Whether it be interest-only, high LTV, high DTI or a 50-year-mortgage, for years subprime mortgage investors have weeded out one type of loan or another fearing borrower default. But the one wild card that continues to rear its ugly head - fraud - is not always found in the expected places.
For example, if one were looking for mortgage fraud, most would point directly to no, or limited, documentation loans, which are also known as "liar loans." But while most CDO managers say they either shy away from such loans altogether or carefully choose the originator they'll buy them from, the effects of mortgage fraud on the least expected products could hurt buy-and-hold investors given the U.S. housing market's downward spiral.
Tightened underwriting standards are eliminating the more traditional routes to fraud. And those who rely on mortgage origination to pay their own bills - such as mortgage brokers - are expected to become more desperate to place borrowers in homes. "There are shops out there where it is an actual arts and crafts show," said one Los Angeles-based mortgage broker. This broker detailed stories of brokers actively using Adobe Photoshop to forge bank statements, employment records and rental histories, among other tricks.
The Mortgage Asset Research Institute (MARI) revealed last week that instances of mortgage fraud reported to its intra-industry database climbed 30% in 2006 from 2005. Interestingly, a recent surge in fraud reports managed to shake up what had been the typical state strongholds of mortgage fraud, such as Georgia and Michigan.
Florida was the No. 1 ranked state in terms of mortgage fraud for 2006, based on voluntary reports to MARI's database, up from fourth place in 2005 and 19th place in 2004. Meanwhile, California moved up to second place in 2006, from eighth place in 2005 and 19th place in 2004. (States are ranked based on the ratio of reported fraud cases to overall loan origination volume.)
The higher profile of these two states at the close of 2006 has a number of market participants nervous. It makes them ponder how much fraud will creep to the surface amid dismal home price appreciation - and how much might still be going on.
Topping the list of reported mortgage fraud incidents in 2006 were inflating income and fudging employment history. But given that the overwhelming number of fraud incidents was uncovered on loans originated less than a year ago, are these two misrepresentations simply the most likely factors to impact a borrower's true ability to pay out-of-the-gate? And if so, will loans affected by smaller, less obvious, infractions - such as a broker temporarily transferring money to a borrower's bank account - be less likely to be weeded out of securitizations through early payment defaults and, consequently, impact investors such as CDOs the most in a cruddy housing market?
Time will only tell. According to MARI, it will likely take three to five years to uncover most of the fraud that exists in the 2006 vintage.
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