The Federal Deposit Insurance Corp. has some suggestions about how mortgage lenders can avoid the fallout from a host of mortgage fraud schemes.
The report outlined what lenders can do to protect themselves, considering losses associated with mortgage fraud surpassed $1 billion in 2005 for the first time and suspicious activity report filings related to mortgage fraud doubled from 2003 to 2004. And the increasing number of SARs do not reflect suspicious activity observed by mortgage brokers — who are not required to file SARs even though they originate two-thirds of all mortgages.
In the year ending Sept. 30, 2006, the Federal Bureau of Investigation estimated that the number of mortgage fraud cases grew to about 36,000 from 22,000 in the previous year. The bureau’s pending mortgage fraud investigations numbered 1,036 as of early March 2007, compared to 818 in the previous year.
FDIC examiners’ responses as to which were the more common types of fraud they were encountering revealed these as broker-facilitated fraud; loan documentation fraud; appraisal fraud; property flipping; and misapplication of funds from construction or rehabilitation projects.
The most prevalent, broker-facilitated fraud occurs when a broker lies about information that a wholesale lender relies on in its credit decision. This fraud can be used for either or both fraud for property, where borrowers overstate income or asset values to qualify for a mortgage, and fraud for profit, which involves use of fraudulent methods by mortgage insiders or third parties to acquire and dispose of property with the inflated profits going to the perpetrators.
In one case, a $165 million community bank that decided to step into mortgage banking purchased a small mortgage company and hired an experienced mortgage banker to run the operation. Almost five years into the relationship, an investor told the bank several loans originated by the same third-party broker were being returned for repurchase. Investigation revealed that the broker conspired with a builder and an appraiser to repeatedly flip properties for higher illegal profits. Over 100 loans were originated to one builder in the same subdivision.
This case went to litigation after the broker refused to reimburse the bank, which incurred a loss of approximately $6 million. The broker argued that the bank should share some responsibility for this exposure because its internal control systems should have recognized a loan concentration to one subdivision and instituted measures to deter this risk. The bank was eventually awarded $3.5 million, according to the report.
Based on the bank’s own analysis, to prevent from being entangled in such situation, the FDIC recommended that lenders establish a system to monitor concentration risk by broker and by project and institute surprise audits to sample loan origination documentation.
Loan documentation fraud extends beyond brokers to all involved in the process, including a borrower or lender knowingly making written false statements or concealing material facts to influence loan approval. Employment, income and occupancy misrepresentations are the most common types of fraud. Research on a sample of loans showed that 90 percent of stated incomes were exaggerated by 5 percent or more, and 60 percent were inflated by more than 50 percent.
In one example of fraud for property and profit, a loan officer hired by a community bank for a new loan program for minorities with poor or no credit histories provided credit to individuals who were using false or stolen Social Security numbers. The loan officer accepted, and sometimes generated, false documents to support the loans. The bank became aware of the problem through an institution that had purchased some of these loans and conducted due diligence. The bank had to repurchase these loans, but its total exposure has not yet been determined.
Had the bank run a background check on the loan officer, it would have seen she used a false Social Security number to get the job and falsified other information on her employment application. The financial institution that formerly employed her would have also revealed she’d been terminated for doing the same type of fraud.
In another case, a wholesale lender began pressuring employees to increase production — leading to the alteration of loan documents. The FDIC continues to investigate the case, including whether a senior manger provided false statements.
In addition to background checks, lenders can mitigate loan document fraud with periodic loan file sampling to spot fraudulent practices, periodic credit checks on existing employees, structure compensation agreements to include loan quality as a contributing factor, and institute adequate internal reporting procedures.
Appraisal fraud, which is usually outright fraud or negligence on the part of the appraiser — often in collusion with other parties, can be avoided by developing reports that track problem loans by loan officer, broker, appraiser, underwriter, branch office, settlement agent, and so on, the FDIC said. They should also vary the internal loan review scope to include a sample from all loan officers, as well as research the background and ownership of appraisal firms.
Lenders can avoid deals with property flipping, which is strictly fraud for profit and involves purchasing properties and reselling at artificially inflated prices to straw or duped borrowers, by verifying the quality of business generated by high-volume producers, establish dual control over loan processing and fund disbursement, and do periodic loan origination audits by officers. Conducting reviews of loan losses and noting any individuals repeatedly named in origination or processing areas could also help.
FDIC noted that some banks are exploring automated fraud detection products introduced in recent years to search bank loan databases and compare borrowers, loan participants, common names, addresses, employers, and appraisers to detect potential red flags of fraud.
“The ultimate decision as to whether these products represent a cost-effective solution remains an independent choice for each institution,” the FDIC said. “However, it is important that all institutions consider the potential impact of fraud and establish adequate provisions for this risk as part of their normal profitability and budgeting process.”
“Mortgage loan fraud is a large and growing problem” and “requires that all parties concerned maintain a high level of vigilance,” the FDIC concluded. “Bank management should keep alert to fraud triggers, ask questions, review mortgage documentation, perform verifications, and report suspicious activity to the appropriate regulatory and law enforcement authorities in a timely manner. While even the best internal control environment will not prevent mortgage fraud in all instances, strong internal controls, coupled with an alert and knowledgeable staff, are a financial institution’s best line of defense.”
