Tuesday, July 8, 2008

Charges Laid in Mortgage Scam

The part of the subprime mortgage crisis that is hardest to understand is how so many people were able to get mortgages for amounts that they couldn’t possibly pay back. One case in Massachusetts sheds some light.

Kenneth Garabedian, a mortgage broker, is charged with selling fraudulent “verification of deposit” documents to make it seem like mortgage applicants had more assets than they really had. The purchasers of these documents knew they were committing fraud, and the mortgage applicants were either incredibly naive or they knew they were breaking laws as well.

On the surface, it might seem that the lenders were innocent victims of this fraud, but I don’t think this passes the sniff test. By allowing low-documentation and no-documentation loans, these lenders were essentially inviting fraud.

The fundamental problem comes down to how people are compensated for mortgages. Each mortgage is presumed to produce a certain amount of profit over its lifetime. The amount of this profit depends on the mortgage amount, interest rate and terms, the borrower’s likelihood of defaulting, and other factors.

The profit from each mortgage is realized over a long period of time, but the various salespeople and other facilitators are paid a fraction of this presumed profit immediately. This creates a strong incentive for salespeople to ignore the credit-worthiness of borrowers. So, lenders must check each borrower’s ability to pay carefully.

Unfortunately, lenders weren’t doing this job well. As long as house prices kept going up, this lack of oversight wasn’t exposed, and regulation continued to become more lax. Now that the bubble has burst, weak oversight by lenders has become obvious.

Maybe a portion of the commissions paid to salespeople on mortgages needs to be deferred and made conditional on the mortgage not going into default. Such a system might have made the current financial crisis a little less painful.

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