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In the late 1990s, a widespread mortgage scam targeted at low-income neighborhoods was uncovered in the Minneapolis-St. Paul metropolitan area. Predatory lending, in the form of property flipping, had taken hold in the Twin Cities.
Predatory lending in brief
Predatory lending is difficult to define, but it usually involves at least one of the following practices:
- Asset-based lending, or basing a loan on the value of a customer's home equity instead of his or her ability to repay the loan.
- Loan flipping, or convincing customers to refinance repeatedly. High points and fees are added each time the loan is refinanced; and
- Fraud and deception, which usually consist of using false loan documentation or other falsified documents to conceal the true nature of the loan. 1/
The last practice reflects what happened in Minneapolis. Twin Cities mortgage-foreclosure-prevention counselors and housing professionals noticed an alarming increase in the number of low-income homeowners who were on the verge of losing their homes. Many of these homeowners had high-interest-rate mortgages, hidden second mortgages and no escrow accounts. The purchase prices of their homes were much higher than the market values of other homes in their neighborhoods. In addition, many of their homes had been purchased and sold on the same day. As Twin Cities housing leaders investigated further, they found that phony appraisals and loan documentation were being used to finance home purchases for low-income borrowers. This fraud and deception formed the basis of one of the more extreme examples of predatory lending: property flipping.
Property flipping defined
Property flipping is the practice of purchasing a home and rapidly reselling it at an inflated price to an unsuspecting borrower. Fraudulent documentation and misleading loan agreements are used to trick the buyer into thinking that the property is worth more than its actual value and that the mortgage terms are reasonable.
A property flip might work like this: an investor purchases a home for its market value of $50,000. The investor obtains a fraudulent appraisal stating that the house is worth more than its market value. The same day, the investor sells the home for $100,000 to an unsuspecting buyer.
The fraud doesn't stop there. To finance the purchase, the investor seeks a mortgage from an out-of-town subprime lender for 70 percent of the inflated price, or $70,000. The lender, seeing a low loan-to-value ratio and having little knowledge of the local housing market, is inclined to approve the loan. In some cases, the investor will also falsify loan documentation, such as income verification, in order to ensure that the loan is approved. The investor offers to pay the closing costs for the borrower and also agrees that the remaining 30 percent of the home price, or $30,000, will be financed through the use of a second mortgage. The investor promises that the second mortgage will be forgiven in full if and when the homeowner sells the home. Despite this promise, monthly mortgage payments include hidden second mortgage payments.
In the end, the investor makes a large profit on the deal. By purchasing the house for $50,000 and helping the homeowner secure financing for $70,000, he or she makes $20,000 when the house is sold. The homeowner, on the other hand, is left with an inflated mortgage, a high monthly payment and a home in need of significant repair or rehabilitation.
Task force addresses the issue
In order to determine the extent of the problem and identify possible solutions, the Property Flipping Task Force was organized in Minneapolis. Under the leadership of city officials, numerous nonprofit organizations, government agencies, lenders, secondary market representatives, legal firms, and others joined together to pool resources and help families who were victims of property flipping.
The first goal of the task force was to identify the extent of the problem. Task force members conducted outreach and research to identify the number of properties involved. They estimate that 450-500 properties were flipped. A local newspaper's analysis of the problem resulted in similar numbers. According to the StarTribune, 300-450 properties were flipped between 1995 and 1999. 2/ A comparison of the homes' original sales prices (the prices the investors paid) to the flipped sales prices (the prices the homebuyers paid) revealed that on average, homebuyers were paying twice the market value of the home. See the table below for more information.
Original Prices vs. Flipped PricesA comparison of original sales prices to flipped sales prices in the Twin Cities between 1997 and 1999.
Source: Property Flipping Task Force, May 2000. |
The property flippers recruited buyers from homeless shelters, laundromats and churches. Most of the homebuyers were low-income, and the flips were geographically concentrated in North Minneapolis neighborhoods.
Next, the task force studied how property flipping affected Twin Cities neighborhoods. The effects proved to be far-reaching and included:
- Increased foreclosures and/or bankruptcies due to high housing costs and repair bills;
- Increased property values—and, consequently, an inflated real estate market—due to fraudulent appraisals;
- Destabilized neighborhoods due to increased foreclosures and property deterioration; and
- Increased demand for legal resources to undo fraudulent transactions.
Once the task force felt confident that the extent and effects of the problem were understood, members formed Home to Stay, a multiagency program to help victims of property flipping avoid foreclosure and decrease their monthly housing costs. Home to Stay partners identified the mortgage company that held the majority of the fraudulent loans. They then negotiated to modify the loans and replace mortgages in default with deed-in-lieu-of-foreclosure agreements. (A deed-in-lieu-of-foreclosure agreement involves giving the property deed to the lender in order to avoid foreclosure. In exchange for the deed, the borrower is allowed to stay in the home for a set period of time and, depending on the terms of the agreement, may make rent payments to the lender.)
The program also partnered with Twin Cities Habitat for Humanity and Fannie Mae to refinance a portion of the loans. The mortgages refinanced by Fannie Mae were pooled, converted to government-backed securities and sold to the Evangelical Lutheran Church of America and United Methodist Church pension funds.
In some cases, refinancing required the borrower to take on as many as four mortgages: the first were 30-year, fixed-rate mortgages; the second helped to reduce the principal in order to keep the monthly payment affordable; the third was dedicated to rehabilitation costs and the fourth paid for closing costs. The second, third and fourth mortgages were financed with help from state government and nonprofits and are deferred until the home is sold.
As of December 2001, a $2 million investment by Fannie Mae had helped 29 families refinance their mortgages. Twin Cities Habitat for Humanity's $400,000 investment helped six additional families. Families assisted through the program have, on average, four members and a total household income of $31,750. Before refinancing, their average monthly mortgage payment was $872.22. The new average payment is $588.57—nearly $300 less.
The task force built an education component into the Home to Stay program. Because refinances make up a large portion of predatory loans, the task force wanted to increase borrowers' awareness of predatory lending to prevent them from refinancing into another predatory loan. The task force also wanted to ensure that homeowners were equipped with the information they needed to maintain and, in some cases, significantly rehabilitate their homes. To meet these education goals, the Home to Stay program required the borrowers who received refinanced loans to attend two years of homeowner education and counseling and to either contribute 50 hours of sweat equity to their homes or perform 50 hours of community service.
Lessons learned: partnerships and prevention are key
Property Flipping Task Force members learned two major lessons as they addressed the issue of property flipping in the Twin Cities. First, they learned that partnerships were essential for their success. The task force relied on numerous partners—including nonprofit organizations, state and city governments and private lenders—to pool resources and identify flipped properties, rework the loans, develop the Home to Stay program and provide counseling. Volunteer legal help was key in correcting the deceptive loans and negotiating with the lenders that held the first mortgages. Legal assistance also resulted in the prosecution of close to 20 parties involved in the property flipping. All of the partners provided unique expertise and helped ensure that scarce resources were leveraged to help as many families as possible.
Second, task force members learned that prevention may be the most cost-effective way to address property flipping. On average, it cost $40,000 per family to correct the predatory loans, and more than 50 families are currently waiting for assistance. The task force faces the continuing challenge of committing resources to help the remaining families. As the task force reflected on the enormous cost of correcting fraudulent loans, members agreed that the best way to prevent future property flipping and other predatory practices may be to educate and counsel homebuyers. Armed with knowledge of the mortgage process, homebuyers might be less likely to enter into costly or fraudulent transactions. The task force now focuses on homebuyer education initiatives, and its members have joined Don't Borrow Trouble, a public education campaign designed to draw attention to predatory lending and provide all potential homebuyers with information that will help them avoid deceptive or abusive lending practices.
1/ Governor Edward Gramlich, member of the Federal Reserve Board of Governors, speaking at Cleveland State University in March, 2001.
2/ Steve Brandt, "Reeling from Deals," Star Tribune, September 12, 1999.
