By William K. Black
“My name is Steven Krystofiak, President of the Mortgage Brokers Association for Responsible Lending.” That is how Krystofiak began his written statement to the Federal Reserve concerning mortgage fraud. It is a follow-up to his oral testimony at a Federal Reserve hearing on June 16, 2006 at the FRB San Francisco entitled: “Responsible Lending and Informed Consumer Choice, Public Hearing on the Home Equity Lending Market.”
Krystofiak came to warn the Fed about “liar’s loans.” The Fed, and only the Fed, had the authority to prevent the fraud epidemic unleashed by liar’s loans. He came to warn that lenders and their agents, mortgage brokers, were putting the lies in liar’s loans.
The Fed did not invite Krystofiak to speak at the hearing. He took advantage of the “open mike” session at the end of the hearing. The Fed did invite the Mortgage Bankers Association to speak. The MBA chose IndyMac to represent it – further proof of our family rule that it is impossible to compete with unintentional self-parody. The MBA had roughly 3,000 members, a plurality of them located in California. It could have chosen from hundreds of firms to represent it at the hearing. It chose the world’s largest lender specializing in making fraudulent liar’s loans as its representative. There was no question where the MBA stood on the desirability of liar’s loans.
The Fed gave Krystofiak only moments to present his warning.
“I’m a mortgage broker that has access to a loan where I can do 100 percent financing, meaning no down payment, stated income. That means the stenographer here could tell me she’s making $200,000 and I’ll believe it. She could also tell me that she has $500,000 in the bank. I’ll believe that, too.
She could also have a FICO score of 620, where 680 is average. So she could have a very low, low FICO score. And I could get her a loan for $950,000. That is scary, also. Banks are lying when they tell you that stated income is only for people with high FICO stores.
Some people might say that there’s a reason why stated income — it helps people get homes. It does. It gets people homes who are on a cash business. I don’t believe that banks should be rewarding people who only make cash, don’t pay taxes, with easier ways to buy a home. I also believe that that makes it an easier tool for people to get homes that they truly cannot afford.”
At this juncture they cut him off, asked no questions, and invited him to present a written statement for the record, which he did. Krystofiak’s written statement is available on line.
I provide key excerpts from Krystofiak’s statement with my brief synopses of the analytical points he is making.
“Currently we see stated income and stated asset loans as the largest problem in the real estate industry.
1. Stated income loans are associated with fraud, and started to become popular in 2002.
A stated income loan is a loan where the income that is put on a home loan application is not verified at all by the banks. The banks simply take your word for it. Home buyers might be unaware of the fraudulent income that is being stated on the loan application because the loan officer, or bank representative have the power to falsify the income on the application.
Stated income loans became popular in 2002, and have since become mainstream. According to one survey it was discovered that 37% of all loans sold in the United States are originated without income being proven. In areas where homes are the least affordable (i.e. California, and Florida) that number grows to over 50%. Some banks doing business nationwide are reporting that close to 80% of loans originated are stated income loans. Fraudulent stated income loans in many cases are the only way for individuals to obtain a home.”
Stated income loans are typically fraudulent and the lender and its representatives often supply the false statements about income. The number of fraudulent liar’s loans is staggering and is leading the continued expansion of real estate in the least affordable regions. Fraudulent loans are heavily concentrated at some major lenders that do nationwide business. They are at risk of failure due to the frauds.
“Since 2002 the United States has seen an enormous appreciation rate on single family homes. During the same period Americans have accumulated millions of dollars of credit card debt, partially due to high unaffordable mortgage payments. Homeowners have been “cashing out” their equity to pay other outstanding debts in alarming numbers in recent years. This cycle is the reason why currently there is a small default rate on stated income loans. Once appreciation goes flat the cycle of “cashing out” will no longer keep default rates low. Stated income loans need to stop now before thousands of new home buyers buy property that they cannot afford.”
The huge losses made inevitable by fraudulent loans are being hidden by the hyper-inflation of the real estate bubble. The housing bubble has allowed American homeowners to go into unsustainable credit card debt. It is vital to stop more fraudulent loans from being made.
“3. Fraud is encouraged by the banks
A large problem as to why these loans have become so prevalent is because the first line of defense against stated income loan fraud are individuals who are commission based; the loan originator, the bank representative, and in many cases the managers for the bank reps have a large portion of their income derived from bonuses based on loan production. Bank employees, i.e. underwriters and bank processors, return applications back to mortgage brokers with instructions to send back an application with a higher stated income. The mortgage industry has become comfortable with stating incomes higher on loan applications.
Online underwriting systems that are used by Fannie Mae and some banks are being exploited by bank representatives and loan officers wanting to obtain a loan with stated income underwriting standards but with fully documented interest rates. The systems allow mortgage brokers to “play” with different incomes more than 15 times until they get the results they want.”
Nobody is making the banks make fraudulent loans. They have shaped their compensation to incentivize fraudulent lending. Instead of being a restraint on fraud, the automated underwriting systems are an aide to fraud.
“4. Stated income loans help no one. Stated income loans cost consumers hundreds of dollars a year because of higher interest rates.
Because of stated income loans, home prices have gone up so dramatically that homes are now unobtainable for Americans wanting to use loan officers unwilling to commit fraud.”
Stated income loans hurt the consumer because they cost more and save nothing.
“5. Exotic loans originated with stated income are now causing foreclosures or forcing homeowners to refinance into negatively amortized loans.”
He warns of “layered risk” and how common it has become in stated income loans. Negative amortization means very low initial payments (typically for two-to-three years). This can greatly reduce early payment defaults (EPDs) – a classic sign of fraud that often requires the originator to repurchase the loan from the secondary market. Ultimately, however, it makes defaults even more likely.
6. Stated income loans are why home prices have skyrocketed. They have caused a large demand in the US housing supply.
Many economists are currently unaware of how prevalent stated income loans are. They attribute high home prices to low interest rates, low to zero percent down payments, speculative purchasing, and interest only loans. What economist [sic] fail to realize is that popular stated income loans are what have led have home prices to skyrocket in recent years.
Loose under writing guidelines caused by stated income loans have allowed individuals to speculate on 3, 4, and in some cases over 5 homes at once.
Homes have a unique situation where demand is directly related to whether or not someone can receive a loan from a bank or lender. With banks loosening their guidelines for the home buying process we have experienced a huge surge in demand for homes over the past few years. These surges have not come all at once. First we saw low down payments become popular. Then interest only loans lowered monthly payments, and now negatively amortized loans do that even more. All of these loan enhancements have been “logs to the fire” of home appreciation. Unfortunately there are no more logs, to throw onto the fire, which will cause appreciation to go flat.”
Stated income loans are hyper-inflating the bubble. Many economists have ignored their role. Stated income loans make it far easier for speculators to purchase multiple homes. Risk layering has extended the bubble, but we have run out of fuel to feed the bubble’s expansion and appreciation will “go flat.”
“8. Almost anyone can get a stated income loan for $950,000.
Consumers have access to loans where a home can be purchased with 0% of a down payment, stated income AND stated assets. This same loan will allow a very low credit score of 620 (680 is average). Lastly this loan program will allow someone to borrow up to $950,000 dollars.”
Lenders will make stated income jumbo loans to subprime borrowers with very poor credit scores. The borrower need not even make a down payment.
“9. Stated income loans allow tax cheats to purchase homes easier.
Banks argue that stated income loans allow borrowers to include income from side jobs that do not show up on their tax returns. It is unimaginable that banks are making the American dream of homeownership easier for tax cheats. Though technically these borrowers are not lying about their income and committing mortgage fraud, they are in fact committing tax fraud, and banks should join in a joint effort with the IRS to cross reference the incomes stated on tax returns and mortgage applications.”
The “three “C’s” of lending are credit, character, and collateral. A borrower who is willing to commit a felony and cheat the government on taxes (or his spouse or kids on support) is unlikely to have disabling moral qualms about cheating a bank. He lacks character and should not receive a loan. Far from aiding such borrowers, an honest banker would alert the IRS to their fraud.
“11. Appraised values are often inflated. Underwriters are basing their decision on inflated home values, inflated incomes and inflated assets.”
Krystofiak cited the statement by the head of a professional appraisal association warning that honest appraisers were being blacklisted by lenders when they refused to inflate appraisals. An honest banker would never inflate an appraisal.
“12. Rules are not enough, they must be enforced.
The FBI has acknowledged that mortgage fraud is a problem that is a growing epidemic.”
He cites the statistics on criminal referrals for mortgage fraud that led the FBI to label such fraud “epidemic.”
“13. Stated income loans must stop now
Stated income loans might be more convenient for a small portion of the home buying population, but it is a sleeping plague on the financial integrity for the rest of us. Federal regulators must end stated income loans now. Greed by mortgage brokers, banks, and real estate developers must not be encouraged by keeping this issue unaddressed and silent. Stated income loans are being used fraudulently in alarmingly high rates and are hurting consumers. If federal regulators don’t act on this now, they will be dealing with the consequences of their lack of actions later.
Data Collected by the Mortgage Brokers Association for Responsible Lending
1. A recent sample of 100 stated income loans which were compared to IRS records (which is allowed through IRS forms 4506, but hardly done) found that 90% of the income was exaggerated by 5% or more. MORE DISTURBINGLY, ALMOST 60% OF THE STATED AMOUNTS WERE EXAGGERATED BY MORE THAN 50%. These results suggest that the stated income loans deserves the nickname used by many in the industry, the “liar’s loan.”
Krystofiak has buried his lead by placing his study at the end. His association has done something vital that could have saved the nation from massive harm. His study shows that fraud was endemic in liar’s loans. The incidence of fraud and the extent of that fraud among liar’s loan was staggering.
The Fed would eventually cite Krystofiak’s study in support of its issuance of a final rule on July 14, 2008 using its unique authority under the Home Ownership and Equity Protection Act (HOEPA) of 1994 to largely ban liar’s loans (while delaying the effective date of the rule to October 2009). Even then, however, it incorrectly assigned credit for the study to the MBA’s anti-fraud unit (MARI) (which actually quoted Krystofiak’s study in its Eighth Periodic Report to the MBA in early 2006). Even when it cited the quantitative study (and a similar Fitch report in footnote 52), in the main text the Fed denigrated the studies by describing them as providing e “substantial anecdotal” evidence of widespread fraud. This was, however, an improvement from the proposed rule, which did not have the word “substantial” in the main text (the analogous footnote in the proposed rule is n. 54).
Link to the final rule and preamble:: http://www.gpo.gov/fdsys/pkg/FR-2008-07-30/pdf/E8-16500.pdf
Link to the proposed rule and preamble: http://www.federalreserve.gov/reportforms/formsreview/RegZ_20080109_ifr.pdf
So, the answer to my question is that Steven Krystofiak is the man who tried to save the nation and the Fed from disaster. He gave the Fed everything it needed. Banning liar’s loans, as Krystofiak made clear, should have been the easiest of calls for the Fed. Such loans had nothing to recommend them and endangered the nation. Greenspan and Bernanke refused on ideological grounds to follow Krystofiak’s recommendations until it was far too late.
In a small world moment, Steven was also a starting forward on the middle school basketball team I coached as a parent volunteer. He was tenacious in defense and had excellent vision then too.
Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.