Lenders face huge fraud losses

Chelsea Building Society has admitted it may have lost £41m in a mortgage scam. More are set to follow.

Just as everyone thought the financial sector was starting to recover, up pops Chelsea Building Society to rain on the parade with a £41m provision against what could be a massive mortgage fraud.

The provision sent the society tumbling into the red, forcing it to report a £26m first-half loss. A team of 12 is poring over the cases – there are several hundred – to find out just how bad the problem is.

The society said the problems had turned up after a "thorough review" of the business in the wake of its £55m exposure to Kaupthing and Landsbanki, the failed Icelandic banks.

It now appears much of the Icelandic cash will be recovered. That may not be true of the mortgage fraud cases.

The society also said that its chief executive, Richard Holbrook, would leave at the end of the month, with his role taken on by the recently appointed chairman, Stuart Bernau. The finance director, Andrew Parsons, is also resigning.

There may be many more executives seeking pastures new at other financial institutions before long – the recession is set to expose a vast number of cases of such frauds. BDO Stoy Hayward, the accountancy firm, has put the potential cost of these scams at upwards at £1bn.

Bradford & Bingley has admitted suffering huge potential losses as a result of fraud, having set aside £271m since the start of 2008. It specialised in buy-to-let loans, where there appears to have been an epidemic of financial crime, which remained hidden as a result of the property boom. Buy-to-let is also what has caused problems for Chelsea, which said the fraud cases had occurred between 2006 and 2008. The society has blamed third-party professionals – mortgage brokers and surveyors – involved in mortgage applications. It says they were responsible for "the artificial inflation of property values" on which loans were advanced.

As with any scam, there are several variations on the theme of mortgage fraud. At its most basic, an individual lies about their income on their mortgage application. However, the Chelsea appears to have been the victim of a far more sophisticated scam, focused on new-build developments. It works by a landlord buying one unit at the full asking price, establishing a value on the type of property. A job lot is then bought at a substantial negotiated discount using a bridging loan. These can then be remortgaged with buy-to-let loans at the developer's asking price, which the surveyor reports to the lender as being the fair value. The profit over and above the bridging loan is pocketed, and usually sent offshore. There can be variations on the theme – the properties can be bought by groups of landlords and passed from one to the next with a higher (fraudulent) valuation each time they change hands, and usually a fraudulent rental contract to seal the deal. In each case the buyer, the seller and the professionals involved in pushing the process through take a cut.

If rental yields and property values are rising, nobody notices what is happening. It is when they start to fall that problems start to emerge, but the landlords will have usually shifted their profits offshore and declared bankruptcy by this time, leaving the lender with a property worth far less than the money they lent on it.

Jonathan Richards, partner at the law firm Eversheds, says: "This latest announcement, in addition to the news last week from Bradford & Bingley, indicates that there is a significant fraud and professional negligence problem in most lenders' loan books. What is different about the current wave from previously is that the full extent of the problem is probably not known or appreciated by many lenders as in many instances the accounts are still performing and interest rates are low."

He adds: "In many cases the properties are unlawfully tenanted and the rent is being used to service the borrowing. The likelihood is, however, that these accounts will default at some stage in the future, particularly if interest rates rise. It is reasonable to expect to see many more announcements of this nature over the next six to twelve months. Lenders need to be proactive in reviewing their loan books to identify these problems early both for accurate provisioning and to have any realistic prospect of recourse against the professionals concerned."

Jeremy Hicks, a spokesman for the Chelsea Building Society, concurs. He says: "We expect there to be more cases. What we have done is here is be open and upfront about this following a review of the business."

Ray Bolger, technical manager at the mortgage broker John Charcol, has an interesting take on Chelsea's troubles: "They were never on any of the best buy tables for buy-to-let loans. They were not the natural place you would go. So you wonder if someone has found they could do this through them because of a gap in their risk procedures and then exploited it."

The building societies that have found themselves in trouble during the credit crunch:

*Banks may have caused the biggest financial disasters during the credit crunch but a string of building societies have also found themselves in deep trouble and Chelsea Building Society is just the latest.

*In June the West Bromwich Building Society sought an emergency rescue as a result of the credit crunch.

*Britannia Building Society approved a merger with Co-operative Financial Services in April. Both said they were "strong" but Britannia had admitted loans made to two collapsed banks and the cost of the Financial Services Compensation scheme were hurting it.

*In March the Dunfirmline Building Society was sold to the Nationwide after the taxpayer took on its toxic assets.

n In December 2008 Yorkshire Building Society took control of Barnsley Building Society after it was hit by the Icelandic banking collapse.

*In November 2008, Skipton Building Society rescued the Scarborough Building Society from the credit crunch.

*In September 2008, Nationwide also took control of the Derbyshire and Cheshire Building Societies amid concerns about their future as a result of the recession.