Loan Injustice, Part 2 of 2

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In Harlem, the abandoned brownstones are minor celebrities now, thanks to the biggest federal housing scandal to hit the city in years. There and in Brooklyn, about 400 buildings stand abandoned or in varying stages of disrepair, after being milked of tens of millions of dollars by schemes that used nonprofit organizations as a front for a federal affordable housing program.

The Harlem plot, first exposed in City Limits in 1999 and now front-page news, was as shameless as it was lucrative. Real estate speculators bought the buildings cheap, then quickly resold them to one of the nonprofits at much higher prices. Those organizations were able to buy the buildings with loans under a federal housing program, known as 203(k), intended to promote the purchase and renovation of decrepit buildings in low-income neighborhoods.

And at every step of the way, there was a single factor that made it all possible: a guarantee from the Federal Housing Administration (FHA) that the financial institutions bankrolling the buying spree would be paid back, in full, should anything go wrong with the deals.

Go wrong, of course, they did. As City Limits has reported [“Empty Promises,” January 2000], the nonprofits stopped making their loan payments early last year, and the mortgages are now heading toward mass foreclosure.

In December, major players in the scheme–including speculators, attorneys, lenders, an appraiser and officers of one of the nonprofits–were indicted on state and federal charges. But recent events have done more than put an end to a vulture operation. They have also exposed, and not for the first time, just how readily one of the nation’s largest affordable housing programs has allowed speculators and scam artists to run away with the bank.

The deals were bankrolled with loans backed by FHA, the arm of the U.S. Department of Housing and Urban Development that encourages banks to lend to moderate-income Americans by insuring their mortgages. New York isn’t the only city to be mugged recently by speculators who relied on FHA-backed loans to make a killing. Baltimore, Fort Lauderdale, Chicago and Los Angeles have also been hit by destructive abuse of HUD loan guarantees, in 203(k) and other programs that have left similar trails of uninhabitable and unaffordable housing.

But these outright rip-offs are just the beginning of FHA’s recent troubles. The agency’s system of publicly insured private loans, say observers of the HUD and the banking industry, has been under increasing strain in recent years, as a Clinton Administration crusade to increase homeownership to record levels nationwide has sent the number of federally insured home loans soaring. In just the two years between 1997 and 1999, total FHA lending had increased a remarkable 63 percent, so that as of 1999, the FHA was backing $475 billion in loans. That year alone, the agency insured 1.3 million home mortgages.

The increase in FHA lending has pumped money into neighborhoods that not so long ago had terrible access to bank loans. But the boom–spurred by new rules making it far easier for buyers to qualify for FHA mortgages–has come at the very same time that HUD has outsourced much of its loan oversight to private contractors.

The result has been an equally huge explosion in the number of defaults and foreclosures on FHA loans, both in New York and nationwide. In just 15 months, between January 1998 and March 1999, the default rate for FHA rose 21 percent. And since 1994, the foreclosure rate for FHA-backed loans has risen an astonishing 39 percent, during a period when foreclosure rates for conventional loans held steady or decreased.

And while FHA is famous for building America’s suburbs, the current crisis is an urban one. In New York City, Atlanta, Chicago and Los Angeles, the abuse of FHA insurance has gotten so bad that HUD placed a three-month moratorium last year on foreclosures on these mortgages in zip codes where rates of default on these loans, as well as complaints of abuse by lenders, are high.

Advocates for community lending say well-meaning efforts to spur private investment in inner cities have led to a rash of abuses by lenders–and a predictable epidemic of defaults and foreclosures in low-income neighborhoods. “HUD holds press conferences to say how homeownership has been increasing,” says Calvin Bradford, a leading national expert on FHA. “But the downside is that people are getting foreclosed on.”

Ironically, it’s FHA’s insurance guarantee, intended to give banks confidence to lend freely in lower-income and working-class neighborhoods, that has been fueling the wave of foreclosures. The guarantee encourages established banks to work with questionable mortgage brokers at the street level. These aggressive players, long a fixture in low-income neighborhoods, often employ a range of shadowy loan practices, duping unsuspecting homebuyers and nonprofits into purchasing overvalued buildings. Because the loans are backed by the FHA insurance, conventional lenders eagerly buy bundles of these low-risk loans to invest in the nation’s thriving secondary loan market.

“They can’t lose–that’s why people figured out how to scam the programs,” says Sarah Ludwig, executive director of the Neighborhood Economic Development Advocacy Project. “Everyone wins. Only the tenants and borrowers or homeowners lose. The secondary mortgage market is what makes it work.”

Ultimately, it’s poorer neighborhoods that pay the price for resulting defaults and foreclosures. In Morrisania, about 12 percent of FHA-backed homebuyers defaulted on these loans in the first year; Far Rockaway, nearly 14 percent; northern Bed-Stuy, more than 27 percent. The average for the metropolitan area is about 8 percent; nationally, it’s just 2.7 percent.

“This destabilizes neighborhoods of color. It doesn’t allow for people to live there continuously or to put down roots,” says Bertha Lewis, executive director of New York ACORN, which counsels homebuyers who have lost their homes to FHA foreclosure. “For many people of color, a home is the biggest thing that they will purchase. What kind of legacy are they leaving to their children?”

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On the surface, FHA’s relationship with the banking industry is the classic example of a successful public-private partnership. Its programs, with low down payments and loan guarantees, are structured to address the complicated reasons why many working families don’t own homes and why banks fear to lend to lower-income people. FHA currently insures about 10 percent of home loans nationwide.

Once a blatant practitioner of redlining, FHA reversed course in the late 1960s to become the leading source of home financing in lower-income and minority neighborhoods. The loan insurance, which pays lenders back in case of foreclosure, is supported by the borrowers themselves, who pay for the program through a small fee on their mortgage payments.

FHA’s loan guarantees give lenders confidence to make mortgages to moderate-income homebuyers, because in the event of a foreclosure financial institutions are paid back for the loan and much of what they spent working with it. The bulk of these loans are made by mortgage companies and brokers, which usually have neighborhood connections and the patience to navigate the intricacies of a government program.

The smaller lenders are able to generate the large volumes of cash they need to stay in this business by selling bundles of these loans on a secondary market, to banks and other financial institutions. The original lender gets an instant pile of cash, with which it can make more loans. And the major banks that buy these loans can profit from collecting payments, virtually risk-free.

Fully 95 percent of FHA-backed loans end up the hands of the Government National Mortgage Association, commonly known as Ginnie Mae, which pools them into mortgage-backed securities for Wall Street. But usually a small lender will sell to a big bank first. That’s what happened in the Harlem deals, in which a broker called Mortgage Lending of America (MLA) sold its loans to two banks, M&T and Firstar.

In these deals, banks typically hold on to the right to collect payments on the loan, taking roughly a half-percent fee on every transaction and then selling the loan itself to Ginnie Mae. For a bank, the profits come with volume, by buying the servicing rights on dozens of properties at a time.

The banks buying the loans also get credit under the Community Reinvestment Act for putting money back into low-income neighborhoods. The most obvious incentive, though, is the golden assurance that they cannot lose money on the deal. “Banks buy more conventional loans than FHA loans,” says Jonathan Pinard, president of the Empire State Mortgage Bankers Association and founder of New York-based National Home Mortgage. “But it is very profitable to do FHA. Banks can’t lose that much money.”

In a perfect world, the FHA insurance guarantee is a win-win-win situation for the lenders, the banks and a nation of homebuyers, generating a torrent of real estate cash. But the fact that the system is so safe and lucrative also leaves it incredibly vulnerable. In many cases, say banking analysts and insiders, banks are more eager to profit from buying the loans and collecting interest on them than making sure they are in business with the right street-level lenders. “Once it has FHA insurance on it, it’s liquid money,” explains Bradford. “You don’t have to worry about the quality of the loan. The risk is absorbed by the government.”

Unscrupulous small lenders can frequently count on banks to buy their loans in bulk, with few questions asked. “The banks are willing to finance this,” says Bradford. “They are willing to work with less than reputable people because they are covered.”

The Harlem scheme could not have worked without banks there to buy the mortgages from MLA. Shortly after closing its 203(k) deals, the lender sold at least 100 loans to M&T and another 70-plus loans to Firstar. In turn, M&T sold the servicing rights for a few dozen of its loans to Chase Manhattan Bank.

MLA’s loans allowed speculators to sell buildings at inflated rates, leaving the nonprofits without enough money to rehab the buildings and too much debt to sell them. When they stopped paying their mortgages, Chase was able to exercise an escape clause in its agreement and sell its rights back to M&T. Mortgage Lending of America went out of business soon after, sticking M&T and Firstar with more than $50 million in bad loans.

So the banks turned to the only other player with a legal responsibility to do something–HUD. M&T argues that the mess is HUD’s fault, the product of poor oversight by the agency.

HUD officials, meanwhile, point the finger at banks. “There’s no question that loan servicers and the secondary mortgage market have some obligation to conduct some due diligence,” says Matthew Franklin, deputy chief of staff for HUD Secretary Andrew Cuomo. “Check out samples of the loans, check out your partners to see if you have confidence in the people with which you are doing business.”

But the tough talk isn’t stopping HUD from bailing out the New York banks. After months of negotiations–during which the banks tried and failed to sell the Harlem buildings at their wildly overappraised prices–M&T and Firstar convinced HUD to make good on the FHA guarantee. The banks will now put the buildings up for sale at market rates, and HUD will pay them for any losses they incur in selling at those lower prices.

Most banks do take measures to make sure the loans they’re buying are solid, says Bud Carter, senior director for regulatory affairs at the Mortgage Bankers Association of America. “There’s a certain amount of due diligence when loans are from risky areas or have low down payments,” he says. Those steps include spot checks to see if paperwork is properly completed or interest correctly calculated. Banks are much less likely, though, to recheck substantial details, such as borrowers’ finances or appraisal records; says Carter, “The originator would have done that.”

In truth, there’s often no one watching the store. Banks commonly refuse to examine the bundled loans they buy on the secondary market. By deliberately maintaining ignorance, banks buying these loans can reasonably claim that any problems that emerge are the smaller lender’s fault–and insist that the mortgage company buy any bad loans back. “It’s usually not a good idea for them to see the details,” explains Pinard, whose mortgage company sells loans to banks. “If they’re looking at it and like what they see, and it [later] goes bad, then why am I on the hook? The bank liked it too! They rely on our representation and warranty.”

M&T spokesperson Michael Zabel would not comment on what procedures the bank followed when it acquired the loans from MLA. But there is reason to believe that M&T did not do its due diligence. Looking at sales histories, a standard banking practice, would have quickly revealed that the properties had been flipped–quickly bought and sold again at markedly higher prices. A scan of comparable sales prices in the neighborhood would have warned bankers that the buildings had been overappraised.

“The originator had to count on the secondary market not paying attention,” points out Kim Harmon, an FHA policy expert with National Training and Information Center, which advocates for investment in low-income communities. “Banks claim that they buy so many loans that they can’t look at them. But it seems part of what they should do.”

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Flipping is probably the most spectacular way to pervert an FHA loan, and it has become a national craze among bottom-feeding realtors. Last June, a Senate subcommittee held hearings on the problem, where it heard testimony that HUD and other agencies were investigating more than 200 schemes in 38 states. Whether buildings are bought and sold between colluding partners, as in Harlem, or sold to unsuspecting homebuyers at wildly inflated prices, which happened in Brooklyn, the result is the same. Speculators run the cost of these homes right out of the market, frequently leaving them abandoned and in disrepair. HUD’s insurance fund pays for the damage.

But a lot of FHA fraud is far more mundane. Mortgage bankers routinely make these loans to homebuyers who do not qualify for them under HUD rules-who don’t earn enough money, or have enough savings, or carry too much debt. The agency’s Inspector General has been tracking the problem; in one audit, the office found that Rochester-based Alliance Mortgage Banking Corp. didn’t even ensure that borrowers had enough money to close on their home purchases. Predictably, those loans defaulted.

As a counselor to borrowers for Neighborhood Housing Services, Lorenzo Villanueva has seen lenders do almost anything to close FHA loans. Widespread practices include creating fictitious cosigners, adding income to borrowers’ bank accounts or creating false assets. In some cases, brokers give money to family or friends to contribute toward the purchase of the home, but not enough to ensure that they will be able to maintain the mortgage payments. In addition to appraisers, unscrupulous lenders will often supply borrowers with lawyers as well; that’s what happened to the nonprofits in the Harlem scheme. If anything goes wrong, there’s no one who is really on the borrower’s side. “These are part of deceptive practices,” says Villanueva. “We pay into the [insurance] pool to make the lender safe, when the lender is being predatory to us.”

Some lenders will also try to pad the value of a home, using false appraisals that leave out structural defects or include unfilled promises to fix these defects before closing the loan. One former HUD consultant says that lenders often asked him to sign off on work that was not being done to help developers or real estate players close a deal.

The consequences of such moves are serious. Once a homebuyer has a loan for more than the home is actually worth, it can be virtually impossible to sell. And if the mortgage is high enough, the borrower may not have the money left to fix structural problems. “The homeowner ends up getting stuck,” says the consultant. “The bottom line is that they signed [the mortgage]. This stuff is really pervasive.”

Practices like this turn FHA loans into predatory loans which can hurt both homeowners and the community. “Home buyers go in thinking that because it’s an FHA loan, they are safe,” says ACORN loan counselor Tara Benigno. “They don’t know that the [mortgage] broker is about to get them hook, line and sinker.”

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Unscrupulous lenders have counted on HUD not to pay attention. And for an agency that’s been undergoing a major managerial overhaul, that’s been easy to do. In 1995, at President Clinton’s urging, the agency liberalized its loan approval standards and made other changes to make mortgages easier to get. Borrowers no longer had to prove that their income would be stable for five years; three years would do. In calculating burdens existing debts place on homebuyers’ finances, debts aren’t considered “long-term” unless they’ve lasted for nearly a year. Child care was eliminated as a household cost, on the reasoning that borrowers could find some other way to care for their children. The agency even allows lenders to establish their own additional criteria for approving FHA mortgages if a borrower doesn’t meet HUD’s own standards.

Over the past six years, Congress has also authorized HUD to substantially raise its price ceilings on FHA loans in high-cost cities, now up to $460,000 for a four-unit building. This move brought FHA loans into much wider play in here New York.

Then in 1997, Cuomo announced the 2020 Management Reform Plan. Spurred by budget cuts from Congress, this streamlining effort resulted in agency-wide staff declines. Now, HUD increasingly relies on private contractors in the banking and real estate professions to manage and sell properties, and to check the soundness of loans and appraisals.

These sweeping changes have decisively shifted responsibility for watching FHA lending out of HUD and onto contractors and banks. The agency’s Inspector General has linked this move to some of FHA’s recent troubles. “In our opinion, the disconcerting trends in FHA foreclosure and delinquency rates are attributable to inadequate management controls to mitigate the increased risk resulting from 2020 Management Reform, specifically the outsourcing of virtually all aspects of the single family loan origination process under substantially liberalized underwriting standards,” the office wrote in its March 2000 Semiannual Report to Congress.

HUD reviews 10 percent of the loans it insures, to make sure that lenders supply mortgages only to qualified borrowers and that appraisals accurately estimate the value of properties. But the IG has found that in many cases HUD’s contractors are not seeing the obvious red flags. One audit found that 46 percent of the loans reviewed by contractors had “substantial underwriting errors” that the contractors had not spotted, such as unresolved credit problems among borrowers. And in 21 percent of the cases, the contractors overlooked obvious signs of fraud or flipping, such as borrowers claiming to have high incomes with no savings, or sellers who didn’t have title on a property until the closing.

To insure that appraisals are not padded or otherwise abused, HUD also hires consultants to do field reviews. But the IG found that HUD officials were not strategic in selecting which appraisers to review for fraud-fully 84 percent of the appraisers who scored poorly in the past did not receive a field review. A low score also didn’t necessarily result in action against an appraiser.

HUD officials rarely agree with Inspector General Susan Gaffney, who has long feuded with Secretary Cuomo, and her assessment of FHA’s recent performance is no exception. They point to a FHA insurance fund that has gone from a deficit to nearly $16 billion in reserves under Cuomo. And they blame many of the FHA problems squarely on the troubled 203(k) program. “Numerous analysis has shown the dramatic positive effect of 2020,” HUD’s Franklin says. “I don’t think they are linked at all.”

To its credit, the agency has also mounted a coordinated attack against FHA lending abuse. In 1999, the agency launched a Credit Watch system to sanction lenders with high default rates and bar them from doing business with HUD. So far, 100 have been hit. “It sent a message to lenders that we were going to be fair but be tough,” says Franklin.

And last summer, HUD started its “hot zone” program in neighborhoods with high default rates, including large swaths of New York City [see map, page 17]. During the moratorium, investigators combed over the work of lenders and appraisers working in these neighborhoods to look for signs of fraud, and property flipping in particular. HUD has pledged that it will not pay insurance claims from lenders who knowingly made bad loans in the hot zones.

This is HUD’s secret weapon: In cases of fraud or extreme negligence, the insurance fund does not have to pay lenders back. Banks and other observers have noticed that in the last year or so, the agency has been getting better at saying no to lenders looking for insurance money. The Mortgage Bankers Association recently reported that 42 percent of its lenders who have been reviewed by HUD monitors had received a penalty or a sanction. And among them, 93 percent lost FHA insurance.

The road to redemption, however, hasn’t been easy for HUD. Lenders are not happy with the prospect of losing business and gaining hassles; when the agency announced the first disbarred lenders from Credit Watch, it got sued by some of them, and lost. (Eventually, HUD did win on appeal.) And HUD’s insurance payments to Firstar and M&T for their losses in the New York 203(k) debacle are likely to mount to the tens of millions.

Ultimately, say agency watchdogs, nothing is a substitute for strong monitoring of lenders. “The system would work if there was oversight and quality control,” insists Bradford.

And refusing to pay claims, they say, is a start. “It’s the most sensible way to punish the lender for not doing what they want,” agrees NTIC’s Harmon. “As long as HUD keeps it up and doesn’t back down, it should be a permanent solution.”

It may have to be. As long as mortgage lenders and their banking partners know that FHA will bail them out, there will be little incentive for them to change what they do. M&T is sticking by its belief that HUD-and not the bank-remains responsible for the soundness of the loans it buys. “Once it has FHA insurance on it, it’s supposed to have met guidelines,” says spokesman Zabel. “We will be looking to HUD to insure that the secondary market for FHA insured loans maintains its integrity.”