The past 10 years have been among the best for real estate investment, causing many lenders to let their guard down in originating mortgage loans. Mortgage fraud is much more common than most lenders know, and most of it will not become evident until the next downturn in the real estate cycle a downturn that already has begun in many commercial real estate markets. This short primer offers advice to lenders and appraisers on how to spot and prevent a variety of common mortgage frauds.

It's only when the tide goes out that you learn, who's been swimming naked."

--Warren Buffett

Odd as it sounds, residential and commercial mortgage fraud can be obvious or hidden. Of the two, it's hidden fraud that is a ticking time bomb in today's mortgage loan portfolios, as defaults will not necessarily occur until interest rates rise or short-term loans mature. And, as we all know, interest rates are now on the rise.

Hidden fraud has become more prevalent with today's predominance of third-party loan originators (brokers and conduit lenders). These originators rarely operate with the internal control structures of regulated banks and thrift institutions and are more likely to fall prey to or commit fraud. Many mortgage brokers are independently employed and merely originate loans without worrying about the consequences of bad loans.

Even bank-based loan originators may bypass proper due diligence if they are paid wholly or in part by commissions based on loan volume. This should come as no surprise, but it's after a "boom" market that the biggest lending mistakes are made. Lending institutions have not necessarily lowered their standards in the current market, but the escalating variety of mortgage frauds compounds the problem.

Degrees of Fraudulent Intent

Obvious fraud: fraud for profit. Three men claiming to be doctors purchased a New York City walk-up apartment building on a residential street. They then applied at the nation's largest thrift institution for a much larger cash-out refinance loan, with the stated purpose of converting the groined floor into a magnetic resonance imaging (MRI) facility. NIRI space would command a much higher rent than was currently earned from the rent-controlled ground floor apartment tenants, and this was reflected in the appraisal done in-house. Once funded, the loan went into immediate default and the borrowers disappeared.