This is off topic of P2P loans, but I have mentioned a few times before the danger of the housing market crisis to your peer-to-peer loan portfolio so I will post this as information to people who are interested in debt markets or the current financial crisis.

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How the conversation occurred
My wife is Russian and we met because I lived in Russia for several years. We often have “Russian parties” where it seems that there are only Russian wives and the American husbands. Although I speak excellent Russian, I am often left to talk with the American husbands, so the ladies can gossip. Usually, I have little in common with the guys other than the Russian spouse so it can be a bit awkward at times. However, sometimes it can be interesting…

Why he started
Recently at one of these occasions, I met a man dating one of my wife’s friends who readily admitted to defaulting on over half a million dollars in mortgages to one of America’s largest banks. He explained that he had a small chain of stores that was running short of cash so he needed cash to fund the shortage. He also worked as a manager in a home construction business so he was familiar with real estate, appraisals, and mortgage financing.

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Since the main business was short on cash, he decided to buy an undervalued house and refinance it at above market value to bring in some cash. (The properties he purchased were undervalued on paper only and not based upon actual condition.) He pulled a list of low value for sale properties in a distressed part of town. Knowing how loose appraisals were running (often only a computerized value check), he ran the list of for sale properties against a list of recently sold properties. He often found that are distressed properties selling in the $15K to $20K range surrounded by properties selling for $40 to $50K. These are not California or New York prices, but repeat multiple times and it can add up to more than a half a million dollars and the same thing must have been happening on a much larger scale in other markets.

How it worked
He would buy a property at $15K, mow the yard, plant $300 in landscaping, paint the front exterior, and add curtains to the windows. In total, he would spend less than $1,000 prepping the house for reappraisal. The initial financing came from a local millionaire who offered his money at around 12% for 60, 90, or 120 day periods. After cleaning up the property a bit — putting lipstick on a pig — he would go to the major bank and refinance so that he could pay back the original financier. The major bank would refinance for $50K based on the surrounding properties’ recent sale values and the bank would often not even require the appraiser do a drive by inspection. He knew this by the appraisal reports he would receive from the bank which only showed comparison values and not a single picture. If there was ever a picture it was only of the exterior.

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So a $15K house would give the owner $50K in cash (less refinance fees and some “lipstick”) netting him about $32K in cash to fund a new house to refinance or to keep the main business above water. Considering that most of the mortgages were in the $50K range and that he defaulted on $600K in loans, he was able to do this twelve times before the scheme caught up with him. He said that he believes that the mortgage mess occurred because the banks did not care if he paid back the loans because the mortgages were immediately resold to other investors after the bank pocketed fees on both sides of the transaction.

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As I mentioned before in relation to Prosper loans, you want the loan originator’s interests to be in line with the investor. Otherwise, you are asking for trouble just like the above example.

Does he feel guilty?
I asked the man who defaulted on the mortgages if he feels at all responsible for the current economic mess, and he did admit feeling a bit guilty about defaulting on the homes but he said that banks were enabling partners in the fraud because they wanted to resell the loans so badly that they did not even care about fraud. He also reminded me that these same banks who gave him this money based on a computerized appraisal are the same banks that congress voted to give $700 billion dollars of tax payer money. Forgive me if I have little confidence.

By the way, you can’t really do this same scheme now because banks are requiring an in-person appraisal.