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An inside job.

A few years ago, a small-town editor in Kansas had the feeling that criminals were actually getting ideas from the crimes he reported in the newspaper. He decided to stop reporting on burglaries--and was suprised to find that, according to the policies records, burglaries actually increased. This phenomenon showed that as the burglary reporting ceased, the citizens of the town became more complacent and left their doors and windows unlocked more often. The town became ripe for burglaries. This example also describes the dangers of a false sense of security in the mortgage lending industry regarding insider fraud.

With all the media attention thrust on the role of fraud in the downfall of some of the nation's mightiest thrifts, mortgage bankers may also be tempted to slip into a state of complacency. After all, mortgage bankers are not backed by the full faith and credit of the United States taxpayer, nor are they necessarily subject to the same regulatory scrutiny as federally supervised financial institutions. In a climate of declining production and revenues, the temptation may be to overlook or even failt to see fraud that is happening in our own institutions. This state of affairs has come to be known by leading professionals as "NIMBO" (Not In My Branch Office).

Who is an insider? Virtually anyone in a position of trust with direct or indirect influence over the loan-decision process. Because of this, malfeasance on the part of trusted associates is the form of fraud most likely to escape detection, yet it also accounts for the largest losses. There is no internal control system developed that can protect lenders from victimization with a 100 percent level of assurance. This is partly because the control function itself may be manipulated by the same individuals who are entrusted to maintain it.

Conflicts of interest

To understand how inside employees may allow themselves to be compromised, it is important to consider how conflicts of interest may arise out of a company's compensation plan. At each phase of loan origination, copensation is typically contingent upon the occurrence of a specific event. This contingency creates a series of "borrower advocates" who share a common self-interest in seeing the ultimate goal of the borrower--loan approval--be fulfilled. In the case of fraudulent or even marginal loans, this may be directly at odds with the best interest of the employer.

A conflict of interest can be implicit in many stages throughout the origination process. Because the loan officer will not be paid a commission unless the loan is approved and his or her employer will not book any fees until the loan funds, and the borrower will not obtain the loan unless all the lender's requirements are met, there is a strong financial incentive to approve, rather than deny, many loan applications.

Other affiliated relationships also want to achieve more loan approvals, and the implicit benefit they receive can create conflict of interest. Appraisers may not get any further business from the lender if they consistently fail to arrive at the desired value. Real estate brokers will not collect a commission until the sale closes. Title companies will not receive any fees for the title policy until the transaction records. Also, the escrow holder may lose business if it does not perform according to its client's expectations or demands. Mortgage insurers will not collect premiums unless the policy is issued. Thus, the fall of each new domino is contingent upon the fall of the previous one.

Even sellers can be caught up in a conflict, because they will not realize a profit (or in some circumstances, avoid a loss) until the lender approves the loan.

A conflict of interest may also arise from management's desire to produce loans in quantity without consideration to the downside risk of loss if quality is sacrificed. This may cause some lending institution officers, directors and managers to place more emphasis on up-front fees and other tangible benefits accruing from a completed loan transaction than on making sure that their institution's risk exposure is minimized. This tendency may be more pronounced when the lender ceases to have a financial interest in the loan after it is sold in the secondary market.

With such built-in financial incentives and disincentives, as well as the demands of production, it is inevitable that some insiders will be drawn into methods that will detour or short-cut the internal controls designed to maintain integrity in loan origination. Quite often, insider fraud may begin relatively innocently, from an employee's overzealous attempt to speed up product, for instance. Once this becomes ingrained as a way of doing business, however, it may be too late to avoid further escalation into more abusive practices. Therefore, mortgage lenders must be cognizant to these potential conflicts of interest in order to guard against the temptations they pose to otherwise honest employees.

What, then, are some of the characteristics that forster the spawning of fraud within a lender's organization? These can be broken down into two sets of factors: individual and environmental. A crisis point exists when both sets of circumstances converge within one functional unit, such as a branch office, subsidiary or even corporate headquarters.

Individual factors

No one--not even the most perceptive psychologist--can predict with any degree of certainty the breaking point at which an otherwise honest employee might resort to crime against his or her employer. We can, however, identify certain traits that characterize employees who have a high propensity to become dishonest. Some are obvious; others are deceptively subtle and may escape notice by management until it is too late.

Some of the warning signs for individual employees include:

* Character deficiencies.

* Psychological or physiological disorders.

* Drug and/or alcohol addiction.

* Indifferent attitude toward white collar crime.

* A past history of successful thefts on the job.

* Peer group influences.

* Greed and self-aggrandizement.

* Gambling debts.

* Personal financial hardship.

* Inadequate income and/or living beyond means.

* Numerous speculative investments.

In addition, the individuals most likely to have the opportunity to commit fraud are those who are most familiar with the details of daily operations (including the capabilities to cover up). In general, these persons occupy positions in which they are trusted with responsibilities and work in close association with decision-makers who can be influenced or manipulated.

This list of characteristics can be used to evaluate current employees; however, the evaluation of new employees is difficult. Even if a history of fraudulent behavior exists, it might be impossible to obtain from prior employers. Because of Equal Employment Opportunity (EEO) and privacy legislation, employers are extremely reluctant to say anything derogatory about former employees for fear of lawsuits. Thus, the domino effect can be passed innocently from one lender to the next, with devastating consequences.

Environmental factors

There may also be factors within the organization itself that tend to create or foster opportunities for insider fraud to take place. Corporate policies should be strictly maintained, and employees should be encouraged to voluntarily reinforce company rules. If this is not occuring, such a lax atmosphere lends itself to fraudulent practices. Additionally, by not adequately documenting dishonest acts and by creating a lack of perceived discipline of fraud perpetrators, the company sends the wrong message to people who might be easily swayed toward malfeasance.

Management must be proactive and in control at all times. "Management by crisis" will catch problems only after they have gone too far. Carefully screen all persons to be hired in positions of trust, and look for rapid turnover of key employees--they may be leaving after making a quick profit. Further, inarticulate production and performance goals leading to dissatisfaction and low self-esteem may create an environment where employees are tempted to say, "Who cares?" Managers who don't closely monitor the details of the origination process may be inadvertently targeting their departments for fraud.

Several steps can be taken that will encourage employees to maintain their honesty and integrity within the corporate environment. Executives should emphasize a corporate code of ethics among all employees. It is also important to provide viable outlets for grievances, encourage upward feedback and keep internal and external lines of communication open. They should also maintain explicit and uniform personnel policies and well-defined promotion policies. If employees believe they won't receive legitimate recognition, or that there are insufficient financial rewards and incentives to get ahead, they may turn to insider fraud.

By ignoring such factors, management can create an environment in which employees can lose the moral restraints and self-esteem that are often the only barriers between honesty and dishonesty. While it may seem that these points are geared toward the line-level white collar worker, management itself should not be considered immune.

Fraud management

The accounting profession has long recognized that more restraint alone cannot be relied upon to any acceptable degree as assurance that fraud will not occur. A number of procedures and policies have been developed that are designed to uncover fraudulent activities on the part of employees. These methods include:

Make vacations compulsory -- During the prolonged absence of a key employee, certain irregularities may be discovered by others filling the position. Another benefit of this program is that each employee is subject to scrutiny and verification by one or more of his or her associates. Collusion with others then becomes necessary to continue a cover-up by any individual acting alone.

Educate employees -- It is essential that all employees, including management, understand the ethical and legal ramifications of fraud, its devastating financial impact and corporate policies and procedures for reporting suspicious behavior.

Segregate duties--The more autonomy one employee may have over an entire portion of the lending process, the more potential exists for this employee to manipulate or exploit shortcomings in the sytem.

Fix responsibilities--Every employee should know exactly what his or her job consists of in relation to others. Employees working directly with others should likewise know what their jobs entail.

Limit authority--Authorization levels with specific dollar amounts should be published, distributed and updated periodically. The absence of this may lead to confusion that may cover illicit activities.

Rotate duties, unannounced--This can uncover fraud perpetrated or in progress. It should consist of a complete change of responsibilities so that irregularities cannot be transferred to the new position without collusion with other employees.

Articulate a corporate fraud policy--Management must determine what constitutes fraud and clearly communicate a fraud policy to employees. Fraud should be a common topic of discussion--not avoided. Company training sessions and new employee orientation can be a means to convey management's concern about the problem. Most important, the immediate supervisor must make it clear what will happen if fraudulent activity is detected.

Encourage an atmosphere of caring and trust--Research indicates that if employees are treated as honest individuals, they will tend to act that way. It is more difficult to steal from a friend than from someone who doesn't seem toc are about you.

Reinforce anti-fraud behavior--Lenders should consider loss-prevention programs with defined goals and reward employees for reaching these. Financial incentive awards have proven to be extremely effective and inexpensive.

Other means of discouraging malfeasance among employees are to quantify the cost of fraud to the organization in whenever dollar terms can be expressed and to distribute this information where appropriate. Employees should be aware of how many new loans must be made to replace the loss on one fraudulent loan--in terms of days or weeks of productive efforts down the drain. Management should also provide good models of organizational integrity. Management can either encourage or discourage fraud through its own behavior and attitudes.

To protect the corporation, mortgage lenders should maintain insurance, including a fidelity bond and errors and omissions coverage. The insurance carrier can be a helpful investigative resource if a lender has grousnds to suspect that one of its own employees may be implicated in fraud. To assure that a company is following good guidelines to congtrol fraud, management should review internal controls with a firm of independent auditors periodically. Another prudent measure is to audit all loans extended to inside or related parties, such as employees, officers, major customers, relatives, agents, consultants and any non-employee who holds a trust position, such as attorney or accountant. Also, management can actually create financial disincentives against questionable lending practices by charging back losses from fraud against commissions earned, branch offices, profit centers and so on.

Other guidelines to help control insider fraud include:

* Provide anonymous employee counseling as an outlet for emotional problems that could lead to anti-social behavior.

* Establish a firm conflict-of-interest policy and require that employees certify annually that they are in compliance. This should define what the employer considers to be a gift, as compared to what could be construed as a bribe. Disclosure of actual as well as perceived conflicts of interest should be mandatory.

* Direct inquiries about questionable loans to persons other than those involved in the origination processing and underwriting. This will help to avoid superficial "fox and the chicken coop" investigations.

* Retain professional background checks on all key employees, including credit history, public record searches, pending litigation and criminal indices.

These are guidelines that can be of value in varying degrees, depending upon prevailing circumstances.

Attacking fraud

One way of protecting against insider fraud is to establish a separate functional unit to investigate it. It is advisable to remove responsibility for investigating problem loans from the individuals responsible for originating them. A measure of independence from the loan origination and underwriting process is mandatory.

Management should appoint a specific corporate officer in charge of fraud control. This individual should keep some distance from the original parties to the loan. He or she should also be preapred to avoid any implied personal commitments that may have come out of past relationships.

Ideally, this individual should report directly to the company's board of directors, rather than to any one executive officer. By spreading out decisions for the appropriate crisis response, decisions that affect individual departments, or "turf," are avoided. It thus becomes difficult for any one person to quash the investigation or exert influence, duress or threat of job insecurity for the purpose of influencing or discouraging legitimate lines of inquiry.

After an anti-fraud program has been established, its first priority should be to educate all employees. An education program must be designed to instill a shared corporate commitment revolving around trust and integrity. Once the groundwork is complete and employees understand what is expected of them, everyone should be tested so inadequacies can be corrected. Improvemen depends on the accurate measurement of conformance and timely implementation of corrective measures.

In an industry that provivdes rich monetary incentives for high volume, the importance of adopting anti-fraud programs should be made clear to each employee. Close analysis suggests that to be successful, the process must begin as close to the point of origin as possible. Each employee involved in the production process should be given a corporate policy on fraud to read and sign. Changes in policy must also be given in writing and reinforced with adequate training, especially for new employees.

From the top

The first and foremost concept of fraud control is a united sense of commitment on the part of senior management. All too often, management may perceive quality control to be a agood idea but would rather concentrate on profitability and production. Interestingly, when management treats quality as equal to profitability and production, the result is a longer lasting, more stable financial environment.

Management's support of quality, however, is simply not enough. Anti-fraud awareness throughout the entire work force is essential. Elevation of quality to a corporate priority level raises its visibility and ensures better employee cooperation.

Management's approach should be to discourage nonconformance by establishing attitudes and controls to prevent fraud. Studies have repeatedly demonstrated that employees will adjust their performance to the standards of their leaders.

Craig Wolfe is currently vice president of credit policy for Weyerhaueser Mortgage Company, Los Angeles. Previously, he was a quality control manager for Fannie Mae's Wester Regional Office. He has been a guest lecturer on financial crimes at the FBI Training Academy in Quantico, Virginia.
COPYRIGHT 1991 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Title Annotation:control measures for lenders to prevent fraud among employees
Author:Wolfe, Craig
Publication:Mortgage Banking
Date:May 1, 1991
Previous Article:The downgrade environment.
Next Article:Calculating risks.

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