The Way We Live Now. The case for mandating fraud reporting by persons involved in real estate closings and settlements

Date02 January 2009
Published date02 January 2009
AuthorCourtney J. Linn
Subject MatterAccounting & finance
The Way We Live Now
The case for mandating fraud reporting
by persons involved in real estate
closings and settlements
Courtney J. Linn
US Department of Justice, Sacramento, California, USA
Purpose – The paper seeks to focus on the causes of the recent subprime lending crisis in the US
residential property market.
Design/methodology/approach – The paper reviews the present situation.
Findings – A number of causes for the crisis are shown, including the fragmented structure of the
real estate settlement process, and the various people involved in real estate closings who operate
under different regulatory and supervisory regimes with varying intensities of enforcement effort.
This fragmentation makes it difficult to regulate the conduct of real estate industry insiders.
Fragmented regulation also provides opportunities for swindlers, con-artists, and fraudsters.
Originality/value – The paper makes a case for a meaningful regulatory reform, namely mandatory
fraud reporting by all those involved in residential real estate closings and settlements.
Keywords Residentialproperty, Lending services, United Statesof America, Financial control, Fraud
Paper type General review
1. Background
Inspired by the financial scandals in England in the early 1870s, Anthony Trollope’s
novel The Way We Live Now satirizes the dealings of a con artist named Augustus
Melmotte (Trollope, 1941). Melmotte, a financier with a dark past, draws investors into
a railroad financing scheme. The railroad investment company is fraudu lent, and, to
one degree or another, its investors come to face this truth. But they do so slowly and
reluctantly. Many of them hold too long to the false conviction that the stock price of
Melmotte’s railroad company will inevitably rise if only foolish optimism prevails and
the company’s lack of fundamentals is kept out of view. When at last Melmotte is
exposed as a con artist, the investment scheme collapses. Fortunes are lost.
The investors’ optimism that forms part of the story line for The Way We Live Now
also forms part of the story line of the subprime lending crisis in the USA. Our story
began with a weak US economy after the bursting of the dot-com bubble in March 2000
and the events of September 11, 2001 [1]. In response, the Federal Reserve lowered the
federal funds rate 13 times between January 2001 and June 2003 to the lowest levels
seen since 1958, ultimately reaching a low of 1 percent [2]. Sustained low interest rates
during this period contributed to Wall Street ’s demand for higher yielding
collateralized debt obligations (CDOs) and mortgage-backed securities (MBSs) [3].
In response to this growing demand, residential real property lenders promoted
The current issue and full text archive of this journal is available at
The views expressed in this paper do not necessarily represent the views of the US Department
of Justice or the USA.
Journal of Financial Crime
Vol. 16 No. 1, 2009
pp. 7-27
qEmerald Group Publishing Limited
DOI 10.1108/13590790910924939
alternative mortgage products, loosely defined as subprime loans. The subprime loans
bore many features that came to define subprime lending: minimal income and asset
verification; adjustable (and hybrid adjustable) interest rates, an eagerness on the part
of lenders to lend despite high loan-to-value ratios (including 100 percent financing),
and severe prepayment penalties for borrowers seeking to prepay or refinance.
The subprime share of the residential lending market rose from 2.6 percent in 2001
to 14 percent in 2005 as the market value of these kinds of loan originations increased
from $160 billion in 2001 to $600 billion in 2006 (New Century Report (2008, p. 32)). By
2006, nearly 40 percent of all loans funded in the US residential lending market were
so-called subprime loans [4]. And, two-thirds of the securitized subprim e loans
originated in 2005 had adjustable rates of which 80 percent were “2/28” hybrid
adjustable rate loans, meaning that the interest rate on the loans was set at a relatively
low rate for the first two years and then reset to higher adjustable rates after two years.
As waves of “2/28” loans began to reset, March 2007 was the peak month for resets
borrowers came under pressure. Property values, which had increased dramatically
over the preceding years, began to flatten out and then decline beginning in the third
quarter of 2005 [5]. Prepayment penalties discouraged borrowers from refinancing or
paying down the principal [6]. Thus, price decreases, combined with loan products that
reset at higher adjustable rates, and prepayment penalties, had the cumulative effect of
locking borrowers into loans that were beyond the borrowers’ financial means to repay
or refinance. The result was a wave of loan default and foreclosure activity that began
to crest in the Summer of 2007, and has yet to subside.
Though as early as 2004 federal regulators warned that subprime borrowers were
taking on mortgages they could not afford, the US Department of Housing and Urban
Development (HUD) indirectly encouraged such risky loans in an effort to place more
low-incomeand minority familiesin homes (Leonnig, 2008a).HUD stuck with an outdated
policy thatallowed Freddie Mac and Fannie Maeto count billions of dollars theyinvested
in subprime loans as a publicgood that would foster affordable housing[7]. As evidence
mounted in late 2006 of an imminent housing market collapse, the HUD Secretary
repeatedly insisted that the increase in mortgage failures was a short-term correction
(Leonnig, 2008b). Indeed, as late as June 2007, the HUD Secretary stated that he was
convinced this spring we will see the [real estate] market again begin to soar (Leonnig,
2008b; New CenturyReport, 2008). Subprime borrowers were not the onlyones taking on
more riskthan they could bear. Encouraged byregulatory changes made by the Securities
and Exchange Commission (SEC), largeinvestment banks did the same.In 2004, the SEC
relaxed regulatory limits on the amount of debt large investment banks could take on
(Labaton, 2008).Large investment banks took advantageof this relaxed rule to buy more
and more MBSs in increasingly leveraged transactions. The investment returns were
large, and for a long time the financial services sector thought it was living in halcyon
days. As thingsturned out, they were reliving mistakesof the Savings and Loan Crisisof
the 1980s and early1990s. In that earlier time, the biggestdanger for financial institutions
[was] lending based on excessive optimism generated about certain kinds of lending
that [were] the fashion of the day (Seidman, 1996).In the subprime era, the same danger
existed. We justdid not see it until too late. In an environment of lowinterest rates and an
unfounded beliefon the part of the public (and perhapseven government regulators) that
real estatevalues would inevitably increase,borrowers, lenders and WallStreet investors
were excessively optimism about subprime lending.

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