pay and collateral that is worth substantially less than advertised.
Current market conditions are forcing brokers/banks to use their creativity, ethical or not, in loan processing to get homeowners qualified. This, ultimately, will give rise to fraudulent market conditions that are already once again showing signs of life.