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'Churning' Ploy Is Resurfacing


CHICAGO — California mortgage industry regulators have been warned to be on the lookout for a long-defunct "churning" scheme in which unscrupulous mortgage brokers generate thousands of dollars in extra fees by convincing unwitting borrowers to refinance their loans every few months.

Though the lenders maintain no one is getting hurt, least of all consumers, authorities say just the opposite is true. Not only do borrowers who participate in the multiple refinance scheme fail to build equity, said R.J. Harvey of the Illinois Office of Banks and Real Estate, they also could lose their good credit standings. "Each time they refinance, their credit scores drop," said Harvey, who sounded the alarm at a conference here late last month. "Eventually, they won't qualify and they'll be stuck with a higher [mortgage] rate."

Perhaps even worse, participants also could unwittingly be named as co-conspirators in a plot that investors in mortgage-backed securities say damages the integrity of their investments. Churning was banned by the Department of Housing and Urban Development more than a dozen years ago.

"We expect the refinance transaction to be in the homeowner's best interest" by resulting in an improvement in affordability, not as a "vehicle for churning new mortgages," the government said in a 1990 memo to lenders.

Fannie Mae and Freddie Mac, the two largest investors in mortgages, also prohibit the practice by refusing to take delivery of any loan in which the broker has taken another application from the same borrower for the same property or has entered into an agreement to do so within a certain number of months. Fannie and Freddie are two giant government-sponsored financial institutions chartered solely to keep the money flowing for home loans. They do so by purchasing loans from local lenders and packaging them into securities that are prized by investors throughout the world.

Because Fannie and Freddie touch perhaps 60% of all home loans and lenders like to have the option of being able to sell their loans at any time, most mortgages are written to conform to government-sponsored enterprises rules. And both companies say they want no part of those that are repeatedly refinanced by the same broker over short periods. Despite these prohibitions, several lenders in Illinois seem to have revived the ploy, according to Harvey, who is manager of supervision in the mortgage banking division of the state banking and real estate office.

Harvey stressed, however, that no charges have been filed because it has yet to be determined whether churning is illegal in Illinois. Harvey told regulators from other states that he also has alerted HUD, Fannie Mae and Freddie Mac, all of which are now in the process of reviewing loan files to see if their rules have been broken.

The scheme in question works like this: Brokers target borrowers with high interest rates and promise to refinance loans to the current market rate or sometimes lower. But rather than make the jump down to the lowest rate in one fell swoop, lenders step the rate down in five-or six-month increments over an extended period.

Because the first refinancing is still above market, brokers can obtain a premium price for the mortgage when it is placed with a lender that actually funds the loan and then sells it on the secondary mortgage market, where Fannie Mae, Freddie Mac and other investors operate. After a few months, the loan is refinanced again pursuant to a prearranged agreement with the borrower, but only to a slightly lower rate so the broker can once again sell the mortgage for a premium price. Then the process is repeated again and again until the rate originally promised is reached.

Each time the loan is refinanced, the broker establishes a "temporary buy-down" by using all or part of the proceeds from the loan to pay the closing costs and fees on behalf of the borrower. Sometimes the broker pays the borrower's entire monthly payment during the step-down period, which can run on for as long as five or six months. In other instances, the borrower is required to make the payment at the lower rate and the broker makes up the difference, keeping the remainder as profit.

But in almost all instances, the lender pockets thousands of dollars in extra fees each time the loan in refinanced. "One young guy [under investigation] is building a $1-million house with the earnings" he generated by churning mortgages, Harvey said.

Originally, the offending brokers targeted borrowers with good credit or those whose loan amounts exceeded the limits set by HUD and Fannie Mae and Freddie Mac. Currently, the Federal Housing Administration can insure loans up to a maximum of $260,600, and Fannie and Freddie can buy loans up to $300,700. Now, the unscrupulous brokers' marks run the entire spectrum, and they frequently sell the loan to different lenders each time it is refinanced to avoid detection.

To persuade borrowers to participate in their schemes, some brokers claim that many major lenders are eager participants. They assert that sharing a commission with a client is "a legal alternative" that can save thousands in interest. The borrower also is told the money need not be reported as income to the IRS. But that may not be correct, Harvey said.

Moreover, many borrowers are not told that to receive a new interest credit, they must requalify each time the loan is refinanced. Thus, if their credit situation takes a turn for the worse, they may no longer be eligible and they would be stuck with the higher rate. If a borrower decides to opt out of the scheme before all stages are reached, he, too, would be throttled with a higher-than-promised rate.


Lew Sichelman writes a weekly housing column that appears in newspapers throughout the country.

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