A Case of Mortgage Fraud
Case was written by MBA student.
15 November 2006
1
A Case of Mortgage Fraud
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 made
the combating of significant fraud in the mortgage3 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
From a brochure entitled: “North Carolina Bankers Association Presents Loan Fraud a
web-based seminar”. Unfortunately, this number is not cited within their brochure.
However, my own research concludes that fraud is ubiquitous in America and elsewhere
and “15%” probably not far from the truth.
2
Ibid. With increased default and foreclosure rates, so too the discovery of mortgage loan
fraud.
3
“A conveyance of an interest in property as security for the repayment of money
borrowed” is known as a mortgage; to mortgage is “to convey or place (real property)
under a mortgage” per mortgage. (n.d.). Dictionary.com Unabridged (v 1.0.1). Retrieved
October 03, 2006, from Dictionary.com website:
http://dictionary.reference.com/browse/mortgage
4
Financial Crimes Report to the Public, May 2005. U.S. Department of Justice, Federal
Bureau of Investigation, Financial Crimes Section, Criminal Investigative Division.
www.fbi.gov/publications/financial/fcs_report052005/fcs_report052005.htm
5
Ibid.
6
Ibid.
1
2
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
market8 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
US are 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
7
"Mortgage Lender Fraud Increase Seen By Law Enforcement." Brown House Media,
Inc., 2006. 15 Nov. 2006
<http://www.mortgagenewsdaily.com/1052006_Mortgage_Lender_Fraud.asp>.
8
“The market in which existing mortgages are bought and sold” is known as the
secondary market. (n.d.). Merriam-Webster's Dictionary of Law. Retrieved October 03,
2006, from Dictionary.com website: http://dictionary.reference.com/browse/secondary
market
9
Financial Crimes Report to the Public, May 2005. U.S. Department of Justice, Federal
Bureau of Investigation, Financial Crimes Section, Criminal Investigative Division.
www.fbi.gov/publications/financial/fcs_report052005/fcs_report052005.htm
10
“The Many Faces of Mortgage Fraud” by James Hennessy may be found at:
http://www.mortgageoriginator.com/NR/exeres/B0E7F00B-99F4-4F2C-A17D4279F34F3300.htm
3
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.
11
USDA Loan Guarantee form at
http://www.rurdev.usda.gov/ca/pdf%20files%20and%20documents/4279-1.doc
4
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
12
WHAT LEVEL OF FIDUCIARY DUTY SHOULD MORTGAGE BROKERS OWE
THEIR BORROWERS? 75 Wash. U. L.Q. 1737 http://www.wulaw.wustl.edu/wulq/754/754-9.html
5
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,
13
April 10, 1994 More Buyers Turn to Mortgage Brokers By NICK RAVO
http://query.nytimes.com/gst/fullpage.html?res=9A01E3DA163EF933A25757C0A96295
8260&sec=&pagewanted=print
6
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, Mike got 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
OCD15 and had recently gone through a divorce where the majority in the office thought
that he was conned by his ex wife 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,
14
Ibid.
“obsessive–compulsive disorder: a psychoneurotic disorder in which the patient is
beset with obsessions or compulsions or both and suffers extreme anxiety or depression
through failure to think the obsessive thoughts or perform the compelling acts —
abbreviation OCD; called also obsessive-compulsive neurosis, obsessive-compulsive
reaction” obsessive-compulsive disorder. (n.d.). Merriam-Webster's Medical Dictionary.
Retrieved October 04, 2006, from Dictionary.com website:
http://dictionary.reference.com/browse/obsessive-compulsive disorder
15
7
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 Mae Form 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
8
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 selfimposed 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 abovementioned 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
9
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 ADA16 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.
“The Americans with Disabilities Act (ADA) is a Federal civil rights law that prohibits
discrimination against people with disabilities.”
http://www.usdoj.gov/crt/ada/business.htm
17
US Department of Justice ADA Q&A page @
http://www.usdoj.gov/crt/ada/employmt.htm
16
10
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
An example of this type of fraud is found in a US Inspector General’s Audit Report of
Keystone Mortgage and Investment Company in Phoenix, AZ dated 24 March 2004 and
may be found at http://www.hud.gov/oig/ig491001.pdf
18
11
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
19
Ethics PowerPoint Slides from MBA-8111 at UMD, Fall of 2006.
12
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).
Some Questions to Consider:
If you were the manager, what would you do with Steve?
If you were the silent partner, how would you advise Mike to handle Steve’s situation?
If you were the investor, how would you handle Steve’s situation?
Does a mortgage loan officer at a mortgage brokerage have the duty to do all that he or
she can to get the customer’s loan approved, closed and funded?
For whom are they an agent: the broker employer, the funding institution, FNMA20 or the
customer?
Should the FBI or the state have been notified?
Was it wrong of Steve to alter the document?
What could Steve have done differently to accomplish his objective?
How would you characterize Mike’s handling of the situation?
Should other investors have been made aware of Steve’s loan fraud so that they might
audit their own Steve-related files?
20
FNMA, also known as Fannie Mae which refers to a mortgage secondary market or
“any of the publicly traded securities collateralized by a pool of mortgages backed by the
Federal National Mortgage Association.” fannie mae. (n.d.). Dictionary.com Unabridged
(v 1.0.1). Retrieved October 04, 2006, from Dictionary.com website:
http://dictionary.reference.com/search?q=fannie mae
13
Should the appropriate agency at the state be made aware of Steve’s loan fraud so that
they might not grant his Mortgage Broker’s License?
How many “utils” could a utilitarian assign to NOT firing Steve for his transgression?
Would a utilitarian fire Steve?
If Mike did primarily rely on Kolberg’s 4th Stage of Moral Development, could he have
found a way not to fire Steve?
What about the customer? Isn’t the customer liable for anything given his signature in
Section IX of the Form 1003 that warrants truth with threats of fines and imprisonment?
Do you know of anyone who has committed loan fraud? Should they be punished? If so,
how?
14
Epilogue
The company continues today, though with less corporate-sponsored trips to Las
Vegas and no Twin-Ports company-paid limousine/hotel pub crawl this year. It is
significantly downsized as consolidation in the mortgage industry is intense with
increased interest rates and less demand. From $3.9 trillion in loans in 2003 to $2.6
trillion in 2004, due to reduced levels of refinancing, the mortgage loan industry was in
decline, though the new home market was strong.21 Now, the new home market has
cooled as well. Thus the mortgage business has cooled even further to just the opposite
of the early 1990’s: too much lender supply for too little borrower demand.
The company went from a profit (after Mike’s $160,000 annual salary) to a loss
of $40,000 in 2004 and a loss of $85,000 in 2005 leading to the layoff of the processor
(who earned $50,000 annually, thus causing loan originators to process their own files in
the entirety and creating more opportunities of fraud if a loan officer was so predisposed)
and a less expensive office space, to slightly above break even in 2006.
Steve went on to work for someone else and then opened up his own mortgage
brokerage which is licensed by the state (recall that the state was never made aware of his
transgression). He continues to make his living by writing mortgages.
21
JUNE 27, 2005 Business Week Online NEWS ANALYSIS
By Peter Coy
Mortgage Bankers: Desperate to
Lendhttp://www.businessweek.com/bwdaily/dnflash/jun2005/nf20050627_9858_db016.h
tm
15
List of Sources
My recollection of past events and conversations as of October 2006...
Fannie Mae Form 1003/Rev. 10/92
Financial Crimes Report to the Public, May 2005. U.S. Department of Justice, Federal
Bureau of Investigation, Financial Crimes Section, Criminal Investigative Division.
www.fbi.gov/publications/financial/fcs_report052005/fcs_report052005.htm
“The Many Faces of Mortgage Fraud” by James Hennessy may be found at:
http://www.mortgageoriginator.com/NR/exeres/B0E7F00B-99F4-4F2C-A17D4279F34F3300.htm
“US Rural Development Loan Guarantee Webpage.”
2006.www.rurdev.usda.gov/ca/pdf%20files%20and%20documents/4279-1.doc
16
"Wash. U. L.Q. 1737." Washington University School of Law 75, Number 4(1997). 15
Oct. 2006 <http://www.wulaw.wustl.edu/wulq/75-4/754-9.html>.
Ravo, Nick. “More Buyers Turn to Mortgage Brokers.” April 10, 1994.
<http://query.nytimes.com/gst/fullpage.html?res=9A01E3DA163EF933A25757C0A9629
58260&sec=&pagewanted=print>
Merriam-Webster's Medical Dictionary. Retrieved October 04, 2006, from
Dictionary.com website: http://dictionary.reference.com/browse/obsessive-compulsive
disorder
Dictionary.com Unabridged (v 1.0.1). Retrieved October 04, 2006, from Dictionary.com
website: http://dictionary.reference.com/search?q=fannie mae
US Inspector General’s Audit Report of Keystone Mortgage and Investment Company in
Phoenix, AZ dated 24 March 2004.
< http://www.hud.gov/oig/ig491001.pdf>
Ethics PowerPoint Slides from MBA-8111 at UMD, Fall of 2006.
Coy, Peter. "Mortgage Bankers: Desperate to Lend." 27 June 2005.
<http://www.businessweek.com/bwdaily/dnflash/jun2005/nf20050627_9858_db016.htm
Treasury: Mortgage Loan Fraud Continues to Rise From the U.S. Department of
Treasury's Financial Crimes Enforcement Network(FinCEN). “Assessment Reveals
Suspected Mortgage Loan Fraud Continues to Rise” November 03, 2006
<http://www.fincen.gov/MortgageLoanFraud.pdf.>
Martin, Vernon. "Detection and Prevention of Mortgage Loan Fraud." RMA Journal
September 2005 November 1, 2006
http://www.findarticles.com/p/articles/mi_m0ITW/is_1_87/ai_n14897572.
"Fannie Mae Home Page." 2006. Fannie Mae. 10 Nov. 2006
<http://www.fanniemae.com/index.jhtml>.
"Freddie Mac: Freddie Mac Corporate Homepage." 2006. Freddie Mac Terms and
Conditions |. <http://www.freddiemac.com/>.
HUD, U.S. Department of Housing and Urban Development. "HUD home page, Homes
and Communities (HUD)." 10 Nov. 2006 <http://www.hud.gov/>.
17
"Mortgage Lender Fraud Increase Seen By Law Enforcement." Brown House Media,
Inc., 2006. 11 Nov. 2006
<http://www.mortgagenewsdaily.com/1052006_Mortgage_Lender_Fraud.asp>
"Federal Bureau of Investigation - Press Release December 14, 2005." 11 Nov. 2006
<http://www.fbi.gov/pressrel/pressrel05/quickflip121405.htm>.
“Mortgage Bankers-Mortgage Fraud” 11 Nov. 2006
http://www.mortgagebankers.org/files/Library/Issue%20Papers/MortgageFraudPerpetrate
dAgainstResidentialLenders.pdf
Vickers, Marcia. "Master con artist commits mortgage fraud - November 13, 2006."
CNN.com. 30 Oct. 2006. Fortune. 15 Nov. 2006
<http://money.cnn.com/magazines/fortune/fortune_archive/2006/11/13/8393072/index.ht
m>
18