The Cause Of the Housing Slump: Exaggeration & Red-Lining

Suit Says Neighborhood’s Boom Was Built on Mortgage Fraud

We are currently facing a downturn in the value of housing. The boom is about to go bust. But one of the reasons for the impending doom of the housing bubble is the practice of flipping that has led to overly exaggerated hosuing values... most of which was brought about by a practice known as red-lining.

The way it works is simple. A company, bank or contractor comes to a depressed neigborhood, argues that there will never be a time that these houses will garner top dollar, provides appraisals that low-ball the values, and convinces folks that it is time to bail out of these bad neighborhoods. Then, after only a bit of cosmetics and bringing these houses into minimal compliance with codes, these same "business people" present new appraisals that reflect the "gentrification" and "renewal" of these same neighborhoods and the increased value of the property.

I was victim to this practice by a bank in Lynn, Massachusetts. My business partner and I owned a triple-decker on the border of Lynn (a not-so-valued real estate town) and Swampscott (a town with inflated real estate values). When we went to the bank in 1990 for a loan to put on a new roof and remodel two of the the three apartments, the appraiser hired by the bank placed the value of the property at $230,000 and estimated that the planned improvements would increase the value to $270,000. After completing these renovations and improvements, we found it necessary to put vinyl siding, insulation and new windows on the building 15 months later. The very same appraiser came out and appraised the value of the house at $150,000. Well, we did some investigation and found that the appraiser was a party to a development effort in the nearby neighborhood, funded by the very same bank we used, and was deliberately red-lining the nearby properties for their own benefit. We threatened a lawsuit after getting an independent appraisal that set the value of the house at $300,000... and another that set the value at $285,000.

We had the original appraisal by the same appraiser used by the bank both times we sought to use the equity for improvements. That evidence, combined with the two independent appraisals, put the bank on notice that we were serious about the law suit... and the bank brough out another appraiser, who valued the house at $292,500... exactly midway between the two independent appraisers. Ain't it funny how the world works?

The article below shows yet another case of red-lining and exaggeration. In Indiana, there a few laws that protect the consumer effectively. Renters are subject to the whims of landlords. Property owners are subject to red-lining without real recourse under Indiana law, unless the property owner has the financial resources to conduct a protracted law suit. And the banks, developers and contractors are not above using the tax laws and foreclosure provisions of a contract to effect their red-lining efforts.

Even by the frothy standards of the housing boom, it was a great deal.

On May 18, 2005, a small Indiana company bought 184 duplex homes in a down-and-out neighborhood in northeast Indianapolis for an average price of $50,000 each.

Less than a month later, the company, Land Economics, began selling the properties, which were built mostly in the 1940’s, for $120,000 apiece to church secretaries, truckers, retirees and factory workers — sometimes as many as three a day to a single individual — all of them 577 miles away in Martinsville, Va. As recently as September 2004, homes in this neighborhood sold in a range of $20,000 to $65,000.

Amid the boom, those details hardly seemed to matter.

A week after the details of those suspicious transactions emerged — and the accusations by lenders and borrowers that they had been defrauded — federal investigators are still trying to sort out the scope of what some are describing as one of the largest cases of mortgage fraud in recent years. Countrywide Financial, which bought the Indianapolis loans soon after they were written, has filed a lawsuit seeking damages from Land Economics, its principals and others involved in the deals.

The Indianapolis situation may prove to be the most vivid example yet of how the boom in housing has provided fertile ground for mortgage fraud, industry experts and regulators say. Rising home prices served as cover for quick-flip plans and an easy hook to recruit investors.

And the boom created incentives for the mortgage industry not to look too closely. As the appetite for home loans soared on Main Street and Wall Street, the industry came to increasingly rely on networks of independent mortgage brokers, appraisers and other officials to keep the lending assembly line well supplied. All had incentives to minimize hold-ups.

“If the deal doesn’t go through, nobody gets paid,” said Bill Matthews, a senior vice president at the Conference of State Bank Supervisors.

Still, the apparent inability of lenders to spot suspicious transactions is puzzling to some. Information about the value of the homes and the borrowers’ modest financial positions could have been easily discovered had someone sought the information.

William A. Birkle, a county assessor in Indianapolis, caught wind of the home sales in the northeast neighborhood, Windsor Village, when a fraud analyst at Wells Fargo Home Mortgage called last year to ask him about them. When Mr. Birkle started looking into the transactions he was flabbergasted at the sales prices.

“It’s just the worst neighborhood in my township," he said. "At one point in time, the police barricaded the neighborhood with concrete so there was only one way in and one way out so they could control the drug trade.”

The mortgage industry has access to extensive property databases and sophisticated computer models that can flag potentially fraudulent loans.

Industry experts say databases can sometimes provide contradictory information. But they believe that the larger problem is that companies too often rely on the representations of mortgage brokers or correspondent bankers without seeking independent verification.

“It’s symptomatic of a faceless origination process,” said Arthur J. Prieston, chairman of the Prieston Group, a consulting and insurance firm that specializes in mortgage fraud. “As the industry has matured, we don’t have the situation where you walk into the bank and the banker knows you and your family and where you work.”

Countrywide, the nation’s biggest mortgage lender, disputes that it did not do enough to detect any problems earlier, noting that the bank that originated the loans, People’s Choice, was contractually obligated to vet and check the loans.

“Countrywide is a victim in this case,” the company said. “We have a zero-tolerance policy against fraud, and dedicate considerable resources toward identifying and investigating possible incidents through our systems, technology and fraud investigation unit.”

The system employed by Countrywide and other lenders has undoubtedly delivered a number of benefits by creating new kinds of mortgages, expanding access to credit for minorities and providing a boost to the national economy.

But the benefits have been accompanied by a growing amount of fraud, forcing state and federal regulators to scramble to get ahead of it. The Federal Bureau of Investigation estimates that mortgage fraud totaled $1 billion in 2005, up from $429 million in 2004 but still a tiny fraction of the $3 trillion mortgage business.

In April, the New York attorney general, Eliot Spitzer, announced the indictment of eight people accused of involvement in mortgage fraud that he said cost banks as much as $200 million during the five years the ring operated, primarily in Brooklyn and Queens and in Suffolk County on Long Island. In Atlanta, Chalana McFarland was sentenced last year to 30 years for a flipping operation that netted $20 million from 1999 to 2002.

The most profitable schemes are run by well-coordinated groups and include mortgage brokers, appraisers, real estate brokers and title agents. They require several things: unwitting borrowers, inflated property appraisals and lax oversight.

The person accused in the Countrywide lawsuit of being the mastermind behind the Indiana real estate scheme is Robert Penn, who, with his wife, Tamara Penn, operated a number of real estate holding companies, including Land Economics.

Though estimates vary, people with knowledge of the accusations say the scheme involved at least $40 million in loans, and possibly twice that amount. At least one other mortgage company may have suffered losses in the suspected fraud, which also involved more expensive homes in suburban Indianapolis.

Investors were lured in by a pair of Martinsville residents: Mr. Penn’s mother, Beulah Penn, and his sister Sharon Penn. The two encouraged people to participate in what they called a real estate investment club, rushing them through the paperwork and telling them that they were signing loan applications.

The deals have left the borrowers with large debts and potential indelible marks on their credit histories.

Their applications were forwarded to another couple, Robert and Amy Pollard, who worked as loan officers and processors for People’s Choice, a unit of People’s Trust Mortgage in Kentucky, the lawsuit says.

As a “correspondent” banker, People’s Choice made loans using standards and practices prescribed by Countrywide in hopes of selling them to the larger company. At the height of the housing boom, correspondent institutions generated up to 40 percent of Countrywide’s loans; they now account for about 35 percent.

In the lawsuit, Countrywide asserts that the Pollards did not follow its underwriting practices. Borrowers were said to have significant bank account balances when in fact, those assets belonged to a company controlled by an associate of Mr. Penn, Countrywide’s lawsuit says.

Mr. Penn also relied on appraisers to provide inflated property assessments and title agents to sanction and execute fund transfers, according to the lawsuit.

The Countrywide suit asserts that the company was defrauded of the difference between the true value of the homes and the inflated prices at which the loans were taken out.

In a court filing in mid-September, the Pollards, who declined to comment, denied Countrywide’s accusations. Calls to Mr. Penn and his lawyer were not returned.

Douglas Grothjan, who worked at another People’s Choice office until 2003, said the company did not monitor or audit branch operations. The company’s chief executive, Jerry Connor, could not be reached for comment.

“It should have been mandatory that you take 10 percent of the loans and completely reverify them, order a credit report from a different bureau, an appraisal from a different company, send documentation to the people again,” Mr. Grothjan said. “Good brokers do that. Jerry just churned out loans and people.”

Most of the homes in Windsor Village were built for sailors and soldiers returning from World War II. The neighborhood is anchored by a former naval air installation that is now home to Raytheon, the military contractor. The neighborhood has a median household income of $27,000, and residents there owned only about 40 percent of its homes, according to the 2000 census.

Mr. Birkle, the assessor for the area, said he had given records for suspicious sales to the Marion County prosecutor’s office, which referred questions to the United States attorney’s office in Indianapolis. Officials with a federal mortgage fraud task force declined to comment.

As Mr. Birkle remembers it, the local prosecutor felt “we don’t have a victim here.”

“We didn’t have these people from out of town saying, ‘We were defrauded’; we didn’t have the mortgage company saying, ‘We were defrauded.’ ”

Another mortgage company, Argent, has said that it, too, bought loans in which Mr. Penn and his associates were involved. But it would not say how many it had acquired or when it had become aware of problems with the loans. “We are aggressively pursuing criminal and civil actions,” said Chris Orlando, an Argent spokesman.

Mr. Matthews of the state bank supervisors’s group said regulators and law enforcement officials deserve some blame for not tightening licensing requirements and pursuing fraud more aggressively. This week, his group and other state regulators said they would establish national standards for registering mortgage brokers, bankers and others.

“Crimes by the pen get a whole lot lighter treatment than crimes with a gun,” he said.