Flipping, Flopping, Short Sales and More

With the demise of the infamous “liar loan” and no- or low-documentation mortgage programs, many industry professionals apparently believe that fraud has been eliminated.  While it is true that fully-documented programs and lenders' use of the 4506-T to verify borrower income directly with the Internal Revenue Service have greatly reduced the incidence of fraud in mortgage originations, it is a dangerous fallacy to believe that fraud has disappeared from the landscape altogether.

Instead, following patterns repeated over the past thirty years, mortgage fraud against lenders has simply shifted focus in order to take advantage of today's areas of maximum opportunity: loss mitigation, short sales and REO.

Fraud schemers are always looking for ways to take advantage of whatever opportunities are presented by the economy and lenders' operational processes. So it's not surprising that since lenders now require fully documented applications, there has been an increase in forged and fabricated documents ranging from deeds of conveyance and satisfaction to anything and everything relating to the borrower's income and assets.

Misstatements relating to intent to occupy are also on the rise as investors return to the market or try to obtain refinancing. However, lenders and servicers are feeling the most pain from schemes that involve underwater borrowers, distressed properties, short sale “flopping” and REO flipping. 

Short sale flopping involves withholding material information about the relationships between the parties, manipulating the property's exposure to the market in order to induce the note holder to accept a below-market price, submitting only low-ball offers or offers from related parties—all in an attempt to get the bank or servicer to let the property go for a below-market price so that it can be sold at market, with the difference between the prices becoming the perpetrator's profit. 

REO flipping is a throwback to 1996, when we were at the bottom of the last real estate boom and bust cycle. The classic hallmark of a flip is a purchase at REO followed by a sale to an end buyer on the same day or shortly afterwards at an artificially high price. In some cases, where a settlement agent is involved in the scheme, the sale to the end buyer may actually occur prior to the REO purchase transaction with the proceeds then being used to acquire the REO. 

REO flipping generally occurs for one of two reasons: to maximize the perpetrator's profit or to “rescue” a friend or family member by acquiring the property at fire sale prices and selling it back to the foreclosed borrower.

Some red flags to look for in REO flipping cases include a seller is not the owner of record, seller is an LLC, end buyer was previously in title, end buyer is a relative of previous owner, the transaction is non-arms length (the selling LLC is owned by the real estate agent or broker or another participant in the transaction and/or the end buyer is a friend or relative of the seller or the previous owner, etc.), and the same real estate and settlement agents are involved in the REO and end buyer transactions.

Additional signs of REO flipping may be that the purchase contract shows an excessive real estate commission or a commission that is based on an amount that is significantly less than the purchase price (may indicate that the real estate agent is uncomfortable with the inflated price to the end buyer and is attempting to avoid liability by taking a smaller fee), the REO is never exposed to the market, and the REO was listed but the listing history shows a token exposure to the market marked “pending,” “under contract” or “office exclusive.”

Two other red flags is that comparable sales show signs of flopping/flipping and/or involve the same parties as in the subject transaction and the sale to the end buyer occurs less than 90 days after the REO sale in which there is a large increase in price but no repairs, renovation or rehab to justify the price increase.

One of the questions I get asked a lot is why should we care about flipping? With all the pressure servicers and lenders are under to resolve defaults and move assets off their books, what does it matter what price the REO went for compared to what it was resold for later?  

There are several reasons we need to care. First, if material information is withheld in order to obtain consent for the REO sale, or a loan to the end buyer, it's fraud because the note holder didn't have all the information it needed to make a fully informed decision.  Second, one of the lessons we should take to heart from the mortgage meltdown is that when the industry tolerates fraud in any form, it encourages a lot of fraud down the road because it tells the perpetrators that the industry doesn't care and is willing to look the other way. 

Third, the chances are that if the end buyer gets a mortgage, Fannie Mae, Freddie Mac or the FHA will be involved in that mortgage. Since fraud increases the risk of default, the eventual loss will be borne by U.S. taxpayers. 

Fourth, if the REO is sold for an artificially low price, taxpayers will be on the hook for the excess loss. 

Finally, the failure to identify and prevent frauds and excess losses exposes servicers and lenders to False Claims Act suits—which permits treble damages—and the FDIC and other regulators are increasingly willing to use this tool to recoup taxpayer losses. There have also been indications that Federal authorities are more willing now than previously to name individual employees in such suits, as was the case in a recent suit where the FDIC named a lender's Chief Financial Officer and its lead underwriter as defendants along with the lender itself.

There are a variety of techniques by which to minimize the risk of getting burned in an REO flipping scheme. First, automated tools that provide an independent estimation of the collateral's value help counter potential manipulation. Tools that automatically check for property ownership and that look for connections between the parties and identify affiliated businesses help to reduce the possibility that there is collusion in the transaction. 

Post-closing reviews obviously won't stop a bad transaction, but careful analysis can identify bad actors—who should then be placed on watch or exclusionary lists as appropriate—as well as process failures that need to be corrected. Of course technology's usefulness is limited if lender and servicer staff don't know what to look for, so ongoing training on the various permutations of fraud schemes is also a must.

Finally, results from Quality Control and pre- and post-closing reviews need to be communicated appropriately so that procedures can be improved and the barbarians can be stopped at the gates. 

Ann Fulmer is the vice president of business relations at Interthinx.