Welcome to the 10th edition of Fighting Fraud with Frank. In this edition I wanted to address the issue of fraud and FHA Lending. As we know, the one fundamental truth about life is that you can always expect change. The same is true with fraud, you can always expect it to change regardless of the hurdles you might put in place to stop it. Nowhere is this becoming more evident than in the world of FHA Lending.

Is FHA the new Subprime?

FHA lending is booming. FHA loans now account for 31% of all loan originations in the US with an estimated 600 Billion in volume for 2009. In 2006, FHA originated loans accounted for only 2% of total volume. There are a couple of reasons for the boom. First, low down payment requirements and the ability for borrowers with less than stellar credit to obtain FHA loans have made them an attractive option for people that had previously chosen subprime loan products. Secondly, the lender of last resort in this tight credit market is usually an FHA lender. As a result of these two factors, demand for FHA has increased rapidly.

FHA loans are insured by the government in the event that the mortgagor is unable to make their payments, but they require the lender to adhere to strict standards of underwriting guidelines. Despite a complex weave of lender policies and underwriting guidelines, clever and even not so clever fraudsters are finding ways to get loans through. As a result, we are now in the early stages of what was a similar problem that the mortgage industry faced with non-prime lending between 2002 and 2004. During that time fraud on non-prime loans was increasing at a dramatic rate, but most of the red flags were ignored. The tremendous increase in demand for non-prime loans coupled with the rapid appreciation in housing prices meant fraud was just a distraction and never really a focus for lenders. We are now in real danger of re-creating a new problem (FHA Meltdown), while we are still struggling to get out of the last one (Subprime Meltdown).

Early Payment Defaults point to dark clouds of fraud

There is a frustrating lack of standardized fraud reporting in the mortgage industry. There are, however, certain leading indicators of fraud which can give you a perspective on the level of fraud that might be occurring. One of these leading indicators is Early Payment Default. In 2006, BasePoint was able to draw a definitive link between loans that defaulted (stopped paying) in the first 6 months and the presence of fraud on the original loan application. BasePoint discovered through analysis that up to 70% of early payment defaults on non-prime loans were caused by fraud on the application. This was significant because at the time most lenders did not measure fraud, but they did measure the early payment default losses, and those losses were high. They were so high, in fact, that they forced many large lenders out of business and essentially crushed the market.

Looking at early payment defaults for FHA lending points to some disturbing evidence that fraud is indeed having a dramatic and growing impact within the booming FHA market. In an article published earlier this month in the Washington Post entitled “Zero Payment Defaults are on the rise at FHA”, they reported that “Over 9,200 loans insured by the agency have gone delinquent in the last two years having one or no payments being made. Instant defaults have tripled in the last year and more than 2 dozen loans are defaulting in this manner every week”.

The increasing rate of instant defaults points to the fact that fraud is likely outpacing the growth in FHA volumes. This is a trend that will inevitably get worse over time.

$7.5 Billion in Fraud Losses

BasePoint routinely conducts research on our Fraud Consortium which contains details on loan originations and performance from 40+ lenders and originators. Based on analysis performed on FHA loan originations and associated performance statistics, BasePoint estimates that $7.5 Billion of the FHA loan originations in 2009 will experience default or delinquency. BasePoint arrived at this by estimating total FHA origination volume in 2009 and applying historical rates of confirmed fraud, and estimated fraud rates on the reported default and early pay delinquency rates of loans within the consortium of data.

How fraud is slipping through FHA Guidelines

With such rigorous guidelines it is natural to question how fraud is slipping through the underwriting process. BasePoint finds that most fraud is slipping through due to borrower misrepresentation of information in the application itself. The fact that much of the information supplied by the borrower is accepted at face value by the lender means that while the information may fit the guidelines, it is in fact falsified so the loan would not qualify otherwise. In addition, when information is falsified, typical guidelines become ineffective. For example, a credit score on an application becomes meaningless when the applicant is a straw buyer using a phony social security number or credit bureau padded with trade lines where they are an authorized user.

The most common types of misrepresentations in FHA loans include falsification of documents and misrepresentation of key pieces of information for the loan to qualify. The falsifications may be made by either the borrower or the lender. There is evidence that certain lenders may be involved in fraud, as their default rates can be twice the average of other lenders.

The most common types of misrepresentation include:

Misrepresentation of Occupancy and/or Straw Buyers — FHA requires the borrower to occupy the property. In cases where borrowers want to buy investment properties they may indicate that they will live in the property, when in fact they will not.

Misrepresentation of Income and Employment (falsified documentation) — Falsified W2s, Paystubs and Verification of Employment are often evident in FHA loans.

Falsified or misrepresented VORs or VODs — Falsified Verification of Rent and Verification of Deposit often accompany fraudulent FHA loans.

Misrepresented Debt to Income Ratios — Debt to income ratios that are reliant on falsified income or employment, or on non-disclosed debts and judgments lead to higher default rates due to fraud.

One of the fundamental differences between FHA Fraud and Subprime Fraud is the level of full documentation fraud in the loan packages. Where most of the Subprime Fraud contained little or no documentation, FHA Fraud is based on full documentation. Falsifying income documentation has become much easier in the last 5 years with the introduction of new printing technology, software that can create paystubs and even internet sites where income and employment documentation can be purchased.

Some in the mortgage industry believed that stated income was the primary driver for fraud loss in subprime; however, as we are now experiencing, fraud losses remain high even with full documentation products such as FHA loans.

What makes FHA lending the newest high risk segment of lending?

There are several reasons why FHA lending is becoming increasingly risky. Most of them seem eerily similar to the drivers that fueled the rise in fraud in subprime lending.

1. Blind belief that guidelines are blanket protection — Some lenders believe that if a loan meets the FHA Guidelines, it is insured and they are protected from liability. In fact, fraud is a legitimate case where the liability does revert back to the lender when identified. This belief creates a situation where lenders rely on guidelines to stop fraud as protection and do not have advanced fraud specific technology or processes in place.
2. FHA screening is limited — The FHA has limited potential to identify fraud in the funding process. This is in large part due to the tremendous increases in volumes and also in part due to the belief that guidelines are providing the needed protection. Without sufficient technology to precisely identify high risk loans and subsequent process to push loans back to lenders for further scrutiny, FHA is subject to significant exposure. This also propagates the belief of guideline protection by the lenders as the lenders are never forced to assume the liability by FHA.
3. Limited Options for High Risk Lending — FHA is often the only game in town for riskier lending segments. This will be the targeted population for fraud.
4. Increasing Volumes — Increasing volumes inevitably lead to higher rates of fraud. The increase in FHA lending from 5% to 31% of the market has created an attractive target for would be fraudsters to take advantage of. With volume increases, significant holes are left for fraud to be perpetrated.

Tax payers will bear the burden of fraud

The hardest lesson of the subprime meltdown was the eventual impact that it had on every American. The subprime meltdown eventually spread to all areas of mortgage lending as the decrease in housing prices exposed the fact that fraud was not limited to those products alone. As the contagion spread, the credit markets froze, banks and insurance companies wrote down assets and eventually required bailout by the American tax payers. The true cost of fraud in FHA lending will eventually be carried by innocent hard working Americans that would never consider committing fraud. The actions of a greedy few will be carried by the many tax payers that live honestly.

What should be done to prevent the crisis from continuing?

While we are in the earliest stages of a potential FHA fraud crisis, it is not necessarily the case that we cannot avoid the same crisis that we experienced with the subprime lending. There are several critical and high priority items that could help the industry avoid many of the problems experienced before. These include fraud screening and monitoring at the FHA, and fraud screening and monitoring at the lender level as well.

FHA Screening and Monitoring of Loans

FHA should receive funding to deploy more resources to the proactive investigation of fraud occurrences before those loans default. Screening and monitoring should be completed by loan, before the loan is insured. Screening and monitoring should also take place across lenders and across loans that are being received to uncover large scale fraud rings that cause catastrophic loan losses.

Consistent push-back of suspected fraudulent loans to lenders will lead to increased scrutiny in the pre-submission lending process and a significant decrease in fraudulent funding and need for later investigation and recovery.

Fraud Screening and Monitoring at Lenders

• Fraud Screening— Regardless of policies and underwriting guidelines, lenders need to evaluate the complete loan package to determine that all representations and documents in the loan file are valid.
• Fraud Technology— Using technology such as predictive models and verification tools to identify the highest risk applications that require further review.
• Monitoring Cross Loan Patterns and Insiders— As we learned in the subprime crisis much of the fraud could have been avoided by identifying larger patterns of fraud in the data and stopping the few bad brokers and loan officers that were involved in the fraud schemes.
• Mandatory Fraud Reporting — Fraud reporting is a critical component to fraud prevention. The fact that there is no fraud reporting standard for FHA lending means that fraud will slip under the radar.

Learning from the past can help us protect the future — Avoiding mistakes

I believe there are simple solutions to stop fraud in FHA lending. We only need to look to the past, to help us with the future. If we learn from the problems which resulted from loose lending and fraud review practices of the subprime boom we can avoid many of the problems with the current FHA lending boom. Some common misperceptions about fraud led to many changes in underwriting that are not stopping fraud. Avoid making the same mistakes that were made in reactionary times.

Steer away from using credit policy to stop fraud — Fraud will adapt to new policies. Fraud is intentional and information will be “tailored” to fit new policies, guidelines and restrictions and documentation will be falsified to support the “tailored” information.

Use a measurable fraud filtering tool before doing costly verifications.Receiving red alerts on 40-50% of applications sent for scoring creates an environment where underwriters will miss the risk even if it is presented due to the massive number of ‘false alerts’. Verify information on high risk applications using a fraud solution that precisely targets risk, having low false positives with a corresponding high detection rate. A precise scoring solution will identify 40-50% of the fraudulent applications in the top 10% of its high scores.

Avoid treating fraud as a compliance or credit risk in underwriting — credit and compliance underwriting procedures will miss fraudulent applications as the information on the application was “tailored” to meet the underwriting guidelines. On those loans that have scored high on a precise scoring solution, utilize a forensic review process specifically designed to expose fraud.

Avoid over-reliance on collateral risk tools to identify fraudulent applications — property valuation only accounts for 20% of the overall fraud risk. Ensure you use a fraud solution that identifies patterns combining income, identity, occupancy, property, and employment within the application with the risk of the entities participating in the lending process to give an overall assessment of risk on the loan. This is the only true method to identify fraud risk as any one of the risk factors is not enough to precisely identify fraud.

When fraud occurs, don’t overlook it — In the past when fraud was identified, there was a tendency to overlook it and in some cases justify why it wasn’t important. This was particularly true when misrepresentations were related to the borrower and not the property. It is important that lenders consider all misrepresentations on an application and decline applications where fraud activity seems apparent.

Author

Frank McKenna is Co-founder and Chief Fraud Strategist for BasePoint Analytics based in Carlsbad, CA. He may be reached at (760) 602-4971 x104 or via email at FMcKenna@BasePointAnalytics.com

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Frank McKenna, Co-founder and Chief Fraud Strategist of BasePoint Analytics

Frank helped develop and introduce advanced predictive technology to detect mortgage fraud. Frank's vast experience in fraud management has enabled him to identify unique and effective tools to manage lender risk through pattern analysis and evaluating other parties in the transaction, such as mortgage brokers.