• Real estate maven Mark Hanson on mortgage fraud.

On Friday, the new annual LexisNexis mortgage fraud report for 2013 was released.

Bottom line:   74% of all loans contained loan application fraud and misrepresentations, higher than in 2006 by a wide margin.

“Application fraud and misrepresentation has been climbing steadily over the past three years. Seventy-four percent of loans reported in 2013 involved some kind of fraud or misrepresentation on the loan application. In 2012, that number was 69 percent; and in 2011, 61%.  The application form is comprehensive in collecting borrower personal identity, employment, asset, and liability information (all of which present verification challenges).  Application fraud and misrepresentations includes, but is not limited to, the following categories on the loan application:  Incorrect names(s) used for the borrower(s); occupancy; income; employment; debt and asset misrepresentation; different signature(s) for the same name(s); invalid social security number(s); misrepresented citizen/alien status; incorrect address(es) or address history; and incorrect transaction type.”

Over the past couple of weeks, following the investigative story in the Journal entitled “Dodgy Home Appraisals Make a Comeback“, I have dug deep into my previous work on the topic and new era appraisal fraud.

Bottom line:  Mortgage fraud is as rampant today as in 2006, which is no surprise given all of the correlations I have uncovered and brought to light, coupled with the parabolic house-price inflation over the 2.5 years ending June 2014, which was greater than the parabolic rise in the 2.5 years ending 2006, affectionately known as “peak bubble”.

Link:  LexisNexis 16th Annual Mortgage Fraud Report

Important Note on Appraisal Fraud: LexisNexis reports that hard “appraisal fraud” was found in 15% of loans, down from last year, and at a 5-year low, which seems to contradict the Journal story.  But, this discrepancy is mainly due to a “definitional difference” between what LN considers “fraud” and what was covered in the Journal. That is, the rampant fraud highlighted by the WSJ is largely a different type of fraud — more of a ‘fraud by omission’ and laziness — and occurs on much more than 15% of loans.  The pervasive fraud by omission, or laziness, is a product of the procyclicality of the sector when prices “always go up” in choosing comparables that “make the deal work” versus the “best comparables” for the subject property. 

Even so, it is important to remember that 15% of appraisals being fraudulent is far more than enough to artificially raise the value of every house in America, as it only takes four or five fraudulent appraisals in a one square mile region to push the values of hundreds of houses higher. 

As a result of this LexisNexis report, I have to add another 10% downside to house prices over the next two-years, on top of my 10% to 20% forecast.  

The following is my most recent note on appraisal fraud released on Friday, Dec 12, 2014:

12-12 Hanson…Systemic Loan / Appraisal Fraud & Incompetence;  Same conditions as in 2005-07;  House Price Headwind

1) Conditions that precipitate systemic loan origination and / or appraisal process incompetence & fraud rearing its head again, as investigated in the recent WSJ article entitled “Dodgy Home Appraisals Make a Comeback:  

a)  Persistently weak loan origination volume like over the past 18 months, following a lengthy prosperous period, such as the multiple Fed-induced refi-boomette’s from 2009 to May 2013, which puts appraisers under pressure to strengthen existing lender-client relationships, dig deep and make lofty commitments for new business, fiercely fight competition, and make every deal “work”.  

b)  The previous must occur in the context of stable and higher house prices after an extended period of house price inflation. This makes lenders and appraisers feel confident and / or receptive to suggestions, or business relationship and volume intimidation and / or threats, promoting procyclicality in appraisal valuation methodology, most notably in comparable analysis and choices.  Obviously, this occurs in reverse as well, as we saw in 2009-12.

2)  New-vintage appraisal process incompetence and fraud is highly psychological and late-stage bubble type stuff;  

Investor & Government investigations will lead to tighter appraisal policy & the stiffest house-price headwind since 2008               

When house prices have been inflating for an extended period of time and are stable and higher;  no significant problems have occurred on appraisals during the past couple of years due to parabolic house price inflation;  and sentiment towards housing is relatively bullish, then appraisers feel more confident, which leads to pro-cyclical valuation analysis. 

In other words, when there are numerous comparables from which to chose (many recently fully rehabbed that commanded top sales prices);  business is extremely slow due to slow market conditions;  lender-clients are pressuring appraisers to “turn deals quickly” and “make them work”;  and appraisal firms feel their lender-client relationships are highly volatile (or vulnerable) and subject to change based upon the performance of the last job done;  then it’s easy to understand why quality suffers, as staff spends less time researching the “best” comparables to their subject property.  Rather, it’s far less time consuming and stressful to simply chose the three or four comparables, out of many, that have the values to “make the deal work”.  Under these market conditions, it’s also easy to understand why — on an Appraisal Management Company (AMC) corporate level — expensive due-diligence and post-appraisal auditing is pared back.   

Because the science of appraisal is highly subjective — when there are so many comparables from which to chose — selecting a certain four comparables with higher values over a certain other four comparables with average or below average values, is easily defensible “in-house”.  However, upon independent appraisal review, or audit by the investor or regulator, the deficiencies become clear, which is what is happening now in the appraisal segment.   

3)  When the procyclicality suddenly ends, the “appraisal fraud delta” evaporates, removing the “air-pocket” under house prices in a short period of time

As investors and regulators dig deeper into recently discovered deficiencies and fraud, find that appraisal quality has dropped significantly over the past couple of years, and call for more investigations — or send back to lenders an increasing volume of loans for repair or buyback –, the procyclical practices will immediately come to a halt. This is akin to a credit tightening event. 

Back in 2008, I called this phenomenon the “appraisal delta”.  That is, the valuation differential between an appraiser using the comparables “that make the deal work” vs the “best” comparables for the subject property. At that time, I figured an industry wide appraisal tightening would be worth 15% to 20% in house prices, and I was probably pretty close.  I think we are close to another appraisal tightening event.  And because in this cycle a small number of large, appraisal bucket shops do the lion’s share of the appraisals, fear and tightening will spread quickly versus during the 2005 – 2007 period, when 10s of thousands of independent appraisers all had to tighten in order to create a catalyst.  

Bottom line:  The past 2.5 years of parabolic house price inflation ending June 2014 — that exceeded the inflation in the 2.5 year period ending at the peak in 2006 — precipitated the exact same fraud and will end the exact same way.  That is, with the “appraisal delta” coming in and house prices hitting a stiff headwind over the next year or more, making the consensus estimates of + 4% to 8% YoY gains, 10% to 20% heavy.    

4)  MBA loan volume vs the Case-Shiller 20

Bottom line:  Anemic loan volume (orange) following a busy period with underlying rising and lofty prices (white) are the exact same conditions that precipitated the massive loan and appraisal incompetence and fraud era, from 2005 to 2007.

5)  If house prices increased 33% in the 2.5 years ending at peak-bubble 2006 and in the 2.5 years ending June 2014 they increased more, then why do people think it’s different this time?

6)  4 or 5 fraudulent appraisals impact hundreds of houses…

As a visual example of the insidiousness of appraisal fraud, in the one square mile section of South Phoenix, if only 4 or 5 appraisals are pushed by 20% or more, then all these hundreds of houses increase by a like amount because most apprisers use the “best” comp, which is generally the highest comp.  If the Journal article is accurate and 20% of all appraisals are pushed “by at least 20%” then the air pocket under markets like these is enormous.

Bottom line:  When the market eventually flips from the pro-cyclical mania to counter-cyclical  on fear, crashes happen.