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Taking a bite out of fraud.

The risk of fraud is heightened in the wholesale lending business. Here are 10 ways to protect against bad apples.

Since time immemorial, fraud has been with us. It was recognized in the earliest reports about mankind and the human experience. If, as Aristotle says, art imitates life, then we have only to look at classical writers such as Homer and Aeschylus, and later, Shakespeare and Shaw, as well as much great literature that followed, to find a myriad examples of avarice. Clearly, greed, a root cause of fraud, is neither new nor endemic to the human condition. Nor is it so for mortgage lending.

This article takes aim at preventing fraudulent practices in wholesale lending. The premise of the article is that because the wholesale business is driven by commissions, and because it requires quick decision making and relies on outsiders rather than employees to carry out major lending functions, it is more susceptible to fraud than retail lending. The prevalence of wholesale operations, in combination with the primary market's thirst for streamlined documentation programs, magnifies these risks. Although abuses are far from commonplace, project margins in mortgage lending are stretched so thin that just a few bad apples can make the difference between profit and loss - survival or extinction.

A look at the business

The single biggest difference between retail and wholesale lending is that the people originating the loans are not the wholesaler's employees. Wholesaling's popularity stems from lower fixed costs - personnel being the largest of those costs. Simultaneously, wholesaling heightens risks because the originator, processor and perhaps even the underwriter may not be employees. Wholesalers are lenders who can no longer exercise complete control. As a result, greater caution is required to gain control.

The fact that some retail and wholesale lenders allow their loan officers to broker loans moves the origination process an additional step away. Streamlined documentation programs that eliminate the need for a verification of the borrower's income, assets, or both, lengthen the distance between the lender and the borrower. While such shortcuts are frequently necessary to expedite the lending process, especially in fast-paced times such as today when the volume of activity is at record-high levels, risks are magnified despite counter-measures such as higher down payment requirements and back-door verification techniques. Aggressive lenders learned painful lessons in recent years that culminated in the taking of tens of millions of dollars in chargeoffs to earnings - all due to insufficient quality-control measures.

Contributing to the potential fraud problem is the unwieldy and unprecedented level of origination activity. Projections from the nation's foremost housing economists suggest that originations of one- to four-family mortgage loans could total upwards of $800 billion in 1992. Needless to say, that is a huge number that dwarfs the levels of late 1986, and early 1987, when activity hit an annualized pace nearing $500 billion. Certainly, lenders are more experienced and more highly automated than they were four or five years ago, but keep in mind that the number of lenders, and people in the mortgage finance business, from loan officers through senior managers, remains well below 1987 levels.

Each loan application generates many demands and a hundred pieces of paper. The more work required, the greater the likelihood that procedures and polices get shaved to move the process along. This is particularly true for wholesalers who are structured to process huge volumes of business. Their control mechanisms must be sterling. New wholesalers must be doubly cautious.

Just as other types of risk can be controlled, the risk of fraud can be managed through a prevention plan. Key components include planning, policies and procedures, and people.

This article examines 10 steps that we believe wholesalers can take to keep their operations as problem-free as possible:

* Promote realistic product

and develop contingency plans.

* Anticipate problem areas.

* Seek assistance and gain knowledge

from others.

* Develop a system and monitor it

regularly and carefully.

* Communicate policies internally

and externally.

* Research new initiatives: look before

leaping.

* Orient policies and procedures to

the wholesaler's programs.

* Hire competent, ethical staff.

* Know the people with whom you

deal.

* Demand adherence to the rules.

Realistic production goals

and contingency plans

The first step a wholesaler should take is to clearly state its corporate goal of developing a profitable operation. The only way to accomplish this is by acquiring loans that have been scrutinized for quality from the initial application through closing. Management must repeatedly trumpet the quality-first goal throughout the organization. Employees must understand what this means for the organization overall, and more specifically, what their responsibilities are in achieving the goal.

When management sets production goals that cannot be attained under any reasonable set of circumstances, it aides and abets poor quality and fraud. The pressure to produce rises. Countless are the examples of mismanagement fostered by orders to double, triple or quadruple the prior year's level of business without commensurate increases in available resources, especially staffing.

To ensure volume goals remain attainable, management should develop contingency plans to determine what actions will be taken if production shortfalls occur. Management must establish upfront what it will do if production falls 20, 40 or 60 percent below projections. Which expenses will be cut, and how many employees will be furloughed? If the business plan indicates what, when and how things will be done, management has a roadmap to follow to ensure that resources are properly allocated. Management can then cut costs and re-establish production goals so that more draconian measures can be avoided later. Contingency plans are an early warning system; they balance revenues and expenses.

Anticipate and monitor problem areas

Certain lending functions require greater care than others. The first potential problem area is the application process; management must ensure that the process is protected from fraud. Because the application is generally taken by someone who has a financial interest in its acceptance, counter-measures should be established to offset the risk. For example, the processor can review the application for any discrepancies and doublecheck key facts for accuracy.

Another troublesome area is the appraisal process. The closer the relationship between the appraiser and the originator, the greater the temptation for collusion. To prevent it, the wholesaler should implement a security system that keeps the parties at arm's length. For example, the originator should be prohibited from choosing the appraiser. Cozy relationships between the parties are frequently uncovered in cases involving fraud.

Circumspect wholesalers require appraisers to hold professional designations and maintain active membership in their trade associations. Before a wholesaler accepts a new appraiser, proper due-diligence should be undertaken: references should be checked, samples of appraisals should be examined, and review appraisals should be conducted.

The third area the wholesaler needs to examine is funding. Funding procedures must be followed. If table funding is used, make sure the closing agents are honest, properly trained and have specific written instructions outlining their responsibilities. Visit them. Development of an approved list of closing companies - title companies, escrow agents or attorneys - is mandatory. If feasible, wholesalers should prepare the legal documents so that they can be reviewed for accuracy before the closing. Finally, monitor the process for exactness to detail and flag any inconsistencies for further review.

Streamlined or alternative documentation programs have increased the quality-control challenge because they reduce available information to the lender. This hastens the origination process but expends the need for scrutiny. Many lenders have reacted to the higher delinquency and default rates associated with these programs by terminating them; others have strengthened controls to curb abuses. Carefully balance the need for fast underwriting turnaround with safety. Keep in mind that accelerating the process can backfire if steps are missed along the way.

Seek assistance and advice

New wholesalers are advised to solicit the advice and assistance of more experienced lenders when developing their quality-control procedures. In recent years, many companies specializing in quality control have been formed. They serve to counsel lenders and originators in developing workable procedures. Assistance also is available from Fannie Mae, Freddie Mac, mortgage and title insurance companies and trade associations. Last year, the Mortgage Bankers Association of America published a booklet titled "Combating Fraud and Unethical Practices in Real Estate Transactions." It details what lenders should look for at each step in the lending process to spot fraudulent ending practices. It discusses information sharing, legal issues and bailment letters, makes recommendations to avoid problems and reviews codes of ethics.

We have found that many wholesalers are willing to share their experiences with newcomers. Conferences and seminars are good places to make such contacts. Find wholesalers who operate in different markets so a competitive situation does not arise. Fannie Mae and Freddie Mac offer regional seminars on underwriting and quality control. Their respective sellers guides address these topics in great detail.

Develop and monitor a system

Wholesalers can minimize the risk of fraud by setting up a quality-control system and a series of timely management reports. Such tools are required by Fannie Mae, Freddie Mac and GNMA, and many private investors. Sophisticated new systems are available as is software to upgrade existing systems. Wholesalers report these systems are worth every dime they've spent.

These fully automated systems track a loan from application forward. Procedures for individual loan files are divided into prefunding and postfunding phases. Prefunding begins with a computer-generated credit report that is compared with the standard factual credit report in the loan file. Underwriting is based on the information provided in the credit package, and key details are validated independently whenever possible. Reverifications and review appraisals are used to ensure investment quality.

Review appraisals are conducted so that their receipt precedes the preparation of signed loan documents and funding instructions. That way, if there is a discrepancy between the appraisals, the review appraiser can contact the appraiser and the originator to resolve the situation.

Prudent wholesalers conduct field reviews on the first batch of loans from a new customer, the first batch of loans prepared by a new appraiser and anytime an underwriter believes there is an indefinable risk associated with a loan. Given the importance of the appraisal, confirmation is sought to ensure that it is complete, accurate and current. This adds to production expenses, but the cost is inexpensive insurance against default risk.

The system should be tested periodically and the audits examined to secure compliance. As conditions change, modifications may become necessary. For example, one wholesaler now orders a credit report to independently verify information from Form 1003 for all low-documentation loans. This wholesaler also checks business licenses to confirm they are current and uses Dun and Bradstreet's credit reports for information on employment and business status.

Communicate policies

Good communication with customers is another preventative measure. It begins when the correspondent applies for approval and continues as the relationship grows. The period following application for approval is the ideal time to set the foundation for the ensuing relationship. Wholesalers who detail what they expect from their correspondents create a base from which strong, lasting relationships can flourish. The fewer misunderstandings, the sounder the base for business, because profitability is directly affected by the depth and flexibility of the relationship.

Communication is always critically important, but the key time to communicate is at the start of a relationship. It is during this training and trial period, the probationary period, that the relationship sinks or swims. Customer service and underwriting criteria either match the verbal interpretation given these critical guidelines at the introduction or they do not. For a good start, it is essential they match. This is when the wholesaler should establish control - by establishing how things are to be done. It is accomplished by letting the first 10 loan submissions be case studies from which the law is set forth. The customer can then truly evaluate the relationship to determine if he wants to continue it. Wholesalers should recognize that the correspondent decides who he wants to send loans to after he has been approved.

On the other hand, the wholesaler decides who gets to continue delivering loans. The wholesaler adds volume by developing and using a reporting system to let the correspondent know how he is doing. Reports that track applications submitted/rejected, fallout, funding, documentation, locks/deliveries, delinquencies and so on are important management tools internally and add value for customers. Such feedback reinforces the wholesaler's push for quality.

As part of the communication process, the correspondent must remember to bring a lengthy list of questions to the initial meeting with a wholesaler. The correspondent should find out everything about its requirements, policies, turnaround times, procedures and so on.

Research new initiatives:

look first before leaping

To accomplish just about anything these days, you need to do your homework, and you need to do it well. You may not need an "A," but the higher the grade, the greater the competitive advantage, or so it is said. However, if you do not do the research in-house, at least have someone else do it.

Let's say you are a wholesaler located in the Southeast. You have been operating there exclusively for 18 months and currently produce $25 million to $35 million of loans per month; volume of $65 million to $75 million is sought in six months. You have a choice: you can hire someone to establish a presence and try it, or you can first examine the market to determine if its growth, economic base, population demographics, income characteristics and so on can support the type of business you want to produce. Is it an expanding market? Can it support another lender? Will you need a niche, and can you provide it? Such questions beg for answers.

Far too much money has been squandered by lenders who moved into a new market only to realize that their objective could not be achieved there. The number of closed operations dotting the lending landscape serves as testament to these failed attempts. Many lenders have shut dozens of branches; some a hundred or more; dozens of wholesale operations have come and gone. While retail branches cost more to close than wholesale operations, the latter's cost to shut down is not insignificant by any means.

The wholesaler must also ascertain the competitive pressure and types of product originated in the new market. Who is the local competition? Is it retail or wholesale? What share of the market does the predominant lender control - the next four, the top ten? How do they get their business? What is it? Is it from specific programs and products?

According to Fannie Mae and Freddie Mac, certain programs and products generate higher delinquency and default patterns than others. Wholesalers who cannot offer what the competitors offer should either avoid the market or play by the market's rules. Markets with a preponderance of low-doc loan programs, portfolio lenders, high-ratio lending and cutthroat pricing practices require a greater investment in quality control.

Customize policies and programs

Two points loom tall in this area: first, as they say, "When in Rome ..." second, unlike retail, where "retail is retail is retail," there are many different types of wholesale business, and each has a different risk profile.

Assume you manage a wholesale operation that just started buying loans from mortgage brokers in New York City. You have never done business there, so your lawyers are taking care of compliance with the various lending and business laws. You structure your program for nonprocessing mortgage brokers; your customers take the application and turn it over to you to handle everything else - processing through closing. The major risks center around the sales contract, the application and the originator. If none is amiss, you are insulated from fraud from the outside. The quality control plan executed by your processors should examine the originator and reverify the borrower's information. A quite different approach would be adopted by the wholesaler who purchases closed loans on an assignment-of-trade basis.

Hire competent, ethical staff

In real estate valuation, the longstanding maxim is, "location, location, location." For wholesale, it is "people, people, people." Say all you want about Wall Street, securities and the GSEs, but in the field, it is still a "people business." Wholesalers must deal with people on various levels, one-on-one, from the loan officers, processors and managers of one company to their counterparts in dozens, perhaps hundreds of other companies.

Based on our experience, the most important trait to look for in an employee is integrity. You can train people to do almost everything; integrity, however, cannot be taught.

This is critically important because if you study the crime of fraud it becomes painfully clear that greed is the common denominator of ripoffs great and small. Behind every petty larceny is a minor miscreant with greedy glands. Likewise, huge heists, like the great S&L robberies, turn up big egos and colorful, often brilliant archcriminals. Greed lies at the floor of all fraud. Ask Michael Milken. If you can eliminate the greed, and tone down the temptation by reducing its likelihood of success, you are on top of the situation.

Assuming you just hired a competent person of probity to manage your regional operation, you can rest easier that this person will hire professional, competent, ethical people, too. Opposites may attract in marriage and be successful, but in business the maxim is: "Birds of a feather, flock together."

Knowest well, those with whom you

do business

Wholesalers need to select their customers carefully. Although it is a pain in the neck to do proper due diligence on one customer after another, there is no alternative or shortcut. The process requires preparing a profile of your ideal customer. Afterwards, strip away the idealism and contact the people with whom you want to do business. Give them goods reason to want to approve you, another wholesaler What can you offer that they do not now have from one or more sources?

Wholesalers who use the shotgun approach, rather than target their marketing effort, attract volume but end up mired in it as it quickly turns into quicksand. Quality customers do not appreciate the delays caused by a "come one, come all" approach.

Earlier, we mentioned the term "temptation" and the need to mollify it. Among wholesalers, the belief that: "people commit fraud but loan programs promulgate it," is familiar. It is common knowledge, for example, that Citicorp Mortgage, Inc. offered a very aggressive no income or asset verification loan at very nonagressive prices. The fact that its delinquency rate is currently several times the industry average, underscore it. Less well-known is a West Coast wholesaler who offered, and to this day continues to offer, the same program. The difference between these two lenders is that the latter had his eyes wide open when he launched his program: first, he built quality controls throughout the program; second, he earmarked which customers "earned the right" to handle it. The moral is, it can be done property. His delinquency rate on the so-called no income/no asset (NINA) is above his 1 percent delinquency rate (after four years) but well below the MBA's latest average 60-day rate.

Although a myriad of additions could be given to this recommended step, it is sufficient to say that wholesalers should give strong consideration to incentive plans structured to reward quality. If quality really counts, it should yield dividends for employees and correspondents alike.

Demand respect

Rodney Dangerfield made famous the saying, "I get no respect." For wholesalers, the operative motto is demand respect and deserve it. Never let your correspondents confuse good service with a relaxation of quality standards; quality customer service contains no connection with loose underwriting. Communicating one's underwriting standards, rigorously enforcing and consistently maintaining them is the key to not giving mixed signals.

Wholesalers, like originators and virtually every other company and business person, must protect their reputations. Word spreads quickly when a company's underwriting standards change, for better or worse. Loose underwriting standards and weak quality-control procedures may generate business, but not the type a wholesaler wants or needs. Set your rules and stand by them.

Without question, fraud s the exception in the residential mortgage lending business. Richard Boysol, who is an expert in these matters, cites that fraud occurs in 1 to 2 percent of residential originations. Most of it is "probably explainable," says the president of Quality Assurance, Inc., and can be readily resolved. Arthur Prieston, founder of Lenders Legal Fraud Service, reports that the most common fraud problems involve owner occupancy, deposit information, tax returns, employment and income information, family status and document preparation.

Fraud is far more prevalent in medical insurance claims, auto thefts, welfare situations, even student loans. Nonetheless, a wholesaler can never let down his guard for if he does, someone, somewhere, will demonstrate the vulnerability theory. Remain vigilant, maintain well-constructed prevention programs, plan ahead and hire and embrace employees and customers who recognize that they have a stake in their wholesaler's success. Live by these 10 preventative measures, and you will avoid getting in harm's way.

Thomas S. LaMalfa is president of TSL Consulting Company, Shaker Heights, Ohio. Charles Blumberg is president of the wholesale division at Lenders Association, Inc., Mt. Laurel, New Jersey.
COPYRIGHT 1992 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Title Annotation:Wholesale Lending; 10 protective measures against fraud in the mortgage business
Author:LaMalfa, Thomas S.; Blumberg, Charles
Publication:Mortgage Banking
Date:Apr 1, 1992
Words:3524
Previous Article:Refimania.
Next Article:Managing with style: a chief executive's unique management style must define and communicate a vision and firmly direct the strategy of a company.
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