Welcome to the 11th edition of Fighting Fraud with Frank. In this edition I wanted to give our readers insight into a real problem that will probably affect them personally in the years to come. That problem is high levels of fraud and misrepresentation that are still occurring on loans that are being originated and sold to Fannie Mae and Freddie Mac. Loans that are packaged and sold to them by lenders are known in the industry as "Conforming" loans since the loans fit the more traditional and "safe" type of loan programs free from the types of risk that occurred in non-prime loan programs. While one could argue that these conforming loan programs are safer in general, the notion that these loans are free from fraud risk is a misconception. According to BasePoint research, these loan programs do in fact have high rates of fraud that impact the performance of loans. As we have seen from the past 3 years, fraud impacts everyone, particularly when the financial impact of it is shouldered on taxpayers and responsible homeowners.

So why should we all be concerned? I will give you a few reasons to consider.

Reason #1 to be Concerned - Fraud Migration has Occurred

It is impossible to eliminate fraud. It is part of human nature (a form of cheating) that can only be managed and not completely expelled from existence. At best fraud can be minimized or moved somewhere else where it is less expected and better hidden. In the case of mortgage fraud, there has been a movement in fraud risk since 2007 from areas of high risk lending (such as Non-Prime and Alt-A lending) into areas of traditionally low risk lending - Conforming and FHA loan programs.

For example, in 2006 BasePoint analysis of fraud in traditional prime lending programs was running .07%. Put another way about 7 cents for every $100 in funded loan value defaulted and had some evidence of fraud misrepresentation in the original loan application. Since that time we have seen a dramatic increase in fraud in these traditional loan programs. In 2009, BasePoint analysis into fraud rates on conforming loans indicated that .53%, or 53 cents for every $100 in originations, will default due to fraud. The level of fraud has increased by 700% in the conforming loan-type programs since 2006.

The primary cause of this dramatic increase is rooted in the phenomenon of fraud migration. Fraud attempts have quite literally been squeezed from exotic and high risk mortgage programs that are no longer available to the programs that are still available such as Conforming and FHA.

Reason #2 to be Concerned - A Conforming Loan Leads to a Conforming Fraud

Ask just about anyone what led to the high levels of fraud and credit risk that caused the mortgage meltdown and they would probably list the following reasons:

• Stated income programs where borrowers could put just about any income they chose on the application,
• No money down loans where the lenders provided 100% financing,
• Lending to too many people with poor credit scores, and
• Poor underwriting standards.

If we look at the conforming loan programs, these factors are not present. Only borrowers with good credit scores, placing a down payment of 20% or more and providing full documentation of their income are considered for the programs. Most of these loans are subject to much higher underwriting standards than were utilized from 2005-2007. Given all this, one would expect fraud to be nearly non-existent in conforming programs, right? Wrong. The fact is that conforming loan programs lead to fraud misrepresentations that conform. Income fraud in a conforming loan file is fully documented; the issue is that the documentation itself is fraudulent. If a borrower's credit score is good, it could be that they are a straw buyer for someone else. Loan to Value Ratios are 80% or less, but the property value might be inflated and the borrower might not be putting 20% of their money down on the property. Fraud hasn't been eliminated, it has just been more cleverly disguised and hidden.

Reason #3 to be Concerned - $6.3 Billion in Loans Originated with Fraud for 2009

When it comes right down to it, the financial impact of fraud on conforming loan files is why most people will be concerned. It is estimated that $1.9 Trillion in loans will be originated this year into conforming loan programs. Given an estimated fraud rate of .53% (53 basis points), this means that $6.3 Billion in loans will be originated with evidence of misrepresentation in the loan file. Many of these loans will undoubtedly lead to high delinquency, default and foreclosure rates. For the lucky borrowers that have been involved in fraud, they could receive loan modifications and quickly default again, exacerbating the problems that the lending agency faces today. The end losers in all this are the taxpayers who are on the hook for the eventual losses, and of course the neighborhoods and responsible homeowners that have been hurt by fraud-related foreclosure losses.

What Steps can be Taken to Reduce this Problem

As I have always stated to our readers, solving the problem of mortgage fraud is not the product of a single silver bullet, but rather employing a host of best practices that have worked in many other industries with great success.

The primary components which I believe are necessary to solve fraud on conforming loans are the following:

1. Deploy Effective Fraud Technology - Use technology such as predictive models and verification tools to identify the highest risk applications that require further review. Technology allows a lender to get in front of new and emerging fraud schemes that may not often be spotted by underwriters during their day-to-day tasks. Technology such as pattern-recognition analytics can provide accurate fraud risk identification early in the process to pinpoint the loans with the highest probability of fraud, enabling prevention of high fraud losses at very low review rates with low false positive ratios.
2. Use 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. Simply putting income documents in a file does not verify income. Income documents should be analyzed by experienced fraud analysts that understand how income documentation can be manipulated. Obtaining an independent verification of the income, such as the 4506-T IRS tax transcript, is recommended.
3. Build a Fraud Department Function - Lenders should build a specific fraud management function that is outside of normal underwriting review and handle fraud reviews as an exception. A specific fraud process that is focused on finding and stopping fraud is a necessary function that must be instituted in lenders' risk management processes.
4. Require Mandatory Fraud Reporting - Fraud reporting is a critical component to fraud prevention. The fact that there is no fraud reporting standard for Conforming lending means that fraud will slip under the radar. When mandatory fraud reporting is implemented it will force the industry to recognize the financial impact of the problem and take the necessary measures to prevent it.

We can bring fraud rates back down by taking more aggressive fraud prevention action

There is no reason why fraud rates on conforming loans cannot be reduced dramatically. By deploying best practices in fraud management, the industry can reduce fraud levels from .53% back to levels of .07% which were experienced prior to the migration of fraud. The savings to the industry, the taxpayers and homeowners would be over $5 Billion.

Author

Frank McKenna is co-founder and Chief Fraud Strategist of BasePoint Analytics, a technology firm that provides fraud and risk solutions to the Mortgage and Banking Industries. BasePoint Analytics is part of First American CoreLogic. Frank McKenna can be reached 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.