Uncovering Fraud In Nonperforming Loans

[i]REQUIRED READING[/i][/u]:[/b] [b]When you look for fraud, you might be surprised at how often you can link the payment issues with a misrepresentation in the original application used to underwrite the loan[/b]. Fraud is lying. Fraud is cheating. When it happens, there are consequences, and far too often, the consequence of fraudulent misrepresentation is a loan default that eventually leads to foreclosure. Servicers usually bear the brunt of dealing with the fraud mess in their modifications, short sales and foreclosures. Servicers are forced to deal with many fraud issues on loans. Based on fraud reports received by lenders and servicers, the most common types of fraud are income and employment misrepresentations, and misrepresentations related to the borrower's claim of occupancy on the property. By all indications, mortgage fraud is having a big impact on the industry, especially for mortgage servicers. Mortgage-fraud reports by industry groups point to the fact that lender-reported fraud losses are at their highest levels in recorded history. The Federal Bureau of Investigation reported in 2009 that mortgage fraud had grown another 84% during the year. Our company's own analysis indicates that lenders will report $14 billion in loan amounts that were funded, or $0.55 in fraud loan value for every $100 originated in 2009. As fraud is funded, the eventual impact is felt by mortgage servicers that are forced to grapple with the fraud in the portfolios they manage. [b][i]Early-payment default losses[/i][/b] One disturbing trend was uncovered in fraud investigations on loans that defaulted within the first six months. Loans that default in this period of time are often categorized as early-payment default. In their investigations, lenders discovered that up to 70% of these early-payment defaults could be traced back to some material misrepresentation in the original loan file. The actual degree of fraud on early-payment default could directly be tied back to how the loans were originated and how diligent the lender was in looking for fraud prior to funding. But fraud usually does not reveal itself until it is too late. For most servicers, fraud is not exposed until the loan falls into default. The first indication of a potential fraud issue occurs when the servicer attempts to make a collection call to the borrower to resolve the payment issue. Common early red flags of a potential fraud occur in the following scenarios: [list]the borrower's work number is disconnected, or the borrower is unknown;*the borrower's home phone number is disconnected, or the borrower is unknown;*the borrower claims to have no knowledge of the loan or the property;*the borrower says that he or she got the loan for someone else; or*the borrower indicates in the collection call that he or she doesn't live in the property that was originally claimed to be owner-occupied.[/list] Conversations with borrowers can be very enlightening and reveal real information that was not discovered when the borrower initially applied for the loan. The fact that fraud has occurred makes the collection and eventual resolution of the loan file challenging. When the loan defaults, the fraud manifests itself and typically ends up in one of three areas of treatment: a loan modification program, a short-sale request or a foreclosure. [b][i]Fraud's impact on loan mods[/i] [/b] Estimates by CoreLogic indicate that one out of every 200 loans contains some fraud that will cause it to default. This means that a high level of fraud is making its way into the modification process. The problem of fraud on loan modifications involves borrowers providing information that is contradictory to what they reported on their initial application. The most common types of loan modification fraud include borrowers underreporting their income; borrowers lying about their occupancy status to qualify for a modification; and borrowers lying about their hardship and not being able to supply documentation. The Home Affordable Modification Program (HAMP) is a good example of how fraud impacts are felt by servicers. Many servicers are reporting that the primary qualification issues arise because borrowers are unable to or fail to supply documentation of their income, are unable to support their occupancy claim or are unable to provide any documentation to support their hardship. [b][i]Short-sale fraud emerging[/i][/b] The number of short sales in the market has more than tripled since 2008 as lenders try to find alternatives to foreclosures and reduce their level of losses. In April, CoreLogic concluded a data study, based on loans from the last two years, that examined the level of fraud in short sales in single-family residences in the U.S. The analysis focused on trying to locate fraud where parties involved in the short-sale process were manipulating the short-sale transaction and/or subsequent transaction for a profit. The study produced several eye-opening findings. Sixty basis points (bps) of short sales are sold to another party within 10 days after the short sale for at least a 20% higher price. As much as 170 bps of short sales are sold within six months after the short sale for at least a 40% higher price. The study also found that the most common fraud scheme in short sales involves a limited liability company or an investment company having a buyer lined up for the property, not disclosing it to the lender and flipping it to the buyer after the short sale is completed. The top five states with the highest level of short-sale fraud were Florida, California, Missouri, Arizona and New Jersey. As the number of short sales increases in 2010, the rates of fraud will increase, as well. New government programs designed to expedite short sales will likely have an immediate impact on the levels of fraud loss. Our company estimates that the net losses due to short sales of single-family residences in the U.S. will top $50 million in 2010. In 2008, CoreLogic studied the impact of fraud on loans that foreclosed with lenders. In one specific lender fraud investigation, it was determined that 25% of loans in foreclosure had evidence of fraud in the application. The types of fraud most commonly perpetrated were borrowers misrepresenting their income or employment, or borrowers lying about their intent to occupy the property (in other words, investors that were masquerading as owner-occupants to get a better rate or terms on the loan). When the lender examined the bottom line (what it had actually lost after the property was sold), the lender determined that it lost 50% more on a property where fraud was involved. The impact of fraud on bottom-line losses was shocking. Servicers are forced to deal with high levels of fraud like never before. New government programs, legislation and regulations are making the task even more difficult. The primary challenge for servicers this year with respect to fraud risk will be dealing with HAMP and other loan modification programs. Finding a way to accurately choose loans that qualify is a daunting task and one that can only get easier with a more analytic and targeted approach to weeding out fraud. In times of uncertainty, however, one thing is always certain: Fraud will continue to reveal itself as we learn more about it through data. [i]Frank McKenna is vice president of fraud strategy for CoreLogic, which provides best-practice consulting services to lenders. Prior to that, McKenna was the co-founder and chief fraud strategist for BasePoint Analytics, based in Carlsbad, Calif. He may be reached at fmckenna@firstam.com or (760) 602-4971, ext. 1


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