Mitigating Mortgage Fraud Risk

The US mortgage industry’s troubles are appearing daily in the headlines of the nation’s press, with many stories about falling property values and rising lender losses as borrowers prove unable to make payments. One thread that has received little press is mortgage fraud. TowerGroup believes this issue deserves the attention of lenders and their risk management executives because the effective application of technology and human oversight at appropriate points in the lending process can curb fraud. This article briefly describes the major types of mortgage fraud, indicates the magnitude of the problem, and discusses what lenders and technology providers can do to help prevent fraud.

The Federal Bureau of Investigation’s bulletin on mortgage fraud warns: “It is illegal for a person to make any false statement regarding income, assets, debt, or matters of identification, or to wilfully overvalue any land or property, in a loan and credit application for the purpose of influencing in any way the action of a financial institution.” This statement covers all the bases, but it is too broad to suggest practicable defensive tactics. Mortgage fraud carried out in the course of the individual loan transaction can be characterized along several different dimensions, as shown in Table 1.

A sizeable problem

Measuring the amount of fraud in the US mortgage industry is difficult. The most comprehensive data is indirect, based on financial institutions’ filings of Suspicious Activity Reports (SARs). From 1996 to 2001, the number of SAR filings grew at an average annual rate of 26%. This was a relatively calm period in the mortgage industry, during which the adoption of tools such as credit scores and automated underwriting systems (AUSs) allowed a move away from traditional underwriting. From 2002 to 2007, SAR filings grew at an average annual rate of 56%. This period featured much more turmoil in the industry, including rapid growth in origination volume, new industry entrants, streamlined processes, and new products with loosened underwriting guidelines; all of these dynamics contributed to the growth in fraud.

In the wake of the subprime debacle, each of these factors has shrunk in relevance. TowerGroup expects that strengthened state and federal regulation, improved technologies to combat fraud, and improved risk management processes by lenders will keep fraudsters at bay. Thus, the rate of increase of SARs will flatten significantly once fraud perpetrated before the subprime meltdown is discovered. With this flattening, TowerGroup predicts an average growth rate in SAR filings between 2007 and 2010 of approximately 15% and industry-wide mortgage fraud losses for 2008 of approximately $2.5 billion, with 10-20% increases in the subsequent several years.

As lenders assess the fraud risks they face, they need to look at these different elements and make sure they have a comprehensive plan in place to address each potential control gap. To assess the biggest risks, lenders must understand both the likelihood of occurrence and the magnitude of potential loss. Such a disciplined approach that assesses both elements of risk is useful for justifying investment in prevention tools and techniques, as well as to prioritize their deployment.

Lenders need to be convinced that the cost to implement a prevention technique (including both technology and personnel expenses) is less than what they are likely to lose. The losses on which they base this assessment should include a factor representing reputation risk, in recognition of the potential loss of new business if consumers see that the lender could have done more to prevent fraud. One piece of good news for lenders comes from TowerGroup’s research indicating that financial institutions can expect to receive a payback of roughly eight dollars for every dollar they spend on fraud prevention.

Fighting back

Fraud for housing typically falls into the category of fraud related to parties to the transaction because it includes fabrications of income, employment, or assets. Identity fraud and broker fraud are other examples. The first level in scanning for fraud related to the parties to the transaction is to confirm that the borrowers are who they claim to be. These include programs that lenders need to set up to comply with “Red Flag” regulations. For example, the lender can validate the parties’ Social Security numbers and check public watch lists such as that mandated by the Office of Foreign Assets Control (OFAC) for anti-money laundering purposes. The next set of checks evaluates a variety of record sources to rate the likelihood that the borrower is legitimate (and flag specific concerns that an underwriter can look at more closely). A third major class of borrower-related data that can be checked for fraud is income and employment information, which can be checked directly with employers and with the Internal Revenue Service (IRS).

Much of the growth in mortgage fraud has been due to the ever-increasing sophistication of fraudsters’ schemes to fabricate values for mortgaged property. The basic tool for detecting inflated property values is the automated valuation model (AVM), which scans local property data repositories and evaluates data about the subject property to estimate its value; these provide an objective tool for validating the appraisal obtained in processing the loan. Whatever the intent of the borrowers, the chance that the lender will incur significant losses is greatly reduced if the property value on which the loan is based is accurate.

Other types of property-related fraud can be much harder to detect. Such schemes include flipping (fraudsters buy and quickly resell a property at a fraudulently higher price) and shotgun credit lines (fraudsters open and draw down multiple credit lines against the same property within a short time period; this scheme is also known as multilien fraud).

The third type of fraud prevention solution is aimed at identifying third-party providers involved in a loan transaction who were previously involved in fraudulent or suspect transactions. These providers can be in any role related to the mortgage transaction but are most typically mortgage brokers, appraisers, or real estate agents. Because licensing and registration requirements for these groups vary widely from state to state, lenders need a common database that can identify whether a third party has been involved in fraud previously.

The latest step in the evolution of mortgage fraud prevention technology is the integrated risk assessment. These tools incorporate many of the evaluation techniques described in previous sections and provide the lender with a holistic view of the likelihood of fraud on the loan application. TowerGroup expects that development of fraud detection tools in 2009 and beyond will focus on increasing the predictive power of integrated solutions and marketing these solutions as a one-stop shop.

What the Industry Can Expect

TowerGroup expects that continuing evolution of mortgage industry fraud prevention will follow four main paths:

Vendors of fraud detection tools will continue to develop professional services capabilities, leveraging their proprietary technology to provide lenders with file reviewers trained in assessing possible fraud.

Many industry participants will recognize the value of pooling data to support more accurate predictive modeling and to improve analysts’ ability to react to innovative fraud schemes. The Mortgage Bankers Association has published a request for proposals for such a database, but this model does not go far enough to allow lenders and analytical firms to work from a common pool of data. The benefit to the common good of improving lenders’ ability to prevent fraud losses is too great for this data to remain proprietary.

Fraud solutions will evolve to become better integrated with industry-standard business process management (BPM) tools. This will be necessary as lenders continue to seek ways to improve their process cycle time. The rate of false positives generated by the fraud detection tools is so high that lenders will need to work to keep manual reviews from slowing the process for the vast majority of loans, which are not fraudulent.

To justify their investments in fraud prevention technology, lenders will push for better data on the effectiveness of the tools in detecting and preventing fraud; this data does not exist in any coherent manner today.

This article is based on research by the Consumer Lending Service at TowerGroup, a leading research and advisory services firm focused exclusively on the global financial services industry. Research Director David Hamermesh can be reached at dhamermesh@towergroup.com. Those interested in learning more about TowerGroup or subscribing to its research services may call +1.781.292.5200 or e-mail service-info@towergroup.com.