The dire consequences of the economic crisis and recession are well known. While William Shakespeare once suggested killing all the lawyers, today, many people would put bankers on the economic hit list.

Imagine this factual scenario taking place a few years ago. A bank customer (Betty Borrower) wants to obtain a mortgage to purchase a dream home. Betty meets with a loan officer (Billy Banker) and provides her paystubs and bank statements. Betty does not have the financial resources to qualify for the loan. Billy says “no problem” and tells Betty to fudge the numbers and put down two times her salary on the application. “It's no big deal.” Betty doesn't read the fine print and signs off on the paperwork. Billy submits the loan application by emailing a copy to Oscar the underwriter. Oscar doesn't question the lack of documents to verify the financial resources of the borrower. Oscar approves the loan and mails the originals to Tina at the title company. Tina does the closing and Betty gets her big mortgage and buys her dream home. Several months later, Betty falls behind on mortgage payments she could never afford to make. The loan goes into default. After months of nonpayment, foreclosure occurs. Betty loses her home.

Can you see any problems? This simple version of what is called a “liar's loan” involves violation of a half dozen federal criminal offenses. Betty is in trouble. Billy is in trouble. Oscar may be in trouble. And the bank may also be in trouble too. The borrower no longer has her home and her credit is shot. The bank has a defaulted loan on its books, housing prices have dropped, and the bank is forced to sell the home at a loss. A few years later, a pleasant man and woman show up at the bank. They have a grand jury subpoena and ask questions of everyone involved. These persons are not auditors. They are FBI agents. The Feds are investigating mortgage fraud.

How could the bank have detected this mortgage fraud scheme early on and prevented it? Now that it has occurred, how should the bank respond to the grand jury subpoena and investigation?

According to the FBI, suspicious activity reports from banks increased by more than a third from 2007 to 2008, and the number of suspicious activity reports continues to rise. Suspicious activity report losses reported in the first six months of 2009 exceed the same period in 2008 by $208 million. Of the top 10 FBI field offices in cities impacted by mortgage fraud, California is home to three: Los Angeles, San Francisco, and Sacramento.

The FBI established the National Mortgage Fraud Team in December 2008, and it now has at least 18 mortgage fraud task forces and 53 working groups devoted to mortgage fraud. The investigators are from numerous federal agencies including U.S. Dept. of Housing and Urban Development's Office of Inspector General, the Securities Exchange Commission, the Internal Revenue Service, the Treasury Department, the Federal Dept. Insurance Corp. the Federal Trade Commission, and other federal, state, and local law agencies across the nation.

Although there is no specific statute that defines mortgage fraud, mortgage fraud schemes have certain characteristics in common. There is a material misstatement, misrepresentation, or omission relied upon by an underwriter or a lender to fund, purchase, or insure a loan. It is illegal for a person to make any false statement regarding income, assets, debt, or matters of identification. It is also illegal to willfully overvalue any land or property, in a loan and credit application for the purpose of influencing in any way the action of a financial institution.

The primary crimes violated by mortgage fraud schemes, and those with the heaviest penalties, include false entries to federally insured institutions, false statements on a loan or credit application, mail fraud, wire fraud, and bank fraud. All of these crimes are violations of Title 18 of the U.S. Code. Each offense carries a maximum sentence of 30 years in federal prison and $1,000,000 fine.

The FBI's efforts are focused primarily on fraud for profit schemes, which often involve multiple loans and elaborate schemes by banking industry insiders seeking to make money unlawfully. Approximately 80 percent of all reported mortgage fraud losses involve collaboration or collusion by industry insiders, including loan officers, brokers/lenders, appraisers, real estate agents, builders/developers, settlement agents, title companies, management companies, and recruiters.

These industry insiders have employed various mortgage fraud schemes over the years, and with the recent economic stimulus legislation and the expansion of Federal Housing Administration-insured mortgages, the perpetrators of mortgage fraud are creatively finding new ways to further exploit the mortgage industry. New and modified schemes include reverse mortgage fraud, credit enhancements, and loan modifications.

Senior citizens are common victims of the mortgage fraud scheme involving the Home Equity Conversion Mortgage, or reverse mortgage. Home Equity Conversion Mortgage is a federal program through the HUD, which enables eligible homeowners aged 62 or older to access the equity in their homes by providing funds (in many instances in a lump sum payment) without incurring a monthly payment burden during their lifetime in the home.

Industry insiders recruit seniors and implement a scheme to withdraw false equity from properties. The fraudsters use straw buyers to claim that they will be using foreclosed, distressed, or abandoned properties as a primary residence. The perpetrator then transfers the property to the senior with no exchange of money. After the senior lives there for 60 days, the perpetrator arranges for the senior to obtain a home equity conversion mortgage, with the aid of a fraudulently inflated appraisal, and encourages the senior to request a lump sum disbursement of the equity. The perpetrator then takes the equity at closing.

Credit enhancements involve industry insiders, such as loan officers or home builders, encouraging borrowers to have their names added to the bank accounts of friends or family members in order to circumvent the underwriting process. Another tactic is for the insider to deposit money into the borrower's account so that the balance is inflated during the loan application process. After the borrower qualifies for the loan, the insider withdraws the money. Some perpetrators create fraudulent retailer financial relationships by purchasing credit privacy numbers and seasoned trade-line accounts.

Loan modification schemes, or advance-fee/foreclosure rescue schemes, are emerging especially in light of recent legislation requiring lenders to work with homeowners to assist them in avoiding foreclosure. Perpetrators offer to renegotiate mortgages, reduce monthly payments, and renegotiate delinquent loan amounts to principal. They typically require an up-front fee, then request the homeowner stop paying the lender and pay a third party instead. They may even convince the victims to quit claim (any portion of) title to a third party.

Most fraud for profit schemes have common characteristics so banks and bank employees should be on the lookout. Some of the red flags identified by Fannie May as possible indicators of a potential mortgage fraud scheme are: an entity other than the buyer makes the payments; the buyer does not intend to occupy the property, as evidenced by the property's unrealistic size, condition, or commute; there is a boilerplate contract that does not reflect true negotiation; documents contain inconsistent signatures; no real estate agent is employed, supporting an inference that it is not an arms-length transaction; there is a common payer and mailing address among loans in the scheme; it is impossible to independently validate the chain of title; multiple mortgages are recorded on the same property; the appraised value is fraudulently inflated; the property was recently in foreclosure, or acquired at a sale at a much lower sales price than the current sales price; the borrower states that he is sending the mortgage payments to a third party; the borrower states that he will be renting back from the new owner; and/or the borrower quit claimed title to a third party at the advice of a so-called foreclosure specialist.

The relevant mortgage fraud documents which investigators are likely to subpoena include the loan application, the HUD-1 form, supporting documentation, appraisals, title paperwork, and closing documents. In response to a subpoena, the bank should consider who prepared and verified these documents, how the information was verified, and whether any of the documents appear to be fraudulent or forged.

Banks and their employees who receive grand jury subpoenas or visits from FBI agents would be wise to consult with legal counsel who is familiar with federal criminal investigations and procedures, conduct an audit or internal investigation, and be cooperative with the investigators without incriminating themselves.

Craig Denney and Carrie Parker both handle white collar criminal defense and litigation matters for clients in California and Nevada.

Reprinted and/or posted with the permission of Daily Journal Corp. (2009).