Fools or Crooks: Testing for Fraud in the Residential Mortgage Market

Abstract

Current explanations for the high rate of default and foreclosure in the U.S. emphasize house price fluctuations and lax lending criteria. An alternative explanation for default and foreclosure, that has generally been neglected, is fraud. One impediment to identifying and measuring fraud is the lack of a statistical test capable of detecting it. This paper proposes and implements the first test for fraud in mortgage lending. In a completely serendipitous turn of events, subsequent to the writing of this paper, indictments for fraud were announced in the area under study. Tests reveal that the proposed test successfully identified the fraudulent activity. The test proposed here is important for at least three reasons. First it can document the role of fraud in the mortgage foreclosure crisis. Second, it can serve as part of a forensic effort designed to detect and deter mortgage fraud. Third, the model developed here demonstrates that mortgage fraud distorts repeat sales house price indexes because it artificially elevates house prices during the period of fraud followed by a subsequent collapse due to the foreclosure sales. Accordingly, fraud can give the false impression that foreclosure lowers area house prices when it actually artificially inflates them. This suggests an alternative interpretation for the recent empirical literature on externalities from foreclosure.