REQUIRED READING: The philosopher George Santayana once famously observed, ‘Those who cannot remember the past are condemned to repeat it.’ Santayana did not work in mortgage banking, but his statement clearly applies to the industry – especially in regard to mortgage fraud. In order to understand where mortgage fraud may shift in the future, it is important to understand the recent trends that shaped fraud schemes in the not-so-distant past.
Fraud perpetrators are criminal entrepreneurs whose schemes shift in order to take advantage of economic trends, regulatory and enforcement gaps, and human nature. The current fraud cycle began in the mid-1990s, at the bottom of the last boom-and-bust real estate cycle. Because property values had been falling for several years, the first type of fraud in this cycle focused on flipping – creating false ‘equity’ in a property by using a corrupt or inexperienced appraiser to create an appraisal that inflated the true value of the subject property through ‘cherry picking’ of comparables, misstating physical characteristics, or falsely claiming that repairs and upgrades had been made.Â
In order to extract this false equity, the perpetrator would purchase the property at market value and then sell it at the inflated price – often on the same day – to a co-conspirator using a stolen identity or to a straw buyer (often a naive and inexperienced real estate investor). One successful ‘flip’ enabled another. And because lenders require that appraisers find comparable sales within a one-mile radius of the subject property, the first flip was used to support the inflated values of subsequent flips in the vicinity.Â
When those values were not recognized as having been manipulated and were published in the county tax digest, multiple listing services and commercial appraisal databases, they were used as comparable sales in additional flips. The appearance of rapidly rising values attracted illicit speculators and investors, whose transactions also helped move prices upwards. In this manner, frauds in a localized area spread from a single street through neighborhoods and subdivisions and, eventually, throughout metropolitan regions.Â
These illicit activities affected the legitimate market as well. In a contagion effect, homeowners and real estate agents, recognizing the apparent appreciation, began to ask for – and received – higher prices on legitimate sales. The irony is that the first wave of fraudulent sales to straw buyers usually ended in default and foreclosure, which normally would deflate local values, but in a rising market and with a recorded history of higher prices, even those foreclosed properties could be sold or flipped again at higher prices.
Over time, unrestrained flipping and the upward pressure it exerted on housing values began to create affordability issues, especially for first-time home buyers in California and Florida. For example, in Los Angeles County, the median price of a home in 2004 ranged from around $300,000 to nearly $600,000 – but the median annual income had dropped to $51,000. Under old-school underwriting guidelines, half of the population should not have been able to qualify for a mortgage of more than $150,000.
The response to the affordability issue was a shift in fraud schemes from predominantly fraud ‘for profit’ (out-and-out criminals and profiteering investors) to fraud ‘for housing’ schemes in which the borrower's financial qualifications were misrepresented. It is no coincidence that this shift in predominant schemes took place concurrently with the rise of brokered originations and their use of stated-income loan programs.Â
Although they are now much maligned, stated-income programs were not inherently evil; they were designed to meet the needs of a niche market of self-employed borrowers with substantial assets and incomes. Eventually, however, they eventually came to be used as the loan of last resort for W-2 wage earners who otherwise would not have been able to qualify for a loan.
This shift was largely accomplished at the instigation of unscrupulous mortgage brokers, who, by 2003, accounted for 60% of all mortgage originations. Since brokers had no loyalties to any particular bank and were compensated only when a loan closed, they sought to close as many loans as possible without regard to whether the borrower could actually afford to repay the loan.
From the mortgage banker's perspective, the danger was not as obvious then as it is today. Before the 2008 collapse, no one thought twice about borrowers who exaggerated their incomes – the argument was that they were only ‘stretching’ to get a home that was only slightly out of reach financially. And since their incomes were expected to rise over time, and these were rare occurrences, such minor white lies could be tolerated with minimal risk of default. This attitude was also reflected in the many instances where borrowers who questioned inaccurate income statements on mortgage applications were told not to worry because the banks ‘didn't care.’
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Hindsight, of course, is 20/20. Rather than being harmless one-offs that never default, the Financial Crimes Enforcement Network reports that 66% of all frauds in post-default mortgage-related Suspicious Activity Reports filed between 1996 and 2006 named the borrower as the subject. But we must keep in mind that these instances of fraud were encouraged and facilitated by the malignant network of mortgage professionals who received a fee or commission every time one of these misrepresented and unsustainable loans went to closing. In the aggregate they are, in large part, responsible for the liquidity and economic crises in which we remain mired.
Looking forward in anticipation of fraud to come, one thing is certain: It will continue to occur, but the mechanisms and scheme specifics will change depending on economic conditions, loan programs, lenders' underwriting and due-diligence procedures, and regulatory/legal enforcement – or the lack thereof. Here are some types of fraud that we need to keep following:
Identity theft. This has been around since Biblical times, when Jacob fooled his blind father Isaac into thinking that he was his older brother Esau in order to steal Esau's birthright. As the industry moves toward all-electronic originations, identity theft will be easier to commit.
Appraisal fraud. This type of fraud has been declining recently, but that may change soon because of the new Uniform Appraisal Dataset (UAD) and a specific provision in the Dodd-Frank Act's financial reforms. The UAD was designed to standardize terminology and improve appraisal quality, but its design is creating inadvertent opportunities for fraud. For example, a drop-down menu on sale type allows an appraiser to select ‘short sale,’ but critical additional information – for instance, that it is a non-arm's-length transaction – must be put in a different part of the form.Â
This additional information is not rolled up into the final report and is only visible if the underwriter pulls up the full appraisal. It will take some time for underwriters to become familiar with the new form and what the various descriptors mean, which presents opportunities for the criminally minded to find ways to take advantage of the learning curve.Â
Furthermore, the Dodd-Frank Act's appraiser independence provisions continue the ‘Chinese wall’ established by the Home Valuation Code of Conduct (HVCC) that prevents loan originators from directly contracting with and contacting appraisers. However, like the HVCC, the pressure exerted on appraisers by real estate agents and home builders is not recognized or addressed.
Even worse, the Dodd-Frank Act specifically allows a broker to ask the appraiser to ‘consider additional…comparable properties to make or support an appraisal.’Â While this sounds innocuous enough, just Google ‘how to influence the appraisal,’ and you'll see that suggesting cherry-picked comparable sales is one of the ‘best’ ways to get the appraiser to agree that your target price is justified.
Income and employment misrepresentations. These have always been a problem – particularly in the current economic climate. While lenders abandoned the stated income loan programs in 2008 and began using the 4506-T form to verify incomes directly with the Internal Revenue Service, borrowers are now filing false income-tax returns or amending previously filed returns to claim a higher or lower income, depending on whether they are trying to purchase a property and need to show a higher income, or to obtain a modification where a lower income is needed.Â
Because the 4506-T form is only good for 90 days, lenders are not able to easily check after closing to see whether returns are amended or re-amended. This is likely to continue for the foreseeable future.
Occupancy fraud and flipping. These often go hand in hand as investors seek to acquire and quickly profit from their purchases are likely to continue until foreclosed and ‘shadow’ properties have worked their way through the system and will increase as property values begin to rise and the price manipulations becomes less obvious. Previous efforts to restrict resales within 90 days of acquisition have not been successful, because there was no verification or enforcement. The only real disincentive to illicit flipping is a buy-and-hold profit-sharing arrangement in which the lender's share of the profit declines over a period of one to three years.Â
Short-sale flopping. This type of fraud involves manipulating the lender into accepting an artificially low price. The new shadow banking system of private joint ventures and lending consortia that provide cash for the acquisitions funding will also persist until the shadow inventory is exhausted and/or the economy improves.Â
The secondary market was extremely vulnerable to fraud during the boom because critical loan-level detail was lost between origination and pooling. Going forward, it will be necessary to obtain as much loan detail as possible in order to verify that the borrower is who he says he is, that he makes what he says he makes, and that the property is worth what the appraisal says it is.
Investors should also require sellers to conduct robust pre-funding due diligence, use available technology and services to assist that effort, and ensure that their staff receives ongoing training in order to recognize current fraud schemes.
As we struggle to recover from one of the worst housing crises in the last century, we would do well to start by acknowledging the role that fraud played in creating this collapse. It was, of course, fraud in many different places and on multiple levels that brought us to this dark place.
To borrow a line from Shakespeare, what's past is prologue. In order to avoid a repeat of what transpired over the past few years, we must be prepared to take a wider view of fraud as we proactively seek solutions that encompass technology backed by the experience of seasoned mortgage professionals.Â
Ann Fulmer is vice president of business relations at Agoura Hills, Calif.-based Interthinx. She can be reached at firstname.lastname@example.org.