Kathleen Engel started to notice something funny happening with home loans in 1999. She lived in Shaker Heights, Ohio, just a few blocks from the city of Cleveland. Out of nowhere, she’d found herself inundated with offers from loan brokers. They called on the phone, left flyers on her porch, sent her direct mail.

All the brokers were offering home equity loans. Engel’s neighbors were flooded with the same offers. When Engel called about the loans, she discovered a pattern: many loans offered low introductory interest rates that skyrocketed after just a few months; others contained costly balloon payments.

[Article: New Federal Rule Protects Benefits from Garnishment]

These loans were designed to fail, Engel realized. Within months, people on her block started losing their homes.

“I started asking, ‘Why are people making these loans?’ It didn’t make sense,” she says. “They were unsustainable from the get-go.”

Engel was a law professor at Cleveland State University. She became one of the first academics in the country to recognize the problem of subprime loans, the monster now known to be responsible for much of the 2007 recession, the largest economic downturn since the Great Depression.

[Article: Finally, Bank Villains Are Named]

Now Engel’s research has culminated in a new book, “The Subprime Virus.” It documents how Wall Street financial firms caused the subprime mortgage bubble, and the recession that followed, by allowing their short-term desire for profits and bonuses overwhelm concerns about the long term health of their own institutions, Engel found. They did it by controlling all aspects of the market, from individual loan officers all the way up to the investors in complicated securities swaps, and convincing Congress and federal regulators to look the other way.

“The investment banks like to portray themselves as just innocent middlemen,” says Engel, who is now a law professor at Suffolk University in Boston. “That’s just not true. They made the market. They were in control.”

The Early Days »

Image: Justus Hayes, via Flickr.com

The United States and the city of Los Angeles filed two different lawsuits against a German Bank this week. The federal lawsuit accuses Deutsche Bank of mortgage fraud.

Meanwhile, the city alleges that “Deutsche Bank has become one of the largest slumlords in the City of Los Angeles.”

In the federal lawsuit, U.S. Attorney for southern New York Preet Bharara accuses Deutsche Bank of defrauding American taxpayers of millions, and potentially billions, of dollars. The bank and its U.S.-based subsidiary, MortgageIT, received insurance from the Federal Housing Administration for more than 39,000 home loans, worth over $5 billion, according to the complaint, filed Tuesday in New York’s Southern District Court.

[Free Tool: Obtain your Identity Risk Score from Credit.com]

But there was a problem: many of those loans never qualified for government insurance in the first place, according to the suit.

“Deutsche Bank ignored every type of red flag and breached every duty of due diligence before underwriting thousands of federally insured mortgages,” Bharara said in a press release. “While the homes the defendants issued loans for may have been built on solid ground, the defendants’ lending practices were built on quicksand.”

In the scam, MortgageIT’s employees allegedly lied on the applications, winning federal insurance for mortgages in which borrowers failed to state their income or make downpayments in accordance with federal insurance rules. With the government promising to compensate investors if the loans failed, MortgageIT was able to charge investors higher prices for the loans, thus allegedly earning themselves more money on the deals.

Of the 39,000 mortgages for which MortgageIT won federal insurance, 3,100 have already failed, costing American taxpayers $386 million, according to the lawsuit.

“(T)hese lenders put millions of dollars of taxpayer funds at risk and violated the integrity of this important program by making false certifications to HUD,” Tony West, chief of the Justice Department’s civil division, said in a press release.

The losses so far may be just the tip of the iceberg. The problem with lenders filing fraudulent applications for FHA insurance was first uncovered in a report by the agency’s inspector general, which found that fully half of all mortgages insured by the federal government never met qualifications for the insurance in the first place. That could force taxpayers to pay over $8.4 billion in fraudulent claims, as we reported in March.

If that ratio holds true in Deutsche Bank’s case, that would mean the bank may have fraudulently received federal insurance for $2.5 billion worth of loans. With the U.S. attorney seeking treble damages, that translates to a potential fine of $7.5 billion for Deutsche Bank.

In Los Angeles, the city’s lawsuit accuses Deutsche Bank of failing to maintain more than 2,200 foreclosed properties. The suit also alleges that the bank wrongfully evicted thousands of people.

“We must fight blight by holding banks accountable when they create vacant nuisance properties that pose threats to our residents and destroy the quality of life in our neighborhoods, and we must protect vulnerable tenants from illegal evictions,” City Attorney Carmen Trutanich said in a press release.

Deutsche Bank responded by saying the city is suing the wrong party. According to comments made by a spokesman to American Banker, the bank serves as the trustee on the loans in question; and a different company actually services the loans, and is responsible for evictions and maintaining foreclosed properties.

Deutsche Bank did not immediately return calls seeking comment.

[Related article: Government May Owe $8.4 Billion on Fraudulent Loans]

Image © Andreas Weber | Dreamstime.com

Having trouble refinancing your mortgage, even though you meet all the requirements set by the federal government? Fannie Mae and Freddie Mac, the two government-owned mortgage giants, announced recently that they will use cash to encourage loan servicers to modify loans, and impose new penalties against companies that break the rules.

Loan servicers that complete a modification application within six months of the borrower becoming delinquent will get $500. Those who miss the deadline will pay $500. After that, servicers that make a successful modification will get between $400 and $1,400, depending on how quickly they complete the process.

“This initiative will direct servicers to reach families earlier, communicate more frequently and clearly, and provide relief,” Michael J. Williams, president of the Federal Housing Finance Agency (FHFA), which oversees Fannie and Freddie, said in a press release.

The final rules will not be announced until the second quarter of 2011. They will include requirements that servicers respond to borrowers’ phone calls and emails within a certain time, and deadlines for how quickly servicers must give notice of delinquency and inspect houses facing foreclosure.

[Related article: Federal Agencies Push for More Mortgage Modifications]

Loan servicers act as middlemen in the mortgage process. They receive checks from homeowners, pay the taxes and insurance, and pass profits on to investors. Unlike investors and homeowners, however, servicers actually earn higher profits when a home slides into foreclosure, reducing their incentive to modify loans and keep homeowners in their houses, according to research and testimony by the Center for Responsible Lending, which we covered here.

The action by Fannie and Freddie is not the first attempt by the federal government to change servicers’ behavior. The Obama Administration hoped the Home Affordable Modification Program would encourage servicers to modify more loans. The program was a spectacular failure, mostly because its incentives were too small compared to how much money servicers continue to make from foreclosures, according to a Congressional Oversight Panel report covered here.

[Related article: Federal Fannie and Freddie Changes Likely Won't Come Soon]

Fannie and Freddie’s goals for their servicing initiative appear to be more modest by comparison. Gone is talk from the Obama administration of saving four million homeowners from foreclosure (at most, HAMP actually will prevent 800,000 foreclosures, the oversight panel found). Instead, the agencies hope homeowners will simply gain better information about where they stand in the process.

The initiative “should give homeowners a greater understanding of the process and faster resolution by requiring earlier contact, more frequent communication, and prompt decisions,” Edward J. DeMarco, the FHFA’s acting director, said in a press release.

Image: James Thompson, via Flickr