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The Cult of Plausible Deniability

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Mortgage fraud is typically portrayed as the classic white-collar crime perpetrated only by "prolific and egregious" offenders. The exploits and subsequent convictions of a handful of notorious fraudsters receive wide spread media attention. At the end of the day, we feel more secure because the federal prison population has swelled ever so slightly with the occasional inclusion of a title attorney, mortgage broker, or real estate investor. In 2006, the FBI successfully obtained 204 mortgage fraud convictions derived from 818 cases investigated.

While the "self-proclaimed" experts prefer to discuss the consequences of a randomly inflated appraisal or falsified loan verification, little is said about the causation factors underpinning a paradigm of esoteric dishonesty that's generally, or conveniently, misunderstood. Only by examining its causes do we surmise that mortgage fraud is properly characterized as a national epidemic, not a series of isolated incidents. Only by scrutinizing the motives of mortgage fraudsters do we recognize the cultural corruption of an entire industry. Mortgage fraud statistics correlate directly to foreclosure statistics which in turn point to a breakdown of professional protocol, and standards, in residential real estate markets.

Mortgage fraud and predatory lending are often classified as distinctly different forms of abuse. In reality, the disparities between them are academic at best. Mortgage fraud is broadly defined as a material misrepresentation, or omission, relating to real property or the application for a mortgage that's substantially relied upon by the underwriter, provider of funds, or the purchaser or insurer of the mortgage loan in question. The presence of mortgage fraud results in the approval and funding of a loan that wouldn't have reached its fruition had facts been presented accurately. While mortgage fraud is properly interpreted as deceitful activity that causes harm to lenders and other members of the lending community, predatory lending broadly describes any deceitful, or abusive, lending practice that causes harm to borrowers. Loans characterized as predatory by nature place undue burdens on borrowers because payments become unsustainable in time. Unethical, often criminal, behavior demonstrated by loan originators, appraisers, real estate agents, and title professionals is the real world nexus that definitively binds mortgage fraud to predatory lending.

Mortgage lenders employ a tiered business model that's based on the retail theory of loan origination to supply a pipeline of loans for bundling and securitization in sophisticated financial markets. Both mortgage fraud and predatory lending are facilitated at street level by real estate insiders who more often than not are intent on earning only commissions or professional fees. In the process, consumers with varying degrees of culpability confront the risk of financial loss along with entities in elevated tiers of the lending model that relied on the integrity of loan originators. An often cited FBI report states that 80 percent of all mortgage fraud involves the tacit participation of real estate professionals. I personally believe the percentage is much closer to 100 percent. Throughout this discussion, the term mortgage fraud is intended to encompass predatory lending practices as well.

Contrary to a belief held by many, foreclosure rates are a dependable bellwether of fraudulent activity. Studies have found that the fees charged by loan originators have a direct bearing on the incidence of misrepresentation in loan applications. The higher the fee structure the more likely an application is to contain misrepresentations. In turn, a direct correlation exists between misrepresented applications and the likelihood that borrowers will default on mortgage payments. A study of 100 stated income mortgage applications revealed that 90 of them contained misrepresentations. More startling, incomes were exaggerated by 50 percent, or more, in roughly 60 percent of the cases reviewed. At this time, 1 out of every 196 U.S. households is in foreclosure. Far too often, mortgage fraud impacts communities and individuals that can least afford the abuse. A boarded up home is the visible symptom of a deeply rooted problem; despair is the human cost that we hear so little about. Every aspect of our society, particularly the economy, suffers when a home is foreclosed and a family displaced.

Consumers are sensationalized as villains by industry pundits and the media when, in reality, all mortgage fraud requires the orchestrated efforts and coaching of licensed real estate professionals. It takes a degree of savvy to navigate the complexities of a "self-imposed" industry culture that discourages transparency to protect income derived from contacts and a limited body of knowledge. Deceitful real estate agents and loan originators enlist the cooperation of title professionals and appraisers to exploit unsophisticated or otherwise vulnerable borrowers. The consumers targeted are often uninformed and desirous of homeownership or favorable refinance terms even though they lack a satisfactory employment, savings, or credit profile. As a group, consumers are decidedly guilty of lesser crimes than the trusted professionals who mastermind the blueprint of fraud and deceit.

The title industry plays a particularly dynamic role in efforts to deter, detect, and report mortgage fraud. Mortgage fraud couldn't exist without the cooperation of title professionals who are uniquely positioned as the "last line of defense" in any transaction. Surprisingly, the industry has allowed anti-competitive forces to erode the enviable position of trust that it once occupied. Not surprisingly, federal authorities hold the industry to the exalted standard of care that's normally associated with the practice of law. Other real estate disciplines are simply not held to equivalent professional standards. The title industry has historically directed its marketing efforts towards real estate agents and loan originators rather than consumers. The draconian business model creates an environment of distinct vulnerability when title professionals are asked by business sources to actively participate in mortgage fraud or to "look the other way." In the vernacular, the situation is best described as "going along to get along." Very often it's notary privileges or powers of attorney that are blatantly abused. The overall effect has been disastrous for the public as evidenced by current foreclosure statistics and the endless count of title professionals named as defendants in criminal indictments.

The title and mortgage lending industries are poised to suffer the greatest losses resulting from fraudulent activity. Inexplicably, there's been little initiative to solve the problem beyond the scope of technology that's failed in the past. The two industries subscribe to a misguided belief that mortgage fraud is containable by profiling high risk individuals and properties based on information aggregated in databases. While the practice has an overall beneficial effect on loan quality, it ignores the broad reach of human cunning and is therefore counter intuitive as a stand alone approach. A mathematical algorithm is no match for the human intellect. The purely technological approach to mortgage fraud mitigation didn't work in 2006, or 2007, and it won't work in 2008.

The application of automation to the loan origination process has had the unintended consequence of elevating mortgage fraud statistics. Processing activities, in many cases, have been removed to regional or national centers where the consumer is reduced to a faceless, ambiguous name on a computer screen. In the past, loan originators conducted business in the same communities in which they lived. There was an organic relationship between lender and borrower. There was a first hand familiarity with the condition and value of the homes being sold or refinanced. The success of a lending institution was, in large part, decided by referrals from past customers who were essentially neighbors. We cannot negate the fact that fraud flourishes when business is transacted from a distance. Many of the "tell-tale" indicators of mortgage fraud are extremely subtle and require direct observation. There is no substitute for human contact in matters of fraud prevention. The incidence of mortgage fraud was statistically insignificant in the past when lending was personalized and community based.

In a practical sense, the recent shake down of housing values marked the beginning of a period of accountability for industry insiders who routinely commit or facilitate mortgage fraud. A dramatic spike in default rates occasioned by rising interest rates has unearthed a generation of loans originated by internally falsified documentation and over inflated appraisals. The crimes of the past decade are finally coming to light. The phantoms of the dirty little secrets are hidden in countless files and countless real estate offices scattered about every community in this nation.

Sweeping reform of the real estate industry, a highly unlikely prospect due to powerful lobbying efforts, would prove an important first step to fraud prevention. The threshold of entry into the industry overall is ridiculously low considering the paramount importance that our society places upon homeownership. For many demographic groups, homeownership is the singular path to any semblance of financial security. Still, the licensing and regulation of the highly paid professionals, i.e. real estate agents, loan originators, and title professionals, that deliver the promise of the American dream varies erratically from state to state. A preliminary report released by the Government Accountability Office in April, 2006 revealed the lax licensing standards that currently exist for the title industry. Keep in mind, title professionals not only examine title, they are also responsible for managing enormous escrow accounts and for guarantying the secured interests of lending institutions. It's a technical and serious job that requires the ability to manage complex risk variables that could potentially cause harm to consumers and lenders alike. One would expect that a newly licensed title professional has been highly trained and required to demonstrate a stellar degree of proficiency and competency. Disturbingly, it's not the case. Licensing requirements are non-existent in 3 states plus the District of Columbia; 18 states and the District of Columbia do not require a title agent to pass a test to become licensed; only 20 states have an educational requirement as a pre-requisite to licensing. A title industry without dysfunction would prove a formidable barrier to the aspirations of all mortgage fraudsters.

Continuing education requirements for real estate insiders present opportunities that deserve focused attention. For the most part, the courses offered at this time are meant only to comply with statutory guidelines, such as they are, and offer little substance or value to veteran practitioners. Particularly in matters of mortgage fraud prevention, awareness through training is the key. All real estate professionals would benefit from exposure to actual examples of fraud with an emphasis on the consequences to the participants and to society. A growing number of business and law schools recognize the value derived by students when white collar convictions are brought to life. In some cases, students are required to spend a day at a federal prison camp where they tour the facility, interact with select inmates, and eat prison food. In other cases, white collar convicts are invited to the classroom to speak candidly about the personal and professional consequences of having made bad choices. The consequences suffered by those who participate in mortgage fraud schemes often include incarceration, the payment of restitution, the loss of a license and career, and the loss of professional legitimacy forever. Additionally, real estate professionals must be exposed to the human suffering that's caused by a particularly heinous form of fraud that targets housing markets. Mortgage fraud inflicts real pain upon children, families, and communities. Only through awareness will real estate professionals fully comprehend the need to develop decision making models that subvert the lure of potential fees and commissions to the interests of consumers. It can't be said enough, mortgage fraud simply can't exist unless it's initiated and facilitated by members of the real estate industry. The primary losses suffered by the lending industry due to mortgage fraud are expected to exceed 4.2 billion dollars for 2006.

H.R. 3915, a bill drafted by the House Committee on Financial Services, exemplified the legislative mentality needed to reform the real estate industry in ways that would reduce the incidence of mortgage fraud. At least it did in its original form before industry pressure diluted the patently consumer friendly bill by changing key language to protect the interests of mortgage brokers.

In oversimplified terms, both the original and modified versions of the bill address consumer concerns by:

  • Creating a national registry, regardless of state licensing criteria, for all originators of residential mortgages. Loan originators must meet certain minimum requirements to qualify.
  • Requiring loan originators to match borrowers with appropriate loan products with payment levels that they can reasonably expect to repay. It seems like absurd rhetoric in this day and age of consumer rights, but for the first time loan originators would have a legal duty to act in the best interests of homeowners.

From the perspective of the mortgage industry, the controversial "sticking point" contained in the original draft was the elimination of the yield spread premium (YSP) as a sub-prime lending tool. Apparently, industry backlash was fierce enough to compel lawmakers to quickly abandon hopes for consumer advocacy by philosophically switching gears. The YSP is an actuarial concept that allows for the packaging of loans with disparate profiles in commodity markets. The seemingly benign concept made its way into retail markets during the mid 1990's with the advent of sub-prime mortgage lending. The YSP represents a dollar amount paid to a loan originator as a fee because the borrower has agreed to pay an interest rate that's above par. In other words, a cash overage exists because borrowers are paying a higher interest rate than they need to. For technical reasons, a mortgage broker has a legal duty to disclose an overage to borrowers while a loan originator working for an institutional lender does not. For all intents and purposes, the disclosures are meaningless because the general concept is difficult to grasp for all except the most sophisticated borrowers. In a perfect world, the YSP would be used as payment for a borrower's legitimate closing costs including a reasonable fee to the loan originator. In the real world, the YSP is often abused by unscrupulous loan originators as a vehicle of theft and deceit. Numerous studies indicate that the YSP has been systematically employed by sub-prime lenders to grossly overcharge borrowers with an ethnic or gender bias. African Americans, Latinos, and women in general are more likely to opt for sub-prime mortgages, while paying substantially more for mortgage money, than members of other demographic groups. A sub-prime mortgage is at least 6 times more likely to result in foreclosure than a prime mortgage.

In spite of all the punditry and lengthy explanations, my message is quite simple. Predatory lending and mortgage fraud, cynical and diabolical twins, are symptomatic of the same problem. Both types of abuse occur frequently and on a small, seemingly innocuous scale. Both are crimes that are perpetuated mostly by real estate insiders. The fraud is most often facilitated in the normal course of business to earn a professional fee or commission. The behavior is often justified as something it's not, victimless. Reformation of the real estate industry, an exceedingly unlikely proposition, would offer a partial solution to a societal blight with costs that escalate exponentially each year. I place the greatest of my hopes in the collective integrity and intelligence of consumers to end mortgage fraud in all its forms. Without a doubt, a properly informed consumer is the fraudsters worst enemy.

 

Ed Rybczynski is a professional speaker who is sometimes mistaken for an aspiring writer. His topics of choice include: the current housing crises, corporate culture as it relates to corruption couched in complacency, and the effects of (more...)
 
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