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    Default Twenty One Flavors of Mortgage Fraud - Howard Lax

    Twenty One Flavors of Mortgage Fraud

    by Howard Lax for iTulip.com

    Mortgage fraud is now a part of our lexicon, but few people understand what this means and the harm it causes. Mortgage fraud is a catch all phrase that encompasses schemes allowing one or more parties to a real estate transaction to obtain money through illegal or unethical means. Mortgage fraud cost us, as a society, somewhere between $946 million and $4.2 billion in 2006, and the cost will increase.

    Residential mortgage transactions are particularly susceptible to fraud, since the mortgage lending industry relies on patterned transactions to simplify home sales and mortgage financing with as little cost and time as possible.

    In a “normal” residential sale transaction, the buyer, seller, and real estate broker(s) negotiate a sale using a model purchase agreement. The buyer meets with a loan officer from a mortgage broker or lender, and chooses a standard loan product to finance the transaction. The lender obtains an appraisal of the property and a credit report for the borrower. An investor underwrites the loan with the assistance of an automated system, conditionally commits to purchase the loan after closing, and “locks” the loan terms. The mortgage broker or lender obtains a title insurance commitment and schedules the closing after the loan is approved. A closing agent (usually a title insurance agency) explains the closing documents, acknowledges the parties’ signatures, accounts for the parties’ funds, distributes the proceeds of the transaction, sends the deed and mortgage to the Register of Deeds for recording, and issues title insurance policies for the buyer and lender. The lender sells the loan to an investor, and the borrower makes monthly payments to the servicing agent selected by the investor. Because the documents are standard, and the roles of the parties are very uniform, nobody spends the time or money to perform much due diligence on the transaction. Hence, it is relatively easy to interject false documents or parties into the transaction to obtain money.

    Mortgage fraud schemes are extensive, ranging from the simple to the complex, and are far too common. It is possible to stop mortgage fraud if one of the parties recognizes the fraudulent features of a transaction before the proceeds of the transaction are disbursed. Some of the more common schemes are:

    Inflated income or assets: Some of the most misrepresented facts on an application for credit are borrower income and assets. Recent audits by one lender found actual income was significantly overstated in two thirds of the applications submitted for credit on a “stated income” basis (i.e. the borrower’s income is not verifiable and the loan is approved based on the borrower’s credit score and statement of income).

    Assets are often misrepresented to make the lender believe that the buyer has funds to make a down payment and to pay closing costs. Sometimes the buyer borrows the down payment without revealing the obligation to repay the funds. A debt may be characterized on the settlement statement as an unrecorded lien, or an invoice for unidentified management services, to hide the fact that the down payment was borrowed.

    Making false representations in a loan application, or providing false documents to verify income or assets, is a crime. It is also a crime for a mortgage broker or lender to knowingly process a false loan application.

    False Social Security Numbers: Borrowers sometimes use the social security number of another person, or fake identification documents of a person with “good credit” to obtain a loan. More sophisticated thieves use a good social security number and a fake name (“synthetic ID theft”) to make it harder to detect and identify the thief. The first five digits of a social security number indicate the area of the country where the card was issued and the year of issue. These values can be checked against the area of the country where the borrower was raised and the age of the borrower.

    Altered documents: W-2 forms, bank statements, title commitments, leases, and all manner of documents used to verify income and asset information can be altered or forged. Fake employment verification forms can be purchased over the Internet. Some borrowers forge discharges from their prior lender, or erase the loan from the schedule of exceptions on a title commitment, to avoid paying the balance of their prior loan. Accepting these documents or verification forms from the borrower saves time, but invites fraud. Asking the source of these documents for a separate copy is safer.

    Multiple loans: Lenders rely on the credit report and title commitment to locate the borrower’s obligations. There is always a “gap period” between the date that documents are submitted to the Register of Deeds for recording, and the date that these documents are available for inspection. There is also a gap between the date of a loan payment (or a missed payment) and the date that information is listed in a credit report. Some borrowers will close two or three refinance loans on a property with different lenders during a “gap period,” knowing that the credit report and title commitment will not reveal recent loan transactions and missed payments. Mandatory electronic recording and universal reporting of consumer loan payments to credit bureaus may some day eliminate gap periods.

    Inflated Deposits and Soft Second Mortgages:
    Consumers who have an equity interest in their home are less likely to default on their mortgage payments. Hence, most loan programs require a minimum down payment. A buyer may give a false purchase agreement to the lender, showing an earnest money deposit twice as large as the real deposit and an inflated purchase price. A buyer and seller sometimes inflate the purchase price of a home, and offer seller financing in lieu of a down payment, so that the buyer may obtain a larger loan than would be permitted by the lender’s underwriting standards. The seller’s note and mortgage are torn up after the closing. Insisting that all loans be documented and that mortgages must be recorded will reduce fraudulent seller financing.

    Identity theft: The closing agent relies on the borrower’s driver license or other forms of identification to verify that persons who physically sign the deed, note, mortgage, and other documents have the authority to sell the home and borrow money. Buyers, sellers and closing agents must remember that a forged mortgage is void. Use a “black light” to locate the reflective seal on a valid driver license card. If a person’s identity is stolen, it is important that one of the parties files a police report. The police report also entitles the victim to obtain a copy of any fraudulent financial documents that used the victim’s identity.

    Straw buyer: A real estate investor may ask a friend or relative, or a stranger, to be a straw buyer (usually for compensation). The real estate investor promises to make monthly loan payments, and to pay off the loan within a year or two. In some cases, a land speculator purchases a home at a low price, and conspires with a straw buyer to sell a home for an excessive price. The net proceeds are used to make monthly payments on the loan and/or the parties split the net sale proceeds and disappear. Besides the criminal liabilities mentioned above for making a false loan application, the straw buyer’s credit rating is ruined when the real estate investor stops making loan payments.

    Inflated appraisal: The homeowner, seller, or mortgage broker may have an illegal arrangement with an appraiser to inflate the true value of the property, or provide improper comparable sales information to the appraiser so that a loan will be approved for an amount that exceeds the home’s market value. Excessive valuations may be justified using fake pictures of the subject property or property values from other fraudulent transactions. Appraisers should thoroughly inspect the subject property and use comparable property data that they independently verify. Federally chartered lenders must review the appraisal if it is provided by another mortgage lender or by a mortgage broker.

    Money laundering: It is very easy to prepare and record a forged deed. To launder money, a straw buyer uses illegally obtained funds to buy the home. The title agency unknowingly takes the illegally obtained funds, and issues its own check to the fake seller with good funds. The object of exchanging tainted funds for good funds is to hide the trail of money from its illegal source. The property may be subject to a forfeiture action if the source of the purchase money is discovered.

    Foreclosure rescue: Avoid offers to "help" a homeowner in a difficult financial situation. The purpose of “saving” a borrower that nobody else considers a fair credit risk is often to “strip” the homeowner’s equity. A homeowner who is facing loss of a home through foreclosure may deed the home to a rescuer, who promises to sell it back at a higher price in a year or two through a land contract or lease with an option to purchase. The rescuer or a straw party (described above) obtains a conventional loan to buy the home. The rescuer may even convince the homeowner to sign over the proceeds of the sale of the home with a promise to pay off other debts owed by the homeowner. The rescuer knows that the homeowner has no means of obtaining a new loan to buy the home back at its inflated price. The investor does not provide any disclosures required by law for these transactions. Courts have held that a deed given as security, and not as a true sale, must be treated as an equitable mortgage. The difference between the amount paid by the rescuer to buy the loan and the price demanded to repurchase the home is interest, subject to state usury laws. Furthermore, these transactions are subject to federal Truth-in-Lending Act disclosure requirements. The homeowner may be able to rescind the transaction and seek the return of the home.

    Servicing transfers: Federal law requires a lender to send a Notice of Transfer of Servicing to the borrower when mortgage payments must be sent to a different entity or address. Since the content of this Notice is proscribed by federal regulations, a thief can send a convincing Notice of Transfer of Servicing to a borrower, instructing the borrower to send mortgage payments to the thief.

    Flipping: Frequent sales of a property are not illegal. Higher sale prices may be justified when the property is rehabilitated. However, frequent sales at increasing prices between parties with a hidden relationship can make the property appear more valuable than it is. Sometimes the parties attempt to justify the price increase with cosmetic improvements that hide more serious problems. Flipping is often accomplished with the help of an improper appraisal, a false title commitment, or intentional misrepresentation of the condition of the property. The FBI website highlights the case of a collapsed Detroit home sold one day for $25,000, and the next day for ten times that amount.

    Occupancy fraud: Mortgage lenders require higher down payments for second homes and investment properties than for a loan secured by a principal residence. To obtain better loan terms, borrowers will state that a second home or investment property is or will become their principal residence after the closing.

    Inflated Credit History: Borrowers with poor credit payment histories may purchase the right to become a “co-borrower” on good credit accounts (“tradelines”). Good tradelines dilute the impact of the borrower’s poor tradelines, and raise the borrower’s credit score. This scheme is not illegal (yet). Companies that produce credit scoring software are trying to identify these borrowers, to eliminate the impact of the purchased tradelines.

    Misleading Disclosures: Federal rules require disclosure of a good faith estimate of closing costs within three days after the mortgage broker or lender receives an application for a residential mortgage loan. Borrowers also receive an estimate of the annual percentage rate and monthly payments within three days after providing a purchase money loan application to a lender. However, there is no requirement that this information must be redisclosed if the actual closing costs are different. Some brokers will arrange a subprime loan for the borrower, even though the borrower would qualify for a conventional conforming loan. This does not violate federal law, and the borrower has nobody to blame but himself if he accepts a loan that is not advantageous. However, engaging in fraud, deceit or material misrepresentation is illegal. Providing an estimate of costs to originate a “prime” loan, knowing that the borrower will only qualify for a “subprime” loan with higher origination fees misrepresents closing costs and the cost of credit. A lender or broker violates state law if disclosures are provided for low cost credit, or low cost credit is promised, when such credit is not available to the applicants.

    Required Use of Affiliates
    : A seller and his/her real estate broker cannot require the borrower to use a particular title agency for the lender’s title policy if the buyer pays the insurance premium. Hence, it is illegal for a real estate broker or for the seller to require a documentation fee solely if the buyer does not use the seller’s preferred title agency. It is also illegal to require a borrower to use the services of an affiliated settlement service provider if the borrower will pay for the services.

    Illegal Kickbacks: It is illegal to directly or indirectly pay or receive something of value under an agreement or understanding that the payment is for the referral of settlement service business. It is also illegal to split a fee for settlement services without doing any work to earn a portion of the fee. Some mortgage brokers, lenders and title agencies find it more expedient to pay kickbacks “under the table” to assure business referrals than to generate business based on the merit of their services. These kickbacks, in theory, increase the cost of credit.

    Failing to Disburse: Some lenders wait until after the loan has closed to finish underwriting a loan. If the borrower fails to meet underwriting requirements, or the loan cannot be sold at a profit, the lender refuses to fund the loan. State law requires that a lender satisfy its lending commitments.

    Selling Fake Loans: Some unscrupulous lenders create documents for loans that do not exist, and sell the loans to raise capital or hide losses. A lender may also sell a loan more than once to hide losses at the company, or to satisfy credit obligations. The proceeds of the sale may be used to make monthly payments on behalf of a non-existent borrower. Perpetrators of these schemes typically receive stiff prison sentences.

    Closing Agent Defalcation: Licensed title insurance agencies are required to keep transaction funds in a trust account. There is no requirement that a notary closing service (a “signing service”) maintain trust accounts. Employees may steal these funds, resulting in the failure of the closing agent to pay transaction proceeds.

    Mortgage Elimination: Some borrowers send an “International Commercial Claim in Admiralty Administrative Remedy” to their lender, and file a frivolous lawsuit to discharge their mortgage. This scheme evolved from the repudiated "Bonded Bill of Exchange" given to payoff mortgage loans.

    What to do? Mortgage fraud succeeds because consumers do not understand residential transactions. Consumer education will help prevent consumers from falling into these schemes:
    • We can to teach financial literacy to all consumers. Financial literacy training could be included in the mandatory public school curriculum. Financial literacy course materials (the Money Smart program) and teacher reference guides are freely available from the FDIC.
    • The FBI and the Mortgage Bankers Association recommend that lenders post a sign to warn borrowers that mortgage fraud is illegal.
    • Interthinx produced a video, Fraud Scheme Investigation, to help consumers and industry employees recognize mortgage fraud.
    We can implement safeguards to prevent mortgage fraud, and to guard against repeat offenders:
    • The Mortgage Bankers Association is sponsoring a committee to draft uniform residential closing instructions. These instructions will require the closing agent to be a gatekeeper against mortgage fraud.
    • Data mining techniques are used by many lenders to evaluate loan application characteristics against a pool of previously closed loans. These computer programs look for similar transactions that might reveal repeat fraud attempts.
    We should prosecute individuals who break the law. The Conference of State Bank Supervisors and the American Association of American Association of Residential Mortgage Regulators recently proposed a uniform mortgage company and mortgage company employee licensing program (pdf) to make licensing in multiple states easier and less costly, and to allow states to share information about bad actors within the mortgage industry.

    Finally, we should draft consumer disclosures that are understandable and meaningful. The Federal Trade Commission released a Bureau of Economics report finding that mandatory mortgage disclosures fail to convey key mortgage costs and terms. Our legislatures must simplify disclosure laws. Disclosures should highlight information that really matters to the average home buyer. Some legislatures are proposing to prohibit unsafe or unsound lending practices, and practices that mislead consumers. Better disclosures, and safer lending practices, may help consumers avoid inappropriate real estate and loan transactions.

    Howard A. Lax is a corporate law attorney and shareholder with Lipson, Neilson, Cole, Seltzer & Garin, P.C., representing financial institutions and title insurance companies and agencies in compliance and regulatory affairs, and real property law issues. He is a member of the governing council of Real Property Law Section. Mr. Lax also writes and publishes The Mortgage News, a bimonthly mortgage banking compliance newsletter, and he writes a column in RESPANews.com, an October Research publication.

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    Last edited by FRED; 10-25-07 at 05:37 PM.
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