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

Current explanations for the high rate of default and foreclosure in the U.S. emphasize house price fluctuations and lax lending criteria. Another explanation for default and foreclosure, that has generally been neglected, is fraud. One impediment to identifying and measuring fraud is the lack of statistical tests capable of detecting it. This paper proposes a simple method to detect transactions where fraud may have occurred. The models proposed here are important for at least three reasons. First they can document the role of fraud in the mortgage foreclosure crisis. Second, they can serve as part of a forensic effort designed to detect and deter mortgage fraud. Third, they demonstrate 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.