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.

Copyright 2004 The New York Times Company
http://www.nytimes.com/2004/10/10/business/yourmoney/10sub.html?oref=login

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