Déjà Vu: ADU’s Are a Dangerous Fraud

The homeowners are deceived into believing that they can increase their income by constructing another house in their back yard and then renting it out to whomever. The TV ads make it sound like a sure-fire thing. We have, however, seen the exact same scam before with the subprime frauds which crashed the world economic system in 2008. 

It’s the 1% Once Again 

As with the subprime mortgage frauds, Wall Street is behind this latest fraud. The individual homeowner who is being cheated, however, has no way to see the overall pattern. So, here’s the outline of the ADU Fraud. 

(1) Increased Mortgages: 

The homeowner takes out an additional mortgage on his home thinking that he will make so much money from his ADU that he can easily pay the new high mortgage. That was the first step in the 2008 Crash. People borrowed money which they knew their present income could never pay off, but Wall Street assured the owners that their home values would increase so greatly in the next couple years that they could refinance for much lower mortgages and start turning a profit each month.  

When the refi time arrived, Wall Street refused and instead its Variable Rate mortgages drastically increased the homeowners’ monthly payments, thereby driving them into bankruptcy. Historically, driving homeowners into bankruptcy had been bad for lenders, but in the lead up to 2008, it became the scam where Wall Street executives made even more money. Yep, it’s déjà vu all over again. 

(2) ADU’s Cost a Fortune: 

Building a house is expensive especially when there is no market for what the homeowner is constructing. After the pandemic, building supplies and labor are priced high but will come down.  Nonetheless, an ADU will raise your mortgage by hundreds of thousands of dollars.   

As of Wednesday, June 9, 2021, current rate in California is 3.04% for a 5/1 adjustable-rate mortgage (ARM). As the increased mortgage will vary for everyone, each has to do their own calculations. How long can an owner pay this higher mortgage when the ADU remains vacant? 

(3) Higher Property Taxes 

The property taxes on the ADU will be at the higher current rate but will not trigger a reassessment of the basic house unless the developer encourages upgrades to the main structure. 

(4) Here’s Where the Subprime and ADU Scams Begin to Coincide 

The market for ADUs is illusory. The 2008 Crash was based on over-construction which meant the owners could not realize the income to pay the mortgages. In order to keep the subprime scam going, lenders resulted to Liar Loans, where the lenders were the liars. They would lie to the new home buyer and then lie on the loan documents without the homeowners’ knowledge. Then, the lender would sell the mortgage to get cash from Wall Street with knowledge that the homeowner would default. 

The local lender not only could get his cash out of the deal by selling to Wall Street, but he would not be holding the hook when the buyer defaulted. By the end of the subprime fraud, some lenders were writing and selling to Wall Street completely fictitious mortgages which Wall Street eagerly bought. Why? See below. ADUs have the same weakness as Subprime borrowers; they have entered into an economically flawed business transaction where they will not realize the income to cover their costs. Since the ADU is tied to their home, they lose everything when the ADU’s costs drag them into foreclosure. 

(5) Why There is No ADU Market 

Los Angeles has a glut of housing and the prime home buying segment, Family Millennials, is moving away. To worsen matters, Family Millennials, do not want to rent a small house in someone’s backyard. Family Millennials overwhelmingly want the American Dream -- to own their own home with a yard near decent schools and to gain equity. No ADU owner can provide those things: (a) The ADU is built where the yard used to be, (b) LAUSD schools are some of the worst in the industrialized world, so Family Millennials usually have to pay for private schools, and (c) no ADU allows the renter to build equity. 

Los Angeles has over 93,000 vacant apartments and houses. Yet, the city continues to promote more apartment construction. Since the only housing shortage is for the lowest end of the market, i.e., the homeless, ADU homeowners will have to turn to Section 8 vouchers to get paying renters, assuming the Feds authorize more funds. Also, the likelihood of finding a simpatico ADU tenant is remote.  Unlike corporate owners, ADU owners live within a couple feet of their tenants. 

(6) Homeowners Fail, Wall Street Thrives 

Wall Street thrived during the Crash of 2008 with a $15 trillion bailout while Main Street America went to bankruptcy court where Wall Street bought up the properties for pennies on the dollar. ADUs are designed for the same fraud. 

Wall Street knows which mortgages are financially compromised by an ADU loan and are likely to default just like it knew which subprime mortgages would fail. Thus, Wall Street bundles together these precarious mortgages, pays a rating agency to give the bundled mortgages a quadruple triple A++++ rating and then sells the bundles worldwide. Ostensibly to entice institutional and national investors to buy the ADU bundles, Wall Street will issue ersatz insurance that guarantees the bundle will earn a minimum return for the buyer. They call the insurance “Credit Default Swap (CDS).”  

Here’s the unique aspect of a CDS: Any Wall Street executive can buy that CDS insurance so that when the ADU Bundle crashes, hundreds of Wall Street executives collect on the same ADUs.   That is the same as allowing 100 mafioso to buy cheap fire insurance on the same house so that they all get to collect the full value when the house burns down.  

Since no Wall Street firm can pay off trillions of dollars in the CDS liabilities when the ADU bundles fail, the government will bail out the Wall Street firms which will pay the money to the corrupt executives holding the CDSs. By the time of the federal bailout, however, tens of thousands of homeowners who constructed ADUs will be financially ruined and there will be no bailout for them.  

(Richard Lee Abrams has been an attorney, a Realtor and community relations consultant as well as a CityWatch contributor. The views expressed herein are his own and do not necessarily reflect the views of CityWatch. You may email him at [email protected]) Photo by Stephen Carr.