The terms the FBI uses to describe mortgage fraud schemes are: exotic, equity skimming, builder bailout, foreclosure rescue, property flipping and short sale. Given the evolving nature of such schemes, which result in estimated losses of up to $6 billion annually, the FBI must continually monitor criminals' efforts to exploit new loopholes.

The FBI monitors two primary categories within mortgage fraud — fraud for housing and fraud for profit. Fraud for housing is generally defined as fraudulent activity perpetrated by an individual to obtain personal housing. Given this limited scope, fraud for housing receives less of the FBI's scrutiny.

However, fraud for profit, also referred to as industry insider fraud, is the primary focus of the FBI's efforts to combat mortgage fraud, and the object of working groups within various government agencies, including the Internal Revenue Service and the Federal Deposit Insurance Corp. Unfortunately, the FBI's criminal investigations in this area are predominantly concerned with the prosecution and cleanup of transactions months and years after the fraud occurred.

Financial institutions must therefore take preventative measures to protect themselves from this evolving threat. Two key areas where lending institutions can focus to help reduce mortgage fraud include general internal controls and loan covenants.

Auditors and CPAs assess a lender's control environment, including the tone at the top, with respect to loss prevention and a good underwriting atmosphere. The tone at the top is a critical aspect of the control environment, and the workplace should allow underwriters and senior credit officers the freedom and latitude to speak up and question files, even at the expense of production goals.

Although the failures of internal control systems that reflect compliance with company policies may look good on the surface, an experienced auditor with the time, authority and objectivity to critically examine vital facts in the file would quickly reject them.

Credit facilities with commercial real estate borrowers frequently contain affirmative and negative covenants involving financial ratios or other requirements calculated based upon the borrower's financial statements. Borrowers are often required to maintain specified levels of debt-to-equity, debt-service coverage and liquidity.

These levels of financial resources for the borrower are expressed in well-known financial ratios. The credit agreement is drafted and executed to reflect that the borrower agrees to maintain its company financial statements at or above these ratios.

When covenants are present, CPAs will almost certainly test and recalculate the borrower's compliance with financial ratio covenants in connection with an audit or review of the financial statements. The financial statements will disclose the existence of such covenants, and note whether or not they were breached and if any breaches were waived by the lender.

Should the auditor identify a broken covenant, they will generally require that the borrower disclose the covenant violation to the lending institution. In response to such a disclosure, the borrower will generally request that the lender waive the violation. CPAs will often require that the lender document this waiver in writing.

Loans to businesses and commercial borrowers should have these covenant mechanisms.They provide early warning of adverse changes in the borrower financial performance as well as the means to authenticate the borrower data used to calculate these ratios.

CPAs see internal controls not only as a detailed necessity, but as evidence of an organization's culture. Thorough controls will winnow out the obvious files for rejection. Furthermore, an environment that reflects management and leadership's commitment to loss prevention is critical. Such leadership allows busy managers the time to spend with the files they need to see.

A lender's best response is loss prevention at the beginning of the lending process, with robust and meaningful controls. Financial covenants provide metrics and benchmarks on borrowers that can be obtained and assessed in the application file, in ongoing monitoring and for early identification of future financial problems.

Alan M. Robinson is an audit partner with Cherry, Bekaert & Holland.

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