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Fraudulent flipping: State agency gets extended power to battle mortgage scams

The housing bubble in Arizona became a cash cow for the unscrupulous. Up until the bubble burst in late 2008, crooked investors and people involved in writing up loan documents bilked banks and homeowners out of millions.

Since then, the scams have slowed to a trickle. But much of that fraud is just now coming to light, says Tom Giallanza, assistant superintendent for the Arizona Department of Financial Institutions. The agency regulates mortgage brokers, state-chartered banks and credit unions.

“Our banks are coming to us and saying, ‘Look, we got hoodwinked on these loans,’” Giallanza says.

The banks made loans based on fraudulent documents filed by loan originators and mortgage brokers. The banks did not spot the trouble. Instead, they repackaged the loans and sold them to secondary mortgage backers, including Fannie Mae and Freddy Mac. But as the loans went bad, Fannie and Freddy — in essence — sent them back for a refund.

But catching up with the frontline swindlers now is tough going, Giallanza says.

“Many of them have gone out of business, and the parties have scattered to the four winds,” he says.

The bad loans were fueled by a convergence of factors. Sub-prime loans made it easy for people to qualify for mortgages they ultimately couldn’t afford. Rising home prices made every loan seem like a solid investment. Appraisers helped by overvaluing homes on the market. And scant scrutiny of loan originators made it easier to fudge — and outright lie — about a borrower’s ability to pay.

Stories surfaced about ice-cream vendors buying $300,000 houses. As for the scammers, the Department of Financial Institutions has authority to levy civil fines and suspend licenses. In addition to other financial sectors, the agency regulates mortgage brokers and bankers, as well as escrow agents. Department officials lack the authority to make arrests, but they can refer criminal fraud to county prosecutors or the Arizona attorney general, as well as federal law enforcement agencies.

The department works hand-in-hand with other agencies as part of a multi-agency Mortgage Fraud Task Force.

Beginning Sept. 30, the agency will have authority to license home-loan officers, also known as loan originators. By July 1, 2010, all mortgage loan officers must be licensed. The mortgage crisis arose, in part, because loan officers aided in securing loans that borrowers could not afford.

One reason for licensing loan officers was to strengthen accountability, says Jack Hudock, DFI spokesman and the agency’s rules attorney. Loan officers have access to a borrower’s private financial information. Some have used that information to steal a loan applicant’s ID — and money.

In the heyday of mortgage fraud, loan officers were often in on the scam. It was usually a team effort. The fraud could include any number of players involved in securing a mortgage — appraisers, real-estate agents, loan officers, mortgage brokers, escrow agents and investors, says Felecia Rotellini, superintendent of the Department of Financial Institutions.

“You’ve got to have more than just the buyer who’s in on the operation,” Rotellini says. If everybody was in the loop, there would be no honest players to alert regulators.

“It was very hard to detect mortgage fraud,” she adds.

Fraud usually surfaces at some point, but often it’s too late to catch the perpetrator. Bankers are learning that many loans went to straw buyers, fronts for real purchasers. Investors recruited straw buyers who falsely told lenders they were going to occupy the home they were buying, says Tanya Wheeless, president and CEO of the Arizona Bankers Association. The investors used straw buyers to get better mortgage rates until they could flip the property.

As the economy soured, however, investors were stuck with houses they couldn’t sell. They defaulted on the loans, Wheeless says. “All of a sudden, the bank will start working with who they thought was going to be the occupant and find out, well, there really was never any occupant. There was a straw buyer,” she says.

In many instances of mortgage fraud, the bank becomes the victim. Sometimes homeowners or buyers are victims. The Department of Financial Institutions investigated one case in which the straw buyer was a minor. It was an elaborate scheme in which a house was sold out from under the owner without her knowledge.

The scam involved an escrow agent who closed escrow on a fraudulent home sale and helped to secure a $112,000 loan. The straw buyer’s signature was forged, according to a complaint filed against Victoria Cervantes by the Department of Financial Institutions.

The straw buyer was Arthur Morales, Cervantes’ 11-year-old son. According to the 2006 complaint, Cervantes used her son’s Social Security number for the loan application, along with a phony employment history.

A deed “ultimately conveyed title of the property to Arthur Morales unbeknownst to Mary S. Salas (the seller),” according to the complaint. “Mary Salas never entered into a loan transaction, never contracted to sell her home, and did not know that her home was sold.”

As is often the case with mortgage fraud, Cervantes did not act alone. A real estate broker received nearly $32,000 from the phony sale at closing.

After the 11-year-old failed to make payments on the new loan, Salas was evicted. She later filed suit in Maricopa County Superior Court against Cervantes and others in on the scam. That was April 2005. In December of that year, Cervantes pleaded guilty to a class 4 felony for forgery. The Department of Financial Institutions took action to strip Cervantes of her license.

In another high-profile case, a mortgage broker preyed on elderly women by convincing them to refinance their homes and invest the take-out cash with his company. His real-estate investment firm turned out to be his own bank account. The case was detailed in a June 23, 2008, decision by an administrative law judge, upholding the Department of Financial Institutions’ claims against Rick McCullough.

An 87-year-old homeowner named Dorothy Resler was one of McCullough’s victims. In October 2005, McCullough drew up paperwork to secure a $45,000 home equity loan on her behalf. The lender was told the money would be used for home improvements. Instead, McCullough deposited it in a checking account he had just opened. Resler had agreed to the arrangement, believing the investment secured her a monthly return of $625 for six years.

McCullough stopped payment after six months. But within weeks of the deposit, he wrote a $42,860 check for jewelry, according to the judge’s decision. On top of that, McCullough talked Resler into a second refinance for more than $30,000. McCullough pulled a similar scam on a 79-year-old woman.

Administrative Law Judge Kay Abramsohn backed the agency’s decision to bar McCullough from working in any state-regulated financial services. McCullough also was indicted for fraud. He pled guilty and is serving a 3-1/2-year sentence in an Arizona prison.

McCullough was just one of many whose practices drew the scrutiny of the Department of Financial Institutions. In June 2008, 36 people were indicted on federal mortgage-fraud charges. According to a news release from the Mortgage Fraud Task Force, the defendants carted off some $100 million in fraudulent loans.

The investigation was dubbed Operation Cash Back, after a type of mortgage fraud. In simple terms, a scammer — through a straw buyer — offers considerably more for a home than the seller’s asking price.

It could be, for example, an offer of $400,000 for a home that’s been languishing on the market for $250,000. A loan is secured reflecting the straw buyer’s offer, well in excess of the original asking price and above what the home would fetch on the open market. Eager to get rid of the house, the seller agrees to give the scammers cash back from the inflated loan.

As the straw buyers are little more than fictions based on phony or stolen ID, the house, once sold, remains empty. The bank is stuck with a back loan and over-valued collateral.

“These loans are all first-payment defaults,” Hudock says. That’s tantamount to a kickback. And it’s cheating the bank. And, as straw buyers have no intention of living in the house or paying off the loan, the loan defaults and the house remains empty.

Of those who were indicted, some have pleaded guilty. Others still await trial.

The heady times of loan fraud have passed, in part because of new regulations. And the collapse of the housing market has deflated the incentive to cheat.

Referring to the cash-back schemes, Financial Institutions investigator Clyde Granderson says: “It’s almost impossible to do what they were doing. It’s probably the education and the home values. Granderson is one of two agency investigators. There used to be more, but budget cuts have reduced the number. In addition, the agency cut by half the number of examiners, the people who look at the books and documents to spot fraud. In all, 17 full-time agency positions were eliminated, Rotellini says.

As for investigators, it can be argued fewer are needed, as the scams have decreased — along with the number of licensed brokers, mortgage bankers and escrow agents who need to be scrutinized. The poor market has driven many out of business.

But the department is taking on more responsibility. In less than a year, it will have authority to regulate loan officers and mortgage-modification officers. The licensing standards were worked out with industry officials, Rotellini says. They wanted regulations to help keep the bad apples from harming the reputation of the rest.

The regulations also provide clearer guidelines for loan officers, Hudock says. “It’s why they paint lines on a baseball field, so you know where the boundaries are.”

Despite funding cuts, the bill (H2143) giving the agency power to license loan officers provided $550,000 to administer the program. The money would come from civil fines levied in fraud cases. But what the bill authorizes is not necessarily what the agency will receive.

Rotellini says the appropriation is tied up in the fiscal 2010 budget, which is mired in the Legislature.

“There is no money for loan-officer licensing,” she says. Rotellini says the agency will still license loan officers, though it could take some time. Applicants will have to undergo a background check and take a test.

“Under my watch, we will not be rubber-stamping these license applications,” Rotellini says.

Still the bad loans keep surfacing. And they have left their mark with empty, foreclosed homes dotting the landscape. “Cash-back schemes have taken over entire communities,” Rotellini says.

Even as the funding dries up, the department will continue to play a role with agencies at all levels to track down mortgage fraud — from the U.S. attorney and the FBI all the way down to city police departments.

Task force members still have their work cut out for them, as schemers find new ways to commit fraud.

One is the short-sale, in which a home is on the market for less than the amount owed on the mortgage. There are variations on the theme, but short-sales usually involve low-balling a mortgage company or a bank that holds the note on a distressed property.

An FBI Web site on mortgage fraud says a short-sale scammer will recruit a straw buyer to a secure a loan. The mortgage defaults. Here, the scammer steps in and offers to buy the home for less than it would have brought in a competitive foreclosure sale. The scammer then flips the home for a profit.

The Department of Financial Institutions has a number of short-sale schemes on its radar, but officials declined to discuss particulars.

Investigations are ongoing. They’ll probably know something’s fishy if they encounter an 11-year-old homebuyer.

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