As mortgage market cools, fraud risk heats up

With rising interest rates cooling down the mortgage market, researchers warn the risk of mortgage fraud may be heating up.

Risky loan applications have been trending up for the past year, rising 75% during 2021, according to the real estate analytics group CoreLogic, which compiles a quarterly index of fraud risk. 

As mortgage transactions fall and the balance of applications shifts from refinancing loans more toward purchases, that threat level is likely to jump in the months ahead, said Bridget Berg, the firm’s head of fraud solutions.

As the housing market begins to cool with rising interest rates, analysts say instances of mortgage fraud have been increasing, particulrly in ways that limit housing inventory.

Bloomberg News

“We can see an inverse relationship with the lending activity and the riskiness of the average loan application,” Berg said. “As overall loan application volumes go down, the randomly chosen loan application is going to be at a higher risk, there’s going to be a higher concentration of higher risk loans.”

This dynamic is often seen when markets slow down and financing costs rise, Berg said. It is driven in part by desperate buyers as well as loan officers who, with fewer legitimate prospects, are more willing to turn a blind eye to fraudulent behavior or even participate in it to get deals done.

In many instances, she added, banks and other lending institutions are less equipped to catch riskier loans during down cycles because dwindling profits force them to cut back on detection. 

“The biggest concern is that they will cut back some of their fraud controls at the time that they need them the most,” Berg said. “So, like outsourcing things, not having the highest-qualified staff looking at them or just trying to cut corners.”

CoreLogic’s index, which compares current loan applications to historical loans that were proven to be fraudulent, gave the overall risk level during the first quarter of 2022 a score of 137, a 15% increase from one year earlier. In early 2020, the index fell below 100 and has risen steadily faster since then. 

The highest-risk metropolitan areas in the report — New York’s Hudson Valley, Greater Miami and California’s Silicon Valley — saw their respective threat risk scores jump to more than 230 during the quarter.

The mortgage market, which had been on a tear since mid-2020, began losing steam last quarter in the face of rising inflation and the Federal Reserve’s interest rate hike in mid-March, its first since 2018. That downturn has accelerated this quarter, with the Fed raising its benchmark rate by an additional half of a percentage point last month and promising more of the same until prices stabilize. Subsequently, the average 30-year fixed-rate mortgage breached 5% for the first time in more than a decade. 

These less-attractive rates have led to a steep decline in interest from prospective buyers. Mortgage applications have fallen week over week for four of the past five weeks, according to the Mortgage Bankers Association. At May 27 refinancing activity was down 75% from last year. 

Coming into this period of reduced activity, Berg said, fraudsters were showing signs of sophistication. One of the most common types of fraudulent behavior is income misrepresentation. It is not uncommon for applicants to create fake employers and pay stubs to make it appear that they are generating enough income to afford pricier homes, she said, with some going so far as to file false income tax reports with the Internal Revenue Service.

Recent changes to underwriting standards have made it easier for borrowers to dupe loan officers, Berg said. She pointed to the asset-only verification method, which looks solely at an applicant’s bank statement. Such products have been adopted by institutions looking to service gig workers who do not have regular paychecks, but Berg said it is easy for applicants to manipulate this process by simply transferring money between accounts.

“When you go to a process that requires fewer documents, it makes it easier for people to figure out how to circumvent things,” she said.

Income misrepresentation tends to be a more common infraction in areas with a higher cost of living, Berg noted. Elsewhere, particularly in areas that tend to have a higher share of out-of-state buyers, occupancy fraud — a borrower saying they are buying a home for their own use when in fact they are purchasing it purely as an investment — is more common. 

By claiming they are buying a home for their own use, fraudsters can secure mortgages with smaller down payments and often qualify for better interest rates than their credit scores would otherwise allow, said Ronel Elul, an economist with the Federal Reserve Bank of Philadelphia who studies occupancy fraud. Unlike other types of frauds it is nearly impossible to prevent.

“You can really only identify it ex post, when someone doesn’t move into the house,” he said. “They say they’re going to be an owner-occupant, they say they’re going to move into it, but then they don’t move into it. I think that it’s harder for people who are trying to catch it.”

Elul, who co-wrote a report on occupancy fraud during the housing bubble of the mid-aughts, said the practice has often been overlooked as a contributing factor to the 2008 crisis. When factoring in occupancy fraud, the number of investors from the era increases by 50%, according to the report. Those borrowers were also 40% more likely to default than owner-occupants. 

While he and his fellow researchers have only examined data through 2018, Elul said the occupancy fraud appears to have been on the rise again since 2012. He estimates such activity equates to between 35% and 40% of the investment annually. 

Jason Richardson, the senior director of research for the National Community Reinvestment Coalition, said it is difficult to quantify the distortionary effects of mortgage fraud on the overall housing market given the myriad issues limiting affordability and attainability. 

Still, Richardson said, some of the markets that have seen the sharpest increases in prices have been those favored by investors over owner-occupants. He pointed to Tampa, Florida, which he said has seen a greater level of investment activity than it did at the height of the 2000s housing bubble.

“They’re all going to be Airbnbs,” he said. “The prices don’t make sense for anything else. You look at the median income of Florida and then you look at what the houses are going for, those aren’t Floridians that are buying them. Those are investors.”

When it comes to curbing mortgage fraud, some market observers question whether it is prudent to focus the gaze of law enforcement on individual borrowers or the institutions that lend to them. Among them is Matthew Edwards, an associate professor at Baruch College’s Zicklin School of Business who published a paper on the misconceptions of mortgage fraud in 2020.

Edwards argues the legal statutes for criminal mortgage fraud are unclear and enforced inconsistently. As a result, much of the onus is put on individual homeowners, many of whom are providing false statements on their application at the urging of their loan officers.

“I am not excusing borrower malfeasance, but the promise and dream of homeownership is a huge part of the nation’s ethos,” Edwards said. “People want a piece of the American Dream. It is easy to see how an unsophisticated, eager borrower might be convinced by unscrupulous mortgage brokers or loan officers that minor misrepresentations don’t really harm anyone.”

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