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Data base detection.

Technology is helping both sides out on the mortgage fraud front. Scam operators can produce more convincing, phony documents with desktop publishing, but data bases on past offenders help sideline the undesirables.

RECENTLY, EXPERTS GATHERED to share the latest information on the incidence of fraud in the mortgage business and ways to detect it. And the picture they painted was not all that new. It turns out that the types of scams being run are not really new at all, but the perpetrators are getting much better at pulling them off. The documentation on the loans in these mortgage fraud cases, as well as the layers of professional collusion, are getting increasingly sophisticated. Furthermore, the neat new software programs that enable small budget newsletter publishers to turn out quality products are helping mortgage fraud rings to put out letter-perfect, phony bank statements.

That's the kind of news the industry could do without.

The Mortgage Asset Research Institute, Inc. (MARI) in Reston, Virginia, sponsored two sessions of a conference entitled "Detecting and Investigating Mortgage Fraud." The sessions were held in Los Angeles and Washington, D.C.

The initial discussions focused on the trends mortgage industry professionals are seeing in the types of fraud being perpetrated. Two messages on that subject emerged from the conference.

First, the same old types of fraud we have seen for years are still present: false verifications of employment, false verifications of deposit, inaccurate tax returns and so forth. However, the level of sophistication in the documents backing up this type of fraud has increased dramatically.

In one recent incident, a loan package contained copies of bank statements that showed regular deposits to an account where the down payment money supposedly had been accumulated. Certain irregularities in the file suggested to the funding institution that the loan package was fraudulent.

When a full investigation of the loan file was undertaken, the bank identified on the statements as the holder of the down payment funds was asked to verify the transactions. The bank determined that there was no such account held by the loan applicant. But a bank staff member later said the phony bank statements were such good forgeries that even the bank had trouble determining they were fraudulent.

The ability of individuals to produce such high-quality documents is an endorsement of the versatility of desktop publishing. It is also one more pain in the neck for mortgage underwriters and quality-control people. The latest technology is being used by rank amateurs to produce documents at low cost, which formerly could only be turned out by printing industry professionals at very high cost.

The second trend identified at the MARI conference on fraud is the new, more involved levels of cooperation evident in some schemes. As an industry, we have built certain checks and balances into the mortgage origination and funding system. These mechanisms are designed to make sure that one individual, checks the work of others, so that mistakes, accidental or intended, are less likely to slip through the system.

However, when the work of the person making the "mistakes" or perpetrating the fraud is checked by someone else who is involved in the fraudulent scheme, then the system breaks down. In other words, collusion among dishonest parties can defeat many of the quality checks lenders have come to depend on.

Some conference participants identified situations that involve fraudulent behavior on the part of numerous members of the mortgage origination chain for a single case, including borrower, broker, appraiser, closing agent and down the line.

Contributing factors

There are several factors that together have allowed these two trends to flourish. One is the segmentation of the mortgage origination process. In a legitimate effort to compete more effectively, to operate more efficiently and to trim fixed costs during the last few years, mortgage originators have cut back on their permanent production staffs. Many have laid off loan originators, processors, in-house appraisers and others they used to employ full-time as part of their mortgage application, processing and underwriting functions. Much of this work is now contracted out and performed by staff not employed by the funding institution.

The business also has evolved so that increasingly people involved with the origination process are paid only if the loan closes. In addition, there are others in the system who are fully dependent for their livelihoods on referrals from fellow professionals. Under these circumstances, there are incentives to be overly "cooperative" in making sure loans get closed.

These incentives are especially alluring for those who have no continuing involvement with the loan once it is closed. There are few headaches for those not employed by the institution that owns and/or is responsible for servicing loans on which excessive creativity was used in gathering or reporting application information.

The second factor that allows these trends to flourish is the high volume of business passing through mortgage companies during the past two years.

One of the leaders in the mortgage industry, Leon Kendall, former chairman of the board of Mortgage Guaranty Insurance Corporation, once said that mortgage fraud occurs most often when the mortgage markets are "frothy." By this he meant that fraud rears its head more often when:

* Demand for mortgage money is high.

* Lenders' origination capacity is stretched to the limit.

* People are working long hours.

* New and untested people are being hired and trained rapidly to fill the gaps.

* There is a great deal of money to be made.

We must face the fact that in recent times we have been going through and in some areas of the country remain in a "frothy" market.

Under these circumstances, some involved with the origination process are tempted to cut corners to keep up with heavy demand. In some cases, honest mistakes are made and then inappropriately covered up later when they are discovered. Quality-control units get overworked and miss some signs of fraud they might otherwise have caught were they not stretched so thin.

In other cases, opportunists merely recognize the weaknesses in a system operating at or beyond capacity. Either way, there is no way around it--we are currently in a period of high exposure to mortgage fraud.

Furthermore, that exposure is likely to grow. The great mortgage delivery machine in the United States in operating at "the red line." And by that I mean that the system is running about as fast as it can go without breaking down.

One of these days, interest rates will rise, and origination demand will fall sharply. The system will slow down, and there will be an inevitable contraction of business. Many marginal firms will drop out of the market, and many marginal players will have to seek employment in other fields. Most of these firms and these people will adjust to this transition with integrity and grace.

However, a few will be tempted to keep feeding the system with the same level of volume experienced for the past two years. Such temptation will lead some originators to stretch to make unqualified borrowers look qualified. Desktop publishing systems will be used to invent creative documents the borrowers only wish they had.

And then it is only a small step to go from creating documents to creating borrowers. It's my view that we are likely to see a substantial increase in completely fraudulent "air loans" when the refinance boom tapers off. These are loans for non-existent borrowers and, in many cases, non-existent properties. The originators of these loans try to sell them in the secondary markets and then use the loan proceeds to make the initial payments for the invented borrowers. Selling and making a year's payments on a relatively small number of these loans can net an unscrupulous originator substantial ill-gotten gains by the time he or she skips town.

Reducing the exposure

The mortgage industry has not been standing by idly and waiting to get fleeced by these fraudulent parties. Several changes have been made in the way mortgage lenders do business in order to reduce their exposure to fraudulent practices. They include:

* Increasing post-closing quality-control reviews.

* Conducting pre-funding checks.

* Doing more formal investigations of fraudulent cases.

* Initiating more careful reviews of professional business relationships.

* Sharing information about perpetrators of fraud and misrepresentation.

Quality-control reviews--Many lenders all over the country have beefed up their quality-control functions. New resources have been devoted to detecting and investigating suspicious cases. Lenders have learned that failure to detect fraud can be very costly.

Misrepresentation is the one underwriting deficiency that the secondary mortgage and mortgage insurance markets find difficult to overlook. Repurchases or denials of insurance coverage on delinquent mortgages that involve fraud have become very expensive. Added investment in systems or staff or other means to help lower these costs is now being recognized as well worth the resources.

Pre-funding reviews--There is also a new anti-fraud focus at many lending institutions. They are interested in prevention of mortgage loan fraud. That is, they are no longer satisfied to discover the fraud in a post-funding audit. Innovative screens to check for signs of fraud on a pre-funding basis are now being implemented. These companies believe it is better to invest in preventing fraud than trying to unscramble the mortgage egg after fraud is discovered.

Formal investigations--When misrepresentation is suspected, some lenders are pursuing investigation more vigorously than ever. Private mortgage fraud investigation firms have sprung up to assist lenders who do not have in-house resources devoted to this function. In some cases, rapid response allows a fairly thorough investigation of a loan submission prior to funding. Users of these private services claim that they save far more than they spend on these investigations.

Checking on professionals--Many lenders are devoting much greater effort to the process of pre-approving the mortgage professionals with whom they do business. This includes doing more thorough background checks before asking the board of directors to approve a list of appraisers or mortgage brokers. Furthermore, corporate board members, in light of their increased liabilities, ar requiring added scrutiny of people on the lists presented to them.

Some firms catering to lenders' needs are now setting up new lines of business. They check licensure, registrations, references and other sources of information for lenders that don't have the staff, resources or data bases to perform such background checks. For example, a major credit investigation company recently established a new line of business to perform background checks on third-party originators.

There is a substantial amount of public information that can be checked during these investigations. These investigative background checks can be done for individuals being considered for positions or business relationships that run the gamut of mortgage industry-related jobs, ranging from real estate agents, appraisers, mortgage brokers and bankers, all the way to people who deal with mortgage-backed securities on Wall Street.

Almost every professional group that plays a part in the mortgage origination, servicing and securitization process has a trade group, professional society or licensing body (federal or state). Each of these groups has ethics and standards committees that review complaints against members or license holders.

A fraud data base

The problem with gaining access to information about enforcement actions taken against various parties is the information is scattered among so many different sources. MARI has compiled a data base that contains information on more than 80,000 cases of public enforcement actions taken against people in the real estate, mortgage banking, financial institutions and securities fields. One search of this data base can screen an individual against possible actions from 65 different sources, plus review published accounts about people taken from more than 100 newspapers and trade periodicals.

Mortgage banking firms, depository institutions, regulators, attorneys and securities firms are checking these entries when they review the backgrounds on people with whom they are considering doing business.

Beyond this, many lenders have expanded the scope and extent of their initial quality-control reviews. Firms that used to do a complete review of the first three loan files brought to them by a mortgage broker are now doing re-underwriting for much longer initial periods. They are also sampling the subsequent loan packages they receive more extensively than in the past.

Sharing information--All of this added attention being given to detecting and investigating mortgage fraud has lead to an explosion of information in the files of companies. Many lenders have invested heavily in new tracking systems. These systems monitor the performance of loans over several years and generate statistics about the behavior of the loans associated with various loan brokers, appraisers, realty companies and even individual underwriters. This information is not of the "publicly available" type that is stored in MARI's data base. It is private, and it is less likely to be shared with other industry members.

Because individual lenders now know more about the performance of loans "touched" in the origination process by various people, they are able to avoid doing business with those groups that consistently produce low-quality and/or fraudulent loans. In addition, they are exploring ways to effectively share information about their experiences with one another.

Fannie Mae has taken a rather bold step in circulating its exclusionary list, which is a list of people with whom Fannie Mae does not wish to do business. Seller/servicers are asked to warrant that loans sold to Fannie Mae were not handled by these parties. This is a powerful way to let Fannie Mae's customers know about the negative experience that the agency has had with certain individuals.

Fannie Mae's exclusionary list raises some interesting possibilities. It sets an example to the industry and suggests it might be possible for lenders interested in promoting quality mortgage originations to band together in an effort to identify those who violate industry standards and norms. It would be unlawful, of course, to "blackball" such people from the industry. However, it might be possible to develop some means of identifying those regularly associated with problem mortgages and clear cases of misrepresentation. It might even be possible, or desirable at some point in the future, to share information about the high-quality producers in the mortgage field.

There are informal networks of lenders already sharing this information. The establishment of more formal means of sharing such information appears to be the logical next step. The computer technology and communications systems required for such information sharing are clearly available. Establishing the legal basis and rules to protect the suppliers, users and targets of such information is a necessary step that would have to be addressed.

Fraud prevention

In the interim, MARI's recent conferences produced a number of practical recommendations about how to guard against mortgage fraud. The three most common suggestions were:

* Know who you're doing business with.

* Know who you're doing business with.

* Know who you're doing business with.

The free exchange of information about the performance of mortgage professionals will eventually make it easier to know those with whom we do business better--before we begin the business relationship.

The conditions upon with mortgage fraud feed are certainly present in the market today. But the fraud identification and prevention systems developed during the past five years are just beginning to pay off. Mortgage lending executives with an appropriate balance between paranoia and responsible skepticism will continue to fund quality control, fraud prevention and information systems in the future.

We should not kid ourselves about the fact that those who feed on vulnerabilities inherent in our origination and servicing systems will continue to plague us. However, their numbers are being reduced, and the chances of these unscrupulous people succeeding in the future are being substantially reduced.

But fraudulent operators are like bacteria. To survive, they mutate by developing resistance to each new method used to frustrate them. Thus each new attempt to screen out fraud produces only a temporary victory. As long as there is big money to be made in mortgage scams, constance vigilance and even more creative responses will be necessary by those interested in detecting and preventing the fraud we all abhor.

D. James Croft, Ph.D. is executive director of Mortgage Asset Research Institute, Inc. in Reston, Virginia.
COPYRIGHT 1993 Mortgage Bankers Association of America
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Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Author:Croft, D, James.
Publication:Mortgage Banking
Article Type:Cover Story
Date:Aug 1, 1993
Previous Article:Electronic mortgage talk.
Next Article:Banks in bondage.

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