As fears of recession rise, one of the inevitable repercussions of a previously buoyant UK housing market bottoming out is allegations of mortgage fraud - a particular concern for professional indemnity insurers. And despite talk of multi-million pound losses, the full scale of the problem is yet to be uncovered. Marcus Alcock reports
If there is one golden rule of capitalism, it is that no boom lasts forever. There may be extended periods of economic growth, rises in equity markets, or burgeoning commodity prices, but all good things must come to an end. And the housing market is no different.
After an extended period of fantastic growth in the UK, which saw a near exponential rise in property prices throughout the country, the market has finally cooled off, with one in five mortgage holders worried about meeting their repayments in the next 12 months, according to the Financial Services Authority.
The situation might not be as severe as it is in the US, where the housing market crash has played a major part in creating the current credit crunch, but there is no doubt the buoyant UK market is bottoming out.
Another rule of capitalism relates to any such slowdown. According to insurance guru Warren Buffett - who last week knocked Bill Gates off the top spot in Forbes' annual ranking of billionaires: "It's only when the tide goes out that you learn who's been swimming naked". And it would appear that, as far as the housing market is concerned, there have been some very peculiar practices indeed; mortgage fraud is now a major concern for many professional indemnity insurers. Such is the potential scale of the problem that multi-million pound losses are now being frequently discussed.
Nature of the beast
Roger Flaxman, managing director of insurance consultancy Flaxman Partners, spells out the nature of the frauds being investigated: "There have been groups of people in syndicates who have persuaded others to falsify valuations in order to obtain loans for properties at an inflated value," he says. "They effectively get the property but the money from the loan doesn't really go into the property at all - it goes to them. So they pay the first two or three instalments and then disappear. In order to do this you need solicitors, valuers and accountants - put them together and that's a nice team."
He explains that if the lender then finds their security is gone and they are not getting paid, they will try and recover money from the people who gave the advice. "What we're talking about is one person in a firm who may have been doing this for years without the rest of the firm knowing," he continues. "And everything to do with fraud is very difficult to defend. A managing partner of a firm came to me the other day and said this terrified him because it could have been going on under his nose."
As Mr Flaxman explains, the problem for the insurance industry is that, although investigations are currently being carried out, no-one yet knows the scale of eventual losses. Nevertheless, he agrees they could well be "multi-million". "The real concern is that what we're seeing at the moment is only the tip of the iceberg. It first came to light before the credit crunch but the continuing crisis has now put more pressure on disclosure. At the moment it looks pretty serious and could be one of the things that drives the (PI) market up."
Same old problem
According to Mike Willis, partner at law firm Beachcroft, these concerns about mortgage fraud are not new. "Linked to a cooling in the property market, lenders must be expecting to incur losses or an upturn in the number of repossessions," he comments. "If what happens this time round reflects what happened last time, then lenders will seek to share responsibility with professional advisers, so it will be the same targets as before."
He says there are already claims being brought against professional advisers by lending institutions, with valuers and solicitors primarily in the frame. Based on evidence from the previous experience in the 1990s, he says the situation could be very serious indeed: "The Solicitors' Indemnity Fund attracted widespread criticism that it might be under-reserved and so had to top up its reserves, which led to a collapse of confidence in the scheme and the introduction of the qualifying insurance scheme. If there is a new wave of claims against institutions, then it could be a very interesting period - my firm is not the only one expecting an upturn in instructions."
But is there really a host of criminally minded people sitting pretty among the ranks of professional advisers? "I'm fairly confident that dishonesty will be established against more than one professional with regard to mortgage fraud in the next few years," states Mr Willis. And he doesn't believe advisers will necessarily find themselves alone in the firing line: "I am reasonably confident that there will be a lot of points against lenders, such as risky lending policies, risky lending decisions and debatable lending criteria. So if a professional adviser gets sued by a lender, then they could argue there is a contributory fault by that lender - or else argue that the lender's loss accrues because of their policies."
Brian Dilley is European head of KPMG's anti-money laundering and financial services practice, and says that the rise of securitisation cannot be ignored: "The growth in the derivatives market has been important here, with the incentive of issuing a mortgage based on the idea of selling on the loan portfolio to somebody else. What you've had in some instances are the so-called 'liar's loans', which are self-certification mortgages where no-one really knows what is correct or not. That's a big area." He refers to a speech made by the chairman of the Financial Services Authority in which he criticised the system and said this will bring a return to responsible lending. "But it's not all fraud; some of it is lax lending on multiples that people simply can't afford. There have also been brokers out there who know the rules but still say to people 'how much do you want to borrow and we'll tell you how much to put down in terms of earnings'."
Mr Dilley says that subsequent losses for insurers from this latest wave of mortgage fraud will not simply be in terms of their PI exposures, however, given that some insurers have been investing in loan portfolios. "AIG has had fairly sizeable write-downs, not just on its insurance, but also on its investment in portfolios as well. So this is going to run and run. The litigation will last for years."
And there are other reasons as to why the extent of mortgage fraud could be huge this time, according to John Porter, partner at law firm Hill Dickinson. "The fortunes of all involved in the buy-to-let market - whether they're involved in funding, designing, building, buying, lending, renting, valuing, conveying, auditing or compliance - are inexorably bound up with the shifts we'll see in the global economic markets in the coming months. Whoever turns out to have lost money will be looking to blame someone else - and there lies the rub. When the credit crunch first started to squeeze financial markets, outwardly people were saying that this would all take a couple of months to work out." This tactic, he explains, is so that whoever has ended up with the losses will know who they are and normal service for the rest can then be resumed.
Behind all of this, adds Mr Dilley, insurers know the problems with the buy-to-let market are linked to a whole host of other issues: "There are certainly some very big hits out there and fraud, money laundering and organised crime can be expected to form a major part of it. It's hard to see who won't be touched by the problems when buy-to-let lenders are part of larger banking groups; when lending portfolios are traded as commodities; when insurers hedge their liabilities through reinsurance; and when your pension fund has stakes in all the major property and equity markets."
Worryingly, he adds that although indicators to date suggest buy-to-let borrowers have lower levels of arrears and repossession than buyers generally, "it's hard to ignore what former and current Federal Reserve chairmen Alan Greenspan, Ben Bernanke and others have been telling us about the state of the US economy. Hence the recent comments from the deputy governor of the Bank of England that the outlook for the UK economy in 2008 has changed dramatically".
However, you might argue that PI insurers should not be overly concerned. After all, despite evidence pointing to some individual frauds, or indeed more organised mortgage fraud at the syndicate level, many potential claims will be spurious ones filed at the behest of money-starved lenders. Well, think again, if the experience of George Raubenheimer at LP Claims is anything to go by. He explains: "I've been involved since I was first working with the SIF in 1991, and LP Claims is now dealing with the old SIF business. I believe there are distinct parallels with the late 1990s and lessons to be learnt. It's pretty clear that dishonesty - where you have your finger in the till - is obvious and not recession driven. But a large number of cases come to light when the wheel stops turning. The deeper the recession goes, the more claims you have. So this current problem could last for four or five years."
Trying to estimate the size of the problem, Mr Raubenheimer claims that "only a small proportion" of solicitors in England and Wales had claims of real value made against them between 1987 and 2000. But given that this involved around 545 practices out of approximately 10,000 in total, whether this figure is really that small is a moot point. One thing seems certain - the value of PI claims can be very high, "running into millions of pounds" according to Mr Raubenheimer, who explains that the SIF paid out £180m.
But surely the marketplace is different today? Well-established PI insurers must be able to cope with the current claims? "Well, risk management is generally effective," he comments. "And this problem only affects a small number of firms. But if someone wants to be dishonest they are going to flout risk management anyway. So it's not necessarily an area that firms can prevent."
"Do I think the profession has insulated, protected and mitigated its risks as best it could with regard to regulation, policing, and systemic risk?," asks Mr Willis. "Broadly speaking the risks of this eventuality arising have been recognised by both sides, and on the whole I have no regrets as to the balance that has been struck over the past decade. But a lot of practitioners, for their own commercial reasons, have failed to keep a close eye on their own risks. There are cycles of attention to good practice management."
Still, according to Mr Flaxman, at least one positive note is likely to come through all this for the PI insurance market: "In every walk of life people are tempted to do things they shouldn't. As far as the insurers are concerned, they do need better risk management but they also need to put their PI prices up - margins are simply too thin at the moment."
MORTGAGE FRAUD CHECKLIST FOR PROFESSIONAL ADVISERS
"Over the last three or four years, we've had a lot of approaches from people about how they might address the risk of fraud," says John Freeman, head of fraud at Capita Claims Services. Consequently, he points to certain key questions people need to ask themselves if they want to address this issue:
Do you have a defined fraud policy?
How do you define mortgage fraud? It can be different to motor or travel fraud, so you can't report it if you haven't defined it correctly.
What methods are you using to combat mortgage fraud? Traditional methods or predictive modelling?
Can you divert funding to deal with suspected fraud early on because you have modelled it already?
Do you make sure that you actively maintain your anti-fraud policy with regard to appropriate training, checks and balances, and relationships with outside sectors?
What actions are taken to tackle fraud? Do you have any deterrents?
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