The past 10 years have been among the best for real estate investment, causing many lenders to let their guard down in originating mortgage loans. Mortgage fraud is much more common than most lenders know, and most of it will not become evident until the next downturn in the real estate cycle a downturn that already has begun in many commercial real estate markets. This short primer offers advice to lenders and appraisers on how to spot and prevent a variety of common mortgage frauds.

It's only when the tide goes out that you learn, who's been swimming naked."

--Warren Buffett

Odd as it sounds, residential and commercial mortgage fraud can be obvious or hidden. Of the two, it's hidden fraud that is a ticking time bomb in today's mortgage loan portfolios, as defaults will not necessarily occur until interest rates rise or short-term loans mature. And, as we all know, interest rates are now on the rise.

Hidden fraud has become more prevalent with today's predominance of third-party loan originators (brokers and conduit lenders). These originators rarely operate with the internal control structures of regulated banks and thrift institutions and are more likely to fall prey to or commit fraud. Many mortgage brokers are independently employed and merely originate loans without worrying about the consequences of bad loans.

Even bank-based loan originators may bypass proper due diligence if they are paid wholly or in part by commissions based on loan volume. This should come as no surprise, but it's after a "boom" market that the biggest lending mistakes are made. Lending institutions have not necessarily lowered their standards in the current market, but the escalating variety of mortgage frauds compounds the problem.

Degrees of Fraudulent Intent

Obvious fraud: fraud for profit. Three men claiming to be doctors purchased a New York City walk-up apartment building on a residential street. They then applied at the nation's largest thrift institution for a much larger cash-out refinance loan, with the stated purpose of converting the groined floor into a magnetic resonance imaging (MRI) facility. NIRI space would command a much higher rent than was currently earned from the rent-controlled ground floor apartment tenants, and this was reflected in the appraisal done in-house. Once funded, the loan went into immediate default and the borrowers disappeared.

Unbeknownst to the appraiser and underwriter of this transaction, these same three "doctors" had mortgaged another property at the same lending institution on the pretext that they would be converting hard-to-lease basement space into a natural foods store. This loan also went into immediate default.

This is the type of "fraud for profit" that is associated with early payment defaults. The perpetrators disappear quickly and leave behind a property worth just a fraction of its appraised value. The lender immediately becomes aware of the problem when a representative makes a field visit to the vacant property. This unfortunate loan default could have been avoided if the appraiser or underwriter at the lending institution had checked with the City of New York to see if such a use was allowable under residential zoning and if permits had been issued for such space; the answer would have been "no" to both questions. Surprisingly, this particular institution did not have such a written policy in place. A database with borrower names as "key variables" would have alerted the institution to multiple applications from the same borrowers.

The most common fraud for profit is property flipping, the practice of purchasing dilapidated properties and reselling them at inflated prices to straw buyers or duped buyers. A straw buyer is either a phony buyer who will never occupy the property or a complicit buyer who is given a financial incentive. A duped buyer is an unsophisticated buyer, without cash or good credit, who is induced into purchasing a home at an inflated price with the hire of "no money down." The transaction is often supported by inflated appraisals, false verifications of income, and false verifications of deposits in order to deceive an out-of-town lender. The borrower is often overwhelmed by the debt and consequently defaults. A particularly insidious aspect of property flipping is that it poisons property sales databases. It presents the illusion of rising property values and deceives lenders and appraisers about value trends in the neighborhoods where the flipping takes place.

Although property flipping used to lie limited to residential lending, it has now crossed over into commercial lending. In Kansas City, for example, data on apartment building sales was recently tainted lay a well-publicized fraud ring that organized limited partnerships to purchase apartment properties at inflated prices, skim the revenues, and then default on the loans.

Hidden fraud: fraud for loans. Other types of mortgage fraud are much more common, but far less obvious. The intention here is to repay the lender if the property's value and performance (as an income property) increase, but to default if the property's performance and value decrease, leaving the lender holding the bag. Such frauds usually either mislead or corrupt a real estate appraiser into tricking the lender into lending more money than is adequately secured by the property and its cash flow, while also minimizing the risk of equity loss to the borrower, who may not even have any actual equity in the deal.