how to become a mortgage broker

Fighting smart in the war against: mortgage fraud

"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.

In addition to an overview of mortgage banking, specific fraud training should include identification of red flags that can alert the astute processor, underwriter, or closer to questionable transactions. For example, a flip transaction is commonly defined as the practice of reselling real estate immediately or shortly after purchase at a significantly inflated price that does not represent the true value of the property. A flip requires the collusion of at least three parties:

1. An appraiser that overvalues the property.

2. A broker, realtor, or other party that orchestrates the fraud.

3. A settlement agent that is aware of the large increase in value and rapid change in ownership, but elects to not notify the lender.

Flips account for some of the largest losses to lenders and can wreak havoc on neighborhoods. According to the Georgia Real Estate Fraud Prevention and Awareness Coalition, after eight years there are neighborhoods in the Atlanta area still combating the effects of flipping schemes that arose from flat real estate appreciation, foreclosed and unkempt properties languishing on the market for years, and the need for manual tax reassessments. The same can be said for Detroit, Baltimore, and countless other urban neighborhoods. To combat flip transactions, lenders should look for the following red flags. Although not all-inclusive, these five scenarios represent the more common red flags signaling a flip:

1. Preliminary HUD-1 Settlement Statement shows payoffs from the seller's funds to persons or entities not listed as lienholders on the title commitment.

2. Inconsistencies exist between the owner as listed on the appraisal, the vested owner as listed in the title commitment, and the seller as listed in the sales contract.

3. Comparables in the appraisal report do not appear to be the best available comps, comps have transferred multiple times within 12 months (making them flips themselves), or the appraisal reflects excessive adjustments.

4. Title commitment reflects multiple deeds necessary to effect transfer of title.

5. Title commitment, sales contract, or appraisal list the owner as "owner of record."

Recognizing red flags is not enough, however. Lenders and their regulators must be trained in the latest fraud schemes and their geographic locations, and lenders need to train all employees on company policy as it pertains to suspected misrepresentation within a file. Just a few areas would be 1) when the file gets elevated to a supervisor; 2) when legal, quality assurance, or internal audit should be notified; 3) how to respond to customer allegations of identity theft; and 4) the proper completion of SAR filings.

Infusions of Quality Lending Practices

Quality lending practices are the second line of defense in fraud prevention. Simply put, quality loans come from quality lenders. Numerous steps can be viewed as adding quality to loan production, and it's not feasible to expect Risk Management to be aware of every safety net known to the industry and to require implementation of all known resources. Technology has created valuable fraud prevention and detection tools in the form of automated valuation models (AVMs) that can be used to validate appraised values, Web-based resources for inquiries about broker licensing, secretary of state filings, and the like. Evolving fraud filter systems can look at the data points of a loan application (Fannie Mac form 1003) and "score" the application while identifying red flags, based on information keyed or transmitted to the system. Quality lending takes more than technology, however, and brick-and-mortar steps can still be the most successful weapons in a lender's arsenal. At a minimum, quality lenders should include the steps outlined below in their normal operating procedures:

* Obtain a signed IRS Form 4506 on all loans.

* Review the preliminary HUD-1 for unusual payouts from seller funds.

* Pull an independent trimerge credit report for all broker-originated loans.

* Compare ownership on the title commitment, the appraisal, and the sales contract to ensure consistency among all three documents.

* Review industry ineligible lists if available (HUD LDP list, Freddie Mac Exclusionary List, investor maintained lists, etc.).

* Perform a verbal verification of employment on all loans prior to closing, or in the case of self-employed borrowers, obtain a copy of the borrower's business license.

* Ensure that funds to close are verified and seasoned for 60 days.

Studies of claim data undertaken by The Prieston Group show that if performed properly, these steps can reduce repurchase requests by up to 85%. This figure has been independently corroborated by one of the largest mortgage loan aggregators against a sampling of its own repurchase demand letters issued to its correspondent lenders in 2004.

Stronger Documentation

Recoveries from borrowers often are unavailable because borrowers may be victimized themselves. If not for the participation of third parties, such as appraisers and settlement agents, frauds in many residential mortgage loan transactions would never have succeeded. So in the absence of statutes or rules, lenders increasingly are protecting themselves against heretofore Teflon defendants by adding teeth to legal documents that establish liability. There is no better treatment course for preventing fraudulent activity than by hitting all those contributing to the fraudulent transaction where it hurts--in the pocketbook.

The specific closing instructions should be the most scrutinized document in the lender's anti-fraud arsenal. Too often, the language in this form has been preprogrammed into a document preparation system. Legal review from a fraud prevention or recovery standpoint could result in language that better defines the responsibilities of these agents.

One example of such language is a requirement that settlement agents not only sign the HUD-1 Settlement Statement but also sign a statement acknowledging the closing instructions. Such a statement should contain a clause affirming that the agent has read, understands, and accepts all conditions of conducting the settlement.

Closing instructions also should require 1) that all funds pass through escrow and 2) that copies of down-payment checks or funds needed to close be part of the conditions to close. We've learned the hard way that settlement agents who knowingly participate in fraudulent mortgage schemes often "lose" this data when the lender requests it after the fact during the course of its audit or investigation. Further, instructions should direct the agent to accept funds only from the borrower, drawn on the borrower's account, or, in the case of official checks, drawn from the verified financial institution and remitted by the borrower.

Instructions also should contain specific language requiring the settlement agent to notify the lender in writing if the agent has knowledge of any of the following:

* The property has changed hands in the last 180 days.

* The property has increased in value more than 25% during the past 180 days.

* There were previous, concurrent, or subsequent transactions involving the subject property or the borrower.

The latter circumstance occurs most frequently in large-scale fraud schemes. A closing attorney in Florida was recently arrested and charged with 16 counts of fraud, money laundering, and conspiracy in a scheme involving $22 million in fraudulently obtained mortgages. There is little doubt that he had knowledge of previous, concurrent, and subsequent transactions involving the subject properties and/or the borrowers. But without the proper language in the victimized lenders' closing instructions, counsel lacks a clear and concise path to monetary recovery.

The Future

Risk managers generally agree that the biggest risk to an organization is the risk you don't know about. Mortgage fraud is here to stay, and its incidence is becoming more widespread, partially because of an increased awareness of successful ways to commit fraud. Left unabated, mortgage fraud will continue to grow and reverberate throughout our economy, our neighborhoods, and our families. For risk management professionals, recognizing mortgage fraud as a serious threat, both to our own businesses as well as to our economy and very lifestyles, is an important first step in defending our institutions and improving our chances of recovery from its effects. Training, quality lending practices, and strengthened legal documents are just three ways to protect ourselves, but they are three of the most effective means available--and steps that no sound risk plan should be without.

Contact Jacqueline Dreyer by e-mail at jackied@LoanCert.com.

[c] 2005 by RMA. Jacqueline Dreyer is managing director of LoanCert--a division of The Prieston Group, a diversified business consulting company serving the mortgage banking industry through mortgage fraud education, insurance protection, and legal recovery. A speaker and trainer in the area of fraud prevention and quality lending, Dreyer presented a discussion of this topic at RMA's 2004 Loan Fraud Forum in November.

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