The introduction of the Home Valuation Code of Conduct (HVCC) by Fannie Mae and Freddie Mac in May pushed the topic of home valuations and appraisal fraud into the spotlight in the U.S. The code's aim - to "enhance the independence and accuracy of the appraisal process" by restricting the mortgage originator from ordering appraisals or having any communication with appraisers - has received plenty of backlash from the American mortgage industry and an 18-month moratorium is being called for to review the set of rules.
While there is no such appraisal regulation in Canada, there has been a noticeable shift in recent years that has, like in the U.S., moved the responsibility of ordering an appraisal from the mortgage broker to the lender and increased lenders' dependence on appraisal management companies (AMCs). These companies aim to remove influence from the appraisal process with a random selection type of model and, consequently, reduce appraisal fraud.
Although brokers may play a smaller role in the appraisal process these days, they can still be a key part of preventing any type of mortgage fraud, including appraisal fraud, says George Maurice, past president of the Appraisal Institute of Canada and a senior appraiser at Scotiabank. This is in part because the attitude of knowing your client is a key factor in preventing all types of mortgage fraud.
"Brokers are the first line of defence against the fraudsters - they're the ones that meet the individual, they're the ones that do that background check and can raise any red flags immediately," says Maurice, adding appraisers also play a valuable role in fraud prevention. "In the end, everyone wins by being more careful."
It is also important for brokers to understand what lenders are doing to prevent appraisal fraud so the two sides can work together to spot inconsistencies.
How appraisal fraud happens
Appraisal fraud - or valuation fraud involving real estate transactions - is the result of a misinterpretation of a property's value, which in turn causes a lender to loan money on the basis of the fraudulent appraisal. For example, if a home's value is inflated, the lender could lend more on the basis of the report.
Appraisal fraud schemes can involve either a fraudster who gets hold of the report and tampers with it to change the appraised value, or an appraiser or third party (often working in collusion with others) who purposefully misstates the value of the property.
"I've seen documents changed by the mortgage originator to make a deal work, I've seen the description of the property contained in the report not match with the photos taken and, in one very rare instance, I saw a file changed by an underwriter who was working in collusion with the broker," says Sharon Castelino, executive vice-president of lending solutions at Solidifi and former vice-president of Home Loans Canada.
"Thankfully, these types of situations are the exception overall in the Canadian mortgage industry, but when they do occur, it usually takes multiple parties to make the fraud work."
Another way fraudsters can artificially inflate property value is to flip a property several times - sometimes between others involved in the fraud - over a short period of time to drive up the value of the home. This can be especially prominent when the housing market is active and prices are already going up.
"If the sales history of the subject property reveals that the house has been sold multiple times in a short period of time before the appraisal is done, a lender should look at who has been buying it, who has been selling it, and why it's been selling so many times," says Steven Coull, executive director of the Canadian National Association of Real Estate Appraisers (CNAREA). "It could be innocent, but it would be a definite red flag area to look into because it could be a fraudulent flip."
While there have been high-profile cases of collusion between an appraiser and someone else in the home-buying chain, such as a banker or lawyer, Coull says he doesn't see home valuation fraud instigated by the appraiser very often. But, he adds, when the appraisal report has been tampered with, it can be hard to catch due to the nature of the reports.
"The problem is that there's not a lot in an appraisal report that would alert you to fraud," says Coull, who also stresses the importance of lenders having a diligent in-house review program. "You can make an appraisal report look awfully good, so even if there's fraudulent information on it, it would be hard to spot."
In a recent case the Bank of Montreal sued mortgage specialist Josephine Tortora, claiming that she facilitated mortgages based on over-inflated appraisals. Tortora has gone on record denying all allegations that she was involved in the manipulation of the appraisals and has sued the Bank of Montreal for wrongful dismissal and negligence. It's worth noting that the Bank and its group of underwriters were unable to determine that the appraisals had been altered, and that none of the claims have been proven. A court hearing is set for October, 2010.
AMC popularity
The increasing pressure for free-of-influence appraisals has caused many lenders, particularly larger institutions, to turn to appraisal management companies like NAS, Centract and Solidifi. This has meant a change for brokers who could previously order their own appraisals for a client.
"Financial institutions want to ensure there is no influence on the appraiser, real or imagined - they want the appraisers to be totally neutral," says Maurice, adding he has seen some resistance of increased AMC usage.
"Some brokers and appraisers feel that some of the personal relationships have gone."
The resistance to a stricter appraisal process, though less extreme than the U.S., shows the Canadian mortgage industry is also going through a period of adjustment in this area. For example, an Ontario broker who spoke to CMP about appraisals called the selection process used by AMCs "bureaucratic and disrespectful" to established appraisers. He said he would rather lenders have an approved list of appraisers for each geographic area (citing Home Trust's process) than have to go through an AMC.
From the lenders' point of view, however, AMCs provide a sound alternative to choosing appraisers or giving brokers free reign to choose, especially because lenders are the ones that stand to lose most from a fraudulent transaction.
"When brokers have relationships with the appraisers, we prefer to stay away from those types of scenarios," says Joe DiGiambattista, senior vice-president of Abode Mortgage Corporation in B.C., which relies on the CMHC for the majority of its appraisal work and uses NAS for properties that need more in-depth appraisals. "One out of 10 deals we have to do our own appraisals and the combination of being CMHC-approved and having random selection through NAS reduces risk."
Following the growth of AMC reliance in Canada, these companies are adding more tools for lenders, such as automated review programs designed to cut down appraisal review time from the lenders' end, and rank appraiser's work (this is also a popular feature of AMCs in the U.S.). Castelino cites Solidifi's IQ program, which measures the completeness of each report and its compliance with a lender's policies.
The program also lets lenders reward appraisers or remove them for future use based on the qualities of their appraisal reports.
Lender onus
As the controversy surrounding the HVCC continues in the U.S., brokers in Canada are also adjusting to different lender practices surrounding appraisals and the AIC and CNAREA are working to keep members informed, as well as setting high standards for the industry. AMCs, as seen above, are also innovating.
But Coull says it's the lenders who have to work the hardest to implement fraud prevention strategies, the key being having in-depth, in-house appraisal review processes, even when the AMCs provide another layer of scrutiny by submitting additional reviews.
"A lot of problems in mortgages arise because of poor appraisal work and because an appraisal was not reviewed when it was received and before a loan was granted," he says.
The Criminal Intelligence Service Canada also stressed the importance of not relying solely on technology for fraud prevention in a report it released about mortgage fraud.
"Financial institutions' heavy reliance on computer-automated underwriting and property valuation systems to conduct mortgage transactions, coupled with the difficulty of verifying the borrower's income or identity, will continue to be a major vulnerability contributing to mortgage fraud," the report read.
To combat all types of mortgage fraud, including valuation fraud, Maurice says several lenders have also implemented "know your customer" type programs which basically stress the need to double-check a borrower's ID and income, among other things. He adds lenders' use of automatic valuation systems (or AVMs) is being reduced in favour of appraisals.
"With the changes in the market and the fraud situation, everybody is being more cautious," he says. "They want to have somebody actually walk up and knock on the door to do the appraisal."
Editor’s note: This article has been amended to reflect the case concerning the Bank of Montreal and mortgage specialist Josephine Tortora. Mortgagebrokernews.ca does not wish to suggest that Mrs. Tortora was involved with mortgage fraud in any way and stresses that the case is ongoing.