Fighting smart in the war against: mortgage fraud

RMA Journal, The, Feb, 2005 by Jacqueline Dreyer

"20 People Indicted in Real Estate Scheme" (Austin American-Statesman, 11/12/04) "Mortgage Fraud Continues to Grow More Sophisticated (San Diego Union-Tribune, 10/24/04) "Maricopa (AZ) County Assessor Indicted" (East Valley Tribune, 11/28/04)

... and those are only the recent headlines. The most effective weapon in the war against mortgage fraud has three ingredients: training, quality lending practices, and strengthened legal documents.

Fraudsters across the nation are giving major newspapers plenty of headlines about mortgage fraud events and their associated losses. From Seattle and Phoenix to Austin and Charlotte and Newark, the stories are the same. Lenders are left trying to absorb losses triggered by the fraudulent and/or negligent acts of others. Flipping, chunking, and churning have become new terms that roll off the tongues of mortgage fraud investigators. But how do these fraudulent practices affect credit managers, risk managers, bank executives, and examiners alike? It's about awareness, training, implementing proper operating controls, and testing those controls to ensure their effectiveness and protect the company's bottom line.

Let's begin with the term mortgage fraud itself. There is no federal crime of mortgage fraud, nor is there a civil statute pertaining exclusively to mortgage fraud. Instead, the term is used as a catch-all. Generally accepted statistics are used by the industry, but remain uncorroborated due to lack of a national database on mortgage fraud. Suspicious Activity Report (SAR) filings account for only a percentage of discovered mortgage fraud cases, because most mortgage lenders are not required to file SARs or are unaware of the red flags that would trigger reporting. That said, however, data collected by The Prieston Group and other industry experts indicates that 1) up to 10% of all mortgage loan applications contain at least one form of misrepresentation, 2) up to 45% of early payment defaults can be attributed to fraud or misrepresentation, and 3) the severity of loss on a mortgage loan containing fraud or misrepresentation is approximately 35%. Mortgage fraud may be best likened to a computer virus, which if left undetected and unquarantined, can rapidly infiltrate a lender's portfolio to the point of disaster on multiple levels. Consider the following typical scenario:

   Lender A approves a broker to
   submit loan applications for
   underwriting and closing.
   Unbeknown to the lender, the
   broker has a penchant for submitting
   falsified income and
   employment documentation, as
   well as inflated appraisals, and
   often misrepresents the borrower's
   intent to occupy the
   subject property as a primary
   residence when in fact the
   property is to be used for rental
   purposes. The borrower may
   know full well these misstatements
   are occurring, or the borrower,
   like the lender, may be
   victimized and duped by the
   trusted broker, appraiser, settlement
   agent, and other third
   parties that participate in the
   fraud. In a matter of months,
   loans go delinquent and must
   be repurchased, borrower credit
   histories are ruined, families
   can be turned upside down,
   and the lender is left looking at
   losses that can quickly hit the
   million-dollar threshold,
   depending on the number of
   loans funded and the severity
   of the appraisal fraud.

Managing the risk associated with mortgage fraud and mitigating its associated losses are critical to any risk management plan. And with the uptick in interest rates, mortgage fraud most certainly will be on the rise as creative perpetrators package loans in such a manner as to ensure ultimate approval and funding. Combating it successfully centers around three lines of defense: training, quality lending practices, and strengthened legal documents.

Regimen of Training

Training for mortgage fraud prevention and detection is a very specialized area. In fact, the industry has only a handful of experts that routinely conduct seminars or go on-site with customized programs. At a minimum, successful training should start with a high-level overview of mortgage banking that includes the applicable purchase/sales contract provisions that exist between lenders and their secondary-market investors--even if the lender/investor relationship is that of mortgage banking subsidiary and parent bank. It is within these provisions that the repurchase request remedy is found--the basis for lender liability that basically states, "I know that you (the investor) don't have time to look at all of my loans prior to purchase, so I'm going to represent and warrant that all the loans meet underwriting guidelines and are deemed to be investment quality; if not, I agree to buy the loans back." In the case of a federally insured depository institution, the receipt of repurchase requests may trigger the need for reserves and the creation of contingent liabilities, both of which can draw regulatory scrutiny as well as shareholder questions.