During recent years, while the real estate industry was inflating with breathtaking speed, the mortgage industry blossomed right along with it. When the bubble burst, what resulted in the overblown mortgage industry could be summarized as a tale of the good, the bad and the ugly.

The "good" might be sincere first-time buyers fulfilling a dream of home ownership, but who had less-than- sterling credit ratings. Federal regulators have identified loans to these barely-qualifying homebuyers as "subprime" mortgages, and the primary cause of rising foreclosures. These loans charge higher interest rates to customers with poor credit histories in order to compensate lenders for the greater risk of default by these borrowers. These mortgages typically have low, two-year introductory rates, but critics contend that this lowered initial cost induces people to buy homes they can't afford.

When the introductory period ends on those loans, interest rates generally increase by several percentage points, driving up monthly payments by hundreds of dollars. Foreclosure filings follow once these borrowers are unable to make the higher payments.

The "bad" would be mortgage brokers or lenders who fudged appraisals or credit reports to sell inflated loans for over-priced properties to these subprime buyers who really couldn't afford them—reaping commissions from vulnerable, unprepared homebuyers.

And the "ugly"... well, they're the vultures who swooped in with promises of saving these homeowners from foreclosure with a variety of schemes.

Some of these "rescue" schemes are legal but others have been downright unscrupulous, and some states are pursuing laws to prohibit "foreclosure rescue fraud." In a worst-case scenario, homeowners who missed loan payments signed over their properties and were left paying rent on the home they thought they still owned. In this type of foreclosure scam, a homeowner in arrears is advanced a small amount of money to stave off a late payment, while inadvertently signing over his deed.

Compounding the problem, "how-to" guides are available on web sites, showing deals in which investors buy foreclosed properties from the lender at a deep discount and resell at a profit. Even the TV series "Flip This House" shows how to generate equity from homes about to default.

Lenders left hanging

Mortgage fraud—the "bad"-—has cropped up all over the country in the hot real estate market. This type of fraud is directly linked to the relaxed underwriting standards that occurred with subprime lending.

For instance, mortgages were written that required little or no proof of income. In 2006, almost half of all subprime loans were of this "no-doc" variety. This situation paved the way for people to flip properties in a virtual pyramid scheme, where they refinanced one mortgage with yet another— borrowing from Peter to pay Paul—and turned a profit with each transaction. This ploy succeeded where demand was hot, while property values climbed. Lenders were often left with deeds to homes, all for sale and no buyers. Industry estimates indicate that over $1 billion was skimmed from lending companies in 2005. Sometimes entire neighborhoods were devalued by these schemes, impacting the unfortunate new-homeowners who actually planned to live there.

The Mortgage Bankers Association stated recently that as many as 700,000 homeowners nationwide were in the foreclosure process in the first quarter of this year. In New England, foreclosures represented 4.5 percent of outstanding loans at the end of 2006.

Foreclosures in Massachusetts, reflected in 6,419 auction notices through May of 2007, are close to the 6,720 posted for all of 2006. The rate of increase has moderated some, however. In January, auction notices were up 282 percent from a year earlier, compared with 143 percent in May.

Nationally, most problem areas are concentrated in that notorious, subprime market. Four states with significantly increased delinquency rates are California, Florida, Nevada, and Arizona. The MBA attributes the rise in delinquencies there to speculators walking away from adjustable-rate mortgages in areas with declining home prices. In these states, house-flipping speculators suffered along with the "good," the many Hispanic home-owners who spent too much of their income on a mortgage. The Midwest was also hit hard. Ohio, Michigan, and Indiana accounted for 19.9 percent of loans in foreclosure, despite having only 8.7 percent of all mortgages.

Where have the feds been?

News reports have cited legislators in dozens of states who have introduced about 85 bills to protect mortgage borrowers from deceptive-lending practices or fraud. State lawmakers, facing pressure from constituents threatened with foreclosure, didn't want to wait for the U.S. Congress to act.

These lawmakers are proposing statutes that would eliminate penalties for prepayment of loans and prevent lenders from offering loans to borrowers shown to be unable to repay them. State-sponsored loans or refinancing plans are being proposed as one remedy for homeowners on the brink of foreclosure.

The only action Congress had taken was to hold hearings on the subprime crisis, which has doomed almost 60 mortgage companies nationwide. Sen. Christopher J. Dodd, head of the banking committee, pressed the Federal Reserve to issue new rules protecting consumers from predatory lenders. Representative Barney Frank, D-Mass., chairman of the House Financial Services Committee, promised to draft a measure to curb predatory mortgage-lending practices.

The U.S. House of Representatives has worked on a non-binding resolution calling on the government to protect homebuyers from "unscrupulous" mortgage brokers and lenders. This would include enforcing rules to eliminate deceptive practices in subprime mortgage lending, urging lenders to evaluate a borrower's ability to repay the loan and curbing abuses in prepayment penalties. Banking agencies, criticized for failing to protect consumers, directed mortgage lenders to toughen standards in new guidelines issued June 29. Subprime lenders should verify income levels and consider potential interest-rate increases when judging whether homebuyers can pay off loans.

Laws against predatory lending already exist in 35 states. North Carolina Banks Commissioner Joseph Smith has been quoted as saying that state efforts to regulate the subprime market "have been met with resistance or indifference from federal regulators and even Congress." And there were "few, if any, significant consumer- protection enforcement actions" by the federal government.

Powerful lobbyists for the banking and mortgage industries rail against the concept of states creating different regulations—since it makes it harder for them to do business across state lines.

Finally, in response, the U.S.House of Representatives Financial Services Committee passed H.R. 1852 earlier this spring. The "Expanding American Homeownership Act of 2007" introduced by Representative Maxine Waters, Chairwoman of the Subcommittee on Housing and Community Opportunity, and Barney Frank, Chairman of the Financial Services Committee, charges the Federal Housing Administration (FHA) to restore its role in providing mortgage loans for low and middle income families. The FHA could approve zero down payment loans, and allow the Department of Housing and Urban Development (HUD) to serve higher risk borrowers as well as raise loan limits in high cost housing markets. The bill now needs a vote by the full House of Representatives.

The Bay State's response

Responding to the surge in foreclosures, officials in a number of states have taken action. In Massachusetts, Governor Deval Patrick moved forward with both immediate regulatory action and proposed legislation to assist families facing home foreclosures. These proposals were based on the recommendations of the recent Mortgage Summit Group report. The Mortgage Summit Working Group led by Commissioner of Banks Steven L. Antonakes included nearly 50 participants from government agencies, non-profit organizations, and the mortgage lending industries who convened to develop a comprehensive foreclosure prevention strategy.

Its initiatives include:

• Immediately bolstering the state's efforts on consumer assistance and education for homeowners who may be facing foreclosure, including: an enhanced hotline; a new awareness campaign; and referrals to reputable foreclosure counselors and lenders willing to be of assistance.

• Implementing regulatory changes that increase licensing and education requirements for mortgage lenders and brokers to eliminate disreputable firms and practices.

• Drafting legislation to increase protections for consumers and provide penalties for mortgage fraud, including: criminalizing mortgage fraud; prohibiting abusive foreclosure rescue schemes; creating a mandatory pre-foreclosure filing notice; and establishing a central repository of foreclosure notices at the Division of Banks.

• Joint efforts would include: developing a foreclosure intervention mortgage program; reviewing and identifying false, deceptive, and misleading advertising practices; reviewing sales practices of real estate brokers and salespersons that refer clients to mortgage lenders and brokers; improving the existing process of mortgage disclosure and pre- and post-closing consumer education; and creating a web site on financial education.

• The governor's actions encompass recommendations put forth by the Mortgage Summit Group that was convened in response to rising foreclosures both locally and nationally.

Defining mortgage fraud as a crime

The legislative portion of the governor's proposal seeks to prevent predatory lending and criminalize mortgage fraud. The legislation also prohibits abusive 'rescue' schemes"

Governor Patrick's bill, HB 4085, is currently in the Committee on Financial Services. It follows several regulatory changes already put in place to address the rising tide of foreclosures in Massachusetts.

The bill includes the following provisions:

• Criminalizing mortgage fraud. In response to rising instances of mortgage fraud, the bill would define mortgage fraud in statute and create criminal penalties for violations.

• Prohibiting abusive foreclosure rescue schemes. With many people facing the threat of foreclosures, unscrupulous individuals and groups have preyed upon consumers' fears of losing their homes by promising to allow homeowners to stay in their home in exchange for signing over the property. Many people who fall victim to this scheme think that they are making mortgage payments when in fact they are paying rent. This bill would prohibit such agreements unless the purchaser is a direct relative.

• Requiring a Notice of Intent to Foreclose and Right to Cure. The bill sets out a right to cure for a consumer that is in default and requires the holder of a mortgage to inform the consumer of this right in addition to the intent to foreclose if the consumer does not cure the default.

• Prohibiting a lender from making an adjustable rate subprime loan unless the borrower opts-out. In reviewing default rates and foreclosure information, subprime fixed rate loans have performed well and allowed consumers with impaired credit to reestablish their credit history. Subprime adjustable rate mortgages (ARMs), on the other hand, have very high default rates and higher foreclosure rates. This bill would prohibit any lender from making a subprime ARM unless the consumer affirmatively opts-out of the fixed rate product and presents a certificate indicating that they have received homebuyer counseling.

• Establishing a central repository of foreclosure information at the Division of Banks. The bill would require lenders and servicers to send a copy of the Notice of Intent to Foreclose and Right to Cure to the Division of Banks as well as the details of any final foreclosure. In addition, the bill requires the Division to establish a database of foreclosure information to track geographic and industry trends relative to foreclosures.

Kimberly Haberlin, press secretary for Massachusetts Office of Consumer Affairs, points out that, "The governor's approach incorporates legislation, regulation and a foreclosure strategy aimed at immediate help." "To date, 70 percent of people in foreclosure have received help through a stay in the process and counseling."

Partnerships among nonprofits and counseling agencies, to help people keep their homes, were established during the Summit.

Consumers at risk, who have missed loan payments, were reached after they filed complaints to the state Division of Banks. The governor's office has asked individual lenders to extend delays for these homeowners of 30-60 days, time to possibly refinance or rewrite the terms of their loans. Counseling organizations have also been enlisted. These measures have been conducted on an individual, case-by-case basis.

Since April, when Governor Patrick first instructed the Division of Banks to seek case-by-case foreclosure delays for homeowners who filed complaints, more than 500 people have reached out to the Division. Just under half of those individuals were already in foreclosure and needed immediate relief. The Division was able to secure 30- to 60-day stays in the foreclosure process in most of those cases. Due to these stays, many individuals and families were able to refinance or are in the process of refinancing their loans, were able to modify their loan terms, have received credit counseling, or were able to sell their homes. In addition, homeowners who contacted the Division and were in financial distress but not yet in foreclosure were partnered with counseling agencies that offer comprehensive services that can help them change direction and hopefully prevent foreclosure from occurring.

Bond sales to create refinancing opportunities

In addition to these initial measures, Massachusetts will become one of the first states in the nation to try to curb rising foreclosures by raising cash through bond sales, a move that will help create a $250 million fund to help struggling borrowers refinance and stay in their homes. Hoping to fend off what he called a nightmare facing many homeowners caught up in the subprime mortgage crisis, Gov. Patrick announced this new state-backed program, aimed at saving up to 1,000 homeowners from foreclosure and helping them to refinance at lower interest rates.

"Too many of our residents were put into loans they couldn't afford," the governor said. "This innovative mortgage loan program will give some of our most vulnerable citizens at least a fighting chance to keep their homes."

Tina Brooks, state undersecretary for housing, said the program will involve no taxpayer obligations, but will use $60 million in state housing bond funds in combination with $190 million from the Fannie Mae mortgage company to refinance home mortgages.

"Our target audience is borrowers who have gotten themselves into subprime or predatory mortgage loans," and are having trouble making mortgage payments, she said.

State bonds and Fannie Mae funds that are being used for refinancing would be repaid through the new mortgages. Homeowners in distress could qualify for 40-year fixed-interest-rate mortgages, refinanced at a below-eight percent interest rate.

A national nonprofit group, NeighborWorks, will administer the program. The group has a network of community-based organizations it works with to help homeowners, including Worcester Community Housing Services and NeighborWorks of Worcester.

The effort to save homes from foreclosure includes cooperation from lenders as well, who gain nothing from defaults when home prices are declining. Companies holding the initial mortgages will likely have to accept less than 100 percent payment for their mortgages, closer to 90 percent. The reduced settlement may be the best offer they will get for a mortgage in trouble.

The program will offer refinancing to homeowners who are 60 days delinquent on their mortgage payments, if the delinquency stems from variable interest rates rising on their mortgage. Also, participants can have credit scores as low as 560—while the standard credit score for most lenders must be at least 630 for mortgage approval.

The Bay State won't be the first with such a program. In April, the Ohio Housing Finance Agency began making refinancing available to at-risk homeowners, with financing coming from $100 million in bonds. Other states are considering similar steps.

What about the brokers?

Everyone seems to be taking a hit except the brokers, who arrange the original mortgage sale, pocket their commission [typically one "point" or one percent] and walk away after the closing. But it's not that simple. Mortgage brokers are subject to a list of regulations that vary by state. In Massachusetts, a broker's license is subject to certain educational requirements and asset levels. Plus, "we get audited every two years," states Andrew Sears, president of SF Financial Services, a mortgage and real estate brokerage in Westminster, Mass. "In addition, we must provide four or five standard disclosures that go out with every loan."

Mr. Sears says he has not seen much subprime lending in the local area, and attributes the region's rash of foreclosures to standard problems: buyers overspending on a house and failing to meet payments when disaster strikes in the form of job layoffs, illness, divorce or other emergencies.

The impact on brokers, he notes, is that "our guidelines have gotten a lot stricter from [our] lenders" with extra credit checks on borrowers. Also, "borrowers get a quarterly report from lenders showing late-payments" on individual mortgages. Lenders can then essentially penalize brokers who have sold defaulted loans—they can cut future commissions to the broker or actually send a bill to recoup commissions paid out on a bad loan.

Since brokers must maintain close, symbiotic relationships with lenders, loans that default will indeed damage a broker's business. And business is suffering mightily right now.

It turns out, none of the participants involved in the foreclosure tragedy is walking away unscathed.