Secondary Marketing Executive, June 2006.

It’s going to be a banner year for fraud, according to speakers at last month’s Mortgage Bankers Association’s National Fraud Issues Conference in Chicago.

In response, secondary market players will be asking third-party originators (TPOs) to do more than just sign a rep and warranty that their production is fraud-free, says John. V. Levonick, senior regulatory counsel for Clayton Services Inc., a Shelton, Conn.-based due diligence firm that runs about a million loans a year through its platform.

As volume drops and secondary market players push out to smaller shops, they will be taking a closer look at fraud prevention and assessing the TPOs ability to fulfill repurchase requirements.

Jeffrey Taylor, CEO of Digital Risk LLC, a Dallas-based risk mitigation firm agrees. “The reps and warrants are great, but if the lending institutions don’t have the assets to repurchase those loans, at the end of the day, what do you have?” he asks. “We’re such a production-based business that if there aren’t controls to make sure only good loans are going into bonds, then how are investors supposed to rely upon the performance of the bonds the secondary market issues to the general public?”

Fraud will become more visible if property values fall, pointed out Michael Pfeifer, managing partner of Pfeifer & Reynolds LLP, a fraud recovery law firm in Orange, Calif. In the past, originators ordered to repurchase bad loans have done so by refinancing the borrower with another company or product. “As property values level out and the broker can’t refinance out, the losses are going to bite harder than they have in the past few years,” he predicted.

From drugs to fraud
Georgia Attorney General Thurbert E. Baker, whose office authored the first anti-mortgage-fraud state law in the country last year, added that experienced criminals are moving into the market.
“We’ve seen drug dealers leave the drug trade for what they see as a safer harbor in mortgage fraud,” Thurbert said. “The profit potential is at least as high, and they’re less likely to get a bullet in the head…The bottom line for many of you is that your businesses are being robbed. In some cases, robbed blind. This problem could undermine the financial integrity of the industry.”

Georgia Assistant Attorney General David McLaughlin said he’s seen a shift in fraud from traditional same-day flips (which are hard to do without a crooked attorney) to front-end fraud where fraudsters use stolen identities to purchase multiple homes.

The U.S. Department of Justice is looking for one such fraudster, Matthew Bevan Cox, who rented properties then stole landlords’ identifies and fraudulently released liens on their properties. Next, he obtained multiple new mortgage loans on the properties.
As part of the scheme, Cox used the stolen identities to obtain drivers’ licenses, purchase vehicles, lease mail drops and apartments, and to open bank accounts in Georgia, Florida, Alabama, South Carolina and North Carolina.

The Georgia law, Senate Bill 100, makes it a felony to willingly and knowingly give misstatements, omissions or misrepresentations within a residential real estate transaction when there is intent to defraud.

“We have defined the act of mortgage fraud,” Baker said. “It is getting people’s attention. We don’t have to wait until money is taken through fraudulent schemes. Prosecutors can intervene as soon as the misrepresentations are made.”

Officials from other states are calling Georgia every week, asking for copies of the bill. Similar bills are pending in Jew Jersey, Utah, Colorado and Oklahoma, and under consideration in the California Senate. And with Baker serving as president-elect of the National Association of Attorneys General, the issue is likely to get even more attention at the state level in coming years.

The federal effort
Federally, regulators and law enforcement officials are taking a fresh attitude toward large-scale mortgage fraud. While a federal bill introduced by Sen. Barack Obama (D-IL) was put on hold this year, several speakers said the senator plans to take up the issue again next year.

“The success of the Georgia law really emphasizes how effective legislation can be in reducing this very serious problem,” said Michael J. M. Brook, an attorney with the Lanahan & Reilley Mortgage Banking Group, Santa Rosa, Calif.

The bill would have created a national standard for fraud prosecution, encouraged settlements, excluded lenders from liability, and created a national debarred or censured mortgage professional database.

However, there are secondary market concerns about the Georgia law and last session’s Obama bill, Brook said. At issue is a definition of mortgage lending that starts at solicitation and ends at funding. A crooked correspondent lender might be viewed as having bad intent toward a secondary market partner who’s not a covered entity, but not toward the borrower who benefited from the loan.
“They haven’t looked at it from that angle,” said Brook.

On the regulatory side, the feds are attacking mortgage fraud on several fronts. Currently, the U.S. Treasury Department’s Financial Crimes Enforcement Network (FinCEN) collects Currency Transaction Reports and Suspicious Activity Reports (SARs) from banks and compiles them in its Bank Secrecy Act (BSA) database. Law enforcement agents can query the FinCEN database when working on financial crimes, such as terrorist financing, money laundering and mortgage fraud.

FinCEN is considering expanding the use of SARs, or a SARs-like report, to nonbank lenders, said Thomas Fleming, acting assistant director of regulatory policy. FinCEN would first propose a new requirement and form via publication in the Federal Register, and would give industry members and trade groups a chance to comment before finalizing new rules, he explained.

Fleming also pointed out that SAR filings rose nearly a thousand percent between 1997 and 2004, which he attributes to institutions getting better at identifying suspicious activity, increased loan volume and possibly, more fraud.

Based on the SARs filed by banks, FinCEN has identified several vulnerabilities:

• faceless loan processing and Internet applications,

• increased TPO originations,

• expansion of credit underwriting into subprime markets, and

• the ease with which free credit reports can be ordered online and used in identity theft.

The data in FinCEN’s BSA database is about to expand. The Office of Federal Housing Enterprise Oversight (OFHEO) has agreed to share with FinCEN fraud findings uncovered during its exams of Freddie Mac and Fannie Mae.

Secondary market vulnerabilities
Secondary market participants must do their part to screen brokers. Rhonda Heilig, supervisory special agent for the FBI’s Financial Institution Fraud Unit, recalled a case of a major secondary market player employing an indicted fraudster who had been a broker for three different companies. The man is now a broker in Las Vegas, working for a firm that is well aware of his past - because the FBI subpoenaed the loan officer’s documents, including those at his current place of employment.

Conference speakers also criticized secondary market organizations, implying that the agency has become frustrated with lenders who complain that fraudsters have taken advantage of them by lying to obtain state income/stated asset (SISA) loans.

“We’re really starting to see some flagrant oversights in some of these fraud cases,” said Stephanie Woods, FBI assistant general counsel. An originator that acts in a “willfully blind” manner isn’t considered a victim. If a lender doesn’t check the borrower’s income before providing a lump sum payment to a fraudster, the lender may be responsible for proving that it wasn’t willfully blind.

Even if you’re not worried about losses, you should still worry about your firm’s reputation, said Alfred Pollack, OFHEA’s general counsel. If originators have to buy back large quantities of fraudulent loans from the pools backing their securities, those repurchases could cast a negative shadow on their firms.

Pollack listed mortgage fraud red flags: operation problems such as failure to produce accurate forms, repeated mistakes, failure to deliver loans and failure to supply required reports.

In the end, there is only so much regulators and lawmakers can do to protect the secondary market.

“As important as this legislation is and laws are, these things boil down to the people on the front lines,” said Pfeifer. If you don’t actively manage the TPOs involved in your transactions, he added, you’re going to suffer the consequences if fraud occurs.

Dona DeZube is a freelance writer based in Washington, D.C.