A lot of things happen first in California. Right now, the state is breaking ground in second-mortgage investment fraud.
Unknown thousands of investors have flocked to mortgage-investment companies offering "safe" 20 percent to 30 percent returns on money invested in residential real estate. Those returns can be honest ones or they can be frauds.
"We have found that about half of those investing in frauds have been the elderly," says John Mackie, California's deputy secretary of business, transportation and housing. "They see their cost of living going up, and California real estate also going up, so it looks like a good deal."
Second mortgages (or deeds of trust) are a second loan against the value of a house. The homeowner makes regular monthly payments on the loan, just as he does with his first mortgage. The payment on many second mortgages, however, covers only the interest due, plus just a little bit of principal. Most of the principal falls due in a lump-sum, called a balloon payment, at the end of the mortgage's three- to five-year term.
How will the homeowner cover that big balloon payment? He expects his house to rise enough in value so that his bank or savings and loan will give him a new and larger first mortgage. That new loan should produce enough cash to retire the second mortgage on schedule. He also hopes that interest rates will fall, so that his new mortgage will be less expensive.
If credit is still tight when the second mortgage comes due, or if his income has not risen very much, the homeowner may find that he cannot get the bigger first mortgage he had hoped for. At that point, the second mortgage could go into default.
Second-mortgage holders tend to assume that their investment is safe, because it is backed by the value of the house itself. But in foreclosure sales, houses may not bring their assumed market value. A house might be sold for just enough to cover the first mortgage (which takes precedence), leaving the second-mortgage holder out in the cold.
In other words, second mortgages can be a riskier investment than many people realize. Mackie's agency is working on about 140 enforcement actions against mortgage brokers. The deceptive practices include:
False claims that an investor's money is protected against loss.
False property appraisals, where a company claims that a house is worth more than is actually the case. If the loan goes into default, you will learn, too late, that there is no effective security backing your investment.
False statements about how long the company has been in business.
False statements about the mortgage investment itself. "We found cases where a mortgage said to be the second loan against a particular property was in fact the ninth loan," Mackie told my associate, Virginia Wilson.
Ponzi schemes. Instead of buying second mortgages, some companies used investors' money to speculate in houses. When the speculations didn't pan out as fast as expected, the companies began using new investors' funds to make monthly payments to older investors. Eventually, the house of cards collapsed.
False return-on-investment claims. Yields are so complicated to calculate that investors cannot easily check whether or not they are getting the promised 20 percent. And as the saying goes, it's not just the return "on" your money that you have to worry about, it's the return "of" your money when the mortgage comes due.
Anyone investing in second mortgages should hire a real-estate lawyer to double-check the mortgage company's claims. Among the questions you need answered: Are there any other loans against the property? Do the combined loans against the property amount to more than 80 percent of the property's value (if so, your investment may not be secure)? Do the appraiser and the mortgage company have good credentials? Is the homeowner financially secure enough to pay off the second mortgage when it comes due? Are the second-mortgage papers in order?
In California, a task force is working on improved disclosure laws for second-mortgage investments. If adopted, the laws could become a model for other states where similar frauds are starting to crop up.