Homeowners trying to sell properties in a falling market now have another problem to contend with, according to a City solicitor. Charles Evans, who specialises in regulation work at Norton Rose, says that mortgage fraud is corrupting property prices. Frauds on banks and building societies cost the economy £700 million a year, the Association of Chief Police Officers (ACPO) estimated last month. The association released the figure along with new guidance to the financial services industry on identifying and investigating organised mortgage crime gangs.

Senior police officers believe these gangs generate significant income from illegal mortgage deals, using property sales as a cover for laundering the proceeds of drug dealing, human trafficking and prostitution.

At the same time, the Law Society updated its advice to solicitors on how to avoid being drawn unwittingly into facilitating fraudulent conveyancing transactions. Mortgage fraud is not just a problem for lenders and borrowers, says Evans. "Consider a new-build block of flats. Mr and Mrs Innocent buy a property, and everything is in order. But organised crime then comes along and buys up three of four of those flats. The criminals then default on payments and their flats are repossessed.

"Because there are then three or four flats for sale in the same block as Mr and Mrs Innocent, that will have an impact on the value of their property."

Nearly half the country's mortgage fraud is concentrated in London, according to ACPO. The problem is particularly prevalent in the buy-to-let market, Evans adds. "Ironically, one of the areas where buy-to-let has really taken off is Canary Wharf, which is the home of the Financial Services Authority."

So what should the regulator be doing about it? This month, the FSA called on banks and building societies to report mortgage brokers suspected of fraud. Suspicions should be aroused when several applicants appear to share the same address or bank details, it advised. Following a pilot scheme, the FSA disclosed that four intermediaries had already been referred for possible enforcement action.

Even more of a threat to lenders is a surveyor's report that substantially over-values the property to be mortgaged. In a rising market, banks and building societies have been able to recover their loans and all associated costs on a default even if the property had been slightly overvalued. That is no longer the case.

While welcoming the FSA's decision to target shady brokers, Evans hopes the authority will not stop there. "The FSA is moving towards a much more principles-based regulatory approach," he explains. "One of these principles is treating customers fairly. In the world of mortgages, that should translate into responsible lending."

Back to Mr and Mrs Innocent, who now find themselves in the offices of a dodgy mortgage broker. "He convinces them they can afford a mortgage of 12 times their joint salary, or something stupid like that," says Evans. "But the lender's obligation to treat customers fairly means it should take account of the customer's ability to repay the loan." In the current market, lenders are likely to be much more wary of "self-certified" incomes. But that was not the case until recently.

"Some of this irresponsible lending may well have gone on. In the course of the next 12 months, cases may emerge where the FSA will look at how lenders have undertaken their responsibilities and whether they have treated customers fairly. If they have not approached their lending responsibly, we may well see the FSA seeking to discipline them."

Lending people more than they can afford to repay may seem generous at the time. But it can leave homeowners homeless and lenders nursing more than a financial loss.