March 2008

Mortgage Fraud: Builder Bailouts, Straw Borrowers & Other Schemes

The recent housing slump coupled with the subprime mortgage crisis has everyone talking about recession. As millions struggle to refinance their homes and avoid foreclosures, the ACFE Research Department provides this review of some mortgage fraud schemes that are not as well known, yet are becoming increasingly more common. The following are excerpted from our two-day course on Mortgage Fraud, written by Jenny Brawley, CFE. Jenny is a Mortgage Fraud Investigation Manager with Freddie Mac's Fraud Investigation Unit in McLean, Virginia.

Builder Bailout
A builder bailout is not new, it's just back. This scheme flourishes in a downturn economy, especially when the housing industry is overextended - as it is now. A builder bailout usually occurs when a builder has sold the majority of homes in a tract but has a few leftover. These lingering homes can be a financial setback and so the builder may need to "fire sale" them in order to payoff delinquent debts. To dispose of the remaining properties, the builder might utilize a variety of schemes including, the use of "hidden" seller financing, lavish incentives, and the use of inflated values.

These incentives usually involve a form of down payment assistance enabling a borrower to purchase a home without any equity contribution. Getting concessions from the seller is not new nor is it necessarily fraudulent. Ask this simple question to determine whether or not the transaction is illegal: are these concessions disclosed and approved by the lender?

Other concessions or incentives that might be offered to attract buyers include, managing the properties as income-generating investments, absorbing any negative cash flow for the first 12 to 36 months, guaranteeing mortgage payments for the first 12 to 36 months, and other "turnkey" services and guarantees, even though the properties may remain vacant. Builders may also agree to pay the buyer a substantial rebate, one that is not disclosed to the lender. For purchasing properties, a builder might promise that, in two years, the property will be sold and the profits split.

Builders will find marginal, legitimate buyers whose intent is to occupy the property and make the payments, or the builder may find straw borrowers who are often induced with "no risk" investment property ownership. Sometimes, the straw borrower is affiliated with the builder in some fashion. In another variation of this scheme, the builder fails to complete construction but obtains a straw borrower and an inflated appraisal to originate a loan.

A Scheme Involving a Legitimate Buyer

• The market value for a builder's new construction is $200,000.
• A borrower wants to buy the house but does not have the necessary down payment (10% or $20,000).
• The builder offers to sell the house for $220,000 and provide silent "seller financing."
  - A verbal or undisclosed agreement that the silent second will be "forgiven" after closing.
• Builder obtains an inflated appraisal for $220,000.
  - This inflation is typically below "fraud" thresholds and just enough to create equity for the borrower.
• Buyer is steered to a "participating" broker and title company.
• Buyer qualifies for a 90% LTV ($200,000) which actually represents the true purchase or sale price.
• Often, the buyer is qualified for the loan based on material misrepresentations.
• Buyer closes on a loan for $200,000.
• Seller gets his original asking price of $200,000 and "forgives" the seller financing.
• Lender now has a 100% LTV loan.
• If the property goes into default, the lender has no equity, especially if the market continues to decline.

A Scheme Involving Straw Borrowers

• Builder recruits a straw borrower to purchase the property for no money down and cash back at closing.
• Builder obtains an inflated appraisal that is used as a basis for the loan amount. This inflated loan amount will allow the builder to recoup his expenses, pay a fee to the straw, and keep the loan current for 2 - 4 years.
  - This might appear on the HUD-1 as a disproportionate commission to a real estate agent (30%) who, in turn, splits it with the builder.
• Borrower is steered to a participating broker and title company and is qualified based on material misrepresentations.
• Builder offers to manage the property for the borrower with promises of "4 years - no mortgage payments."
  - Cash back at closing.
  - No down payment.
  - Prepaid property hazard insurance and property taxes.
• Property may remain vacant and the neighborhood deteriorates.
• Loan remains current for a period of time but then goes into delinquency.

Foreclosure Rescue Scams
Unfortunately, as an increasing number of homeowners struggle with potential foreclosures, more will fall prey to foreclosure rescue scams. There are some legitimate foreclosure assistance programs in which the homeowner is offered short-term financing that pays off the delinquent debt. This allows homeowners to stay in their home as tenants until they can repair their credit and obtain long-term financing. However, some programs are not so well-intentioned.

Foreclosure rescue scams come in several variations:
"Phantom help" scam - the scammer promises to save the homeowner's credit or get them low monthly payments. Instead, the homeowner pays thousands of dollars in fees, and the scammer does nothing or files bankruptcy on behalf of the borrower to stay the foreclosure and then absconds with the fees.
"Bailout" or "Rescue" scam - one of the most troubling schemes is where the homeowner is tricked into conveying the deed to his house to the fraudster and ultimately loses it and the equity.

The "Bailout" scheme unfolds when a homeowner is solicited with an offer of private, non-qualifying, short-term financing that will pay off the delinquent debt and allow the homeowner to stay in their home while they repair their credit. As part of the agreement (usually verbal), the homeowner is convinced by the "investor" that as part of the short-term financing, the homeowner will need to convey title of the property to the "investor" as collateral. Once the fraudster obtains the title, he sells the property at fair market value, pays off the debt, and skims the equity that was owed to the homeowner.

• But where does the investor get the money to provide the short-term financing?
  • The rescuer relies on a lender's funds to accomplish this scam.
• The rescuer recruits other borrowers to purchase these properties once the rescuer has obtained title.
  • The borrower may be a legitimate person believing that he is buying investment properties, or the borrower could be a straw that is paid to purchase "turnkey" investment properties.
• The borrower is steered to a mortgage broker (or perhaps the rescuer himself is a mortgage broker) and qualifies for a mortgage to purchase the property at the fair market value (not the amount that is due on the outstanding loan).
  • Unbeknownst to him, the borrower is qualified for a loan based on misrepresentations.
  • Or a straw is compensated for their participation in the scheme.
• Collusion with a title company is paramount.
  • Homeowner is instructed by the rescuer to use a particular title company, or the rescuer convinces the homeowner to execute a power of attorney giving the rescuer authorization to close the transaction, or papers are closed at the homeowner's house in a "kitchen closing."
  • Either way, the homeowner is, in essence, deeding their property to the rescuer's borrower.
    - Generally, in these cases the homeowner does not understand what is being signed.
• The lender disburses funds for this transaction.
  - Proceeds pay off defaulted loan.
  - Equity goes to the rescuer.
• Loan to the straw goes into default.
  - Straw merely walks away from the transaction.
  - The legitimate new owner (borrower) discovers that the "tenant" can't keep up the rent payments and has depleted cash reserves to keep the loan current.
  - Title company fails to pay off the old debt and the original lender starts foreclosure procedures immediately.

Many states are aggressively passing legislation to protect homeowners in foreclosure from these scams.

Characteristics of a Foreclosure Rescue Scam

• Prey on the elderly or a long time resident with a large amount of equity.
• Borrower, which can be a straw or a legitimate individual, receives a "remodeling allowance" from a recruiter outside of closing.
• One-transaction that is closed at a "kitchen closing."
• Underwriter has noted on the closing instructions that a copy of the purchase contract must be provided at closing, so unbeknownst to him, the seller signs a purchase contract at closing or the seller's name is forged in order to meet that condition.
• Purchase contract in the originating loan file is a FSBO - no realtor.
• "Seller" on the transaction is delinquent or in foreclosure.
• HUD-1 indicates that most of the "seller's" equity outside of the mortgage payoff is going to a third-party and not to them.
• No value issues.
• Title company has knowledge of the true transaction.
• Title issues.

Short Sales
Short sales in which the lender agrees to accept a lesser amount than the balance on the loan are a viable option to avoid a foreclosure. However, short sales can provide fraudsters with access to cheap properties. Lenders are pressured to move REO and pre-REO properties, and may, at times, let them go for less than they are really worth. With the rise in foreclosures, the inventory for potential short sales will increase; so will the opportunities for scammers to obtain cheap property to use in the advancement of other schemes. The short sale scenario utilized by fraudsters allows them to obtain properties at low cost under false pretense and fraud, generally accomplished by acquiring an under-valued appraisal.

Most lenders will entertain the idea of a short sale because, for them, the foreclosure process is timely and expensive. Lenders would rather avoid the costs associated with a foreclosure; that way, the bank does not have to take the property in as a non-performing asset and try to sell it. The borrowers are receptive to a short sale because it keeps a foreclosure off their credit report.

How a Deceptive Short Sales Works

• A distressed owner facing foreclosure opts to sell property as an option to foreclosure (for example, the owner owes $75,000).
• The owner is approached by a schemer willing to buy the property for $50,000.
• Schemer influences the appraised value obtained by the bank.
• Lender agrees to the short sale of $50,000 and executes an assignable contract with the schemer.
• The schemer then lines up a straw, assigns the purchase contract to him based on an inflated appraisal of $200,000 that the schemer has now obtained, and sells the property.
• In order to assure an under-valued appraisal, the schemer helps the owner "stage" the property so that when the appraiser makes his inspection, he will be predisposed to assign a lower value.

Characteristics of Short Sale

• Fraud occurs well after the loan origination, in the lender's workout/servicing department.
• Property is facing foreclosure.
• House is "staged" to obtain an under-valued appraisal.
• Functional obsolescence is listed on the appraisal report to the workout department.

It is hard to say exactly how big the mortgage fraud problem is because the government only gets reports from federally regulated financial institutions, but there are thousands of mortgage broker firms that aren't required to file such reports. But a quick look at the record number of foreclosures is a good indication that mortgage fraud is a big problem that will have an effect on our economy for the next several years.