UNDERSTANDING THE BASICS OF MORTGAGE

The Life Cycle of a

THE LIFE CYCLE OF A MORTGAGE LOAN

Learning Objectives • Identify the players in the mortgage loan process and their responsibilities. • Understand what is important to look for in critical documents.

Introduction A key to fraud detection, prevention, and investigation is to understand the weaknesses and stress points in the mortgage loan process. Those who commit understand how to exploit those weaknesses. In this section, we will look at the mortgage loan process as a fraudster would, and point out its weaknesses so that we can become better at enacting controls, detecting red flags, and investigating fraud.

The majority of fraud is committed by, or with the direct assistance of, industry insiders (such as builders, sellers, loan officers, appraisers, realtors, attorneys, and title agents). One study indicates that more than 81% of all mortgage fraud is committed with the knowledge and often the participation of an industry insider.

Fraud can be perpetrated at any stage of the process, but the majority of mortgage fraud is perpetrated at origination. Fraud can be committed by anyone who has access to the loan application and supporting documents.

Following is a discussion of the players, the expectations (from the perspective of a fraud investigator), and the fraud trends among each of the players involved in a mortgage loan transaction.

Property Seller In a purchase transaction there is a property seller. The seller should be the individual listed on the public records found in the county courthouse where the property is located. It becomes problematic when someone other than the owner of record enters into a transaction to sell a property he doesn’t own.

A refinance transaction should not involve a property seller because, technically, the borrower is the owner of record at the time of the refinance. Exceptions to this include divorce and inheritance.

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A property seller can be an individual home owner, a builder or developer, a manufactured housing dealer, a investor, or a bank.

Individual Home Owner In the majority of residential home transactions, the seller is an individual whose desire it is to sell his property, with knowledge and in good faith, near its market value, and who seeks to profit only from the sale of the home, whether it is his primary residence, an investment property, or a second home.

Builder or Developer If someone is purchasing new construction, the seller is likely to be a corporate builder or developer. Sometimes, builders also purchase and renovate older apartment complexes into individual condominium units. A builder profits only when the property sells. Builders and developers have a vested interest in finding buyers that qualify for financing.

Builders are generally prohibited from requiring the use of a specific lender or title agent as a condition of the sale. Allegations against builders for this practice include: • Raising the prices of homes when buyers decline to use the builder’s mortgage affiliate or subsidiaries. • Requiring buyers to deposit extra money in escrow accounts if they refuse to use an affiliated lender. • Coercing buyers into using a designated lender with the threat of withdrawing a seller’s credit toward costs.

Manufactured Housing Dealer Manufactured housing is now considered . Buyers purchasing manufactured units can obtain permanent financing through mortgage loans rather than chattel loans from banks. Therefore, manufactured home dealers now participate as sellers in mortgage transactions. In some cases, the manufactured home dealer may also own the lot and sub-development where the manufactured home unit is or will be located.

Real Estate Investor Investors who purchase , renovate them, and resell them are known as property flippers. It is not uncommon for such a property seller to be in title for a short period of time, usually just long enough to renovate the property and find a buyer. The flipper may take title to the property under a corporate name or an LLC and, therefore, when the property is sold, the property seller might be a corporation rather than an individual.

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Bank-Owned Real Estate When a bank takes a property back due to , the property becomes an asset of the bank. Therefore, a bank (or investor) can become the property seller when that property is sold. This property is often referred to as (REO).

Expectations of a Property Seller • To sell his property in good faith and at market value. In a distressed situation, the value might be at the lower end of what the market will bear. • To be the owner of record of the property when entering into a purchase contract to sell it. • In an arm’s length transaction, to expose the property to the open market so that competition will dictate its market value. • In a non-arm’s length transaction, to disclose the relationship between the seller and buyer. • To list in the purchase agreement all the contributions the seller is willing to make toward the buyer’s purchase of the property. • To require a good faith earnest money deposit (EMD) from the buyer to be placed in escrow with a title agent. • To disclose addenda with all incentives on the purchase contract.

Fraud Trends – Property Sellers • In many cases of mortgage fraud, the property seller is the orchestrator. • The seller may have a mortgage broker’s license or may steer a buyer to a certain loan officer with promises of instant qualification or reduced origination points. • Property sellers may recruit borrowers via advertising or real estate investment clubs. • A seller may enter into a purchase contract with a borrower on properties not currently owned by the seller (misrepresenting himself as seller). • A buyer may provide all documentation to the property seller and have no contact with the loan officer. • The seller may coach the borrower through the loan application process. • The seller may access the loan officer’s credit bureau subscription and run a credit report. • The seller may order and pay for the appraisal, and supply comparable sales for the appraiser to use. • The seller may offer lavish undisclosed incentives to borrowers. • The seller may make an undisclosed offer to pay the borrower’s down payment. • The seller may offer a turnkey service. • The seller may float a loan by making the first year’s mortgage payments. • The seller may misrepresent the condition or construction of the property he is selling.

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Real Estate Listing Agent Real estate listing agents are usually independent sales workers who provide their services to sellers and buyers through a licensed real estate broker on a contract basis. The listing agent is paid a commission on the sales price received for the home.

Licensing and Regulation Every state requires real estate brokers and sales agents to be licensed. For more information about each state’s licensing and regulation, visit the National Association of Realtors State and Local Leadership Directory at www.realtor.org/leadrshp.nsf/?OpenDatabase.

Multiple Listing Service The multiple listing service (MLS) is a database that allows real estate agents representing sellers to share property information with other brokers who may represent potential buyers. The MLS combines the listings of all available properties within a given MLS service area and can be utilized by any broker who is a member of the National Association of Realtors (NAR).

The purpose of the MLS is to enable efficient distribution of information so that when a finds a potential buyer, that agent may search the MLS and retrieve information about all homes for sale in a given area or price range.

The MLS is governed by private entities, such as a county or regional board of realtors, and the rules are set by those entities with no state or federal oversight, beyond any individual state rules regarding real estate. MLS systems set their own rules for membership, access, and sharing of information.

Listing agents create the listings for properties being sold by their clients, the property sellers. Only the listing agent can modify, update, and change the information in these listings.

A person selling his or her own property, or for sale by owner (FSBO), cannot put a listing for the home directly into the MLS. Similarly, an agent who chooses not to join the trade association or operate within the association’s rules cannot join or access the MLS.

In many transactions where sellers are looking for buyers, the property will be listed in the MLS. Typically, a sale listed in the MLS is considered exposed to the open market. Sales that occur between two people and have not been exposed to the market are considered private sales. Because of their limited exposure, these sales may not be good indicators of market value.

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Limited Service Listings The real estate industry offers flat fee MLS or limited service listings, which entail a licensed subscribing agent placing pertinent information about a property into the MLS for a flat fee. FSBO properties are sometimes listed this way.

Expectations of a Real Estate Listing Agent A real estate broker who becomes an agent of a seller is called a fiduciary. As a fiduciary, a real estate broker is held by law to owe specific duties to his or her principal (the seller). The following services are typically provided by the listing agent: • Running a market analysis to help determine the fair market value. • Advertising the property. • Negotiating the best possible price and terms. • Reviewing all written offers with the seller.

For representing the seller, the agent receives a commission when the house is sold. A typical commission for listing a property is between 3% and 6%.

Fraud Trends – Real Estate Listing Agents • The listing agent’s fiduciary duty may be to someone other than the client. • The agent may also be the loan officer. • MLS listings may be created after the property has been put under contract or has sold. • The agent may recruit emerging market buyers and provide fraudulent identifying information. • The sales price may be negotiated over and above the listing price with a stipulation that the excess goes to the perpetrator. • An earnest money deposit (EMD) may be held from the borrower rather than placing it in escrow with a title agent. • As the listing agent for a bank REO division, he or she may provide a fraudulent BPO value under the market value, purchase the property from the bank, and then flip it to someone else. • An agent may accept limited service listings with unreasonable or unlikely listing prices.

Borrower For the purpose of this course and the industry standard, the buyer in a purchase transaction and the owner in a refinance transaction are referred to as borrowers.

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The Armchair Investor This type of borrower is typically naïve and trusting, having been seduced into thinking that investing in real estate is quick, easy, and profitable. This type of borrower might have read a book on how to get rich quick by investing in real estate, or may know co-workers or family members who have profited from recently acquired properties.

The armchair investor’s hope is to cash in on the lucrative real estate market by essentially getting something for nothing. He believes industry insiders who claim borrowers can qualify for multiple property purchases with no money down. The properties being sold are often in inner-city areas and may need extensive repairs. The seller might claim that the repairs have already been made and the property is occupied by responsible tenants. In some cases, the borrower does not even inspect the property before closing.

The borrower may have no idea how he was able to qualify for multiple loans and might not even know the loan officer listed on his loan application. In many cases, the borrower is unaware that his qualifying documentation has been altered or fabricated. Even though all this information is included on the documentation signed at closing, the closing may be rushed, and the borrower may be told to sign blank documents, or be assured that any corrections noted by the borrower will be fixed after closing.

These investment schemes often involve affinity group fraud, which occurs when a group of individuals who are joined together by a common affiliation or goal, such as religion, education, employment, ethnicity, or political beliefs is targeted; often it is a trusted member who preys on the other members of the group.

Straw Borrower A straw borrower is someone with good credit who, for a fee, takes out a loan for the benefit of someone else. A straw borrower believes that he will not be obligated to reside on the property or repay the loan.

Credit for Sale A borrower may be recruited for his good credit and then receive a fee for purchasing property. The borrower may be told that his only contribution will be to qualify for the loan and that another party (often the perpetrator or a recruiter) will handle all other aspects of ownership, including renovating the property, finding a tenant, collecting rent, and making the mortgage payments, and then ultimately the perpetrator will split the proceeds with the borrower.

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Sponsor A sponsor is typically a well-meaning family member who agrees to co-sign for another family member with poor credit, only to find out at closing that the sponsor is the only person listed on the loan. Under duress, they are convinced to sign the closing documents as the sole borrower with the reassurance that, in one year, the title and loan will be transferred into the other family member’s name.

In cases involving an out-of-state straw borrower, the straw may be sent one set of closing papers thinking they are a co-borrower signing a duplicate set. Two things may then happen: either the original borrower did not sign a duplicate set of closing papers, or those duplicate documents signed by the original borrower are discarded after closing. In either case, the qualifying documentation in the loan file has most likely been altered and false statements may have been made to facilitate loan approval.

Identity Fraud Victim Identity fraud involves stealing a person’s identifying information for the purpose of committing theft. A good example of identity fraud is using someone else’s Social Security number (SSN) to apply for a credit card or loan. Victims of this type of fraud are often unaware that someone has used their information illegally.

While there are many reported instances of security breaches resulting in compromised private personal information (PPI), there have been no rashes of security breaches that have resulted in the origination of mortgage loans. It is much more likely that industry insiders, who may retain PPI from previous transactions, use this information over and over without the knowledge of the borrowers.

Some schemes involve the use of a deceased individual’s SSN, while other cases involve using an issued SSN that hasn’t been used, creating a new credit profile.

Accomplice In some cases, the borrower is an overt accomplice to the scheme, but this is the exception rather than the rule. Since the borrower is typically the one most affected, and therefore most likely to squeal when the loan goes into default, perpetrators prefer to use the identities of unsuspecting borrowers.

Expectations of a Borrower • To enter into a purchase agreement in good faith and with a full understanding of the magnitude of the transaction. • To shop for a loan officer with the best loan product and understand the loan product being solicited. • To accurately represent to the loan officer the borrower’s purpose for the loan, as well as his employment, income, assets, debts, and occupancy.

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• To review, or hire an attorney to review, the closing statement prior to closing. • To profit at the time of purchase only by becoming the owner of a property that is likely to increase in value through natural appreciation over time.

Fraud Trends – Borrowers • The borrower may use armchair investors, straw borrowers, or accomplices, or use information obtained via .

Real Estate Buyer’s Agent In legitimate transactions, buyers may select real estate agents to help narrow down the choice of homes for sale. Buyer’s agents have the same duties and fiduciary responsibilities to their clients (the buyers) as listing agents. They typically have access to the MLS but are not allowed to alter or update listings they did not create.

Fraud Trends – Real Estate Buyer’s Agents • There may be no buyer’s agent for the transaction. • The realtor may also be the mortgage broker, may recruit the borrower by means of the MLS, and, with access to the borrower’s PPI, may misrepresent the borrower’s qualifications for a loan. • The realtor’s fiduciary duty may be to someone other than the buyer. • The realtor may not disclose contract addenda to the loan officer.

Lender The lender is the institution that provides the money for the loan. The loan officer may or may not be affiliated with the lender. As mentioned earlier, many lenders are non-depository institutions. Aside from those lenders that do loan against their own portfolios of assets, lenders typically secure loan money from the following sources: • The secondary market (as discussed earlier) • A correspondent lender • A warehouse line of credit

Correspondent Lender A correspondent lender is an entity that typically closes mortgages it originates with a purchasing lender’s funds. A correspondent performs some or all of the loan processing functions, such as taking the loan application; ordering credit reports, appraisals, and title reports; and verifying the borrower’s income and employment. The correspondent may or may not delegate underwriting. The mortgage is

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closed in the correspondent’s name but is funded by the purchasing lender. A correspondent may also commission a mortgage broker to perform some of the origination or processing functions.

Warehouse Line of Credit Many non-depository mortgage lenders, and some commercial banks, maintain warehouse lines of credit to fund loans prior to sale to another lender or the secondary market. The lender handles all aspects of the origination, processing, and underwriting, and closes the loan using funds from the warehouse line of credit. The loan remains in the warehouse line just long enough for a lender to sell the loan to another lender or in the secondary market. Once sold, the warehouse line is repaid. A lending institution with a warehouse line of credit might commission a mortgage broker to perform some of the origination or processing functions.

Loan Officer The loan officer may or may not be affiliated with the lender that funds the loan. Loan officers are typically either retail loan officers or third-party originators (TPOs).

Retail Loan Officer A retail loan officer works for the funding lender, whether a commercial bank or a non-depository lending institution that utilizes secondary market funds, correspondent relationships, or warehouse lines of credit.

Loans originated by a retail loan officer are the most basic transactions with the fewest third parties involved. All parties can be employees of the financial institution, including the appraiser. All steps in approving the loan can be done in-house and once the credit decision is made, the transaction is often closed in-house.

Being salaried, a retail loan officer may not make as much per loan as someone on commission, but the retail loan officer can utilize the referral network within the lending institution to originate more loans. A salaried loan officer is not as reliant on commissions and therefore not under as much pressure to close the loan.

Third-Party Originator A third-party originator (TPO) is a mortgage broker or correspondent that partially originates and processes a loan for a funding lender. The funding lender then underwrites and approves the loan. The funding lender rarely has direct contact with the borrower during the origination process, and relies on the TPO to order and obtain the appraisal. The funding lender relies solely on the integrity of the information provided by the mortgage broker when making an underwriting decision.

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A TPO is usually paid a commission and therefore may be more incented to produce and close as many loans as possible. Because the TPO is in control of all information related to the loan transaction, an unscrupulous TPO is able to misrepresent any components he wants.

Case studies and reports show that fraud involves TPOs more often than retail loan officers.

Expectations of a Loan Officer Regardless of what state a borrower resides in, or what kind of loan officer they go to, there are duties that loan officer performs. In general, the loan officer: • Looks out for the borrower’s best interest. • Interviews the borrower and takes a completed loan application, whether online, over the phone, or in person. • Educates borrowers regarding the mortgage loan process and available products, assists borrowers in deciding which program is best for them, and ensures borrowers have a clear understanding of what qualifying documentation is needed. • Gathers the appropriate documentation from the borrower and not through an intermediary (such as the property seller). • Maintains contact with the borrower throughout the approval process.

The Three Cs of Underwriting Underwriting a mortgage is a fairly standard process. When lenders are considering extending a loan, they must assess the three areas of underwriting: credit, capacity, and collateral — the three Cs.

Underwriting is a blended analysis of these three factors: • Credit – The likelihood that the borrower will repay the mortgage. • Capacity – The borrower’s ability to repay the mortgage. • Collateral – What the borrower has to offer if he can’t repay the mortgage.

If one of the three Cs is weak, a borrower is still likely to qualify for a mortgage, but the risk to the lender is greater, which means the interest rate on the loan, or the amount of required documentation may be higher. Lenders layer the risk so if the collateral risk is low, a lender might be willing to accept a higher capacity risk. If all three risks are low, the lender might lower the amount of documentation required. If all three Cs are weak (i.e., the risk to the lender is high), it may be difficult to obtain a mortgage.

Automated Underwriting Systems One of the major changes that has occurred in the mortgage lending industry during the past few years is the utilization of automated underwriting models to underwrite and approve mortgage applications.

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Today, automated underwriting systems (AUSs) enable lenders to obtain a risk classification without traditional manual calculations and subjective analysis. Automated underwriting shrinks the timeline of the mortgage approval process from weeks to minutes, saving borrowers time and money and eliminating much of the frustration and uncertainty involved in getting a mortgage. The objectivity of the system also assures consumers that their applications will be evaluated fairly.

The two largest mortgage investors — Fannie Mae and Freddie Mac — have each developed their own AUS for evaluating mortgage loans. Fannie Mae’s system is called Desktop Underwriter® and Freddie Mac’s is Loan Prospector®. These systems employ artificial intelligence with a predictive model that assigns a quantitative risk factor to individual mortgage applications. Many lenders will underwrite their files according to these secondary market investors’ guidelines to ensure eligibility of being purchased by Fannie Mae and Freddie Mac.

With these systems, the mortgage broker or mortgage lender enters the loan application data into the AUS. Based on the data entered, the system generates a Findings Report that indicates whether or not the loan application is approved, and if it is, sets forth the documentation required to verify the application data.

AUSs allow for multiple submissions so it is possible to adjust unknown variable data fields such as the purchase price, interest rate, or repayment schedule in order to gain an approval. However, it is not okay to manipulate non-variables such as income, assets, or occupancy for the sake of approval. The integrity of the data is only as good as the person submitting it.

It is possible that the final submission will look quite different from earlier submissions. However, some data should be relatively unchanged. For example, income does not typically increase dramatically over a 30- to 60-day period. Bank balances could change, but would require explanation. One thing that might change is the primary borrower; it may be decided that a relative is needed to co-sign for a borrower with poor credit.

Fraud Trends – Loan Officers • Fraud is more likely to be perpetrated by a third-party originator (TPO) than a retail loan officer. – A TPO may target lenders that have a reputation of lax controls, and send them all of their loans. – A TPO may accept completed loan packages from a property seller or other interested party. A TPO might have no contact with the borrower. – A TPO may accept a borrower’s qualifying documentation from someone other than the borrower. • There may be excessive AUS submissions for one loan.

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• There may be consistent excessive YSPs. • A TPO may originate numerous loans with similar patterns (for example, loans using the same appraiser, loan officer, or loan type). • The address listed on the loan application may be a post office box.

Fraud Trends – Mortgage Brokerage Firms The mortgage brokerage firm may: • Lack controls and procedures to prevent fraudulent originations. • Not perform background checks on loan officers or branch managers. • Not have adequate pre-funding quality control processes in place. • Not properly train, monitor, or supervise loan officers or branch operations. • Allow branch operations to operate autonomously.

Loan Processor Some loan officers gather all documentation directly from the borrower. Others turn this duty over to a loan processor. In smaller TPO branches, the loan officer may also be the processor, whereas in larger companies, the processor may be at a central location removed from the office of the loan officer. A loan processor often has access to and utilizes the AUS.

The loan processor carries a lot of responsibilities. The processor gathers and validates all of the information and verifies if it is complete and accurate. Verification requests may be sent to employers, mortgage holders, , and lending institutions to verify the borrower’s monthly income, employment history, and funds to close. The loan processor should verify that all the loan documents are provided by the borrower and are true and correct originals, and not fraudulent. Typical verifications sent out: • A verification of employment (VOE) goes to current and past employers to verify employment information. • A verification of deposit (VOD) goes to the borrower’s banks to verify the funds in the borrower’s accounts. • A verification of mortgage/verification of rent (VOM/VOR) goes to any current mortgage company or to verify current payments and the timeliness of those payments.

The loan processor typically orders the appraisal and places the order for the title commitment.

When all the information is collected the processor verifies that basic lender loan requirements have been met, and then the file is packaged in a manner that the lender specifies. The complete package, including the appraisal and the title commitment, is then sent to the underwriter. If a loan scored high

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enough in an AUS, there may be significantly fewer documentation requirements, making the process much quicker.

If the underwriting process (discussed later) determines that there are deficiencies in the documents provided by the processor, the underwriter will issue certain conditions, known as stipulations, or stips. The responsibility to satisfy these stips typically falls on the loan processor. These closing conditions can include items that perhaps need updating or more explanation.

Fraud Trends – Loan Processors The loan processor may: • Work exclusively for one or more loan officers and not on a rotating basis. • Clear conditions with fraudulent or forged documentation in order to get a loan approved and closed. • Hurry the loan’s turnaround. • Accept documentation from the property seller or another third-party instead of the borrower. • Manipulate the AUS. • Not even exist.

Appraiser An appraisal is usually obtained as part of the underwriting process. An appraisal is an opinion of the quality, value, or utility of a specific property.

An appraiser is retained by the loan officer or processor. Appraisers may be employed by financial institutions, government agencies, or real estate corporations or organizations. Many real estate appraisers are in business for themselves and work independently.

Appraisal management companies (AMCs) are becoming more popular with lenders. An AMC offers appraisal services to lenders by making use of professional appraisers acting as independent contractors; a fee-sharing arrangement compensates both the AMCs for their marketing efforts and the appraisers for their expertise. An AMC manages appraisal vendors and all of the ordering, tracking, and delivery tasks that need to be attended to in a real estate mortgage transaction.

There are four generally accepted classifications of appraisers: • Appraiser trainee: Someone who is qualified to appraise those properties overseen by, inspected by, and signed by a supervising certified appraiser.

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• Licensed residential real property appraiser: Someone who is qualified to appraise non-complex one- to four-unit residences having a transaction value less than $1,000,000 and complex one- to four- unit residences having a transaction value less than $250,000. • Certified residential real property appraiser: Someone who is qualified to appraise one- to four-unit residences without regard to value or complexity. To be a state-certified residential appraiser qualified to do appraisals for federally related transactions, a state must have requirements that meet or exceed a minimum standard. • Certified general real property appraiser: Someone who is qualified to appraise all types of real property. To be a state-certified general appraiser qualified to do appraisals for federally related transactions, a state must have requirements that meet or exceed a minimum standard.

The appraiser’s responsibility is to independently determine the value of the property. Because collateral is such a major component of a loan decision, an accurate value is critical to originating a quality loan.

Licensing Requirements To become a real property appraiser, a candidate will need to obtain education and experience, and pass a state-administered licensing or certification exam. The minimum number of education hours as set by the Appraisal Qualification Board (AQB), an independent board of the Appraisal Foundation, are as follows (many states require more):

Classification Hours Appraiser Trainee 75 Licensed Residential Appraiser 150 Certified Residential Appraiser 200 Certified General Appraiser 300

The AQB has set the following minimum criteria for experience:

Level Hours of Experience Required Appraiser Trainee Subject to direct supervision by a supervising appraiser who is certified in good standing Licensed Residential Appraiser 2,000 hours in no fewer than 12 months Certified Residential Appraiser 2,500 hours in no fewer than 24 months Certified General Appraiser 3,000 hours in no fewer than 30 months

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