Fighting an Outbreak of Mortgages Too Good to Be True

By JIM DWYER

Published: September 8, 2007

Last week, the lawyers at a legal clinic in Brooklyn set the answering machine to stop taking new messages. So many people in Brooklyn and Queens are in trouble with mortgage bills that the lawyers cannot keep up.

“That’s the first time we’ve had to suspend taking on new clients,” said Meghan Faux, co-director of the Foreclosure Prevention Project at South Brooklyn Legal Services. “There’s no way we could answer all those calls and provide proper representation to our clients.”

Through this week, notices of pending legal action against homeowners are up by 48 percent in Queens and by 40 percent in Brooklyn over last year, according to the county clerks. Foreclosures in the city have doubled since 2005.

The subprime crisis that has knocked the financial markets began, at least in New York, as fliers taped to lampposts in Brooklyn and Queens over the last decade. These posters promised good deals on loans or home refinancing. Lending to low-income people at high rates became a thriving business.

Last year, Tilton Jack, a retired transit worker, opened the mailbox at his home on Cortelyou Road in Flatbush, Brooklyn, and found a leaflet advertising low-interest loans. He was soon visited by Michael Goltche of Golden First Mortgage, according to court papers, who told him that he qualified for a 1 percent mortgage.

Too good to be true?

In fact, the rate was 1 percent — but for one day. On the second day, it increased to 8.13 percent. Now, it is 8.77 percent. But those jumps are not what is sending his mortgage into a financial death spiral.

Under the terms, Mr. Jack’s monthly payment is set as if the mortgage cost just 1 percent, even though it is much more. So the seemingly low rate is a trap: every month, the unpaid interest is being piled onto his principal. When it reaches 110 percent of the original loan, the payments will be adjusted to the full 8.77 percent — on the principal that has been swollen by the unpaid interest.

“The principal has been increasing ever since he got the loan, and his payments will go from $1,100 a month to over $3,000,” said Navid Vazire, a lawyer with the Foreclosure Prevention Project who is representing Mr. Jack.

Mr. Jack, 82, had fallen into the grip of a maddeningly dense mortgage scheme known as “payment option adjustable rate mortgage.”

“Nearly all our clients with these loans are elderly, on fixed income, so they have no prospect of making the dramatically higher payments,” Mr. Vazire said.

Feeling uneasy about the loan after the closing, Mr. Jack tried to exercise his right to cancel it within three days, according to court papers, but could not reach Mr. Goltche. A person who answered the phone yesterday at Golden First Mortgage, which is based in Melville, on Long Island, said Mr. Goltche no longer worked there and referred inquiries to a lawyer who did not respond to a message.

In early June, Nerida Cuccia of Queens Village said she got phone calls from people who claimed they could give her a mortgage at 2.25 percent for five years, and then 20 years at 5.5 percent.

Ms. Cuccia, who will be 61 tomorrow and retired in March as a nurse practitioner from the city hospital systems, said she was deeply skeptical.

“But even if your gut tells you something’s wrong, the percentages make you forget about the gut,” she said. The loan was issued by Countrywide Financial, the lender that had come close to collapse. The closing took place at her home on 215th Place. She did not have a lawyer examine the papers.

“They told me, don’t worry about it,” she said. “I’ve refinanced before with just a notary.” She said the papers she signed showed the promised rates, but when her first statement arrived, she found that the loan was for 8.25 percent. And like Mr. Jack’s loan, her payments were set at a rate that meant she would lose ground every month. She is now being represented by the Foreclosure Prevention Project, which is considering a lawsuit.

The phone number of the brokers in Monroe, N.Y., who set up the Cuccia loan has been disconnected.

“It mortified me, for sure,” Ms. Cuccia said. “I will handle this. It makes me sick to think of some little old lady getting stuck with this.”

And the answering machine at the legal clinic will be turned back on next week, Ms. Faux said.

E-mail: dwyer@nytimes.com

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So This Subprime Lender Walks Into an Audit...

By FLOYD NORRIS

Published: September 7, 2007

The auditor got cold feet, and the company may die.

It would no doubt be interesting to hear a tape of conversations last week between the senior management of NovaStar Financial, a subprime mortgage lender, and its auditors at Deloitte & Touche.

NovaStar, like many of its competitors, has seen its business model blow up this year. But in mid-July it got a lifesaving $48 million infusion of capital from two institutional investors, with a promise of $101 million more to come.

Now Deloitte has effectively revoked its audit of NovaStar — evidently without claiming that any number in the report was wrong — and the investors do not have to put up the cash.

Deloitte seems to have invoked a little-known auditing standard that says an auditor cannot allow a previously audited financial report to be cited by a company if there are subsequent events “of such a nature that disclosure of them is required to keep the financial statements from being misleading.”

Deloitte won’t talk, but by NovaStar’s account, the auditors’ qualms did not surface until last week, when Deloitte said it thought that the 2006 annual report should have more disclosures on business problems and that there were questions about the company’s ability to continue as a going concern. But even with those changes, Delolitte was not prepared to quickly recertify the financial statements.

Since the company had to make a filing with the Securities and Exchange Commission to get the additional money, and since it could not do that without Deloitte’s blessing, the additional money will not be coming.

NovaStar says it will soldier on, cutting costs and hoping to get by. Since the stock is still trading around $6 a share, it appears that some investors think it can do so. But at current prices, the company has a market capitalization far below the dividend it is supposed to declare later this month.

NovaStar holds a special place in the market not because of the problems it has encountered, which are similar to those of others in its business, but because of the long and bitter battle waged between investors who believed in the stock and those who did not.

Before Overstock.com, Nova-Star was the stock of focus for those who believed their stocks were being sabotaged by “naked short sellers” who drive a company’s share price down by selling shares they had not bought or borrowed.

It was NovaStar that Patrick Byrne, Overstock’s chief executive, pointed to when he began what he called his “jihad” against naked shorts. There is a suit pending by some NovaStar shareholders against major brokerage firms, charging that they aided naked shorting and thus cost the investors money.

At last report, NovaStar had 9.5 million shares outstanding, and a short position of 8.1 million shares, a very high proportion. Overstock, by contrast, has a short position equal to less than a quarter of the shares outstanding. (It also has confounded the shorts by rising sharply this year.)

In its prime, NovaStar appeared, to its fans anyway, to be a money machine. It was organized as a real estate investment trust, and it reported high taxable income that it paid out in dividends. The high yield attracted investors and made it easy to sell more shares, which it regularly did. Its shares were worth $1.8 billion.

Critics asserted NovaStar used questionable accounting to produce those profits as well as other dubious business practices. One of its current problems is a $46 million judgment won by a competitor who said NovaStar conspired to drive it out of business.

Accounting in the mortgage business is notoriously inexact. NovaStar, like many other companies, sold mortgages on terms that left it with some of the risk. Just how much profit it reported depended on a series of assumptions about those risks.

“If our actual experience differs materially from the assumptions that we use,” NovaStar said in the annual report that Deloitte is no longer willing to certify, “our future cash flows, our financial condition and our results of operations could be negatively affected.”

That warning was prescient. With mortgage defaults rising, it appears NovaStar paid dividends from ephemeral profits.

The REIT status that helped make NovaStar attractive is now its albatross. The company’s last estimate said it would have to pay $157 million more in dividends to satisfy tax rules that require REITs to pay out profits to shareholders. In July, it talked of paying the dividend with preferred stock rather than cash.

But that may be tricky. At current market prices, the entire company is worth far less than $100 million, so how can it give out preferred stock worth more than that?

The $48 million July investment in NovaStar, made by funds affiliated with the Jefferies Group and the MassMutual Corporation, seemed bold at the time. Now it seems foolish, providing for the purchase of preferred stock convertible to common at $28 a share.

The funds will not comment, but there is nothing — other than a fear of throwing good money after bad — to stop them from making a new investment, presumably on better terms. Perhaps significantly, Jefferies and MassMutual have not exercised their right to name two new NovaStar directors.

Had Deloitte not rebelled at the last moment, NovaStar would have the extra $101 million. Without it, the battle for survival will be that much harder.

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