SEC Whistleblower Alleges Systematic CMBS Fraud By Industry's Biggest Players

Major banks have engaged in widespread fraud in recent years by inflating the value of properties associated with mortgages packaged into commercial mortgage-backed securities, according to a whistleblower complaint filed to the Securities and Exchange Commission.

Securities and Exchange Commission headquarters
The Washington, D.C., headquarters of the Securities and Exchange Commission

The whistleblower accused 14 major lenders and seven CMBS servicers, the nonprofit investigative organization ProPublica reports, citing a complaint submitted to the SEC last year. The complaint revolves around inconsistencies on the reporting of profits of commercial properties, which the whistleblower alleges artificially inflated the value of their real estate, allowing them to secure bigger, riskier loans.

Though the alleged fraud involves commercial real estate, it has similarities in the financial misdeeds that helped crater the residential real estate market in 2008 and precipitate the financial crisis. Namely, false financial information made loans possible that would have otherwise been too risky to underwrite.

In the aftermath of the Great Recession, it was discovered that banks such as Wells Fargo and Deutsche Bank overstated the ability of borrowers to repay subprime mortgages. Loans originated by Wells Fargo and Deutsche Bank are also at the center of the latest complaint, made public as missed payments in the CMBS market have started to pile up.

In the case of the new allegation, commercial property financial data was altered to make the properties appear more valuable, ProPublica reported. These lower-quality loans were then packaged and sold as part of CMBS deals, with investors unaware of their potential weakness.

ProPublica examined a sample of six loans sold as part of CMBS in recent years and found the profits for some of the properties associated with the loans were overstated by as much as 30%. In each of the loans, profits were overstated by understating costs. Expenses reported for a particular year simply disappeared in CMBS disclosures, the publication found.

Now that the pandemic is putting pressure on CMBS, especially those backed by retail and hospitality assets, any weakness in the underlying loans increases the probability of default. The SEC declined to comment about the complaint to ProPublica and didn't respond to a request for comment Friday.

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