California has the second-highest risk level for mortgage application fraud in the nation, according to the Interthinx 2014 Mortgage Fraud Risk Report. Even a 15% decrease in mortgage fraud activity during 2014 failed to free the Golden State from its dubious standing as the second-greatest state at risk for mortgage fraud. Another sand state, Florida, is the first.

Homebuyer occupancy misrepresentation is now the most common form of mortgage application fraud in California. Occupancy misrepresentation occurs when the buyer of a property to be funded by a mortgage lies about whether the property they’re purchasing will be used as their primary residence. [See first tuesday Form 202-2 and 202-3]

Los Angeles, Riverside and Fresno are all listed in the top ten metropolitan areas at risk for occupancy misrepresentation in mortgage originations.

Why lie about occupancy?

What benefit do these unscrupulous single family residence (SFR) buyers reap when they lie?

Buyers of houses misrepresent occupancy with the intention of misleading the lender to originate a lower interest rate consumer-purpose mortgage with minimum down payment requirements.

On taking title, the deceptive buyer is really an absentee owner who rents out the property either as an income-producing investment property or one to hold until it can be flipped at a profit.

The current high demand for rental accommodation in California tempts more and more speculators and investors to commit what they incorrectly believe is merely a minor infraction.

Speculators instigate occupancy fraud

California’s many metropolitan areas with high foreclosure and short sale rates are the main reason for the state’s top standing in the risk list. High turnover rates mean more short-term investors, called speculators, are likely to purchase and flip property while claiming primary residency. [See first tuesday Form 202-3]

Two types of speculators prey on properties available to flip. Speculators who appear with cash during an imploding market offer a way out for sellers and REO lenders unable to wait for a buyer offering to pay a higher price. When the market is starved for buyers, as in the Great Recession, these cash speculators provide much-needed liquidity in the face of a greatly diminished demand by owner-occupant buyers, called users.

The other type of speculator crowds the market when momentum is high, forcing out willing and able users by offering hassle-free cash to sellers.

These speculators tend to sit on these properties depriving buyer-occupants of housing while waiting for momentum and an artificial reduction in available housing to do its magic before selling at optimum prices.

Do the crime, do the time

Occupancy misrepresentation is terrible for all involved. Borrowers caught committing mortgage fraud are flagged by name on Suspicious Activity Reports (SARs). SARs are filed with the Financial Crimes Enforcement Network (FinCEN), a database maintained by the federal government. As penance for their fraud, these alerts will prevent the listed speculators and investors from obtaining new mortgages or refinancing existing ones, regardless of their legitimacy.

Further, when the speculator gets caught, the mortgage holder may call the mortgage and demand immediate repayment of the balance – extracting their ultimate payoff at the speculator’s expense.

Lenders are just as guilty as speculators

The real salt in the wound comes from mortgage lenders and mortgage loan originators (MLOs) who are willingly complicit in the fraud. Many mortgage lenders turn a blind eye, even encouraging the fraud through their MLOs or NMLS registered employees, electing to originate the present mortgage rather than maintain long-term business integrity.

The promise of greater earnings will continue to entice lenders and MLOs into compromising situations with occupancy fraud. Lenders need to originate greater volumes of mortgages if they are to increase their profits. This economic force means the likelihood of occupancy misrepresentation diminishing in California is minimal.

We have been here before. During the 2004-2006 housing bubble, loose lending practices allowed speculators to run rampant in that momentum market. Speculators took advantage of adjustable rate mortgages (ARMs) with low short-term interest rates and little to nothing down, flipping properties until the 2007 crash stuck them with a whole lot of nothing. With no organic, end-user buyers to ultimately hold the properties for a prolonged period, speculators defaulted on their mortgages en masse. This, in turn, contributed to the massacre of property values and left a badly hemorrhaging real estate market.

This brings us to the current threat of occupancy fraud. If mortgage lenders continue originating high-risk mortgages for quick but small profits, momentum speculators will be free to damage the market – again.

The need for 20% down

As first tuesday has iterated and reiterated before, it is time lenders return to fundamental lending practices.

Minimum 20% down payments ensure only borrowers able to sustainably meet the terms of the mortgage are granted funding. Consider that in the late 1970s, many lenders required 30% down when the buyer was not going to occupy the property. Fickle profiteers are far less likely to drop 20% on a property they’re going to flip – but they will gladly buy and flip with OPM (other people’s money).

Of course, strict mortgage qualifications will produce disgruntled, unqualified applicants struggling to reach homeownership in California’s slow financial recovery. However, even those homebuyers who are today unqualified will be grateful when lending restrictions act to stabilize the housing market and avoid originations that nearly always lead to another miserable housing crash.

Re: “A little lie on a mortgage application can cost you big,” from The Washington Post