A Case of Mortgage Fraud

Case was written by MBA student.

15 November 2006

General Introduction

It is estimated that 15% of all goods and services in the US are the direct result of fraud.[1] Loan fraud is thought to be the largest category of all frauds.[2] Because of the overall effect on the US economy, the Federal Bureau of Investigation (FBI) has madethe combatingof significant fraud in the mortgage[3] lending industry a priority.[4] Mortgage fraud schemes contain some type of “material misstatement, misrepresentation, or omission relied upon by an underwriter or lender to fund, purchase or insure a loan.”[5] The Mortgage Bankers Association anticipated $2.5 trillion in mortgage loans made in 2005.[6] “The Wall Street Journal quoted The Federal Bureau of Investigation as stating that mortgage fraud led to losses of $1 billion last year, more than twice that recorded in 2004. There is apprehension that some of the fraud that was perpetrated during the recent housing boom has yet to surface. Financial institutions filed 25,000 Suspicious Activity Reports - which can cover problems other than the mortgage related - up from 5,000 in 2002.”[7] Though thought by the FBI to be “pervasive and growing”, the true level of fraudulent mortgages is unknown as fraud is thought to be underreported in the secondary market[8] and there are few mandatory reporting requirements within the industry as a whole.[9] Some mortgage industry experts believe that 10% of all mortgage loans in the USare fraudulent, with most fraudulent loans having more than one type of fraud associated with it.[10]

Borrowers Are Warned Not to Commit Fraud

In a typical mortgage loan transaction one will find that the borrower signed Section IX, entitled “ACKNOWLEDGEMENT AND AGREEMENT” on page 3 of Fannie Mae Form 1003 (Rev. 10/92) which warrants, among other things, the following: “Certification: I/We certify that the information provided in this application is true and correct as of the date set forth opposite my/our signature(s) on this application and acknowledge my/our understanding that any intentional or negligent misrepresentation(s) of the information contained in this application may result in civil liability and/or criminal penalties including, but not limited to, fine or imprisonment or both under the provisions of Title 18, United States Code, Section 1001, et seq. and liability for monetary damages to the Lender, its agents, successors and assigns, insurers and any other person who may suffer any loss due to reliance upon any misrepresentation which I/we made on the application.” The borrower also signed the bottom of page 4 that read: “I/We fully understand that it is a Federal crime punishable by fine or imprisonment, or both, to knowingly make any false statements concerning any of the above facts as applicable under the provisions of Title 18, United States Code, Section 1001, et seq.” Though not listed on the mortgage loan application, Section 1001 of Title 18 in the United States Code states: “Whoever, in any matter within the jurisdiction of any department or agency of the United States knowingly and willfully falsifies, conceals or covers up by any trick, scheme, or device a material fact or makes any false, fictitious or fraudulent statements or representations, or makes or uses any false writing or document knowing the same to contain any false, fictitious or fraudulent statement or entry shall be fined under this title or imprisoned for not more than five years or both.”[11]

No Fraud Warnings to the Loan Originator

The interviewer, or loan originator, will have signed the Form 1003 at the bottom of page 3 in Section X entitled “INFORMATION FOR GOVERNMENT MONITORING PURPOSES” below the borrowers ethnic and sex designations. Note that the loan originator did not have to sign and agree to any of the legal language to which the borrower agreed.

Commissions

Most loan originators are paid like many sales people: on a commission basis, mostly. If a loan does not close, there no commission earned, even though time and work is expended. Thus the motivation to originate, expediently process, close and fund the deal is great. Perhaps this motivation leads to cutting corners as well.

Agency Relationships

Whereas other mortgage lenders have no duty to their customers other than legal disclosure of their product and contractual obligations therein, some courts have found that mortgage brokers have a fiduciary duty to their clients.[12] Our company’s disclosures, however, clarify this agency question and state that we act as an agent of ourselves and our investors. We also disclose any business relationships with other vendors who might be involved with the borrower’s loan.

The Importance of Contracts

If not implicit, there exists an implied contract between the employee and the employer such that the employee shall always act in the best interests of the employer. The broker has a contract, including liabilities for fraudulent loans, with the institution funding the loan or purchasing the mortgage from the broker who will pool said mortgage with others to be sold into the secondary market. Thus this mortgage must meet predetermined guidelines to have the value required to be bought and sold. This huge secondary market is indirectly responsible for the fact that a home mortgage has some of the best value for the customer when it comes to borrowing money in that loans may be amortized to over 30 years with fixed interest rates just a few percentage points higher than the prevailing rates of inflation. For example, borrowing $200,000 at a 5.75% fixed interest rate for 30 years to purchase a home that is appreciating in value and not suffering the investment opportunity cost of using your savings that can earn 15% in other investments is certainly not a bad deal for the average customer. Refinancing an existing mortgage to pull cash out of ones equity to payoff higher interest consumer debt or invest in better yielding investments also improves a customer’s personal financial situation.

Case Background and the Win-Win of Mortgage Lending

There is nothing like making money by genuinely satisfying peoples’ needs. It’s the epitome of a “win-win” situation. That’s how it was for me in the early 1990’s writing mortgages in the Twin Cities. I felt like a kid in a candy store. My loan production was consistently in the top ten out of 500 other loan originators throughout the country in the company for which I worked. I would go into work at 6 am and see clients all day and into the evenings and on weekends—often driving to their homes to originate the mortgage loan application package. My recollection: every mortgage that I originated then, we closed and funded. The customer demand exceeded the supply of competent loan originators as interest rates fell. In 1993, 50% of all mortgage originations were done by mortgage brokers; only 20% in 1983 and almost none in the 1970’s.[13] Of course, refinances constituted up to 75% of the business back then [14] and it was more than 90% of my own business then as well. It was in this environment where I met my current boss and owner of my current employer, Mike. Back then, he was a high-school graduate who had made his living as a bartender and attempting to also write mortgages. Over the years, Mikegot some good experience, established lucrative business contacts, and ultimately built a company, sales force and business presence. In addition to me, he has hired a lot of loan originators. Today, if one wants to be a good loan originator and make a decent income, they must have significant purchase business—origination of loans to purchase real estate as opposed to refinance transactions. Therefore, they must have good, established relationships with real estate agents for access to prospective borrowers. This is not easy to do in an environment saturated with mortgage brokers of varying degrees of competence and ethics. Do to his ability to ‘get the deal done, my colleague, Steve, was extraordinary in his ability to cater to the needs of real estate agents and their customers. Mike had hired Steve in 2000. Steve was an interesting character, to say the least. Earlier in life, he had a brain tumor removed. He was diagnosed with OCD[15] and had recently gone through a divorce where the majority in the office thought that he was conned by his exwife to give her money so that she could live with her new boyfriend. His limited drinking of alcohol was memorable for others, yet not for him, literally. Nonetheless, Steve’s loan production exceeded that of all of our employees, other than Mike. While his income was in the six figure range, his contribution to the company’s overhead was somewhere between $150,000 to $200,000 per year.

In 2004, Steve was making good money. He had the tenacity of a bull dog when it came to taking the application, facilitating the processing of the loan, and closing the deal. The basics of a mortgage loan application involves the completion of the application known as the “1003” (ten ‘o three) which discloses identity of the borrower, some specifics of the real property, assets, income and debt (usually uploaded from the credit report) of the borrower. The borrowers represent their truthfulness in the execution of this form; other terms, state, federal and company-specific disclosures are provided to the borrower in proximity to the time of application and also at the execution of closing documents prior to funding. Everything on this Fannie MaeForm 1003 is then satisfactorily verified prior to being underwritten.

Fraud Discovery and the Mechanics Therein

In the case of one of Steve’s files, the underwriter had noticed that a verification of deposit form had looked as if it had been altered with white out. When Mike questioned Steve about this, Steve had admitted to “correcting” the dollar amount on the verification of deposit form returned from the bank where the customer had funds on deposit. Steve stated that he “knew” that the customer had more money in that bank than the bank disclosed. Mike inquired how he knew this to be so. Steve stated that he knew because he (Steve) had deposited some money into the customer’s bank account to meet the criteria established when Steve used AU (automatic underwriting via the internet) to pre-underwrite the file. Note that while the physical loan package eventually lands in the hands of an underwriter, the loan application specifics can be entered ahead of this event electronically and various data may be changed in this process as the application package progresses thus yielding varying degrees of approval along the way: it could be rejected, conditionally approved at a higher rate of interest (a “leveled approval”) or a standard full approval. Through this electronic underwriting process, Steve felt that he knew exactly the amount of assets the customer needed to get the loan approval. Given the self-imposed pressure to get the deal done for his borrower and his real estate agent, whose commission also relied upon the deal closing, Steve took an illegal short cut by altering the verification of deposit.

Irony: No Fraud Was Required to Close the Deal

Interestingly, the loan file in question actually closed shortly thereafter in conformance with all underwriting guidelines insuring its salability in the secondary market. Utilizing the vast experience that Steve lacked, Mike was able to present the various facts of the loan to the underwriter in such a way that it was approved.

Managerial Decision Time

With fraud in mind, the investor began auditing Steve’s current and previously closed and funded loan packages. They also began to audit other files that our company had with them currently and in the past.

Mike contacted his silent business partners to make them aware of the above-mentioned instance of loan fraud. His partners trusted his managerial judgment and stood behind, in advance, any decision that he would make.

Mike called me, as well, seeking my counsel. I had known Steve for a few years and was aware of some of his eccentricities. I also knew that he was a producer and added more value to the bottom line than any other employee, with the exception of Mike, perhaps. I detailed the downside of loan fraud from an employee of the company—some of which Mike was experiencing given the extra audit scrutiny. I had also suggested to Mike the possibility that if (1) an audit of Steve’s files had shown no other evidence of fraud, (2) that this event seemed like an isolated incident and (3) the investor believed these things to be true as well and did not insist on Steve’s termination, that Steve, perhaps, be allowed to continue his employment under extra scrutiny with increased checks and balances so that this situation would never present itself in the future. I would also recommend getting Steve some counseling to determine why his judgment had lapsed and how to increase the likelihood that it would not lapse again to such magnitude. Any cost associated with these changes could come from Steve’s reduced compensation as well thus adding more to the company’s bottom line or at least covering the incremental cost of increased supervision and judgment remediation.

There was also the ADA[16] to consider and the qualification and quantification of any potential legal repercussions from Steve as employees may be considered to have a “disability” if they have a “mental impairment that substantially limits one or more major life activities, has a record of such impairment, or is regarded as having such impairment.”[17] In my opinion, this law was nebulous and inadequately written resulting in an inevitable series of court cases to define its scope and meaning over time.

In fact, the investor had no problem with Steve staying on with the company. Mike’s partners had no problem with Steve staying on with the company. Steve wanted to stay on with the company—at whatever cost. Mike and Steve were friends.

Legally, it was clearly wrong of Steve to alter the verification of deposit. He violated his implied employment contract and did not act in the best interests of his employer by committing loan fraud. He created a legal liability for his employer and jeopardized a lucrative business arrangement that his employer had with an investor through his ill-conceived actions. His actions were not only illegal, but they were unethical as well. Besides, the loan was approvable with the right amount of expertise. Seeking help from his supervisor would have been a better solution to Steve’s particular situation.

However, Steve’s mortgage fraud was extremely small relative to the examples of mortgage fraud that can’t be missed with a quick internet search. The industry is rife with bigger, greedier, intentions of fraud. I suppose that it is to be expected when individual, corporate, investor profits lead to increasing cases of fraud or various agency disconnects or conflicts of interests. Given the age of digital technology, it is easy to falsify realistic documents like pay check stubs and IRS W-2 Forms as alternative documentation of employment, for example.[18]

Mike, however, could not trust Steve again. So when Steve, returned to the office for his meeting with Mike at the designated time, Mike gave him his paycheck and terminated his employment with the company. Mike equated continuing Steve’s employment with condoning loan fraud. Mike is an admitted fixed deontologist who relies upon Kolberg’s 4th stage of moral development (though he declined to take the test).[19]

Mike then offered for Steve to meet with a crisis intervention specialist immediately thereafter. Steve accepted Mikes offer and met with said specialist a few minutes after meeting with Mike. Mike’s actions in this case were thoughtful and decisive. Though he had a useful and profitable friendship with Steve, Mike’s principals dictated his actions in a socially responsible way. Mike also sought differing confidential opinions from a variety of sources. He might have also contacted the company’s employment attorney; however, one of his business partners was an attorney and also fairly well versed in employment law through other businesses that he owned and operated. Mike also did not make an immediate decision given the emotions of the moment—other than sending Steve home for the weekend.

Mike’s use of a crisis intervention specialist (at no charge to the company) was a clever and socially responsible thing to do in this circumstance. Mike’s knowledge of Steve led him to believe that Steve had emotional issues that could result in self injury associated with Steve’s propensity to depression associated with OCD. Thus keeping his initial reproach of Steve to a minimum and addressing the issue after the weekend was probably appropriate for this reason as well. While I cannot “fault” Mike for terminating Steve, I think that he could have kept him on with adequate increased checks and balances (paid for through Steve’s reduced commission structure). This would have kept healthy profits for the company and its various funding investors, kept Steve’s customer base with the company, and avoided the potential for any ADA associated litigation (though the company’s legal defense would be strong, frivolous litigation in this case could only be a further drain on profits in this case).