The upsurge in housing over the past few years has given way to an unprecedented amount of questionable activity in the mortgage market, including fraud. And while regulators have ramped up their combative efforts, fraud's growing breadth has proved to be alarming for U.S. RMBS.
"The [mortgage market] boom created job opportunities, and people who didn't even know there was a t' in mortgage all of a sudden had a brokerage operation and were making hundreds of thousands of dollars," said Rebecca Walzak, CEO of Walzak Risk Analysis.
Walzak explained that with the uptick in liquidity, mortgage fraud has expanded to organized, multiperson operations. "The criminal element has come to realize it's a safe way to launder money and to make money," she said, noting that faking a mortgage application could create profit in the hundreds of thousands of dollars with a much lower chance of getting caught, compared with a bank robbery, which yields significantly less.
However, the type of fraud that seems to be prevalent in terms of the first payment defaults, which the market is currently seeing, is borrower fraud, if it is in fact fraud at all, said Karen Gelernt, partner at Cadwalader, Wickersham & Taft. "There is still a lot to be seen as to how much of this is due to actual fraud, where you can point a finger at institutions or some kind of pervasive "schemes," or to consumers taking advantage of relaxed guidelines to obtain credit," she said. "I think that if borrowers lie about their stated income to enable them access to more funds, they may not have even perceived that they were committing fraud - but technically it is fraud, because they made an intentional misrepresentation of fact," she said.
Others agreed. "What is troubling is the question, Is omission of data an intent to deceive?' Is the fact that the borrower is unwilling to document income a true intent to deceive?" said Bernard Maas, vice president in U.S. structured finance at DBRS.
Yet, despite the discord on where to place the blame, misrepresentation is fueling problematic loans. In the Mortgage Industry Data Exchange (MIDEX) database, fraud submissions on loans originated in 2006 are running 30% higher than fraud submissions on 2005 loans. "It ties into what you are seeing in the market," said Merle Sharick, vice president and national manager of business development at Mortgage Asset Research Institute (MARI). "The significant amount of subprime and alternative instruments that are now becoming problem loans, and when in particular, stated income and some of these other types of loans are being investigated, they are finding that there was either some fraud or misrepresentation involved in obtaining that loan."
Don't Believe What You Hear
Stated income loans warrant the most concern, according to market participants. These loans, originally designed for borrowers with extraordinarily complex incomes, like business owners or people who worked on commission, have morphed into fraud, fueling vehicles with inaccurate income information that was never verified. "It got to be accepted that stated income meant you stated whatever you needed to qualify," Walzak said.
However, while certain product lines attract more fraud than others, it does not mean that full-doc loans from prime borrowers did not contain or will not contain fraud in them, said Arthur Prieston, CEO of the The Prieston Group.
"Full-doc loans contain a substantial amount of fraud because full-doc loans are cheaper and if you can get a sophisticated process in place, then in fact those are the ones that cause the most damage," he said, noting that verification is key, especially of the lender. "In the current environment, where we have this so-called flight to quality, it is really about flight to best practices, because best practices yield quality," he said. "This is not about loan level due diligence anymore. It is about lender due diligence."
Reverification of loan documents by all parties involved to confirm that borrowers are in the position they say they are is also increasing in importance. "The old adage, You need to know your customer,' is truer now than ever before. You just can't take things at face value. You need to go in and find out that they are legitimate and they are real," Sharick said.
Some borrowers do not exist at all. On Aug. 9, 58-year-old Ronald Walton was sentenced to 97 months in federal prison, followed by three years of supervised release, for a multimillion-dollar bank fraud scheme that resulted in the closure of Georgia-based nBank. The participating loan division at nBank extended short-term credit to mortgage brokers, which was then used by the borrowing mortgage broker to fund subprime loans. The mortgage broker was to sell the subprime loans to investors in the secondary market. These investors would then pay nBank for the funds advanced to the broker. Walton knowingly allowed multiple brokers to submit false loans or submit the same loan multiple times, according to MortgageFraudBlog.com, a Web site sponsored by Interthinx, a provider of risk mitigation and regulatory compliance tools for the financial services industry. The amount of restitution is expected to be in the millions of dollars, the site said.
Despite the allegedly risk-averse environment, a New York-based doctor said she was recently asked by a mortgage broker to fudge payment documentation for one of her employees so that the employee would be able to refinance on her initial zero-down mortgage loan worth $500,000.
The Low Down
Fraud has commonly been divided up into two forms: fraud for housing, which is misrepresentation to get a bigger house, and fraud for profit, which is stealing money. One example of fraud for profit is the false appraisal, which is a by-product of flipping, DBRS's Maas said. In a false appraisal, the home is bought for X amount but valued at Y times that amount, typically by an unscrupulous appraiser. It is then usually sold to straw buyers - who are typically paid for their identity as a good creditor, in order for the flipper to lock in the profit.
Walzak added fraud for income as a third category. In this instance, the loan officer is trying to make sure the loan gets approved so he or she gets the commission. The appraiser is trying to get the value where it needs to be so he can not only get paid for that loan but also sustain an income stream. "Realtors will tell [appraisers] If you don't bring this property in at value, I will never use you again,'" she said. "Probably the biggest fraud in this whole process was fraud for income."
Wrapping It Up
These loans destroy the value of the securitization they're wrapped into, market participants agreed, noting the pullback from the RMBS market as a result. One feature found in most of the contracts for mortgages sold into the secondary market is a provision for early payment default: If a borrower misses the first or second or sometimes even third payment, the originator will be required to buy the loan back because it is defective. Whether the underwriting was not quite what it should be, or whether it was fraud, is hard to tell, said Cadwalader's Gelernt. But with the delay, of 60 days or more, in loan repurchases by originators, as well as originators' diminishing liquidity, these loans may never be bought back.
"If you are operating at a net loss and you are a thinly capitalized company to begin with, it is not going to take you very long to burn through your cash," Gelernt said, noting that there is often a lag with loan buybacks because of the time needed for originators to get the documents back and examine the servicing file to make sure payments were not somehow missed or not applied in the transfer of servicing. Originators may also delay repurchases in an effort to conserve cash for new loans and other business functions.
Fraud also affects private mortgage insurance companies, because such insurance covers a borrower's inability to pay in a normal default but does not cover fraud or misrepresentation, MARI's Sharick said.
With heightened risk aversion and the proliferation of tools to combat mortgage fraud, however, the market has had to re-evaluate risk mitigation instruments. Walzak launched a product in late 2006 that provides a "wrap score" on how good the lender is at putting loans together. "There is a proliferation of broad tools out there that bring in information," Walzak said. "Those tools unto themselves can point you in the direction, but they can't tell you what the risk is associated with that file." For example, Walzak said that these tools might tell you that the income is disproportionate for the borrower's job. But what does that mean? Does that mean you should not do the loan? Should you check the loan, or should you ask even if the borrower's income is higher, is that creating risk in the file? "If we want to get smart about securitizing loans," she said, "we need to look not only at the loans themselves but also at the lenders. If lenders do a good job, they will find the fraud, or it will be so deeply ingrained in the loans so that you will never find it."
States, too, are increasing their efforts to combat fraud. This month, North Carolina passed House Bill 817, or S.L.2007-163, which now criminalizes mortgage fraud and includes all residential real property, including structures for residential purposes such as apartment complexes. The bill prohibits residential mortgage fraud, which includes omissions, misrepresentations, and misstatements, along with the receiving of proceeds as a result of these activities, DBRS's Maas said. He noted that forfeiture and restitution may be required.
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