A 'Silent' Menace

The term "silent second" is used to describe self-serving or perhaps fraudulent schemes by which house sellers accept second mortgages as part of a sales transaction without the full knowledge of the first mortgage lender. The "silence" refers to the absence of disclosure to the first mortgage lender.

One type of fraud can arise when the second mortgage replaces part or all of a down payment. For example, the buyer and seller agree on a price of $200,000; the buyer has a commitment for a first mortgage loan of $180,000 but doesn't have the $20,000 required for the down payment. To make the deal work, the seller agrees to accept a silent second mortgage for $15,000. As far as the first mortgage lender knows, the down payment is $20,000, but in reality it is only $5,000.

The silent second increases risk to the first mortgage lender because it takes only a 5 percent decline in home value to eliminate the borrower's equity, rather than the 20 percent decline that the lender counted on. When equity is depleted, some borrowers stop paying their mortgages.

This silent second is also risky to the seller because it can't be recorded at the time of the sale -- that would give the game away. This means the seller has an unsecured loan until the transaction is completed and the lien can be recorded. How long the seller must wait before recording the lien is usually negotiated between the parties. The longer the seller waits, the greater the risk that other liens will be placed on the property, which would endanger the silent second.

An even more serious deception of the first mortgage lender arises when the silent second is used to inflate the sale price beyond the true value of the house in order to increase the size of the first mortgage. Assume the same house as before, with buyer and seller agreeing on a true price of $200,000, but in this case the buyer has no down payment. The buyer and seller collude to set a fictitious price of $222,200, on the basis of which the first mortgage lender agrees to lend $200,000. This is 90 percent of $222,200 but 100 percent of the true value of $200,000. The seller agrees to a second mortgage for $22,200.

In this case, the first mortgage lender would know about the second mortgage. What the lender wouldn't know -- where the silence comes in -- is that after the transaction is completed, the seller will forgive the second mortgage. In this way, the lender is deceived into making a 100 percent loan, believing it is a 90 percent loan.

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Q I am in the market for a home. I have good credit but not the substantial assets needed to get a good rate. I know a real estate lawyer who will temporarily move me onto one of his bank accounts so I will be able to show stronger reserves. He charges a small fee for this. Once the deal is funded, I would be removed from his account. I really need to know if this transaction is legitimate.

A How can showing someone else's money as your own be legitimate? When you sign the mortgage application, attesting to the truthfulness of the information shown there, you will be perjuring yourself.

And you will be doing so to no purpose. Showing higher cash reserves will not get you a better price on a mortgage unless you use the reserves to increase your down payment. You can't do this because the money is not yours.

Lenders do want borrowers to have a cash reserve on top of the cash required for down-payment and settlement costs. Flashing someone else's bank account as your own could meet that requirement, but this required reserve is modest, typically amounting to no more than two or three monthly payments.

When you buy a house, you can be 100 percent certain that unanticipated expenses will arise. That is what the lender's reserve requirement is about. If you can't meet the modest requirements with your own funds, you should seriously reconsider whether you are ready to purchase a house.

And that lawyer ought to be disbarred.

Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site, http://www.mtgprofessor.com.

Copyright 2007, Jack Guttentag

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