Fraud, mortgage-backed securities and Ginnie Mae: this article by the inspector of the Department of Housing and Urban Development (HUD) spells out what is being done to protect the Ginnie Mae is a growing concern, and the government is serious about cracking down on it.

I want to start by telling you a story of greed and fraud that involves a mortgage lender, Charlotte, North Carolina-based First Beneficial Mortgage Corporation, and its victims--Fannie Mae and Ginnie Mae. * This is a story of how a group of friends and relatives colluded to defraud Fannie Mae, Ginnie Mae and investors of $38 million. The First Beneficial story is also a story of bureaucratic buck-passing that allowed a fraudulent scheme to grow and victimize government institutions and investors. * You might ask: Why am I telling you this story now? My response is that the past is often prologue to the future. First Beneficial illustrates how fraud in the loan origination process eventually becomes fraud in the government securitization process. * During my tenure at the Resolution Trust Corporation (RTC) in the 1990s. I witnessed the meltdown of the savings-and-loan industry as a result of fraud and malfeasance. Now, with the subprime meltdown, we are witnessing once again massive malfeasance, misconduct and often sheer criminal conduct in the subprime mortgage industry, which has adversely affected securities markets and investors. So, although the First Beneficial case is an individual story, it has larger ramifications and contains important lessons for the insured mortgage-backed securities (MBS) industries including Ginnie Mae.

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First Beneficial

Fannie Mae approved First Beneficial as a single-family mortgage lender in 1995. In 1997, First Beneficial was approved to sell Title I loans. Title I loans are home-improvement loans and manufactured-housing loans.

In 1998, Fannie Mae began noticing problems with the Title I loan program nationwide and decided to review First Beneficial's loan portfolio. This review uncovered approximately $1 million in Title I loans that did not meet Federal Housing Administration (FHA) loan criteria or were purported to be FHA-insured, but, in fact, were not.

During this review, First Beneficial was not truthful about whether the Title I loans were FHA-insured. Fannie Mae demanded First Beneficial repurchase the portfolio, but First Beneficial did not have the funds to repurchase. Fannie Mae worked out a deal by which it would purchase new, preapproved, single-family loans from First Beneficial and apply the proceeds from the sale of these loans to repurchase the ineligible Title I loans.

Several weeks after these events, First Beneficial called Fannie Mae and said it had an investor that was willing to buy the bad Title I loans with a single cash payment. Accordingly, in September 1998 First Beneficial paid Fannie Mae the nearly $1 million it owed. Fannie Mae did not ask, and First Beneficial did not tell, the source of the funds.

Because of the problems with First Beneficial's Title I loans, Fannie Mae became suspicious of First Beneficial's single-family loans and began an inquiry into those it had purchased. Fannie Mae found that many loans were in the names of First Beneficial's owners and employees. That should have caused Fannie Mae concern. First Beneficial maintained that the loans were "investor" loans, and agreed to repurchase them.

On Nov. 3, 1998, Fannie Mae wrote First Beneficial and said it would not purchase any more of the company's loans without prior approval. On Nov. 19, 1998, Fannie Mae received a telephone call from a financial crimes investigator with the North Carolina Banking Commission, who said First Beneficial was making loans without insurance and was trying to get Ginnie Mae to accept the loans. The investigator gave Fannie Mae the names of two First Beneficial employees, who confirmed their effort to pass the loans to Ginnie Mae. Fannie Mae learned that First Beneficial had only two investor sources: Fannie Mae and Ginnie Mae.

On Nov. 20, 1998, Fannie Mae suspended First Beneficial as a lender and called in the owner for a meeting. At this meeting, Fannie wanted to know more about First Beneficial's purported investors, but it did not receive a satisfactory response from First Beneficial. Following this meeting, Fannie Mae began to take a closer look at some of the properties in the loan portfolio by physically inspecting the properties.

What Fannie Mae discovered was that many of the properties were, in fact, vacant lots or did not exist. A check at the court house revealed the named borrowers did not own the properties and that some were not even owned by First Beneficial.

Fannie Mae did not pass this information about First Beneficial's transgressions to others, thus allowing First Beneficial to continue to operate a fraudulent enterprise and ultimately victimize Ginnie Mae.

As most in the mortgage industry are aware, Ginnie Mae "securitizes" loans insured or guaranteed by the Department of Housing and Urban Development's (HUD's) FHA, the Department of Veterans Affairs (VA) or the Department of Agriculture (USDA) Rural Housing Development. Ginnie Mae guarantees investors timely "pass-through" payments of principal and interest on mortgage-backed securities. Ginnie Mae securities are the only MBS to carry the full faith and credit guaranty of the U.S. government.

In late 2000, Ginnie Mae discovered these First Beneficial transactions through a compliance audit. It was found that First Beneficial, in order to repay Fannie Mae, had pooled the false mortgages--purportedly endorsed for FHA insurance--and sold them to investors in the form of MBS guaranteed by Ginnie Mae. In actuality, these mortgages had never been endorsed by FHA.

First Beneficial issued more than $21 million in fraudulent mortgage-backed securities guaranteed by Ginnie Mae. In order to conceal its false mortgage scheme from MBS investors and Ginnie Mae, First Beneficial used money received from the sale of pooled false mortgages to make monthly pass-through payments to investors as if they were regular payments of principal and interest received from actual mortgage loans. First Beneficial also filed monthly reports with Ginnie Mae that concealed the true nature of its loans.

Because the original fraud to Fannie Mae was passed on to Ginnie Mae, costs to Ginnie Mae ballooned. By the time all was said and done, the American taxpayer was defrauded out of approximately $38 million. What began as a mortgage fraud scheme grew into a securities fraud scheme as well.

Eventually, justice was done. In 2002, seven defendants associated with First Beneficial were indicted. All seven either pled guilty or were convicted at trial.

Sentences ranged from one and a half years' imprisonment and $10 million restitution to 21 years' imprisonment and $23.5 million in restitution for the ringleader of the scheme--the latter being one of the longest sentences ever meted out for a white-collar crime. More than $8 million in property, including a yacht valued at nearly $1 million, was seized and forfeited. The court recognized that such serious fraud deserved substantial penalties.

In addition to the ringleaders, on Feb, 15, 2005, the independent public accountant who provided false annual financial statements to Ginnie Mae was sentenced to a year and a day in prison. These false statements allowed First Beneficial to sell pools of mortgages to Ginnie Mae. I cite this particular facet both to indicate how such schemes tend to pull in others, as well as to show that those who choose to act as accomplices also face severe penalties.

Fannie Mae agreed to forfeit First Beneficial funds that it held, and on April 7, 2005, through the U.S. District Court in Charlotte, North Carolina, a check for approximately $7.5 million was issued to Ginnie Mae. On June 15, 2007, a second check for approximately $4.4 million was presented by federal prosecutors to Ginnie Mae. It represented the proceeds from properties that were for feited and sold as substitute assets for part of the ill-gotten gains of the defendants.

Some might say this case is about a relatively small amount of money when measured against the billions invested in government-backed securities. Others might maintain that such fraud is merely the cost of doing business. But you can see from the severe sentences issued by the trial court that the court viewed this case as a very serious matter.

The full faith and credit of the United States stands behind Ginnie Mae and is the source of the integrity of the programs that investors rely upon. The First Beneficial case adversely affected the integrity of Ginnie Mae--and Fannie Mae--programs. It was a red flag that something needed to be done. It was imperative that our office--with the strong and invaluable assistance of the Department of Justice--aggressively investigate this fraudulent scheme.

FHA

Ginnie Mae's, and Fannie Mae's, problems in the First Beneficial case originated with a bold loan origination scheme. As with any waterside community, Ginie Mae suffers from the "down stream" effect of pollution--in this case, the pollution of the MBS pools by fraudulent, lrtgage loans.

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The FHA, a major component of HUD, is one of the largest home mortgage insurers in th world, and FHA-endorsed loans are the largest soruce of pooled loans for ginnie Mae. Fha had seved its role ably over the decades. In recent years, however, what may be called a paradigm shift in mortgage lending proctices has occurred, with a devastating impact on FHA market share and its tradition mission.