Eight common mortgage loan origination fraud schemes to watch for today

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1 Eight common mortgage loan origination fraud schemes to watch for today Prepared by: Al Kohl, Manager, McGladrey LLP , January 2013 Despite closer scrutiny by regulators and new rules and laws put into effect after the mortgage market meltdown, and even with the reduction in mortgage activity in this slower housing market, mortgage loan origination fraud continues to proliferate. According to the FBI s website, mortgage fraud continues to be on its list of the agency s 11 white-collar crime investigative priorities. 1 One of the ways the FBI becomes aware of mortgage fraud is through the analysis of suspicious activity reports (SARs), which are filed by federally insured financial institutions. Mortgage fraud SARs have increased from 6,936 in fiscal year 2003 to 67,713 in fiscal year 2008 to 93,508 in fiscal year McGladrey has investigated several large mortgage origination fraud schemes in the past year, including all eight types of schemes described in this paper. In each of our investigations, these schemes were occurring unbeknownst to the institution s internal and external auditors or senior management. All of these investigations involved loans originated after the regulatory crackdown on mortgage fraud. One fraud case involved a loan officer who misappropriated funds held aside in escrow for property repairs, and funds intended to pay for government agency guarantee fees. The loan officer used the money to cover other, unrelated closing costs and fees. In another case, the loan officer used the misappropriated funds to cover her own daughter s origination fee on a mortgage loan. Another fraud case involved undisclosed second mortgages used to pay for borrower down payments. The same loan officer falsified loan documents to make some of the loans appear to have been recently closed when, in fact, the loans had been closed many months earlier. The loan officer falsified the information because she could not originally sell the loans due to unsatisfied underwriting conditions involving the required payoff of existing debt. The same loan officer also facilitated falsified real estate contracts that allowed borrowers to take cash out from real estate purchases. A number of factors, including low perceived risk by organizations originating loans, and considerable economic motivation to close business for individual loan officers, all play a role in continuing patterns of mortgage loan origination fraud

2 One key step to combating such fraud is understanding the ways it is perpetrated. In a moment, we will outline eight common mortgage loan origination fraud schemes. But first, consider the environment underlying mortgage loan origination fraud. Lax oversight at lenders Mortgage loan origination frauds often involve loans originated by broker/dealers, banks, or savings institutions which then sell the loans on the secondary market. Since the originating institution will not bear the ultimate risk of default, these schemes usually result in a low risk to the originator itself. Because the originating institution bears little risk, the activities of mortgage loan originators often are insufficiently scrutinized by internal and external auditors. This combination of low perceived risk and lax auditor attention means that internal controls are often missing or not followed during the mortgage process, creating an environment that is ripe for fraud. Originating institutions may be underestimating their risk. Buy-back provisions in the sales of mortgage loans to the secondary market allow the purchaser of the loan to force the originating institution to buy the loan back if the underwriting performed on the loan is found to be substandard or fraudulent. However, even if an investor audits the defaulted loan file, the schemes are particularly difficult to detect without a detailed review of each step in the loan application process, which usually does not occur. The originating party also often destroys the evidence of the fraud, making it particularly difficult to trace, even if one suspects a fraud has been committed. A buy-back is not the only risk. Because these loans are eventually sold on the secondary market and guaranteed by federal agencies such as the Federal Housing Administration and the U. S. Department of Agriculture, mortgage loan origination fraud can be prosecuted under several federal statues, including wire fraud, mail fraud and false statements. Furthermore, many loan originators and banks are regulated by federal agencies such as the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and the Federal Reserve Bank. After the massive losses sustained in the mortgage secondary market near the end of the last decade, the federal government has been particularly vigilant in prosecuting mortgage loan origination frauds. Economic motivations push fraud Lax oversight by originating institutions is only part of the problem contributing to mortgage loan origination fraud. The individual loan officers originating the loan also face economic motivations and business pressures to close as many loans as possible. Many originators are paid a commission on each loan they sell and, therefore, want to sell as many loans as possible, even loans outside of normal secondary market loan program underwriting parameters. Additionally, in real estate deals that have gone sour, real estate agents, attorneys, buyers and sellers can place tremendous pressure on the loan originator, especially when a real estate agent could lose a significant commission. Even if a loan officer is not paid on commission, his or her performance is often judged by the volume of loans originated, with raises and promotions based on meeting certain origination goals. Finally, loan originators depend heavily on referrals from the real estate community. And those referrals go to the originators with the reputation for being able to make loans even in difficult circumstances, not to the originators with a reputation for fastidious adherence to underwriting standards. With an understanding of market motivations for mortgage loan origination fraud in place, let s consider the nature of the fraud itself. According to the Federal Bureau of Investigation s 2010 Mortgage Fraud Report, mortgage fraud is a material misstatement, misrepresentation, or omission relied on by an underwriter or 2

3 lender to fund, purchase, or insure a loan. Mortgage loan origination fraud often involves misstatements of borrower income, debt, cash reserves, employment history, or other representations made on the borrower loan application. However, misstatements can also be made at any step in the origination process, including falsifications of real estate contracts, misrepresentations of down payments, falsification of closing dates, side deals between buyers and sellers, false appraised values and payment of closing costs. Although this paper focuses on mortgage loan originators, mortgage fraud can be perpetrated by anyone involved in the process, including borrowers, lenders, closing agents, title companies, real estate agents, loan purchasers and packagers of mortgage securities. Eight common mortgage loan origination fraud schemes The following are examples of some common mortgage loan origination fraud schemes: Inflated income schemes - Generally, income fraud schemes inflate the borrower s actual income by either making deceptive calculations of monthly income or outright falsification of documents used to determine qualifying income. In the past, inflated income was a huge problem with loan programs that allowed a borrower to qualify using stated income rather than conducting underwriting to verify that income. These loans were generally available to borrowers who could qualify for the stated income loan programs because they had a decent down payment or equity position in the property. Often these loans were taken out by selfemployed borrowers who did not have the required income reported on their tax returns. These loans have recently become much less prevalent, however, due to tighter underwriting requirements in place since the housing crisis of the late 2000s. Common inflated income schemes include: y Calculating income using higher seasonal income that is unlikely to continue throughout the rest of the year y Inflating of income on the verification of employment form by a company owner or insider, or allowing the form to be filled out by the loan originator, borrower, family member or acquaintance y Using short-term or one-time payments to qualify when the income is not likely to continue y Altering or forging W-2 forms, pay stubs or tax returns One way to counter inflated income schemes is to conduct a detailed secondary review of all loan files prior to submission and sale to the investor. Silent second mortgages - These schemes involve the borrower taking out a second mortgage secured by the subject property that is not disclosed on the borrower s first mortgage application. The lien for the second mortgage is not recorded in the county land records until after the first mortgage has been closed and recorded; therefore, the second mortgage lien does not appear when the title search for the first mortgage is performed. The second mortgage proceeds may be used to cover some or all of the borrower s down payment on the property. The undisclosed second loan can cause two problems from an underwriting perspective. First, the additional monthly payments required under the second mortgage may cause the borrower s housing expense ratio or total debt-to-income ratio to exceed the limits for the first mortgage loan. Second, the second mortgage often causes the combined loan-to-value ratio for both the first and second mortgage to equal or exceed 100 percent of the property s appraised value. One of the ways to control silent second mortgages is to periodically review in-house loans made to second mortgage borrowers against a list of mortgage loan borrowers for loans originated and sold on the secondary market. 3

4 Undisclosed side deals with sellers - This scheme involves the buyer and seller making transactions that are not disclosed on either the HUD-1 settlement statement or the real estate contract. A second real estate contract can also be executed between the buyer and seller with terms that are different from the actual real estate contract. The falsified sales contract becomes the contract submitted to the loan purchaser. These side deals may involve undisclosed seller take-back financing, seller paid closing costs, a falsified sales price, or payments by the seller for repairs that have not been disclosed. These side deals may or may not be disclosed to the originator. Since these schemes usually occur outside the normal loan underwriting process, they may be very difficult to detect. In our investigations, these schemes were usually detected by a detailed review of the loan file for anomalies coupled with a review of loan originator s and other correspondence. Appraisal schemes - Appraisal schemes are varied, but usually involve inflating the subject property s appraised value in order to qualify the property for a loan program. These schemes may involve using inappropriate comparable sales data, such as sales data on properties not comparable to the subject property, using stale comparable sales, or using comparable sales from outside the subject property s market. Appraisal schemes also may involve omitting or exaggerating facts about the subject property. Since the implementation of the Home Valuation Code of Conduct (HVCC), these practices have become much less prevalent; however, HVCC has not prevented lenders from attempting to circumvent the code. HVCC outlines practices that lenders and appraisers are supposed to follow that are intended to shield appraisers from undue influence by the lender. Appraisers are not supposed to know the loan amount being applied for. Lenders are not supposed to choose their appraisers and are not allowed direct contact with them. However, mortgage originators sometimes still use in-house appraisers or appraisers willing to make the necessary adjustments in order to gain future business. In some instances, lenders continue to apply pressure to the appraiser or attempt to appraisal shop by using alternative appraisers until they get the value they need. These or other attempts to influence the appraiser s opinion are all violations of the HVCC. In order to detect these schemes, look for unusual correspondence between the loan originator and the appraiser, or evidence of multiple appraisers being contacted for the same borrower transaction. Cash back schemes - These schemes involve falsifying the real estate contract to show a sale price greater than the actual sales price agreed to between property buyer and seller. Because the sales price is falsely overstated, the buyer can borrow additional funds which are not paid to the seller, allowing the buyer to take money out of the transaction. In some cases, the additional funds are shared with the seller, loan originator, real estate agent or other party in on the scheme. These schemes require an inflated appraisal, which may be accomplished by paying off the appraiser with some of the excess loan funds, or through any of the inappropriate appraisal methods outlined in the appraisal schemes discussion. Similar to undisclosed side-deal schemes, these schemes usually occur outside the normal loan underwriting process so these schemes, like side-deal schemes, are usually detected by a detailed review of the loan file for anomalies coupled with a review of loan originator s and other correspondence. Undisclosed sources of down payment - In these schemes a borrower secures a loan for a down payment from a non-originator source that is not disclosed on the borrower s application or the HUD-1 settlement statement. These loans are generally from nonfinancial institution sources, since loans from those entities would show up on the borrower s credit report. Such loans could be from relatives, friends or other outside parties. These loans may be paid back all at once upon obtaining a second mortgage or other loan after the 4

5 first mortgage closes, or may be paid back in installments over time. However, they are repaid; they create a financial obligation that, if disclosed, could have put the borrower s debt-to-income ratio outside loan program parameters. In order to detect these schemes, up-to-date bank statements should be requested immediately prior to closing. The lender should investigate the source of funds for any recent deposits. Forgiven or covered closing costs schemes - These schemes involve forgiving, refunding or paying for real estate settlement closing costs that are disclosed as having been paid by the borrower on the HUD-1 settlement statement. The HUD-1 settlement statement is the official accounting for all transfers of funds and costs paid related to the real estate closing. In addition to closing costs, other costs related to the real estate transaction that may be covered by the originator in such schemes include inspection fees, real estate taxes and repairs to the property. Mortgage originators have even sometimes covered portions of the borrower s down payment. To the extent the covered charges or costs are not disclosed on the HUD-1 settlement statement as having been paid by the originator, seller or other party, the omission may result in a violation of the Real Estate Settlement Protection Act (Regulation X). Originators also sometimes choose to cover these costs because the parameters of the loan program require the funds to be collected from the borrower, but the borrower has insufficient funds to pay them, putting the loan at risk. In other cases, the costs are not covered by the originator, but instead are covered through a second, undisclosed loan, which could put the borrower over debt-to-income guidelines. The costs are often paid by the following mechanisms: y Drawing money from a general ledger account such as loan suspense, loan income, loan gain on sale or miscellaneous revenue or expense y Refunding the borrower the closing costs by official check or by depositing the amount into the borrower s account at the institution after the closing has taken place y Originating an undisclosed side loan and applying the proceeds to the closing costs y Covering the costs by applying unused official checks left over from other mortgage loan transactions, or funding from loan sale profits y Funding by way of an undisclosed side loan between the buyer and seller of the property y Covering the costs by the real estate agent out of the agent s commission on the real estate sale y Simply not charging the closing costs at all, although disclosing it as having been charged on the HUD-1 One of the ways to detect forgiven or covered closing costs is for the lender to conduct a regular review of loan fee revenue accounts to determine if adequate fees have been collected against the volume of loan sales. Additionally, the lender should conduct a periodic review of loan suspense general ledger accounts and other mortgage-related accounts to look for unusual transactions. The lender should also regularly reconcile loan suspense and escrow accounts and cleared outstanding items. Falsified closing date schemes - These schemes involve falsifying the closing date of the loan on the loan paperwork, including the note, deeds of trust, HUD-1 settlement statement, closing disclosures and other documents. Originators engage in falsified closing date fraud in order to close a loan before certain closing conditions required by the loan program have been met, such as the sale of a former residence, payment of existing debt, or the start date of a new job. These schemes require the originator to manufacture closing documents that falsely show that the required conditions for the loan closing and sale have been met, and may also require either the buyer or the seller to sign falsified documents. Appraisals and credit reports may have to be reordered to show they have been completed within so many days of the falsified closing date. 5

6 A detailed loan file review by a disinterested third party can often detect falsified closing date schemes. Attention should be paid to evidence of document alteration. Also, dates between documents should be consistent. Stale appraisal dates can often provide clues that closing dates have been altered. Mortgage loan origination fraud continues to be a real issue in the mortgage lending industry. Despite the harsh lessons and considerable costs that the housing market crash and resulting recession offered, some lenders still refuse to learn. Understanding these common origination fraud schemes and tightening controls to prevent them is a vital step in keeping the lessons of history from repeating themselves McGladrey LLP is the U.S. member of the RSM International ( RSMI ) network of independent accounting, tax and consulting firms. The member firms of RSMI collaborate to provide services to global clients, but are separate and distinct legal entities which cannot obligate each other. Each member firm is responsible only for its own acts and omissions, and not those of any other party. McGladrey, the McGladrey signature, The McGladrey Classic logo, The power of being understood, Power comes from being understood and Experience the power of being understood are trademarks of McGladrey LLP. January 2013 McGladrey LLP. All Rights Reserved. 6