Sheila Klostermann: How Economic Cycles Change the Mortgage Fraud Landscape


PERSON OF THE WEEK: Although it’s nowhere near as prevalent as it once was, mortgage fraud continues to persist in a small fraction of loan documents. What’s more, mortgage fraud seems to ebb a flow almost predictably based on market cycles: For example, the risk of fraud increases in a purchase market, because in general there are more borrowers providing their personal information for the very first time.

To learn more about the types of fraud and how they change as economic conditions fluctuate, MortgageOrb recently interviewed Sheila Klostermann, director of quality assurance at Enact Mortgage Insurance.

Q: How prevalent is mortgage fraud in today’s market?

Klostermann: Thankfully, mortgage fraud is very minimal today. CoreLogic’s 2022 annual mortgage fraud report stated 0.76% of all mortgage applications contained fraud, about 1 in 131 applications.

Although fraud frequency is low, lenders and other mortgage professionals must remain vigilant and aware of how the economic cycle can influence fraud trends.

Q: What are the types of fraud that are being attempted in today’s market?

Klostermann: Income and liability fraud consistently account for a portion of mortgage fraud, regardless of the current economic cycle. Liability fraud occurs when borrowers have debt that is not disclosed during the loan application process.

Income fraud, which includes misrepresentation of the existence, source, or amount of qualifying income, has risen, up 27.3% from 2021 according to CoreLogic. When liabilities and income are misrepresented, the borrower’s qualifying ratios do not represent their true financial situation and likely overstate the borrower’s ability to qualify for the home.

Occupancy fraud also has seen a slight increase, up 0.8% from 2021 per CoreLogic. Rising home prices, relatively low interest rates and a strong job market prompted some to take the leap and purchase a second home or investment property. However, these occupancy types have higher down payment, reserve and financing costs, providing temptation to present the purchase as owner-occupied to avoid the larger cash requirement. 

Q: How do economic cycles impact the type of fraud that is trending?

Klostermann: Just as market conditions affect home prices, market conditions also affect the prevalence of specific mortgage fraud types due to their influence on potential homebuyers. While there are many factors at play and many forms of fraud, I can highlight a few:

  1. During periods of rapidly rising homeownership costs, whether because of high home price appreciation or rising interest rates, income or liabilities may be misrepresented in order to qualify for the also increasing payments. Would-be buyers may worry that if they don’t secure home financing now, they may never be able to afford it if current trends continue. This creates the motivation to misrepresent important information, such as income or debt.
  2. Rapidly rising home prices may also drive real estate investors to misrepresent occupancy in order to secure financing at favorable terms. They may flip the house after a short period for a profit or rent the house for a positive cash flow.
  3. Alternatively, in periods of slow or negative home price appreciation, sellers have an increased motivation to sell properties so sales incentives to the buyer may be hidden to avoid the negative impact that those contributions have on the loan-to-value calculation. The potential for straw buyers also increases as property owners seek to extract equity before values fall further.
  4. Finally, Corelogic reports that the risk for fraud increases as the percentage of purchase and cash out transactions increase in the marketplace. As interest rates have risen, the prevalence of rate term refinances have declined, leaving higher risk transaction types, purchases and some cash out refinances, to dominate the marketplace.

Q: What are some best practices for identifying fraud?

Klostermann: Lenders should identify any changes that would alter the borrower’s application prior to closing. One of the simplest ways to do this is to reverify employment and income prior to closing to validate the originally disclosed information is still true.

Ideally, income and employment are reverified as close to closing as possible so that any recent changes can be evaluated for their impact on qualification. Some lenders employ a service that will identify any new debts obtained prior to closing. Surprisingly, it’s not uncommon for borrowers to purchase a new car or other large, financed purchases right before closing and these debt monitoring services can help identify those instances. 

Other lenders simply reach out to the borrower frequently during the application process to provide updates and to also ask if there have been any changes to their original application.

A lender’s origination and underwriting teams are the first line of defense against fraud. Ensure all team members are aware of common red flags. Awareness of red flags provides team members the knowledge needed so that they know when to ask, “Does this make sense?.” For example, new employment with a significant increase in income is a potential red flag. In today’s low unemployment environment, such a change in earnings might be warranted or it may merit further investigation. 

Empower teams to ask questions. A pause in the processing cycle to investigate a red flag could save hundreds of thousands later if that fraud were to go undetected.

Facilitate communication among team members. Fraud may not be evident on a single transaction but when multiple team members encounter similar scenarios, fraud patterns become clearer. It’s particularly important in a remote environment to provide team members with same-time chat capabilities, to have frequent meetings and to encourage them to share what they are encountering day-to-day. 

Lender servicing teams also can be a fraud identification source. For example, a change of address for mortgage payment or homeowner insurance billing may suggest that occupancy has changed. A modification to the terms of the homeowner’s insurance coverage such as a change from “contents and dwelling” to “dwelling only” also may be suggestive of a change in occupancy. 

Q: What resources are available to assist in the identification of fraud?

Klostermann: There are many great resources available that lenders and their origination and underwriting teams can use to improve the identification of fraud. In addition to the mortgage fraud prevention resources available from Fannie Mae and Freddie Mac, other mortgage partners often have their own resources that lenders can leverage. 

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