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C.
Robert Simpson of The Wolf Firm
and Rebecca Walzak
(Mortgage Banking, December 1996)
Bank robbery is more dramatic than mortgage fraud but not as lucrative. According to the U.S. Department of Justice, mortgage fraud losses exceed $60 billion per year far in excess of the amount taken in bank robberies. Moreover, mortgage fraud is increasing at an alarming rate. FBI statistics for 1996 indicate that mortgage fraud accounts for 17 percent of all losses suffered by federally insured institutions.
To reverse this trend and decrease the losses due to fraud, the mortgage industry is making greater efforts to protect the integrity of the data upon which underwriting decisions are made. Doing so, however, requires a careful balancing of the interests of origination and quality control.
Industry culture --it is true-- has tended to regard quality control as simply a necessary cost of satisfying investor requirements, as well as a hindrance to customer service. QC is more often associated with micromanagement and the "reprocessing" of loan files than with profitability. Because of this, quality control has often failed to get support from senior management.
Fortunately, the technologies exist and are increasingly being put to work to allow lenders to control the integrity of appraisals, credit reports and income verification without reprocessing each loan submission or dramatically increasing costs. In addition, data bases to monitor the perpetrators of fraud are allowing lenders to police themselves. This article addresses how these technologies will change the face of mortgage lending and alter the methods by which we control the investment quality of our portfolios.
Fraud for profit vs. fraud for housing
Fraud is legally defined as a misrepresentation of a material fact whether by words, conduct or concealment. Frauds that lenders confront come in two distinct varieties. First, there is the category of "frauds for profit". These are the malicious, intentional and criminal scams that are perpetrated not by the average gameplaying borrower, but by persons whose intent is everybit as criminal as that of the bank robber. They most often involve fraudulent appraisals, tax returns and phony credit and borrower profiles.
Second, there are the "white lie" frauds. These are the frauds committed by borrowers simply to play the home-approval game and are found most frequently in the form of false lease agreements, occupancy statements, letters of explanation and profit-and-loss statements.
The common link between these two types of frauds is that the integrity of the data upon which an underwriting decision will be based has been compromised. And whether you're dealing with fraud for profit or fraud for housing, either can lead to repurchase requests and heavy losses.
The mortgage industry's response to these frauds relies heavily on technology to protect the integrity of the data on which underwriting decisions are based. It is a response that will dominate the future of quality control. This technological response will seek to curb the abuses of inflated appraisals, deceptive credit reports and income falsification.
Appraisals
Fraudulent appraisals are at the core of some of the most financially devastating mortgage scams. With an inflated appraisal, it is possible to obtain refinance or purchase loans well in excess of the market value of the house. This makes eventual recovery against the property impossible. When the fraud is discovered, the security for the loan is worth only a fraction of the amount of the loan, and the remainder is all a hard loss.
Given current industry practices, appraisal fraud is relatively easy to perpetrate. Most lenders accept appraisals from any one of a multitude of appraisers on the "approved list." Samples of the appraiser's work, together with a resume and a couple of letters of referral, are sufficient to get set up. The standards for inclusion on such lists are not rigid, and many lenders have bloated lists that contain names of appraisers about which very little is known.
A wholesaler that keeps an expansive list of approved appraisers is a relatively easy target for those wishing to use a fraudulently inflated appraisal. Recognizing this, many wholesalers manually review all appraisals before funding. This manual "reprocessing" solution, however effective, is labor intensive and costly
Rather than manually reappraising every home, the future of property valuation, industry experts say, lies with automated appraisal systems that can quickly and efficiently make a statistical valuation of the property within a range of error. These systems are key to reducing both the time and cost of the appraisal process.
There are two major types of automated valuation systems. The first relies on a system of comparable sales, similar to current manual appraisals, wherein the price and characteristics of the subject property are compared with other properties having similar characteristics. The second method uses a statistical analysis of an area's housing price levels over time, by examining the price changes for the same houses over several transactions.
These automated systems can be used to generate the original appraisal or function merely as a review, though they are most useful with similar single family homes in large metropolitan areas. They are of less use when the subject property is unique or when factors such as view or upgrades add special value to the property. In those instances, the manual appraisal, with its physical inspection of the home, is the best method of determining value. Overall, however, automated appraisal methods will have an increasingly important role in property valuation in the years to come, as they reduce costs and streamline a process that is currently so subject to abuse.
Income falsification
Unscrupulous originators can falsify tax returns, employment information, verifications of deposit and can even create borrowers out of thin air. Computers, scanners and sophisticated graphics software are the tools of the trade for the modern mortgage fraud perpetrator. Commercially available tax preparation software makes it possible for brokers and borrowers to prepare tax returns that are artful enough to get past the visual inspection of even the most seasoned underwriters.
To address this type of fraud, two forms are available and in use: the IRS 4506 and the 9501. These forms allow lenders to check borrower income and even pull original copies of the returns from the Internal Revenue Service (IRS).
The 4506 form was adopted several years ago in response to rising concerns over tax return fraud. This form, signed by the borrower, grants the lender the right to receive original copies of the borrower's tax returns directly from the IRS. The 4506 is generally signed along, with the other loan documents immediately before closing. Therefore, the 4506's most practical application is to intimidate borrowers who have submitted false returns and discourage them from completing the transaction. If they are not frightened away and they close the loan, the lender is in the unenviable position of using the 4506 form after funding the loan, only to find out that the returns are fraudulent and the loan is a likely request for repurchase.
More powerful still is the IRS 9501 form, which has been tried experimentally in California. This form allows the lender to coordinate by fax with the IRS to check the veracity of the income information before funding. The form simply asks for IRS verification of whether a return was filed and, if so, what income was stated. The advantage of the IRS 9501 is that the lender can determine before funding if a return is false and prevent an eventual repurchase request.
Comments from mortgage bankers regarding the 9501 form are generally favorable. The praise derives from this tool's efficiency (same-day turnaround), its ease of use and its ability to relieve the underwriter of the burden of trying to catch fraudulent returns by purely visual inspection.
Industry experts foresee a time when all verification of income is done through coordination with the IRS. The success of the 9501 is leading to greater coordination between the IRS and the Mortgage Bankers Association of America (MBA) and is likely to spawn similar automated income verification systems throughout the country.
Credit fraud
Credit reports are an essential element in the evaluation of the likelihood of default and an important part of any loan file. Yet, credit cleaning companies advertise openly, and sophisticated borrowers and loan officers can work to clean up a report so that the final version looks nothing like the original profile.
Credit cleaning can take many forms. Loan officers may take a loan application, fail to complete the liability section of the 1003, run the credit report, then handwritten on the application only those items of credit that show on the credit profile. This passive form of credit manipulation depends on the credit bureau not reporting certain line items of credit information. More egregious cases of credit fraud can involve the use of other's Social Security numbers or identities to create fictional borrowers
Between these two extremes lie the credit cleaning companies. For a fee, they work within the system to get certain items of derogatory credit temporarily removed. For a period of time, the credit report will look cleaner than it actually is. If no backup credit report is run from another credit bureau, the lender is supplied with a credit profile that does not fully reflect the borrower's track record, and the manipulated credit report is relied on to fund the loan
With the coming of underwriting that relies on credit scores, lenders more than ever need accurate, not sterilized, credit information. If there are blemishes, lenders need to see them. Yet as long as the reports are ordered by others and supplied to lenders by third parties, there is always the question of what the report looked like before.
Two credit scoring methods will find increasing application: the credit score that incorporates data on the borrower's credit profile, and the mortgage score, which incorporates attributes of the property and the loan into the score along with the credit history. The credit score gives the borrower a grade, or a score, based upon myriad information available through the credit bureaus. Factors such as the amount of debt, the payment history, and the ratio of new debt to old combine to give a borrower a credit score or grade. With the FICO scoring system (a product of Fair, Isaac & Company, Inc., San Rafael, California), for example, a score of 700 indicates a very high rating and is indicative of a borrower very likely to repay obligations in a timely manner. A score of 500 is indicative of a very high risk candidate, on the other hand.
More effective still is the mortgage score, which takes all of the information and results of the credit score and adds many factors commonly considered by the underwriter when approving loans. These factors include the loan-to-value ratio, the borrower's reserves after closing, the time on the job, and whether the loan is for an owner occupied property. In this way, the mortgage score is made up of factors beyond what is found in the credit report and is designed specifically to give an accurate grade on the likelihood of repayment of a mortgage loan. By contrast, the credit score merely rates overall credit worthiness without regard to the type of loan being sought.
It is important to note that with the mortgage score, there comes an increased risk of borrower or broker fraud. As a reaction to these abuses and as future technology allows, industry experts anticipate that more of the credit profile of the borrower is likely to be controlled by the lender instead of the front-end originator. Rosalyn Hardy, regulatory compliance administrator with Weyerhaeuser Mortgage Company, Woodland Hills, California, says, '`If we control the integrity of our data, including appraisals, income and credit, we do much to increase the likelihood of repayment."
Early payment defaults
The frauds described earlier have not been that difficult to commit. Further, they represent serious threats to the industry because they are associated so closely with early payment defaults (EPDs), that is, loans that cease performing early on. Most of these cease performing within the first 12 months and in the most egregious cases become first-payment de- faults. When the frauds involved have more to do with the intention to pay than the ability to pay, the results are disastrous.
EPDs account for a relatively small number of total loan defaults, but their effect on overall profitability is disproportionately large. Industry experts estimate that the average loss on nonperforming loans is 33 percent of the outstanding balance, while the average loss on fraudulent loans is 49 percent of the outstanding balance. To counter this attack on profitability, the industry is beginning to take serious steps to meet the wrongdoers head on and battle their technology with technology of its own.
Regional and national data bases
There are unscrupulous industry insiders, whether appraisers, brokers or underwriters, whose names are repeatedly associated with fraudulent activity. When their reputation is spoiled in one area, they move on to another. What is most disturbing is that even after their identities are known, they remain active in the industry, originating and funding mortgages.
To address this concern, regional and national data bases are growing in importance and helping lenders keep track of huge amounts of data, including the names of persons and organizations involved in fraudulent activity. As an industry, we are just beginning to take advantage of the technology available. These data bases will serve at least two purposes. First, they will allow lenders to monitor the people and companies with whom they do business, and second, these data bases will be useful in monitoring and evaluating loan production for potential quality control problems and compliance issues. Such data bases already exist and are growing. There is widespread support for the concept of a data base to monitor unscrupulous mortgage brokers and other industry insiders linked to past frauds. Industry leaders agree that identifying those insiders most often associated with fraudulent activity will greatly improve the chances of reducing losses due to fraud. Currently, mortgage fraud artists who gain a reputation in one geographic area for fraudulent activity are able to move and begin operations all over again in another locale. We are an industry where ones reputation is quite geographically limited.
However, national data bases that are able to monitor these bad actors will serve to create national reputations. MIDEX, one of three data bases developed by the Mortgage Asset Research Institute (MARI) of Reston, Virginia, contains non-public records of alleged fraud, material misrepresentation and serious misconduct, in addition to public records of various disciplinary hearings. For a fee, subscribers can access the data base to check the history of anyone they consider doing business with and, thereby, take a large step toward better controlling their loan quality. Jim Croft, president of MARI, sums it up by saying, "When reputations are national and not local, we will create a climate in which the ethical will thrive and the unethical will die on the vine."
In addition to monitoring the unscrupulous, data bases also are providing a powerful tool to assist in monitoring compliance with investor requirements and analyzing loan portfolios. As Croft says, "Data bases are going to be used not only to keep track of problems, but to keep track of what is going right."
Cultural roadblocks to quality control reform
Three main hindrances have stood in the way of the adoption of more aggressive quality control protocols. The first of these can best be illustrated by example. Recently these authors attended a seminar on loan fraud sponsored by the MBA conducted via remote feed in 42 different locations throughout the United States. Prominent industry leaders from Fannie Mae, Freddie Mac, VA, FHA and the FBI gave insightful and accurate information about how best to increase loan quality and compliance.
The seminar was advertised widely. Yet from a total of 42 sites across the country, there were only 112 paid participants altogether. And therein lies the problem. Had this been a seminar on loan origination, every site would have been full. But because quality control is the unexciting stepchild of mortgage lending, the turnout was just slightly more than two people for every state in the Union. It is true that the origination and funding of new mortgages is the key to high profitability, but quality control for all the talk about a penny saved being a penny earned is still viewed by many CEOs as a budgetary drain.
The second hindrance to aggressive quality control, interestingly, is the tolerance afforded certain frauds by otherwise honest professionals. When referring to false lease agreements, suspect letters of explanation, and dubious profit and loss statements, the sentiment that "everyone does it" seems to pervade this industry.
It is not uncommon to find successful, well respected loan officers and underwriters who will say that as long as the borrower appears able to make the payment, then this game can be played with no ill effect. It is an unspoken truth among many that these white lie frauds should not prevent the funding of an otherwise good loan.
And finally, no lender wants to have the reputation as the toughest lender in town when it comes to reviewing files. Most lenders now see the folly in advertising "No 4506 Required," but, still, no lender is going to advertise "We Catch Everything!" The fallout from a funding halted by the quality control department is real and complex, and a middle-of-the-road reputation is acceptable for many lenders.
Yet if origination and quality control are often at cross purposes, there is some common ground. Both are adverse to the time consuming inspection and reverification process that slows down production and increases costs. This is why macro changes in the processing and funding of loans, not micromanagement, will ultimately prove the source of the solutions. And at the heart of those changes is the technology that will allow for data verification without slowing down the underwriting process or adding greatly to costs.
In the future, to what extent will the industry burden the origination side of the business to ensure the integrity of the information contained in the loan application? Can lenders originate and monitor quality without adversely affecting their relationships with brokers and borrowers? The answer appears to be yes in light of the technology that allows for the reverification of crucial data quickly and at minimal cost.
With technology now allowing for the automated generation of appraisals, mortgage credit scoring and verification of income directly from the IRS, lenders will be assured that there is a solid basis in fact for their underwriting decisions. As an added protection, data bases will serve to alert lenders about those underwriters, brokers or other inside personnel who have by their actions built a reputation for dishonesty. A national reputation will soon dog those who used to count on anonymity. These coming changes will serve to ensure the integrity of the data upon which underwriting decisions are made and protect the profits now lost to fraud.
For further information please contact:
The Wolf Firm, A Law Corporation, is an "AV" rated law firm which concentrates on providing superior legal services to the mortgage banking industry. The firm's national clientele includes many of the largest mortgage bankers in the country, as well as a variety of savings banks, commercial banks, commercial finance companies, credit unions, and the Resolution Trust Corporation. With a staff of approximately forty individuals, including attorneys, certified paralegals, legal secretaries, administrators, clerical personnel, and a full time computer systems analyst, the firm represents its clients on a wide range of matters including all aspects of both residential and commercial/multifamily mortgage loan origination and servicing, securitization, regulatory compliance, bankruptcy, and litigation related to the foregoing in both federal and state courts throughout California. For more routine matters, such as residential bankruptcies, evictions and receiverships, The Wolf Firm has developed extremely cost-effective and efficient programs using specially trained paralegals and computer technology to assist its attorneys in handling these matters at rates that are the most competitive in the State of California and, through its membership in the USFN, the Firm is able to arrange similar services in virtually every state in the nation.
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