Standard & Poor’s Ratings Services is asking issuers of mortgage-backed securities how they detect and manage fraud at the origination stage.
While loose underwriting standards and declining home prices are reasons often cited for the recent dramatic rise in delinquencies and foreclosures, industry reports suggest fraud has also been a factor. An industry database maintained by the Mortgage Asset Research Institute (MARI) registered a 30 percent increase in reports of suspected mortgage fraud in 2006.
The database revealed that the most common types of fraud involved misrepresentations of borrower income and employment. So Standard & Poor’s says it’s asked the 25 largest issuers of mortgage-backed securities (MBS) to explain the procedures they use for verifying that information.
Standard & Poor’s also wants to know how MBS issuers are using automated tools that validate income, generate red flags about suspicious valuations, and detect flips, straw buyers and other schemes.
“Using these risk management tools during a pre-funding audit may help originators identify loans that may need additional focus and review before funding,” Standard & Poor’s said in an announcement Wednesday. The ratings agency said it has “been meeting with various risk management companies to better understand the available products and how originators use them.”
Standard & Poor’s said fraud mitigation and control is even more complicated when independent mortgage brokers are involved.
“The limited amount of oversight on brokers and the absence of regulation of their business may have led to increased incidents of fraud as both brokers and borrowers have incentives to close on the loan,” Standard & Poor’s analysts said. “These issues become more acute when coupled with excessive home-price valuations, or ‘inflated appraisals,’ in which appraisers face pressure to meet the value needed to ‘get the deal done.’ “
The three major rating agencies — Standard & Poor’s, Moody’s Investors Service and Fitch Ratings — have come under criticism as some of the mortgage-backed securities they rated during the housing boom performed poorly.
The agencies have downgraded their ratings on billions of MBS and, even as lenders have tightened underwriting standards, changed their methodology for evaluating such investments.
Critics say the rating agencies have an incentive to give securities favorable ratings, because they earn fees from the financial institutions and investment firms that issue them.
Under the Credit Rating Agency Reform Act of 2006, the Securities and Exchange Commission has the authority to police conflict-of-interest issues, but not to regulate the substance of the agencies’ ratings or their procedures or methodologies.
Testifying before the Senate Banking Committee on Sept. 26, SEC Chairman Christopher Cox said the commission is examining whether the ratings agencies “were unduly influenced by issuers and underwriters of MBS to diverge from their stated methodologies and procedures … to publish a higher rating.”
The SEC will attempt to determine whether the ratings agencies’ role in the process of bringing MBS to sale “impaired their ability to be impartial,” Cox said in his prepared remarks.
Vickie A. Tillman, head of Standard & Poor’s Ratings Services, told the committee that the ratings agency had “learned hard lessons from the recent difficulties in the subprime mortgage area.” But MBS ratings are intended to address only credit risk — the likelihood of default — and not market performance, she said.
“The current credit crunch is very real, but we certainly have not witnessed widespread defaults of mortgage-backed securities,” Tillman said in her prepared remarks to the committee.
The “issuer pays” model creates transparency in the market, Tillman said, as it allows Standard & Poor’s to make its ratings available to the public free of charge.
Citing a 2003 report by two Federal Reserve Board economists, Tillman said there is no evidence that rating agencies act in the interest of issuers due to a conflict of interest.