MICHAEL A. KNOX thought he had run out of ways to pay off his credit card bills
when he got the salesman's call two years ago. To wipe out his nearly $20,000
debt, he was told, all he had to do was take out a new, bigger mortgage on his
house.
Mr. Knox, then 60 and on disability, signed up. The mortgage broker sent him
eight checks already made out to his creditors, and Mr. Knox dashed to the post
office the day they arrived to mail them.
But the bigger house payment devoured 75 percent of his income. He quickly fell
behind. And the full meaning of what he had done suddenly became clear.
By using his mortgage to pay off his credit card debt, Mr. Knox had avoided the
humiliation of filing for bankruptcy. But he had put at risk something much
more important to him than his pride. In late January, with Mr. Knox in
arrears, the Wall Street firm that had bought his mortgage informed him that it
was taking away his home.
"They're going to have to carry me out of here," he told a lawyer in early
March. Days later, Mr. Knox, who had suffered for years from depression, was
found dead of carbon monoxide poisoning in his sealed-up car.
Encouraged by low interest rates and rising home values, millions of Americans
have been using their homes to pay off credit card bills. One-fourth of
homeowners who refinanced their mortgages took out larger loans on their homes
in order to pay off credit cards and other debts, according to a recent study
by the Federal Reserve.
The maneuver is known as debt consolidation, and mortgage lenders are using
national campaigns - from prime-time advertising to e-mail spam - to pitch it
as a sound way to ease the sting of credit card debt, which averages $13,000
for people who don't pay off their balance each month, according to
CardWeb.com. For many, probably a vast majority, it has been a boon. Experts
say the device is a factor in a recent leveling off of credit card debt and a
drop this year in personal bankruptcies.
But each year, tens of thousands of people - not just the poor - lose their
homes after trying to cope with their debts this way, industry figures show,
and their heart-rending tales are raising alarm among consumer advocates,
federal regulators and some mortgage lending officials.
In Bluefield, W. Va., a retired coal miner, William Anderson, 80, and his wife,
Kathleen, 79, owned their home of 45 years free and clear, but lost it in March
after falling behind on a new $48,000 mortgage that they were persuaded to get
in order to pay off their automobile loans.
Robert and Shirley McCall of Paris, Ill., were trying to pay off $7,720 in
medical bills when they took out a new $22,000 mortgage on their house, but in
failing to keep up with the larger mortgage payments, they were warned by their
lender in August that they were nearing foreclosure.
In Macon, Ga., Melissa and Shawn Lynch are trying to salvage their home. In
order to pay off credit card debts, they took out a second mortgage on the
three-bedroom home they bought in 2001 for $71,000, but then were hit with
medical bills on top of the new, larger mortgage payments. Three weeks ago,
they sought help from a debt counselor and discovered that their house was at
great risk. "We were young," said Ms. Lynch, 28, and the lender "smelled blood,
really."
While not everyone affected is a poor credit risk, much of the booming business
of debt consolidation focuses on such borrowers - what is known as the subprime
market.
The industry, which has an estimated four million outstanding loans, has
enabled many people with modest incomes to own their homes. But last year, more
than 16 percent of subprime mortgages were delinquent or in foreclosure. More
than 76,000 families with subprime mortgages tumbled into foreclosure in the
first quarter of 2004, and an additional 47,000 in the second quarter.
While statistical evidence is piecemeal, the rush to pay off credit cards and
other consumer debt by taking out bigger mortgages appears to be playing a
growing role in this trouble.
Many people who refinance mortgages, of course, do so simply to lower their
house payments. But the people who refinance for extra cash are as much as
twice as likely to lose their homes through foreclosure than those who
refinance for other reasons, according to statistics from the PMI Group, a
major mortgage insurer. And most subprime loans being made today - estimates
run as high as 70 or 80 percent - are debt consolidation loans like Mr. Knox's.
"Financing credit card debt on your mortgage, in general, is a bad idea,"
Edward M. Gramlich, a Federal Reserve governor, said in an interview last week.
"With the credit card debt you can go into bankruptcy, but if you put it on
your mortgage you could lose your house, and that happens a lot."
Policy makers see the very existence of these debt-consolidation loans as the
next issue in their battle with the subprime lending industry, which until now
has been criticized largely about its high costs, prompting new state and
federal laws.
Some industry officials say lenders have pushed too hard in selling dangerous
loans to vulnerable homeowners who may not fully appreciate the risks. Larry
Litton Jr., the chief operating officer of Litton Loan Servicing, based in
Houston, which collects mortgage payments on behalf of lenders, said that most
of the delinquent subprime loans he was handling involved debt consolidation
and borrowers who did not realize that they would go back to running up more
credit card debt unless they found some way to balance their income and
expenses.
"Even though, conceptually, debt consolidation is used to retire debt, it often
leads to increased debt burden," he said. "People make decisions sometimes that
aren't real rational whenever it comes to incurring debt. I sure hate for
people to draw conclusions that these people are irresponsible as a drug
addict, but they are similar in the sense that debt can be very addicting."
William C. Apgar, an assistant housing secretary in the Clinton administration,
said that homeownership "can't be used as an everlasting reserve fund for folks
who have more expenses than income on a perpetual basis."
But as the case of Michael Knox shows, many homeowners do use mortgage
refinancing that way and some lenders have sold the maneuver aggressively to
people hooked on the promise of easy credit.
Mr. Knox's story, pieced together from financial documents and from the
increasingly despairing letters he wrote to company officials, regulators and
others, is a particularly sad look at this dark side of the mortgage
refinancing boom.
Mr. Knox may have seemed like someone you would not want to lend money to. But
by the logic of the subprime market, he looked like a desirable customer.
Subprime lenders charge higher-than-usual interest rates and can protect
themselves by selling the loans to Wall Street, which in turn consolidates
large numbers of loans into investment pools and markets them to investors
worldwide in the form of asset-backed bonds.
But experts say that the market is susceptible to overzealous salesmanship and,
sometimes, fraud.
Mr. Knox had already refinanced twice in six months when he got the call from
an Aames Financial broker. In qualifying Mr. Knox for a $90,000 mortgage at
9.23 percent that he ultimately could not afford, company records show, Aames
waived its own rules for verifying income and employment. The mortgage was also
based on an assessment of his house that was considerably higher than an
official county estimate.
Aames, a medium-size lender based in Los Angeles, said it had done nothing
wrong in lending money to Mr. Knox, particularly because he had almost always
paid his bills on time. As Aames pointed out to an arbitrator who ruled in its
favor after Mr. Knox filed a complaint, "No one was pointing a gun to his head
to do it." More broadly, the company said it had stringent measures to avoid
problem lending, including a system adopted last year to determine whether
borrowers would truly benefit from its loans.
In April, the company disclosed that it was cooperating with a Federal Trade
Commission inquiry into subprime lending practices nationwide. And in Iowa, the
state justice department is investigating Mr. Knox's case, saying that it may
show that the lending industry is undermining homeownership by pushing too hard
for growth.
"In addition to being appalled by what happened to Michael Knox, we are very
concerned about appraisals that are inflated and we are very concerned about
incomes that are inflated or completely made up," said Tom Miller, Iowa's
attorney general.
Serial Refinancings
Mr. Knox became a homeowner in 1988, using a traditional bank mortgage to buy a
wood-frame house built in 1946 just north of downtown Des Moines. He paid
$29,000 for 984 square feet; ownership was a huge achievement for him. "He
loved that house," said his daughter, Marlene Knox.
Divorced and living alone after raising four children, Mr. Knox was anxious
about money, people who knew him say. He had held various jobs, from welding
grain elevators to working as a security guard at parking garages. But he
increasingly suffered from depression, compounded by circulation problems, and
his disability check of $1,068 a month left him perennially short of funds.
A neighbor, Janet L. Bequeaith, recalled that he would often buy cream cheese
on sale as a substitute for higher-priced protein. He also made his own
furniture, dabbled in unlikely inventions and taxied people to the doctor for a
few extra dollars. A financial high point came in 1998, when he won $15,000 in
a game show sponsored by the Iowa state lottery.
But then he found a surer way to instant cash. Or rather, it found him. Credit
card companies sent Mr. Knox blank checks, out of the blue, that he had only to
fill out to get thousands of dollars. "I tried to tell him that's not the way
to operate," said Dennis M. Wilhelm, a neighbor. "But he couldn't resist."
Mr. Knox opened charge accounts at Wal-Mart, Target and Sears. To pay utility
bills and other expenses, he used credit cards from Providian, Wells Fargo and
three other banks. His luxury was a desktop computer with an e-mail account,
neighbors say.
But eventually Mr. Knox was borrowing cash from one card to pay off another,
and when he ran short he would grab a two-week loan from a storefront lender
who charged interest at the annual rate of 520 percent.
That was when he started refinancing his home - first for $49,400 in September
2001, then for $67,000 in March 2002. Yet it was never enough.
Aames's brokers hunt for customers by using lists of people who recently
refinanced their mortgages. In telephoning these prospects, brokers said they
asked about credit card debt, both as an incentive to refinance again and to
increase their own commission with a larger loan.
"It's a dog-eat-dog world out there, and you do what you have to, to get
loans," said Stephen Black, a former Aames loan officer in Tysons Corner, Va.
"You don't lie to your client, but you make them feel like you're their best
friend and can be trusted."
Still, Mr. Knox posed something of a challenge. The real estate agent who sold
him the house said its value had risen to perhaps $65,000, which the county
confirmed in a recent assessment. That was not nearly enough to get Mr. Knox,
who was already spending 55 percent of his income on his mortgage, the new loan
he needed to pay off his bills.
Six months later, in September 2002, Ames said it would lend him $90,900 based
on a $101,000 valuation by an independent appraiser. Startled, Mr. Knox said he
worried that his taxes would soar. But he later wrote to the arbitrator that
Aames had assured him the appraisal would not be disclosed to the county. "The
appraisal was a complete sham," Mr. Knox wrote to the arbitrator.
In an interview, the appraiser, Mark S. Wallace, said all appraisals were
matters of opinion, and that he frequently resisted entreaties by lenders who
wanted inflated valuations. He has surrendered his license to settle an
unrelated case brought by regulators, state records show.
Aames said it had the appraisal checked for accuracy through a consulting
appraisal firm.
Who Wrote the Letter?
For Mr. Knox, the new appraisal left a major problem. The bigger mortgage would
raise his monthly payment to nearly $800, with taxes and insurance, from $643.
But he got only $1,068 in disability from Social Security, and Aames required
that his income be at least twice his debt.
Mr. Knox's broker, Matthew Wright, who was then with Aames, first suggested
inflating his income by creating a phantom renter, according to Mr. Knox's
written account. When he balked, Mr. Knox wrote, Mr. Wright said he could claim
income from his attempts to sell a mimeographed book on magic that he had put
together.
Mr. Knox wrote that "I never made a dime trying to sell my books," but his loan
papers - which Mr. Knox later said he did not notice - reported $820.42 in
monthly income from book sales, putting his debt-to-income quotient at 49.9
percent, slipping just under the company's 50 percent cap.
Still, Aames required additional proof of self-employment, and a reference
letter appeared in his file from a local banker. The letter was a fabrication,
The New York Times learned by calling the bank, which said the name of the
banker on the letter was fictitious; no such person worked for the bank.
Mr. Knox's family and friends say it is inconceivable that he concocted the
letter. In an interview, Mr. Wright disputed each point in Mr. Knox's account
of the loan and denied any involvement in the letter. "I've never, ever
committed fraud and never will," said Mr. Wright, who said he left Aames for a
better opportunity shortly after Mr. Knox got his loan. "If a customer tells me
this stuff you have to believe it."
Experts estimate that fraud is at play in at least 20 percent of all loans that
end up in foreclosure; inflated valuations are rampant, experts say, and
appraisal trade groups say the system needs to be overhauled. Connie Wilson of
AppIntell, a firm in Weldon Spring, Mo., that helps lenders avoid problem
loans, said employees of the lender and others who profit from the loans are
almost always involved in loans that later end up in foreclosure.
Last month, the Federal Bureau of Investigation warned of a looming "epidemic"
in mortgage fraud involving loan brokers, appraisers and lending officers. Its
caseload of open fraud inquiries surged to 533 investigations in June from 102
in 2001.
Aames credits a hot line it set up in 2001 with exposing employees who
improperly qualified borrowers. In other cases it was the borrower who
discovered irregularities. A disabled elderly woman in Seattle who settled a
case against Aames last year found fabricated letters and invoices in her file
verifying income she did not have.
Whatever the precise origin of Mr. Knox's fake letter, Aames's rules require
harder proof of self-employment, like a business license or advertising
receipts. Aames said the underwriter who checked the loan had waived this
requirement at his discretion.
A New Cycle of Debt
Mr. Knox had expected the new mortgage to leave him free and clear. But
borrowing $90,900 cost him $7,259 in fees and other expenses. After repaying
his existing $67,000 mortgage and mailing $15,574 to his creditors, he still
owed $3,800 in credit card bills.
He did what most borrowers do in this situation, debt counselors say: he ran up
more credit card debt. Even filing for bankruptcy on this new debt, which he
did six months later, could not save his home. The mortgage alone was simply
too big.
"My health has been ruined, my medical bills have gone up because of the stress
this loan has caused me," he wrote to Aames.
To consumer advocates, stories like Mr. Knox's show the need, at a minimum, for
some government intervention to warn borrowers of the risk in this debt
maneuver. With rising interest rates, some say the pressure on homeowners will
only increase.
"Credit is not just a benefit; it is also a dangerous instrument," said Margot
Saunders, a managing attorney at the National Consumer Law Center in
Washington. "Everything from cars to toasters that have some danger are
regulated, but loans which can cause such devastation when provided in the
wrong situation are not regulated."
Aames says it would object to any measures that unfairly restricted access to
credit. "It would be a great disservice to deny millions of prime and subprime
borrowers the opportunity to tap into the equity in their homes to pay for
important purchases and consolidate debt when the vast majority of these
customers repay their loans," Ian Campbell, a spokesman for Aames, said.
In a recent speech on subprime lending, Mr. Gramlich of the Federal Reserve
warned that steps being taken to curb lending excesses would apply only to
banks and other companies that are closely scrutinized by banking regulators,
and not to independent mortgage companies.
"We as an industry do a lot of great things in providing liquidity," said Mr.
Litton, the mortgage servicer. "But the problem is, we often lose sight of
common-sense things. Is it good business practice in principle to do three
cash-outs in one year?"
Mr. Knox pursued arbitration because his loan contract barred him from suing
Aames. In November 2003, the arbitrator rejected his case without explanation.
Aames, which said it received very few complaints about its loans, said it
stopped requiring arbitration because of controversy over the practice.
In Mr. Knox's case, the loan was sold to Bear Stearns, which says it offered to
extend his payments to avoid foreclosure. Consumer advocates say such offers
generally involve too little money to help people like Mr. Knox.
Instead, he bought more lottery tickets. He visited the local casino. And when
the foreclosure notice arrived, he phoned his brother, Christopher, in Arizona
to say goodbye.
"I told him to come out with me," Christopher Knox recalled. "And he said, 'I'm
too old to start over again.' "
A few weeks later, in early March, he made a last call for help. He phoned a
lawyer, and the lawyer contacted former colleagues at the state justice
department and told them that Mr. Knox had a strong case. When an investigator
there could not reach Mr. Knox, she phoned the police. They found his body in
the car.
Last Thursday, the sheriff's office held an auction to sell Mr. Knox's home,
which had an opening price of $64,200. Nobody bid on it. Bear Stearns will have
to dispose of the property by itself.
