Where's the Line? What Am I Missing? (Long) - Posted by Ed Wachsman

Posted by Irwin on April 25, 1999 at 17:26:12:

You don’t create 2nd mortgages to purchase property. You create them when you sell.

Where’s the Line? What Am I Missing? (Long) - Posted by Ed Wachsman

Posted by Ed Wachsman on April 24, 1999 at 05:27:13:

I have a friend who is an experienced investor. Recently he has done about a dozen deals (sales, not purchases) with what I consider to be phantom seconds. I’ve pointed out to him what I feel are the dangers but he has come back with an argument I am having trouble refuting relative to HIS liability.

His contention:

  1. He was approached by a mortgage broker who claimed he had lenders who would do 100% deals if the investor would carry back a second.
  2. He buys with cash or credit line with the intention to flip either immediately or within several months after repairs. He buys for his own benefit, not in an arrangement with the ultimate buyer (though he sometimes has someone in mind, he doesn’t go shopping with them.)
  3. The investor markets and sells to people who are not knowledgeable about price and who only care about payment and owning their own home.
  4. The investor does no comps but has a general sense of the values in the area and sells to the buyer at the highest price he thinks the appraiser can find comps for.
  5. The appraiser finds comps at $70,000 and the lender provides a first at $56,000 and the seller (with lender approval) provides a second at $14,000.
  6. The seller submits a note to the mortgage broker for lender review if requested. The note only requires payment on sale of the property.
  7. The seller never requests any particular appraisal amount, doesn’t offer the appraiser any special inducement for any particular appraisal amount, doesn’t even know the appraiser.

His contention is that he is sending a buyer to the broker and what the broker, buyer and appraiser do is their business. Based on my buddy’s explanation, I don’t believe he is asking the buyer to misrepresent anything.

The problem arises with the fact that if the buyer stubs his toe financially (loses his job, high medical payments, etc.) the lender is going to get creamed on a foreclosure repo because the true value of the house in the example is probably low $50’s at best. However, in the neighborhoods where my buddy works, there are a lot of investor deals with phantom seconds and a lot of property transfers in the $60’s and $70’s. Most (all?) of the seconds are fraudulent devices to get the investors nothing down deals on purchases or are used by the investors to get their buyers nothing down deals and the seconds are forgiven, torn up, etc… The appraiser doing comps for my buddy’s sale ends up with what on the surface appears to be legitimate comps but which any appraiser with an ounce of brains would know are worthless given the neighborhood. All those investor purchases around $70k are really sales in the low to mid $50’s. For example, I’m assuming that when the appraiser does comps he/she finds a group in the 50’s and a group in the $70’s but each group would typically have similar characteristics. Seems like they should be resolving the discrepancy to determine why the disparity exists. In my mind they are overlooking the obvious and just go for the “number”. But that is to keep them in the good graces of the mortgage broker, not to help my buddy.

Additionally, any lender should know that when a seller carries back a note (whether it is a long term note or a short term note and whether or not it has monthly payments) in effect, the face value of the note is not its present value so that my buddy’s sale (or any other sale with these terms) is technically not a $70,000 sale. Given the terms of his note (assuming it is written for 30 years) and its true present value, it is actually a sale somewhere between $56000 and $56,700 or so. I think the present value of a $14,000 note with monthly payments based on a 30 year schedule at 10% would be somewhere around $600 or $700. With no payments due until the sale of the property (he doesn’t want to be accused of not pursuing the borrower for non-payment of the note and have it be characterized as a fraudulent device) the present value of the note probably approaches zero.

So I can see where the mortgage broker, appraiser and, perhaps, even the lender may have some culpability but I am having trouble seeing where my buddy is doing anything fraudulent provided he initially presents the property to the buyer as a $70,000 property and doesn’t screw with the price after the fact just to get the buyer a nothing down deal. Even if he knows the neighborhood is a lower value it 's not against the law to sell for more than what a property is worth in the eyes of most other people.

Is there a difference between doing something like this with “federal” lenders vs. non-federal?

What am I missing here?

Thanks and a comment - Posted by Ed Wachsman

Posted by Ed Wachsman on April 26, 1999 at 03:55:45:

Thanks to all who took their time to share their ideas on this.

My uneasy conclusion that it is not fraud on the part of the investor seems to be the concensus. I also agree with Scott that these deals are not necessary to make a good living; but not only that, even if done within in the parameters I outlined, I beleive making a practice of conducting business this way opens the investor to needless liability.

Lawsuits and arrests are often initiated on appearances (vs. absolute hard fact) - very often circumstantial appearances. This practice is so very close to the line that if even one loan that goes bad gets audited/investigated it could trigger a more widespread investigation. Since, of all the parties, the investor has the most to gain (and, in fact, typically would gain the most) it would be a logical (though incorrect) conclusion of any person or agency investigating the deals that there probably was collusion between the investor and one or more of the other parties. In fact, there would likely be a working premise within the investigation that the investor was the driving force behind what the investigators would be thinking was a fraud. I believe that while you could fight and probably win the legal battles, you would lose a significant amount of time and money doing so. Additionally, there is also a chance that you might lose the war - even though you were not guilty.

All in all, if you only did one deal this way (perhaps just out of expediency because all of the pieces happened to fall in place) there is probably only a small chance of a major problem developing. If a person made it a pattern and practice and did many deals this way, the chances of one or more loan defaults increase which increase the likelihood of audits and investigations and major problems.

Re: Where’s the Line? What Am I Missing? (Long) - Posted by JPiper

Posted by JPiper on April 25, 1999 at 18:10:34:

Based on the scenario you’ve given I don’t see ANY lender fraud. It appears that there is only one contract, that the contract contains the terms of sale, that all terms are disclosed. Further, there is no collusion with the appraiser. I can see no way this would be considered lender fraud.

There is no law that I’m aware of against either lender stupidity or appraiser stupidity. If lenders choose to make 100% or for that matter, 125% loans, my ethics don’t require me to NOT use them because I happen to think they’re foolish.

Appraisers have a tough job these days. In my area, it’s not going to be easy to determine the total financing picture from the MLS comps. It could be determined from the public records, but these aren’t online. So the appraiser is going to have some problems in this area?.and probably will not reflect the financing appropriately in the case where seconds or other forms of financing have taken place. Unless the appraiser does a title search on each comp, he’s not going to have the full picture?.and I doubt the appraiser has time to do a title search on each comp for each appraisal. In the MLS comps there’s not even a slot for a seller-carried second in the sales information.

But I don’t regard this much differently than the difficulty appraisers experience in an older area where values can shift considerably for similar square footage and other features, depending on the specific street the property is located on. For that matter I have seen considerable variation in value for properties with “views”, depending on what the specific view was. Minute changes in the view can create vastly different perceptions in value?.and how the appraiser can effectively determine this is beyond me.

As far as I’m concerned, when I sell a property I’m going to try to get the highest price possible. My ethics don’t require me to be a caretaker for the lender, or a caretaker for the appraiser. I think they’re more than sophisticated enough to take care of their own needs.


unethical - Posted by Michael

Posted by Michael on April 25, 1999 at 13:21:58:

I’m concerned reading this thread that too many people
are solely concerned with the legal aspects. This sort
of behavior should be avoided as it is both unethical
and dishonest.

To justify this sort of transaction because the lender
should have done better homework frustrates me. I guarantee there will come a time when you will personally be grateful that someone who could have
ripped you off chooses to be honest.
grateful that some

What is “Lender Fraud”? - Posted by Scott Britton

Posted by Scott Britton on April 25, 1999 at 11:35:17:


Having been in the non-conforming mortgage business… I can tell you this type of transaction goes on daily. Is it legal? Is it fruadulent?

My opinion is this is Lender Fraud. The representations to the lender are different than what actually transpires… ala… the closing statement which the buyer and seller sign.

One of the biggest problems is that the salesmen for the sub prime market encourage this type of thing. Does that make it any less fraudulent? No!

In fact… these seconds are none as “throw away” seconds in the industry. They have no market value… and are often times just thrown away.

Why not do the deal straight up and fashion a second where the Buyer can make payments (soft)? I have experienced good success with these paying off… thus increasing my profits.

Best of RealEstateSuccess!

Scott Britton

Re: Where’s the Line? What Am I Missing? (Long) - Posted by Irwin

Posted by Irwin on April 25, 1999 at 08:42:55:

Hi Ed:
In my area, you can’t create phony comps this way because non-brokered-investor sales are not reported to MLS and aren’t used for comparable sales. As long as I am not doing anything to unduly influence the appraiser, or the broker, I don’t worry about the consequences to the lenders. I look at it this way: Why should I worry about their money, when, judging by the loans I see them make, they don’t worry about it very much themselves. I don’t know what the investment theory is behind deliberately making terrible loans, but these fellows seem to have discovered one.
Also Ed, isn’t what your friend calls a 100% loan, just your typical 80% loan to a lesser credit buyer? ($70k X .80 = $56k). If buddy bought the house for $45k and after loan expenses, he nets $52,500, a $7,500 profit, he’s probably happy with that, and calls it a 100% (of all he’s going to get) loan.
As for Federal vs Non-Federal, the Feds (FHA/VA/FNMA) use entirely different loan criteria than the non-conforming guys, and appraisals and inspections are much tighter. I don’t think you see this problem on those loans, except to the extent that a Mom & Pop seller might fib a little on the down payment being made.

Re: Where’s the Line? What Am I Missing? (Long) - Posted by SCook85

Posted by SCook85 on April 25, 1999 at 02:09:34:

This is or was a very serious problem in Baltimore. There are not many programs available such as this one in the area anymore for the investors to pull off such deals. They have really tightened up underwriting guidelines and some lenders want to hold te first and the second (therefore getting 2 appraisals) to be sure the deals are legitimate. I personally don’t like the practice. Many deals in Baltimore have gone bad and the lenders are taking a bath.
If I had to point fingers and pick someone to hold accountable I feel that it should be the appraisers. If the appraisers would do there job accurately these situations can be avoided. An appraisal should include for each comp the details of how a deal was funded. Then they could do adjustment factors to the value of the homes based on the type of financing that was offered.


Isn’t this the “straw man” ploy? - Posted by Michael Murray

Posted by Michael Murray on April 24, 1999 at 15:08:06:

Wasn’t this discussed at the convention, or am I getting it mixed up with something else?
Michael Murray

Re: Where’s the Line? What Am I Missing? (Long) - Posted by Zeus(ID)

Posted by Zeus(ID) on April 24, 1999 at 14:59:07:

I don’t know if this still applies, but I remember learning a while ago that if you did this type of deal, in certain states, you would be ok if you had another written agreement stating that the seller would discount the note to $1/paid in full after the purchase was complete. The lender didn’t have to know about this so it was a way to allow buyers to get a no money down deal. Loopholes are all around and used every day. This practice may not seem ethical, but it is legal if you cover all the bases. You really need to know what the laws in your state are pertaining to discounting notes or releasing them altogether.

Re: Where’s the Line? What Am I Missing? (Long) - Posted by PBoone

Posted by PBoone on April 24, 1999 at 10:55:44:

This very same practice is happening rampantly in our area also (Portland OR) as long as the second is disclosed to the lender there is no fraud, but it is my belief that when a second is created then torn up after close a lender would say nothing UNLESS they lose on the deal later down the road. There seems to be a common mentality in the community that it is ok to do something wrong until you get caught. These very acts are the groundwork for failure and shortsightedness on the part of the investor.
This very act you speak of is being headed up by the people who are “Non-Profit” recieving the gov’t grants so who am I to say there is something wrong with the action.

Re: Where’s the Line? What Am I Missing? (Long) - Posted by BankRobber

Posted by BankRobber on April 24, 1999 at 10:33:21:

Interesting phenomenon (comps clouded by a deluge of phantom seconds).
I can imagine a senario whereby the same lender is scammed on multiple properties in the same neighborhood, then does some detective work and finds that your buddy has a pattern of creating “phantom seconds” and agreeing to release them upon sale of the property. I do not think that it would be difficult to prove that this pattern showed a willful and premeditated intent to misled the Lender. Of course the lender would probably never do such an investigation.

Re: Thanks and a comment - Posted by JPiper

Posted by JPiper on April 26, 1999 at 10:27:51:


I’m rather amazed at this conclusion?.and for that matter, at the conclusion of Scott Britton. Frankly, I think Britton misinterpreted your post. He seems to feel the note isn’t shown in the contract or on the settlement statement, which I’m gathering it is.

Here are the facts that you have presented:

  1. There is one contract which contains all the terms and conditions of the sale.

  2. The sale is an arms length transaction.

  3. The lender has received the entire contract, as has the appraiser.

  4. The appraiser is unrelated to the investor/seller

  5. The settlement statement reflects the contract.

Next, you ASSUME the following:

  1. Buyer defaults

  2. An investigation ensues

Given the above 5 facts followed by the two assumptions, it would appear to me that every transaction you are involved in which involves institutional financing of any kind exposes you to the same identical risks that you suggest in your conclusion.

Let’s assume that in your scenario the property is sold for $70K with FHA or VA financing. The appraiser bring the appraisal in. The buyer defaults. What changes?

Let’s assume that the investor sells the property for $50K with 100% financing in the manner you set forth. The buyer defaults. What changes?

Your conclusion seems to imply that if the buyer defaults that you are responsible for either the lenders faulty judgment regarding the buyer and his ability to pay, AND/OR the appraisers appraisal which may not have been accurate in your estimation. If I sell 10 properties for $50K with 100% financing, and half of the buyers default?.don’t the same questions arise? Isn’t price irrelevant in your conclusion?

In fact, to implement your conclusion in my area would require a check at the court house of EVERY comp as to the terms of sale evidenced by recordings of the deeds of trust. Without this, you would never know the complete terms. The MLS does not report “non-conforming loan with seller-carried financing” in it’s sale information. Nor does the courthouse. Frankly, to carry out your conclusion in my area would be completely impractical.

Further, to carry out your conclusion would require any investor/seller to become the monitor for the lender regarding the buyer’s ability and willingness to pay under all types of loan scenarios, and a monitor for the results of the appraisal, because a buyer default under any type of loan or terms would bring up all the same questions (particularly if there are several defaults).

Unless I have misunderstood the facts here, or unless there is a factor that I’m not aware of, I strongly disagree with your conclusion.


Re: Where’s the Line? What Am I Missing? (Long) - Posted by J.D. [Journey] Swindell

Posted by J.D. [Journey] Swindell on April 25, 1999 at 13:20:49:

As a newbie investor, if I am biding against an investor who is creating a phony 2nd to purchase a property, how can I offer a competitive bid, but without useing a phony 2nd? I have seen the aftermath of inflated property values in my area and don’t want to see this happen again.

Re: Isn’t this the “straw man” ploy? - Posted by Sue(NC)

Posted by Sue(NC) on April 24, 1999 at 16:47:49:

After thinking on this a little longer, this could fit the ‘straw man’ mold-

Investor A owns/has interest in many houses in a neighborhood. He gets strawmen B, C, D etc to buy some of his inventory at an artificially inflated price due to a phantom note. Miraculously, his remaining stock appears to be worth a whole lot more now…

Certainly would help his balance sheet, but seems to me (not a lawyer) that this would be an ‘unfair and deceptive trade practice’ (treble damages) if he were ever smoked out.

Re: Isn’t this the “straw man” ploy? - Posted by Sue(NC)

Posted by Sue(NC) on April 24, 1999 at 15:25:36:

Don’t know what was discussed at the convention, but the term ‘straw man’ usually means one person buys for another, so that the public doesn’t get wind of the fact that the second person is acquiring the property.

It usually happens in cases of assembly- like a developer needing to acquire several tracts of land for a shopping center. He wouldn’t want an individual parcel owner to know what he was doing, for fear that the owner might charge more, knowing that the property was a required part of the puzzle.

Re: Where’s the Line? IN Dallas/Ft Worth area too? - Posted by J.D. [Journey] Swindell

Posted by J.D. [Journey] Swindell on April 25, 1999 at 13:30:37:

Can anyone tell me if this is also happening in the Dallas Ft.Worth area? If it is, is it being done in the same way as the post above or how? Since I am a newbie I want understand what is happening in the area I am investing in. Thank you for any info.

Re: Thanks and a comment - Posted by Ed Wachsman

Posted by Ed Wachsman on April 26, 1999 at 12:04:54:

Hi Jim,

I agree that the bulk of Scott’s answer came from a mis-reading of my post but I wanted to concur with his point (primarily for clarity to newbies) that you don’t need to do deals on the edge in this business. There are plenty of deals with good to great profits without having to come anywhere close to even the appearance of an ethical problem.

Perhaps I wasn’t clear in my second post. I agree with your conclusion that if the investor does everything legit on his end he should have no problem. The very reason I originally posted the scenario was that I couldn’t find anything wrong with what he was doing and I wanted confirmation that I was analyzing the situation correctly (or a kick in the butt to get me thinking correctly if I had overlooked something). Both you and Irwin as well as some email I received indicated that the investor was on solid ground legally as long as he stayed within the parameters outlined. Again, I agree with that.

However, this is real life and sometimes even the appearance of problem can cause you lots of grief. I will hold to my belief that if you did a lot of deals like these that you stand an increased chance of being sucked into the problem when/if the loans go into default. The truth is that the investor is benefiting from the greed and/or incompetence of the mortgage broker and/or the appraiser. I agree, its not his fault and should not be his problem. As I have outlined the circumstance, by definition the properties are being appraised at roughly 20% more than their true value. I agree, not the investors fault. But the truth is that whether or not it is his fault I strongly believe that, since he has the most to gain, he will be looked at just as closely - if not more so - than the appraiser, broker, and buyer if some of these deals go to default and the lender starts asking hard questions. The logical assumption by those investigating will be that it is unbelievable that the investor could be involved in so many deals of this type without having been involved in some sort of collusion with the other parties. I agree that their logic would be wrong in this case but in most cases their logic would be on solid ground. The investor would say, “Prove it” and they probably couldn’t - but it could cost a lot of time and legal fees along the way. It wouldn’t be right, it wouldn’t be fair, but it would be the real world. Not long ago a very active investor in our community was featured on an “expose” on the nightly news. His crime (actually described below in brief to save time and space)? He bought a house from a woman subject to her mortgage. At the time he bought it he literally saved the house from foreclosure. Now she is upset because she says she was denied credit due in part to the mortgage still being in her name. Here’s the kicker. While I feel it is important for an investor to make sure that a seller has good information about “subject to” deals so they can make an informed decision, this woman was represented by a real estate agent. Why wasn’t the agent or the broker on the expose explaining why they hadn’t looked out for their client? They should have been advising her at a minimum to get legal counsel if they didn’t feel she fully understood the deal. I’ve seen the contracts, in my opinion he did nothing wrong but he was the one with egg on his face. I could go on with other examples of the state making rulings against investors with no basis in fact and other things. The point is you can be right and still pay a price as if you were wrong. If you consistently do deals in ways that will have a higher likelihood of scrutiny you risk (admittedly not greatly) more problems - even those you technically don’t deserve.