The extent of insurers' exposure to professional liabilityclaims from the subprime mortgage crisis remains uncertain–and onefactor that's fueled the collapse of that market is mortgage fraud,an expert has advised actuaries.

Ann Fulmer, vice president of Interthinx, an Agoura Hills,Calif.-based unit of the Jersey City, N.J. ISO, described themechanics of mortgage fraud during a meeting of the CasualtyActuaries of Greater New York last week, noting that problemsunderlying subprime loans and mortgage fraud tend to cluster.

She went on to describe schemes related to “stated-income” loanproducts that helped to push down the quality of mortgage loanunderwriting in recent years and helped to encourage borrowers tolie.

A “stated-income” product, she explained, is basically one wherethe lender doesn't verify the amount of income for a borrower.“We've seen cases where people literally made $6,000 per year andwere able to get $150,000 mortgages.”

Mortgage fraud “is the 'X-factor' in the subprime meltdown,” Ms.Fulmer said, explaining that “the scope of mortgage fraud isunknown and it is not quantifiable.”

She noted that published reports from the Federal Bureau ofInvestigation peg the direct dollar loss to lenders in 2006 arisingfrom mortgage fraud at $1-to-$4 billion, “which seems like a dropin the bucket in relation to $3 trillion in mortgageoriginations.”

Such figures are misleading, however, because they're based onsuspicious activity reports that only about one-third of thelending industry is required to file. They also don't include thecategory “fraud for housing,” which involves borrowers stretchingthe truth or lying about their ability to afford a house.

“Fraud for profit” is less prolific, but instances of “fraud forprofit” are more financially damaging and therefore these get theattention of law enforcement agencies, Ms. Fulmer reported.

From the lenders' perspective, she said that “fraud for housing”has been tolerated in recent years because loans tended to perform.When real estate values were rising, lenders were made whole evenif they had to foreclose on properties, she noted.

At one point, Ms. Fulmer revealed that not only has fraud beentolerated, but that 80 percent of mortgage fraud involves collusionby industry insiders–mortgage brokers, real estate agents, loanofficers, appraisers and settlement agents.

Interthinx, based on its real-time review of mortgage loanapplications, flags 25 percent for indicators of fraud, she said,going on to describe “liar loans” of many varieties, includingmisused “stated income” programs.

She said that “stated income” loan programs were originallydesigned for a niche market of high-net-worth borrowers who didn'twant to disclose all of their financial dealings. She said theseprograms were misused by brokers who used them to close loans forpeople who did not qualify at all and could not afford theloans.

Interthinx, she said, interviewed a Florida mortgage broker whosubmitted four applications for a single unqualified borrower,raising the stated income on each successive application, until allthe qualifying ratios for the loan worked out.

“It was 'stated income' program. I thought I was supposed to'state' whatever it took to get the loan closed,” the broker saidin an interview conducted by Interthinx when the loan fellapart.

Whether such brokers will be sued for professional negligence ormisconduct, and how much liability insurers could pay out, remainsunclear.

Robert P. Hartwig, president of the Insurance InformationInstitute, who spoke prior to Ms. Fulmer at the CAGNY meeting, toldthe actuaries that it's too early to ascertain the extent ofliability insurance risk related to errors and omissions coveragefor mortgage brokers and other real estate professionals anddirectors and officers liability claims against firms sufferingstock drops as a result of the mortgage crisis.

Responding to a question from one of the roughly 150 actuariesin attendance, Mr. Hartwig said, “We would expect that there wouldbe significant litigation, but…because the subprime issue has notrun its course, I don't think we can say at this point with anyconfidence, the extent [it] will cost.”

Ms. Fulmer also described situations where mortgage lenders makefaulty assessments of risk. For example, they may not review fraudpotential for borrowers that have high FICO (Fair Isaac & Co.)credit scores, she said, noting, however, that these scores can bemanipulated.