Subprime Payback time(ZT)

Payback time
By Brooke Masters and Saskia Scholtes
Published: August 9 2007 03:00 | Last updated: August 9 2007 03:00
Atthe height of the US subprime lending boom, taking out a mortgage couldnot have been easier. Low credit score and history of bankruptcy? Noproblem. Income too low to qualify for a mortgage? Inflate what youearn on a "stated income" loan. Nervous that your lender might check upon your "stated income"? Visit www.verifyemployment.net.

For a$55 fee, the operators of this small California company will help youget a loan by employing you as an "independent contractor". Theyprovide payslips as "proof" of income and, for an additional $25, theyalso man the telephones to give you a glowing reference should yourlender need it.

But perhaps the most absurd aspect of the USsubprime mortgage market in recent years is that lenders became sogenerous with credit provision for out-of-pocket borrowers that veryfew checks were ever made.

That left the system extraordinarilyvulnerable to widespread fraud, a possibility that federal and stateprosecutors across the US have begun to look into. With the subprimecrisis expected to cost investors between $50bn (£24bn, €36bn) and$100bn, according to the US Federal Reserve, these investigations couldtransform it from a market correction to a full-blown national scandal.

Atthe root of the subprime problem was easy credit: lenders and theirbrokers were often rewarded for generating new mortgages on the basisof volume, without being directly exposed to the consequences ofborrowers defaulting. During several years of strong capital marketsand strong investor appetite for high-yielding securities, lendersbecame accustomed to easily selling the risky home loans they made toWall Street banks. The banks in turn packaged them into securities andsold them to investors around the globe.

Such ease of mortgagefunding allowed thousands of borrowers to get away with fraudulentlymis-stating their incomes, often with the encouragement of theirbrokers. More ambitious fraudsters appear to have taken out multiplemortgages and walked away with the cash.

Karen Gelernt, apartner at law firm Cadwalader, Wickersham & Taft, says: "Thedifficulty is getting a handle on the size of the problem, becausethere is no real mechanism for reporting fraud for most originators inthis market. In fact, they had every incentive not to report."

Fraudhas been detected up and down the financing chain: just as borrowershave lied to get better rates and larger loans, mortgage brokers andloan officers have lied to borrowers about the terms of their loans andmay also have lied to the banks about the qualifications of theborrowers. Appraisers, likewise, have lied about the value of theproperties involved.

"The recent rapid expansion of the subprimemarket was clearly accompanied by deterioration in underwritingstandards and, in some cases, by abusive lending practices and outrightfraud," Ben Bernanke, Fed chairman, recently told lawmakers. Withmortgage rates rising and house prices falling, subprime borrowers havebeen defaulting at record rates.

The fallout is working its wayup from the retail level - forcing people out of their homes andlenders into bankruptcy. Investment banks have lost revenue asinvestors back away from mortgage securities and a handful ofhigh-profile hedge funds have collapsed - most notably two highlyleveraged funds managed by Bear Stearns. The crisis has contributed toturmoil in financial markets in recent weeks and could threaten thehealth of the US economy as lenders tighten access to credit, putting adrag on consumer spending.

For some, this rapid and dramaticunravelling of the subprime lending industry has echoes of the costlysavings and loans crisis of the early 1980s - a meltdown that also hadits origins in financial market innovation and inadequate oversight,and which many cite as a contributing factor in the 1990-91 economicrecession. That crisis ended with a federal bail-out of $150bn and ahandful of high-profile convictions for fraud.

This time around,the major losers have been hedge funds, which in theory are limited towealthy investors. But some analysts believe the pain could spread -many pension funds and college endowments have turned to hedge funds toheat up their returns and some, including Harvard University, arestarting to get their fingers burned. Harvard is estimated to have lost$350m of the $550m it invested in a hedge fund run by Jeffrey Larson, aformer Harvard money manager, that collapsed recently as a result ofpositions related to the subprime market.

If the losses trickledown and end up hurting small investors, pressure may grow for a publicbail-out. Rumours swept the market earlier this week that Fannie Maeand Freddie Mac, the government-backed mortgage agencies, might get theauthority to make sweeping purchases of underpriced mortgage securities.

"TheUS mortgage landscape has become a top-of-mind political talking point,and we would not be surprised to see the usual 'flow like mud'legislative process fast-tracked with respect to items offering reliefto the -troubled mortgage market," says Louise Purtle, strategist at-CreditSights, a research firm.

Most fraud in subprime lendingappears to have been so-called "fraud for purchase" - lying aboutincome so as to win a mortgage approval. In reviewing a sample of "nodoc" loans that relied on borrowers' statements, the Mortgage AssetResearch Institute recently found that almost all would-be home ownershad exaggerated their income, with almost 60 per cent inflating it bymore than 50 per cent.

These fraudulent borrowers are oftendifficult to uncover, says Ms Gelernt, because they often stretch tomeet their minimum payments for some time before they eventuallydefault. The time lag between initial fraud and default also makes aconviction hard to obtain, she adds, while mortgage investors also havelittle chance of recovering their losses from individual borrowers inthese circumstances.

Many of the originators to blame for poorquality control standards may not be held to account either - withseveral such lenders already in bankruptcy. "There's a real problem infinding fraud after the fact because the money is already out the doorand you won't get the recovery," says Ms Gelernt.

Loose lendingstandards also facilitated fraud for profit. US prosecutors around thecountry have broken up at least a dozen mortgage fraud rings and morecases are expected.

In one New York case, the FBI charged 26people who used stolen identities, invented purchasers and inflatedappraisals to obtain subprime loans on more than $200m of property. Inan Ohio case, 49 per cent of the mortgages processed by a -singlebroker never made even a first payment.

The fate of a series ofNorth Carolina neighbourhoods built by Beazer Homes may offer aforetaste of the looming problem. Low income home-buyers aroundCharlotte have sued the builder alleging that its lending arm steeredthem into mortgages they could not afford, leading to widespreadforeclosures.

The homeowners allege that sales agentsmisrepresented their personal data, including assets and income, tohelp them qualify for government-insured mortgages starting in 2002. Bythe beginning of this year, 10 Beazer subdivisions in Charlotte hadforeclosure rates of 20 per cent or higher, compared with 3 per centstate-wide, according to a local newspaper analysis.

The FBI isprobing Beazer for possible fraud and the US Housing and UrbanDevelopment is examining whether its sales practices violatedgovernment-insured mortgage rules. Beazer has defended its salespractices and says it has a "commitment to managing and conductingbusiness in an honest, ethical and lawful manner". In June it announcedthat it had fired its chief accounting officer for allegedly attemptingto destroy documents. The company's shares have lost 75 per cent oftheir value since the probes began.

Several stateattorneys-general are also on the trail. Andrew Cuomo of New York statemade headlines this spring with a series of subpoenas to propertyappraisal companies and has said publicly that he is probing the entireindustry. Sources familiar with the office's work say the investigationis still at a relatively early stage.

Marc Dann, the Ohioattorney- general, is looking further up the funding chain. He has beenoutspoken in his criticism of the role the financial services industrymay have played in the large numbers of foreclosures in his state."There's a whole series of people that knew or should have known thatthere was fraud in the acquisition of these mortgages," Mr Dann toldthe Financial Times. "We're looking at ways to hold everybody who aidedand abetted that fraud."

Mr Dann's office is looking at brokers,appraisers, rating agencies and securitisers and plans to use severallegal methods to hold bad actors accountable. The Ohio attorney-generalnot only has criminal enforcement powers, but also represents thethird-largest set of public pensions in the country and can thus filecivil lawsuits on behalf of investors.

"But for the mechanism ofpackaging these loans, the fraud never would have existed," Mr Dannsays. "We're following this trail from homeowner to bondholder." Hesays his investigation could take six months to a year to bear fruit.

TheSecurities and Exchange Commission, for its part, is investigatingwhether Bear Stearns and other hedge fund managers were forthrightabout disclosing the rapidly declining value of their holdings.

Manyof the mortgage-related securities bought by the hedge funds are rarelytraded and difficult to value accurately. They are often valued inportfolios according to complex mathematical models because real marketprices are not available, making it possible to disguiseunderperformance if models are not updated.

The SEC has notbrought a case in the area so far, but current and former regulatorsnote that it has previously won settlements from several mutual fundsand banks that failed to revise the prices of illiquid assets during afalling market.

Private securities lawyers are also starting tofile securities fraud lawsuits on behalf of investors who have lost outbecause of the subprime meltdown.

Jake Zamansky, a lawyer whonegotiated an early settlement from Merrill Lynch in the scandal overskewed investment bank research, has filed an arbitration claim againstBear Stearns alleging the firm misled investors about its exposure tothe mortgage-backed securities market.

The class action law firmof Bernstein Litowitz is also preparing a claim against Bear Stearns,alleging the firm made material mis-statements in the offeringdocuments for its now defunct hedge funds.

"This was simplyabout a hedge fund strategy that failed," said a Bear Stearnsspokesman. "We plan on defending ourselves vigorously against theallegations in these complaints."

Other hedge funds may also come under political or legal pressure over their role in the loan crisis.

RichardCarnell, a professor at Fordham law school, says it may be possible tohold the investment banks that securitised the mortgages at leastpartially responsible in the case of a major collapse of the market."There are two things you can object to in the securitisers' conduct:failing to disclose material facts about the credit quality of themortgages; and you can also criticise them for acting as an enabler forsomeone they know is a bad actor," he says.

But putting togethera case will not be easy because the hedge funds and other investors whobought such securities are presumed to be sophisticated about financialmatters. This means it will be harder for them to prove they were notproperly warned about the risks involved.

In the case of theBear Stearns funds, investors may face new hurdles to recovering anymoney through US lawsuits. Though the funds operated mostly in NewYork, they were incorporated in the Cayman Islands and that is wherethey have filed for bankruptcy. In what could be a test case forinternational bankruptcy laws, the liquidators have applied to the UScourts asking them to block US lawsuits during the liquidation process.

BearStearns said in a statement: "Because the two funds are incorporated inthe Cayman Islands, the funds' boards filed for liquidation there . . .The return to creditors and investors will be based on the underlyingassets and liabilities of the funds not on the location of the filing."

Evenif the US lawsuits do go forward, a case pending before the SupremeCourt could also prove crucial to investors who hope to make a casethat hedge funds and rating agencies enabled widespread fraud.

InStoneridge Investment Partners v Scientific Atlanta, the court isconsidering whether investors can recover from firms - includingaccountants, lawyers and bankers - that help a public company commitfraud by participating in a "scheme to defraud". If the high courtrules against "scheme liability", investors who lost money in thesubprime market will have very few places to turn to try to get some ofit back.

William Poole of the Federal Reserve Bank of St. Louisthinks that this may be what investors who lose money onsubprime-linked securities deserve for not looking at them closelyenough.

Criticising Wall Street underwriting standards recently,he said: "The punishment has been meted out to those who have donemisdeeds and made bad judgments. We are getting good evidence that thecompanies and hedge funds that are being hit are the ones who deserveit.''

Copyright The Financial Times Limited 2007