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DBRS: Fraud For Profit Creating Heavy Losses in the Past Two Years
By James Comtois
Losses related to mortgage fraud have amounted to $2 billion over the last two years, according to the latest U.S. Structured Finance Newsletter from credit analysis firm DBRS.
In the newsletter, DBRS points out that in the past two years, fraud for profit has accounted for 80% of fraud-related losses and is expected to capture the industry's interest as its role in the market turmoil becomes clearer.
Common techniques used to perpetuate fraud for profit (as opposed to fraud for housing) include inflating property values via appraiser collusion (appraisal fraud), inflating property values via repetitive sales (property churning) and falsification of documents (such as stolen identities, straw buyers, income misrepresentation and appraiser identity theft).
A fraud-for-profit scheme will often begin with a fraudulent appraisal. Within the past two years, investigators have attributed 25% of fraud-based foreclosures to significantly misstated property appraisals.
However, DBRS asserts that in reality, appraisal fraud may be more prevalent than this number suggests, since it can often be accompanied by other irregularities. For example, underlying appraisal fraud may not be reported as such if the initial fraud investigation uncovers a misrepresentation in the documentation that accompanies the loan application.
Since the loan-to-value ratio is a factor in the lender's loan decision, losses due to fraudulent appraisals will be magnified by the disparity between the loan amount and the true market value of the home.
Lenders manage property valuation risk with the expectation that there will be an "upward bias" in appraisal values, especially on cash-out refinance mortgages. In an effort to manage property overvaluation risk, lenders often rely on monitoring portfolio valuation against available repeat sales indices (for example, OFHEO and Case-Shiller indices).
On a more granular basis, at the loan level, lenders refine assessments by using neighborhood public record data sources. The salient factors for a more microscopic analysis include the property's value in relation to other sales in the immediate neighborhood, the proximity of the property to public services and the prevalence and distribution of foreclosures in the neighborhood.
In particular, DBRS points out that properties that are in located in areas where there is a high level of foreclosures will lack the benefit of comparable sales data as a reference point.
Consequently, unless a competent and diligent appraisal is undertaken, they can be subject to significant valuation inaccuracies.
Fraud continues to be an ongoing concern for the mortgage market. In the last two years, 41% of all fraud investigations were related to fraud for profit. On average, with the backdrop of a strong housing market, a foreclosed property will sell at 15% discount to the average for the surrounding market. In particular, the toll of appraisal fraud will become more transparent as slowing home price appreciation magnifies losses.
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