Fitch: Operational Enhancements Reducing Fraud Risk in U.S. Mortgages

Fitch Ratings, New York, said widespread changes to U.S. residential mortgage origination practices since the financial crisis have reduced the risk of fraud and misrepresentation.  

Fitch noted a key driver behind poor performance of the peak vintage collateral was weak operational controls for the information used in the loan decision process. “The industry as a whole, through its own initiatives, investor demands and regulatory mandates, has created a new lending paradigm that has improved the quality of the information and should result in lower credit risk,” the agency said.  

Fitch said lenders implemented a number of additional changes to reduce operational and misrepresentation risk since 2008. It noted loan officer compensation now typically includes consideration of quality control results and often includes claw-back provisions for poor performing loans. Similarly, underwriter compensation also typically includes quality control results in addition to volume measures.  

“Quality control reviews pre- and post-closing are now more frequent and comprehensive than prior to 2008,” said Fitch Managing Director Grant Bailey.  

The report noted several improvements have been driven by legislative changes. In 2008, national standards for non-depository loan officer licenses were introduced for the first time, requiring a written test, completion of education courses and a criminal background check. In 2014, the Ability to Repay rule was implemented, prohibiting “stated income”-a common place for misrepresentation.    

“Nowadays, lenders typically do not rely solely on the income documentation provided by borrowers,” Bailey said. “Most lenders require borrowers to sign Form 4506 T, enabling the lender to verify the income documentation provided by the borrower directly with the IRS.”  

The report also noted components of the loan production process have been separated to prevent “inappropriate” influence. “Underwriting departments and loan origination departments are now typically separated to allow for greater underwriting independence,” Fitch said. “Direct communication between loan officers and appraisers is typically constrained, and appraisers are now typically selected by an independent Appraisal Management Company or by a lender group outside of production. Many lenders have added specialized internal appraisal underwriting units to either independently review the appraisals or provide a resource for credit underwriters to maintain appraisal quality.”  

Bailey added that technology advancements have also played a key role in reducing risk. “Fraud risk tools, which were uncommon prior to the financial crisis, are now widely available and heavily used to assess misrepresentation of identity, occupancy, employment/income and a number of other types of fraud, such as non-arms-length transactions, straw-buyers and concurrent closing schemes,” he said. “Publicly available information on the internet, such as Google Maps and Zillow, are also commonly relied on to review appraisals in ways that were not possible prior to the financial crisis.”