Insights & Reports > Kroll Global Fraud Report

Among the many factors which led to the current financial crisis, fraud in the US mortgage market played an important role.

The story begins nearly a decade ago, when the US government decided to encourage mortgage lenders to make credit more available to subprime borrowers – those with weakened credit histories arising from delinquencies, charge-offs, judgments, or bankruptcies. Through the 1990s Fannie Mae and Freddie Mac had helped many lower-income individuals purchase homes, but after 2000 there were even more borrowers who would not have met the underwriting requirements in place before that year.

For US mortgage lenders, subprime borrowers meant higher profits, so long as the payments were met. The financial institution could charge a much higher interest rate to these customers as a “penalty” for the increased risk they represented.

The level of the Federal Funds Rate – the US Federal Reserve’s rate for lending to financial institutions and a tool to regulate the US money supply – also helped feed the current crisis. The low cost of money for financial institutions over a significant period made credit more readily available to residential and institutional buyers. After reaching 6.50 percent for the last six months of 2000, the rate slid to 1.00 percent in June 2003 (a figure not approached since the early 1960s). From June 2004 to June 2006, it increased steadily to as high as 5.25 percent. As the rate climbed, non-traditional mortgages – such as adjustable rate or interest only – for subprime borrowers became more attractive to the lenders. Twenty-one percent of all mortgage originations from 2004 through 2006 were subprime, more than double the 9 percent from 1996 through 2004.¹

In addition, changes in fair value accounting rules and a $50 trillion credit default swap/mortgage-backed-security (MBS) market contributed to an environment conducive to deregulation, aggressive lending tactics, and, ultimately, fraud.

The accompanying chart provides a graphic overview of how the mortgage and MBS markets work.

Fraud in the Mortgage Origination Market

Several types of fraud related to the origination of mortgages, which have existed for decades, were even easier to pull in an overheated market.

Illegal Property Flip

Several colluding perpetrators are typically involved, including: an appraiser, who values a property higher than market value; an investor, who supplies any required funds; a mortgage broker, who fraudulently represents the loan to the mortgage lender; and a straw buyer, a buyer in name only.

The investor purchases a home, with the intention of selling, or “flipping” it to the straw buyer. The latter, working with the mortgage broker, receives funding for the purchase at the overstated value, fraudulently represented by the appraiser. The parties then divvy up the proceeds, and may either sell the house to another buyer at an inflated price or walk away from the mortgage leaving the financial institution holding a loan on an over-valued asset.

Short-Sale Fraud

The perpetrator here recruits a straw buyer to finance a home for 100 percent of its value. The buyer may then also take out additional credit on the property for “home improvements,” which is simply pocketed. After the straw buyer completes the purchase of the property and secures the additional funding, he defaults on the mortgage but recommends the perpetrator to the financial institution as someone who might purchase the property at a reduced price. The perpetrator can then sell the property at actual value or use it in an illegal flipping scheme.

Foreclosure Rescue Scam

The perpetrator convinces a home owner that he or she can save the latter’s property from potential foreclosure by transferring the deed for a fee. Once the deed is transferred and the fees received, the perpetrator either takes out a second mortgage on the property or sells it, without the home owner’s knowledge.

Fraud in Underwriting

The heady environment also caused upper management to apply ethically questionable pressure on loan originators and underwriters to process as many loans as possible. This can lead to a lack of due diligence by the lending organization, a particular problem in view of the increased use of no-document/no-proof-of income loans.

Fraud in the Secondary Mortgage Backed Securities Market (“MBS”)

On September 23, 2008 SEC Chairman Christopher Cox stated “significant opportunities…exist for manipulation in the $58 trillion CDS [Credit Default Swap] market, which is completely lacking in transparency and completely unregulated.” The SEC is investigating not only whether lenders made adequate risk disclosures, but whether investment banks and broker-dealers actually “defrauded retail customers by making false representations, or by putting investors into unsuitable mortgage-backed investments.” Frauds in this market include:

Falsification of Payment Histories

Here, historical payments for the mortgages included in a MBS are manipulated to show payments as current when they are in arrears. An executive at Olympia Mortgage was prosecuted in May 2008 for, among other things, allegedly selling non-performing loans through such falsification. One of the perpetrators recently pleaded guilty; the case against the other is still pending.

Misrepresentation and/or Improper Disclosure of Risk

Each of the pools of loans in a securitized portfolio is assigned a credit rating, and as this worsens the rate of return on the investment increases. A residential MBS may include total debt ranging from $100 million to over $1 billion. At an average home value of $200 thousand, an MBS could thus consist of between 500 to 5,000 individual loans. Government agencies are investigating the accuracy and disclosure of the ratings for these assets. Questions include whether sellers made purposeful misrepresentations and/or improper disclosures about the risk, and how many portfolios were fraudulently sold with the sellers’ knowledge that some of the underlying assets were already delinquent or in default, or indeed had been bogus from the start.

Common Corporate Fraud

More ordinary frauds, such as misappropriation of funds or overcharging fees, can occur because of the volume, dollar value, and unregulated nature of MBS. Kroll has also seen examples of this in the Title Insurance industry.

Potential Fraud in Accounting for and Valuing Assets

Financial institutions held many MBS and loan portfolios under mark-to-market (“MTM”) accounting guidelines. Valuing these assets using MTM was difficult because no real outside market existed. Instead, internally generated models were used, resulting in inaccurate valuations because the models were often based on management’s “best estimates” and/or faulty or overly-optimistic assumptions. One of the latter was that the trends in the housing market would continue at the booming growth rates experienced from 2001 through 2005. The line between incorrect assumptions and fraudulent manipulation of values is thus potentially very thin.

Understanding the types of frauds which were taking place is only the first step. Critically we must now ask what the potential for recovery is for investors and financial institutions that have been affected by frauds, and how might this type of collapse be avoided in the future. We hope to address these and other issues in future articles.

1 John Waggoner, “Subprime Woes Could Spill Over Into Other Sectors.” USA Today, March 15, 2007, http://usatoday.com/money/perfi/columnist/waggon/2007-03-15-subprime-woes_N.htm

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John Slavek is the managing director of Kroll’s Philadelphia-based Forensic Accounting and Litigation Consulting practice. He is a CPA and Certified in Financial Forensics and has testified as an expert in accounting, fraud investigations, and the quantification of financial damages in litigation. Prior to joining Kroll in 1998, John was a forensic financial investigator and auditor at a Big Four accounting firm and has more than twenty-eight years of combined experience in the manufacturing and services industries.

Paul Donato is a senior associate in Kroll’s Philadelphia office. He is a CPA and Certified Fraud Examiner with more than seven years of experience providing a variety of investigative and forensic accounting services in matters involving SEC investigations, hedge fund fraud, bankruptcy, complex damages, and financial statement manipulation.

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