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Recognizing the impact of mortgage fraud and taking preventive steps result in a huge increase to the bottom line. One reason this isn't happening is our very reluctance to see just how bad mortgage fraud is. This article offers four steps that can help lenders manage those costs. The industry needs to act now for the good of our customers and our shareholders. [PUBLICATION ABSTRACT]

In late 2006, the Financial Crimes Enforcement Network (FinCEN) released a report that paints a particularly troubling view of mortgage fraud. FinCEN concluded that filings of Suspicious Activity Reports (SARs) in the first quarter of 2006 increased by 35% over the first quarter of 2005. What makes this even more troubling is that 35% isn't the whole story; in fact, it's not even half the story. Most experts estimate that only 25% of all mortgage lenders are required to file SARs, leaving the true number of mortgage-fraudrelated suspicious activities much higher than is reflected in the number of filings.

Given the downturn in the housing sector, the accompanying thinning margins, and increased pressure to keep up profits, this upward trend in incidents of mortgage fraud is likely to continue. The good news is that there also is growing awareness of mortgage fraud within the industry, as well as a greater willingness to talk about it. But the question of the true impact of mortgage fraud remains.

Fraud Affects Everyone in the Enterprise

Let's begin our search for the true cost of mortgage fraud by acknowledging that all employees are involved in both the problem and the solution.

* On a daily basis, quality-assurance professionals, processors, underwriters, and closers must try to protect their companies against bad loans.

* While trying to salvage relationships with their secondary-market investors, secondary-market managers must also resolve unsalable loans on a warehouse line or repurchase loans already sold to secondary outlets.

* CFOs must accurately and consistently determine the cost of doing business, taking into account their contingent liability to purchasers of their loans and the associated losses they may sustain as a result of fraud. Additionally, they must maintain capital requirements and strategize a cost-effective fraud-resolution process.

* In managing the day-to-day operations of their companies, CEOs must develop strategic plans that consider the possibility and impact of fraud in each delivery channel, each product type, and each region where the company conducts business.

Once we have accepted the premise that fraud affects everyone within an organization, the focus can shift to cost.

Hard and Soft Costs

The more notable facets of fraud's cost to the industry include the following:

1. Hard-dollar losses from fraudulent loans entering the pipeline and closing.

2. Hard-dollar costs of tools and services to prevent and protect against fraudulent loans.

3. Soft-dollar costs from loss of goodwill in the marketplace (both with secondary-market outlets and with consumers if the victimized lenders are the subjects of news reports).

4. Hard-dollar costs associated with internal resources spent unraveling fraud schemes, servicing those loans, and formulating resolution costs.

Because soft costs are difficult, if not impossible, to quantify, let's use hard-dollar losses as a way to examine the cost of fraud to the industry.

Claims data from PBIS Insurance Services (an affiliate of The Prieston Group) shows an overall loss severity from fraud of about 21% of the original loan balance. This figure, based on years of insuring loans and paying out on those that contain fraud, includes the benefit of lossmitigation successes. As another measure, Standard & Poor's estimates that loss severity due to fraud averages 35.6%. Using 36% for purposes of illustration, consider a fraud scheme involving 100 loans. Assuming that a lender was fortunate enough to book only 10 such loans with a combined unpaid principal balance of $2 million, a 36% loss severity easily results in the lender sustaining $720,000 in hard-dollar losses-perhaps even more, depending on the accuracy of the original appraisal. Again, that figure represents only the actual losses associated with the loans and not other costs, such as employee time spent attempting to resolve these loans. That is a significant amount of money, especially considering that it's based on the assumption of only 10 loans containing fraud and that's for one lender alone.

From $100 to $817: Per Loan

What impact does fraud have on the industry as a whole? The Federal Bureau of Investigation estimates that losses due to fraud are in excess of $1 billion. Other calculations show that losses do, in fact, exceed $1 billion-and quite significantly.

The Mortgage Bankers Association estimated that the mortgage market for 2006 would reach $2.49 trillion. By applying calculations proprietary to PBIS Insurance Services, we can conclude that 60,000 of those loans were fraudulent. The losses on those loans will most likely hit $4.2 billion, based on S&P's loss severity estimate of about 36%. Yet even $4.2 billion is not the total cost. Assuming that the industry, on average, spends $100 per loan to combat fraud in the first place, the total cost of fraud is quickly pushed to $5.4 billion- well beyond the FBI estimate. In addition, if we spread that $5.4 billion across all originations, we can estimate the cost of fraud at almost $435 on a per-loan basis. That hardly insignificant figure ultimately ends up being passed down to the consumer in one way or another.

Even $5.4 billion is a conservative estimate of fraud's true cost. It has become a fact of life in our industry that delinquencies and foreclosure figures are rising. Of course, not all of these are due to fraud-a weakening housing sector, particularly in certain parts of the country, and adjustable-rate mortgage increases occurring without any increases in income levels have certainly played roles as well. Yet the fact remains that some of these delinquencies are the result of fraud; there are estimates that 1% of all delinquencies across the board can be traced to some type of fraud. If we assume that just 1% of delinquencies are due to fraud and then apply our loss-severity calculations, the total losses to the industry due to fraud approach $10 billion. That figure is nearly 10 times the FBI's estimate. On a per-loan basis, the cost reaches $817 for each loan originated in 2006.

Grim Choices

Given that fraud adds significant costs to the industry-much larger than often estimated-we need to address how we deal with these costs. As an industry, we have historically relied on the repurchase remedy to somehow absorb these losses, yet the changing marketplace and the reality of thinning margins make that remedy less and less of a true option. An increasing number of mortgage bankers are facing razor-thin profits and break-even points and, in some instances, are seeing losses. Repurchasing loans is simply not possible for many. For some, just originating loans is no longer possible. A number of lenders in the market have closed up shop rather than continue to risk their personal assets in a challenging marketplace. Each lender that closes is one more correspondent lender that will not be buying back any repurchases.

Tough Expectations

Everyone-from law enforcement to the media, and from regulators to legislators-is focused on mortgage fraud and expecting the financial services industry to fix the problem. We must begin this daunting task by analyzing various solutions, seeing which ones work, and then employing them in our organizations. Organizations like TPG are attempting to do just that.

Our nation's housing finance system is the envy of every other country in the world. Nowhere else is there a 70% homeownership rate, with each year seeing a larger share of mortgage loans going toward financing the American dream for immigrant and other emerging-market homeowners. This segment of the market is particularly vulnerable to fraud, given language barriers and financial literacy gaps and the fact that the mortgage process is one of the most complicated financial transactions a consumer enters into. If the industry does not take the lead and address this issue, we not only will continue to lose credibility with consumers, but we will run the risk of having new regulations and requirements imposed on the entire mortgage industry. So both consumers and lenders need to take steps now.

What to Do

Be aware. First, lenders must always be aware of trends in fraud as well as the geographic fraud hot spots. Claims data from PBIS Insurance Services shows that undisclosed mortgages/properties top the lists of the most common types of fraud and are found in 27% of all claims filed. That is followed closely by employment/ income fraud at 26% and occupancy misrepresentation at 23%. Additionally, the number-one geographic fraud hot spot continues to be the metro Atlanta market, followed by Miami, Detroit, Raleigh/Durham, New York City, Houston, and Chicago.

Lenders also must be aware that fraud is not limited to stated income loans and non-prime loans. In fact, up until the third quarter of 2006, PBIS claims data showed that only 55% of claims stemmed from reduced-documentation programs. That means 45% of claims containing fraud came from full-documentation loans, and in the third quarter, that figure jumped to a full 66%. The average FICO score in the third-quarter claims data also has increased; it is now 644, up from 628 a year before. Having this background knowledge of types of fraud, hot spots, and other fraudulent loan characteristics helps lenders better assess the potential risks of different loans.

KYBP. Second, lenders can protect themselves and their clients by making the effort to know their business partners. Now is the time to review how business partners are approved. How strong is your application process? How effective is your due diligence process for correspondent lenders? This is particularly important since the repurchase-request remedy can continue to strain your client relationships. Lenders should examine whether they require transaction-specific closing protection letters from settlement agents and, if not, then consider doing so. They also should know whether appraisers carry valid errors-andomissions coverage in the event of appraiser fraud.

Train. Third, employees must be properly trained. As an industry, we have historically done well in training quality-control and underwriting employees in fraud prevention and detection, but that is not enough. Fraud detection is everyone's responsibility- loan officers, account executives, and those involved in input, processing, underwriting, closing/funding, and even postclosing. Not only should all employees be aware of fraud schemes and hot spots, but they must also know precisely what to do internally should they detect fraud. It is continually surprising to learn how many employees do not know the red flags signaling fraud and the internal procedures for reporting it. Training must be addressed industry-wide. All employees should know exactly what to do if they uncover a potentially fraudulent loan.

Prefunding practices. Fourth, lenders need to refine their prefunding practices, which should be a combination of technology and more traditional steps. Technology alone can never get the job done satisfactorily. Nearly 80% of all PBIS claim files had been run through at least one technology tool in the hope of detecting fraud. Clearly, we must not be overreliant on technology; instead, we must combine technology with welltrained humans who perform steps that have been proven to reduce the incidence of fraud.

These four steps can help manage the risk of fraud and reduce its incidence. Bringing industry leaders together to talk about their best practices and collectively developing industry best practices for quality lending will be another major step in our fight against mortgage fraud. Yet it is important to remember that none of these steps will have a real impact on fraud reduction unless we fully understand and accept the cost of mortgage fraud to our industry and to individual lenders. It is incumbent upon us to discuss this problem in a truthful manner and not sugarcoat it. Understanding mortgage fraud's real cost and impact is a good, solid step in that direction.