Internal Controls: VA Lacked Accountability Over Its Direct Loan and Loan Sale Activities

Published by the Government Accountability Office on 1999-03-24.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                 United States General Accounting Office

GAO              Report to the Subcommittee on Benefits,
                 Committee on Veterans’ Affairs, House
                 of Representatives

March 1999
                 VA Lacked
                 Accountability Over Its
                 Direct Loan and Loan
                 Sale Activities

                       United States
GAO                    General Accounting Office
                       Washington, D.C. 20548

                       Accounting and Information
                       Management Division


                       March 24, 1999

                       The Honorable Jack Quinn
                       The Honorable Bob Filner
                       Ranking Minority Member
                       Subcommittee on Benefits
                       Committee on Veterans’ Affairs
                       House of Representatives

                       As part of our responsibility to audit the consolidated financial statements
                       of the U.S. Government for fiscal years 1997 and 1998, we participated in
                       the Department of Veterans Affairs (VA) Office of Inspector General (OIG)
                       audit of the VA’s Housing Credit Assistance (HCA) program. In its report on
                       VA’s fiscal year 1997 financial statements, the VA OIG described several
                       deficiencies that contributed to the VA receiving a qualified opinion on
                       those statements. Among the areas of concern was the level of control and
                       accountability over HCA’s direct loan and loan sale activities. Specifically,
                       the OIG

                   •   was unable to conclude that the $3 billion loans receivable account
                       balance of the direct loan portfolio was fairly stated because of inadequate
                       controls and incomplete records and
                   •   identified a number of errors in recording loan sale transactions, including
                       inaccurate and untimely recording of loan sales and improper accounting
                       of loan guarantees.

                       VA is working to address the internal control weaknesses identified in the
                       audit of its fiscal year 1997 financial statements, but many of the internal
                       control weaknesses that prompted the qualified opinion have not yet been
                       satisfactorily resolved.

                       As you requested, this report describes weaknesses in the level of VA’s
                       accountability and control over HCA’s direct loan and loan sale activities
                       and recommends actions needed to improve VA’s internal control
                       environment and financial and budgetary reporting for these activities.

                       VA did not have appropriate management and operational controls in place
Results in Brief       to maintain accountability over its direct loan and loan sale activities. VA
                       provided little oversight of contractors that were managing billions of
                       dollars of assets on its behalf and did not ensure that revenues and

                       Page 1                       GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

expenses were accurate or that cash receipts were deposited promptly in
Treasury accounts.

When VA outsourced the servicing of its direct loan portfolio to a
contractor in fiscal year 1997, it did not adequately plan or manage the
transfer. It concurrently shut down its automated direct loan system and
surrendered almost all hard copy loan records to the contractor without
retaining basic information needed to confirm or reconcile the number
and value of loans serviced by the contractor. As a result, VA was unable to
appropriately manage its loan portfolio, including knowing the
composition and value of its loan portfolio, reconciling cash flows, or
properly monitoring the contractor’s work.

Further, the data transferred to the contract servicer, which up to that
point had been maintained by more than 40 VA regional offices, was
incomplete and inconsistent. This immediately created loan servicing
problems. There were delays in allocating payments to borrowers’
accounts and in paying property taxes on behalf of borrowers as well as
property taxes on VA-owned houses. Also, some borrowers did not receive
year-end statements showing interest paid that would be needed for filing
tax returns.

VA lacked assurance that receipts from loans were properly collected and
allocated to borrowers’ accounts, and did not determine the propriety of
property tax expenses associated with VA-owned property and,
accordingly, could not be confident that appropriate amounts were
transmitted to the government. For example, VA reimbursed the contractor
for property tax expenses without verifying that such expenses were
appropriate and at the correct amount. In addition, VA lacked a basis for
properly reconciling the financial activity reported by the contractor to the
data recorded in VA’s general ledger.

VA’s relationship with its contractor had cash management implications. VA
had allowed the contractor to open an interest bearing account and retain
interest earned on government funds held by the contractor. VA also
authorized the contractor to retain receipts until payments could be
allocated. In addition, provisions of the servicing agreement called for the
contractor to transfer loan payment collections to Treasury on a monthly
rather than a daily basis, substantially delaying submission of such
collections to the federal government. Both the servicing agreement and
VA’s subsequent authorizations to the contractor resulted in a violation of

Page 2                       GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

federal law and the Treasury Financial Manual concerning timely deposits
of collections.

Regarding VA’s loan sale activity—in which VA packages some of its direct
loans into a trust and sells shares in the trust to investors with a guarantee
of full payment of principal and interest—we found that VA’s failure to
timely monitor the contractors that service the loans, representing roughly
$9 billion since 1992, allowed servicing inefficiencies and improper actions
by two servicers to cause financial losses to VA. For example, delayed
reporting of loan liquidations by two servicers resulted in excessive
payments to investors. Another servicer was charging unauthorized sales
management and referral fees to realtors who listed foreclosed properties
for sale. VA officials estimated that these two problems had cost VA more
than $6 million.

We found that VA’s financing and accounting for the guarantees associated
with loan sales in effect masked both the existence of the estimated
liability for defaulted loans as well as the sources of funds being used to
finance those liabilities. Until 1997, VA had not reported or disclosed the
loan sales in its financial statements or budget reports or requested
funding to cover the cost of these guarantees. For example, VA funded
initial cash reserves maintained by its trustee with loan sale proceeds and
did not record this transaction in its financial records. VA also improperly
directed its trustee to use the unreported investment income from some of
the earlier trusts to replenish the reserves to finance the guarantee costs
associated with more recent trusts. When that income became insufficient
to cover the growing guarantee costs, VA used appropriated funds for such
purposes, but lacked the information to accurately tie those costs to the
fiscal year when the loans were sold (guarantees issued). Thus, it could
not properly reflect costs consistent with the underlying principles of
credit reform.1

VA has started efforts to address these deficiencies. For example, it has
developed an action plan and recently contracted with a consulting firm to
bring its financial and budgetary reporting into compliance with credit

 We use the term “credit reform” to encompass the (1) Federal Credit Reform Act of 1990, which
generally requires that agencies calculate and record the net present value of loans and loan
guarantees in its credit programs and include the net cost to the government in the budget,
(2) Statement of Federal Financial Accounting Standards No. 2, Accounting for Direct Loans and Loan
Guarantees, and (3) OMB Circulars A-11 and A-34, which provide guidance to agencies for budget
formulation and execution. For additional information on credit reform implementation, see
GAO/AIMD-99-31, Credit Reform: Key Credit Agencies Had Difficulty Making Reasonable Loan
Program Cost Estimates, January 29, 1999.

Page 3                               GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

                 VA reported in its fiscal year 1997 Accountability Report that the HCA
Background       program, managed by the Veterans Benefits Administration (VBA) under
                 the direction of the Under Secretary for Benefits, had over $69 billion in
                 guarantees outstanding on mortgages with a face value of $198 billion. The
                 primary objectives of the HCA program are to:

             •   assist veterans, certain reservists, and active duty personnel in obtaining
                 home mortgage loans from private lenders;
             •   assist veterans in avoiding foreclosures; and
             •   deliver loan guarantee benefits as efficiently as possible.

                 The loan guaranty activity is the primary activity within the HCA program.
                 VA partially guarantees the loans in lieu of veterans making substantial
                 down payments and meeting other conditions generally applicable to
                 conventional mortgage transactions. VA reports that it guarantees
                 approximately 200,000 loans per year to veterans, certain reservists, and
                 active duty personnel.

                 VA, through the HCA program, has responsibility for two secondary
                 activities described in detail in this report. These activities, intended to
                 mitigate HCA program losses, are (1) a direct loan activity with a portfolio
                 valued at over a reported $3 billion as of September 30, 1997, and (2) a
                 loan sale activity where a reported $1 billion of loans from the direct loan
                 portfolio are packaged into trusts and sold to investors each year. (See
                 figure 1.) When a financial institution notifies VA that a veteran’s loan is in
                 danger of foreclosure, VA may provide assistance to the veteran by
                 assuming the loan and modifying the terms. The veteran then has a direct
                 loan payable to VA rather than to the financial institution. This loan
                 becomes part of VA’s direct loan portfolio. VA estimated that it assumes
                 2,700 to 3,000 such loans per year.

                 VA also has the option of allowing foreclosure and paying the claim
                 resulting from VA’s guarantee. In cases where VA pays the claim, VA’s
                 involvement ends at this point. However, in approximately 80 percent of
                 such cases, VA purchases the mortgaged property, having determined that
                 it can recover part of its costs by reselling the property. At the end of fiscal
                 year 1997, VA reported more than 16,000 such properties in foreclosure

                 When these properties are resold, VA uses the proceeds to reduce the cost
                 of the loan guaranty activity. A VA property may be sold for cash or offered
                 with a 30-year, fixed rate mortgage. These mortgages are referred to as

                 Page 4                        GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

vendee loans. VA reported that it sells approximately 80 percent of its
properties with vendee loans and estimates that it will generate
approximately 18,000 of such loans per year. Although veterans have
preference in the bidding process for these properties, vendee loan
financing is available to all qualified borrowers. The assumed loans and
vendee loans together constitute the majority of VA’s direct loan portfolio.

Page 5                       GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

Figure 1: Processes Supporting VA
Guaranteed Loans in the Housing
Credit Assistance Program

                                    Page 6     GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

                     Three times a year, VA selects marketable loans from its direct loan
                     portfolio. The loans are packaged into a trust, and shares in the trust are
                     sold to private investors through private sector underwriters with a
                     guarantee of prompt payment of principal and interest owed. VA backs the
                     guarantee with the full faith and credit of the U.S. Government. With each
                     sale, a new trust is created, and each trust is to have a cash reserve based
                     on the size of the portfolio sold and the terms of the sales agreement. VA
                     reported that since 1992 it has sold approximately $9 billion of loans in
                     this manner. Before 1992, VA sold loans under a different financing
                     structure wherein VA retained a percentage of the ownership in the trusts.
                     As a result of these pre-1992 loan sales, VA reports that it holds an
                     investment valued at $318 million.

                     In response to a growing recognition of federal financial management
                     problems, the Congress enacted a series of laws designed to improve
                     financial management and the quality and use of cost data in
                     decision-making. To address the deficiencies in recognizing the cost of
                     credit programs, the Federal Credit Reform Act of 1990 (Credit Reform
                     Act) was enacted as part of the Omnibus Budget Reconciliation Act of
                     1990. The Credit Reform Act was intended to ensure that the full cost of
                     credit programs would be reflected in the budget so that the executive
                     agencies and the Congress could consider these costs when making
                     budget decisions.

                     Our objectives were to assess the level of control and accountability over
Objectives, Scope,   VA’s HCA direct loan and loan sale activities. To address our objectives, we
and Methodology      reviewed the VA OIG’s audit documentation on the loans receivable and
                     liability for loan guarantee line items, and interviewed VA officials from the
                     HCA program, accounting, and budget offices. We discussed the processes
                     for managing credit activities and recording related financial information.
                     We compared VA’s accounting practices to federal accounting standards
                     and industry standards. We interviewed staff at the nation’s largest
                     portfolio manager of residential housing loans to obtain information on
                     management and monitoring processes.

                     We analyzed VA’s internal memoranda regarding planning for the transfer
                     of the direct loan portfolio to an outside servicer, and interviewed VA staff
                     at headquarters and regional offices as well as contractor staff. We
                     assessed VA’s monitoring of contractors’ work in the direct loan and loan
                     sale activities and reviewed VA’s monitoring reports. We also reviewed a

                     Page 7                       GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

                        1996 report on internal controls over loan sales, for which VA contracted
                        with a consulting firm.

                        We briefed VA’s management on the deficiencies in the HCA program
                        uncovered in the audit of the fiscal year 1997 financial statements, for
                        which the OIG issued a qualified opinion. We also obtained and reviewed
                        information from VA about the current status of corrective actions on the
                        reported issues.

                        We conducted our work from September 1997 through January 1999 in
                        accordance with generally accepted government auditing standards.

                        We requested written comments on a draft of this report from the
                        Secretary or his designee. The Secretary of Veterans Affairs provided us
                        with written comments, which are discussed in the “Agency Comments”
                        section and are reprinted in appendix I.

                        VA did not effectively plan or carry out the transfer of its direct loan
VA Lacked               portfolio to an outside contractor for servicing in fiscal year 1997.
Accountability and      Although outsourcing loan servicing is common, VBA officials did not
Control Over Its        sufficiently consider the control implications of transferring such a
                        significant asset to an outside contractor.
Direct Loan Portfolio
                        An effective internal control structure is as important, if not more
                        important, under outsourced loan servicing arrangements than when loan
                        servicing is performed in house. While the authority for daily operations
                        has been shifted to a private sector entity, cognizant agency officials
                        remain responsible for the efficient, effective, and economical
                        management of the outsourced activity. In this case, VA was responsible
                        for determining the adequacy of the servicer’s internal control
                        environment, as well as establishing and maintaining its own data or data
                        sources for comparison purposes to allow it to be confident that the
                        activity is being managed in the best interest of the federal government. As
                        of September 1998, about 15 months after the transfer, VA was unable to
                        fully account for the number, value and status of direct loans in its
                        inventory, and had been receiving payments through the servicer for
                        several hundred loans that could not be matched to either servicer or VA
                        loan account records. VA had not yet established adequate controls over
                        cash collected or disbursed on its behalf by the contractor and was unable
                        to properly reconcile the cash flows reported by the contractor to those

                        Page 8                       GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

                          recorded in VA’s general ledger. In addition, there were serious delays in
                          depositing receipts to VA’s account at Treasury.

                          Furthermore, VA had transferred incomplete and inconsistent loan data to
                          the contractor. This situation contributed to the contractor’s problems in
                          servicing the loans and resulted in inconveniences to some borrowers. For
                          example, there were delays in allocating payments to some borrowers’
                          accounts and in paying property taxes on their behalf as well as paying
                          property taxes on VA-owned houses.

Inadequate Planning for   VA officials stated that in outsourcing the servicing of the direct loans in
Outsourcing               June 1997, they saw an opportunity to replace outdated systems2 and
                          concurrently to reduce staff. Rather than managing the loan portfolio out
                          of more than 40 independent regional offices, the direct loan portfolio
                          would be serviced by a private-sector contractor, in cooperation with VA’s
                          regional office in Indianapolis. The outsourcing was also seen as a way to
                          better meet the cost data requirements for federal credit programs, since
                          the contractor’s systems offered the ability to code all loans and
                          associated expenses and revenues by the loan origination year, necessary
                          information for satisfying the Credit Reform Act. Because the same data
                          are required for financial reporting, the outsourcing was also seen as a
                          way of enabling compliance with federal accounting standards.

                          The outsourcing plan called for VA to transfer its direct loan portfolio to a
                          contractor that would provide computer facilities and programs for
                          servicing. The contractor also received records related to property still
                          owned by VA and awaiting sale. The winning bidder, Computer Data
                          Systems, Incorporated. (CDSI) (hereafter referred to as the contractor), had
                          a commercial system, called the Loan Servicing Automated Management
                          System (LSAMS), to process, service and account for mortgage loans. CDSI
                          subcontracted with Seasons Mortgage Group (SMG) (hereafter referred to
                          as the servicer) to service the loan portfolio, a function consisting of
                          collecting and allocating mortgage payments from borrowers, pursuing
                          delinquent accounts, maintaining custody of escrow accounts, paying
                          property taxes and hazard insurance for borrowers, and transferring
                          revenue to Treasury for crediting to VA accounts. In addition, the servicer
                          was to pay property taxes related to VA-owned property. (See figure 2.)

                           Starting in fiscal year 1986, the inadequacy of VA’s portfolio loan system, implemented in 1964, was
                          reported as a material weakness in VA’s Federal Managers’ Financial Integrity Act (FMFIA) reports.

                          Page 9                                 GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

Figure 2: Contractors Involved in VA’s
Direct Loan and Loan Sale Activities

                                         In preparation for the transfer, VA supplied CDSI with a list of the data fields
                                         in VA’s Portfolio Loan System (PLS), including those containing borrower
                                         names and addresses, amounts for principal, escrow and outstanding
                                         balance, and status of payments of property taxes and hazard insurance.
                                         CDSI then mapped3 those fields onto the fields in LSAMS in preparation for
                                         the initial transfer of loan records. VA created a tape of the information in
                                         PLS and sent the tape to CDSI to be loaded onto LSAMS. VA also created a tape
                                         of information from its Property Management System (PMS) to provide CDSI
                                         with information on VA-owned properties for which it would be paying
                                         property taxes.

VA Did Not Retain Records                As discussed later, even though the loan data originally submitted to the
to Account for the Number                contractor were not adequate for servicing purposes, VA was able to
and Status of Loans                      reconcile contractor and agency records on the 24,000 loans with an
                                         outstanding balance of $1.2 billion4 that were initially transferred.
                                         However, its ability to reconcile and to provide assurance regarding the
                                         accuracy of contractor data in LSAMS deteriorated almost immediately.
                                         Right after the data transfer, VA shut PLS down, eliminating its most

                                          Mapping involves matching the fields (e.g., loan number) from one database to the fields in another
                                          The $1.2 billion represents only the outstanding balances on loans transferred to CDSI. For financial
                                         statement reporting, the $3 billion loans receivable account balance includes the outstanding balance
                                         for loans, VA-owned property, and accrued interest.

                                         Page 10                                GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

                        comprehensive source of automated information on its direct loan
                        portfolio. Concurrently, VA management instructed staff at the regional
                        offices to send all hard-copy loan files to the servicer, except the originals
                        of property deeds and deeds of trust that document the loans. The intent
                        was to aid in SMG’s loan servicing. According to VA officials, although the
                        regional offices included an inventory of loan information with the files
                        they sent, regional staff were not advised to retain a copy of the inventory,
                        nor did they do so. Three months after the transfer, the regional offices we
                        visited had retained only a few files, aside from the original mortgage and
                        title documents, regarding the loans originated in their offices.

Data Quality Problems   There were immediate problems with SMG’s ability to service borrowers’
                        accounts because of inconsistencies in how name and address information
                        had been recorded by regional offices. The data transferred had not been
                        critically reviewed to determine whether it would meet the contractor’s
                        data requirements, nor had the data been cleaned up prior to transfer to
                        LSAMS. As a result, what would typically have been a straightforward
                        procedure for developing a mailing list to send loan coupons to borrowers
                        led to serious problems. Loan coupons were sometimes misaddressed
                        because of name problems (e.g., “Mr. Smith John” instead of “Mr. John
                        Smith”) or address problems (e.g., the mortgaged property addresses
                        instead of where borrowers actually lived). In some cases, insufficient
                        information resulted in SMG not being able to contact borrowers at all. All
                        of these factors contributed to delays in payments being made, increasing
                        VA’s financial risk. Meanwhile, borrowers were not getting information
                        they needed. VA officials informed us that they were not able to send IRS
                        Form 1098, the 1997 Mortgage Interest Statement tax form, to some
                        borrowers by January 31, 1998.

                        A major reason for the extent of the inaccurate and incomplete data was
                        the presumption that VA regional offices had consistently and completely
                        entered the data into PLS. Although the regional offices had administered
                        the direct loan portfolio for more than 30 years, we found that VA did not
                        adequately involve them in planning for the transfer or adequately advise
                        them of procedures to be followed after the transfer. Prior to outsourcing,
                        VA’s regional offices entered loan information in PLS according to their own
                        preferences, because VA had not established standardized procedures. For
                        example, some regional offices used PLS for certain loan information while
                        maintaining other loan-related data elsewhere. Among the data that were
                        not consistently entered in PLS were real estate tax data. This was because
                        each regional office worked with a limited number of taxing jurisdictions

                        Page 11                      GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

and some regional offices may have it found more convenient to maintain
the data elsewhere.

SMG staff soon realized that in many cases they lacked basic information
about amounts and deadlines for taxes due on VA-financed properties.
Within a few months of the transfer, SMG staff notified VA that they could
not ensure that property taxes would be paid on time and in full on every
property. Although the contract clearly stated that late payment penalties
were the servicer’s responsibility, VA acknowledged that it had contributed
to the delays and VA agreed to pay all penalties for late taxes. According to
VA officials, during fiscal year 1998, these penalties amounted to $26,000 to
$27,000 per month. VA told us that, prior to outsourcing, it had paid
approximately $6,000 per month for penalties for late taxes. As of
January 1999, VA and SMG were discussing available options for reducing
late-payment penalties.

Concurrently, in the months immediately following the outsourcing, VA
was experiencing difficulties in accounting for the loans in the direct loan
portfolio. As regional staff continued to foreclose on VA-financed
properties, take back foreclosed properties, resell properties with new
mortgages, and assume veterans’ loans, there were serious timeliness and
accuracy problems in getting the necessary information to CDSI/SMG. As a
result, LSAMS started presenting an incomplete picture of the loans in VA’s
portfolio. The major breakdown was the delay in VA providing data to SMG
on loans that VA assumed when borrowers defaulted. As of September 30,
1998, LSAMS data showed that the assumed loans represented
approximately 53 percent of the value of VA’s direct loan portfolio. VA data
showed that assumed loans often went unrecorded for extended periods
because it frequently took months and even years for VA staff to receive
final documents from financial institutions. In addition,VA did not
thoroughly review the data for accuracy.

The process under which VA assumes a guaranteed loan has proven to be
an extended task. It includes purchasing the loan from the financial
institution that holds it and then typically modifying the loan terms, such
as interest rates or repayment periods. Prior to the outsourcing
arrangement, VA regional staff serviced assumed loans, collected the initial
payments, and entered these loans in PLS.

Page 12                      GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

SMG would not accept assumed loans in its system unless and until the
loans were fully established.5 After the transfer, assumed loans were not
being recorded in any automated system until they were fully established.
Since regional offices maintained paper files for assumptions in progress,
there was no overall central reporting mechanism to establish visibility,
and therefore accountability, over these loans.

VA has developed procedures for loan assumptions that VA officials believe
will shorten the time it takes for it to assume VA defaulted guaranteed
loans. These procedures include required settlement dates for all assumed
loans within 60 days after VA approves the loan assumption request. By
refusing to pay supplemental claims after 60 days, VA believed that it would
increase the incentive for lenders to transfer all necessary documentation

Over the period of our fieldwork, data on assumed loans was recorded by
VA’s regional staff on a multipage form, which was reviewed by the
Portfolio Loan Oversight Unit (PLOU) staff in Indianapolis before being
entered into LSAMS. We found that PLOU’s review was not an in-depth
assessment, since PLOU staff maintained no loan files and were, therefore,
unable to check the accuracy of important items such as payment amount,
outstanding principal, amortization and escrow amount. PLOU staff
informed us that they checked that all fields on the sheets were filled in
and that the correct fiscal year was entered for the assumption. If errors in
this basic information were found on the data sheets, PLOU staff returned
the sheets to the regional offices for correction. As of September 1998,
PLOU staff told us that they were having an error rate of up to 40 percent
for these data sheets. This error rate further delayed loans and their
associated cash payments from being recorded in LSAMS records and VA’s
general ledger, and understated the loans receivable balance. As discussed
in a later section of this report dealing with cash management problems,
such errors also resulted in delays in cash receipts for the federal

In July 1998, VA issued instructions to the regional offices to have the
multipage form reviewed by their respective finance departments, since
they have access to the vital information, before the form is sent via
electronic mail to PLOU. As of December 1998, a PLOU official told us that
the error rate had dropped substantially but was still about 5 to 6 percent.

 A loan is established when VA has a modification agreement with the veteran and has received all
necessary documents pertaining to the loan.

Page 13                               GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

VA also experienced problems in transmitting to LSAMS reliable data on
properties previously owned by VA which had been recently sold with VA
direct financing, referred to as vendee loans. Previously, there had been an
electronic link between VA’s Property Management System (PMS)6 and PLS,
so that as VA-owned properties were resold with VA direct financing, that
information would update PLS. After the shut-down of PLS, VA created a
temporary arrangement whereby a staff member would download vendee
loan information monthly from PMS and transmit it to LSAMS for entry.
Under this system problems such as duplicate loan numbers, which delay
servicing of the loans, were not detected until the monthly transfer. As of
October 1998, VA was developing an automated file transfer system with
CDSI, which is intended to give VA the means to transfer this information to
LSAMS automatically each month.

All of these problems negatively affected allocation of payments to the
appropriate accounts. During the period of our review, we found that SMG
was regularly receiving loan payments, which for the most part referenced
a loan number, but SMG could not match the payments to the accounts of
any borrowers in LSAMS or VA’s records. In some cases, as many as 10
months of unallocated payments were involved. In September 1998, VA
continued to receive payments for 289 loans that could not be found in
SMG’s database. VA officials told us that no records of the loans involved
could be found within LSAMS or in paper files at regional offices. At that
time, unallocated payments totaled over $541,000 for these 289 loans. Our
analysis of these 289 loans showed that VA had received at least two
payments for 154 of these loans. VA was unable to explain the nature of
these loans or why they had not been recorded. Lengthy delays in getting
loan data into LSAMS increased the risk that borrowers may not have been
making payments on some loans and that neither the servicer nor VA
would be aware of it.

VA officials reported that as of December 4, 1998, they had reduced the
unallocated loan payments to approximately $160,000 and were initiating a
new procedure to further reduce this total. The new procedures require
the servicer to (1) hold, without depositing, loan payments that could not
be allocated to a specific borrower’s account and (2) return the loan
payments to the borrower in cases where two or more payments were
unallocated, or part of the loan number was missing, unless either VA had
instituted the paperwork for the loan in process or the servicer had
received e-mail instructions from one of the regional offices regarding the

 PMS tracks program costs on property owned by VA as a result of foreclosure.

Page 14                               GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

                           This new procedure, however, does not address the underlying problem of
                           VA’s incomplete direct loan portfolio and creates additional cash
                           management problems. By not depositing these checks, the federal
                           government may not be receiving cash that it is owed. Common practice in
                           the mortgage banking industry is to establish a suspense account for
                           unresolved items and to deposit the checks in the bank until the
                           appropriate research is completed and the items are allocated to the
                           proper accounts. Creating suspense accounts heightens the visibility over
                           the extent of the problem and establishes a control mechanism for
                           resolving open items. This technique also would help ensure that loans
                           originating in the regional offices are recorded in VA’s loan database.

Inadequate Controls Over   Many of the problems that followed outsourcing, including the breakdown
Assets and Cash in the     in the control environment for loan assets and cash, could have been
Direct Loan Portfolio      avoided or mitigated if VA had developed a loan origination database. For
                           example, in the mortgage banking industry such a database is commonly
                           used to manage portfolios of direct loans and loans sold with a guarantee
                           that are serviced by other entities. The database generally contains all loan
                           information needed to amortize a loan, including origination date, original
                           and current loan balance, interest rate, payment date, and term of the loan.
                           Additional information includes the borrower’s name, property and
                           borrower’s address, borrower’s social security number and escrow
                           balance on every direct loan and loan guarantee. Using a similar database
                           as a management control for its direct loan program, VA would be able to
                           forecast expected cash flows, and reconcile cash receipts, disbursements,
                           and loan activity with servicer records. Discrepancies between VA and
                           servicer’s data then could be investigated and reconciled promptly.

                           Furthermore, VA, in the absence of such a database, did not confirm the
                           validity and accuracy of collections and disbursements reported by the
                           contractor by alternative means, such as examining SMG’s bank statements,
                           lockbox statements, or tax invoices. Without some kind of verification
                           procedure, based on its own or third party information, VA did not have an
                           independent source of data against which to test and validate the
                           legitimacy of collection and expense amounts reported by SMG. As a result,
                           VA had no way of knowing whether SMG was collecting all payments that
                           were due or whether VA was reimbursing SMG for only valid expenses.

Insufficient               In VA’s reconciliation at the end of September 1998, reflecting CDSI’s entries
Documentation to Perform   through June 1998, VA could not reconcile differences between contractor
Reconciliations            and VA records. For example, there was a difference of almost $4 million

                           Page 15                      GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

                  for loan principal outstanding. Since VA does not have either a complete
                  list of loans, or information on adjustments made by CDSI or the regional
                  offices, VA could not determine whether this difference was due to errors,
                  irregularities or merely timing differences.

Cash Management   Under the terms of the servicing agreement, SMG established an
Problems          interest-bearing bank account in its name for the deposit of all loan
                  payments made by VA’s borrowers. As payments were received, SMG
                  attempted to apply payments to the appropriate borrowers’ accounts and
                  allocate payments to principal, interest, and escrow amounts. The contract
                  called for SMG to remit by wire to VA on the third business day of each
                  month the total sum of funds collected, including all principal and interest
                  due, with respect to payments received by SMG during the previous month.
                  In addition, VA allowed SMG to defer remittance of any receipts that could
                  not be allocated to loan accounts. VA also allowed SMG to keep all of the
                  interest accrued in this account which, essentially, resulted in additional
                  compensation to SMG. The Contracting Officer’s Technical Representative
                  (COTR)7 told us that since the contract did not specifically require SMG to
                  remit to VA unallocated funds until they were allocated or to remit interest
                  earned on this account, these practices were permissible.

                  These unallocated funds included funds for which SMG could identify the
                  loan account, but, for a variety of reasons, SMG did not allocate. This pool
                  of unallocated funds remained high throughout the period of our
                  fieldwork. For example, in October 1997, 3 months after SMG began
                  servicing the direct loan portfolio, SMG reported $3.2 million in unallocated
                  funds. When we questioned VA officials about the reasons for this large
                  amount, they attributed it to “the float.” They explained that loan payoffs,
                  which required only a few days to be allocated, represented the majority of
                  the unallocated funds, and that because new payoffs were constantly
                  being added, the balances of unallocated amounts in SMG’s account
                  remained relatively stable.

                  While our limited testing did confirm that the majority of these unallocated
                  funds were loan payoffs and the amount of unallocated funds remained
                  relatively high but stable, we also found that loan payoffs did not always
                  clear in a few days. For example in September 1998, we requested from
                  SMG schedules of unallocated funds on deposit as of August 31, 1998, and
                  February 28, 1998. On the February schedule, SMG reported over

                   A COTR is designated as VA’s authorized representative for technical monitoring and other functions
                  of a technical nature not involving a change to the scope, price, terms, or conditions of the contract.
                  The COTR is responsible for certifying as to the satisfactory delivery of service.

                  Page 16                                GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

$2.5 million in unallocated funds of which loan payoffs represented
$1.6 million, or 64 percent of the total. We traced loan payoffs from the
February schedule to the payoffs on the unallocated schedule of August
1998. We found that approximately $618,000, or 37 percent of the loan
payoff amounts on the February 1998 schedule were still unallocated 6
months later.

Allowing the contractor to deposit these federal collections in its account
and the delays in transferring funds to federal accounts violates federal
law. An important statute governing federal fiscal management is 31 U.S.C.
3302(b), known as the “miscellaneous receipts” statute. Section 3302(b)
requires that government officials and agents of the United States
government receiving money on behalf of the government from any source
shall deposit the money in the general fund of the Treasury as soon as
practicable without deduction for any charge or claim. As a result of
section 3302(b), officials and agents of the government may retain and use
funds they receive, rather than depositing them in the general fund of the
Treasury, only if authorized by another law.

Subsequent legislation, the Credit Reform Act requires that cash flows to
the government resulting from direct loan obligations or loan guarantee
commitments made prior to October 1, 1991, go to the credit of the
program’s liquidating account at Treasury, which is a budgetary account.
The act also requires that cash flows to the government resulting from
direct loan obligations or loan guarantee commitments beginning
October 1, 1991, go to the nonbudgetary financing account at Treasury
associated with the related credit program. In this regard, VA has not
provided us and we have not identified any statute that authorized VA to
contractually or otherwise permit SMG to retain the interest earned on
these government moneys as a form of compensation, instead of crediting
the interest to the appropriate VA account.

Section 3302 also addresses the timing of deposits to the Treasury. Section
3302(c) requires that a person having custody of public money deposit the
money in the Treasury, or in a depository designated by the Secretary of
the Treasury, not later than the third day after the custodian receives the
money. Subsection (c) also authorizes the Secretary of the Treasury to
prescribe a greater or lesser period for deposit. The Treasury Financial
Manual states that depositors should deposit funds in Federal Reserve
Banks unless otherwise authorized, and that deposits should be made
daily.8 VA did not request Treasury to designate a depository before it

 See I TFM Sections 4010, 4015.

Page 17                           GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

                        authorized SMG to establish a bank account and remit funds to VA only once
                        a month. Had SMG, instead, deposited the funds it collected in a Federal
                        Reserve Bank for credit to the liquidating and financing account on a daily
                        basis, no interest would have accrued to SMG on the deposit of payments
                        made on VA loans. To the extent SMG earned interest on the loan payments
                        it received, VA should have had SMG remit the amount of interest to VA for
                        credit to the appropriate liquidating and financing accounts. Because VA
                        permitted SMG to retain interest on loan payments SMG was not entitled to
                        receive under law or contract, these amounts should now be recovered.

                        In comparison to VA’s contractual arrangement with CDSI/SMG, we looked at
                        the practices of Fannie Mae, the nation’s largest portfolio manager, which
                        regularly uses private-sector servicers for its direct loans. We found that as
                        a means of maximizing its interest income while controlling cash flow,
                        Fannie Mae requires servicers to remit cash receipts at a minimum on a
                        daily basis, and more frequently if collections exceed $2,500.

Noncash Adjustments     Noncash adjustments represent changes made to principal loan balances
Were Made Without       without cash payments or disbursements being made. After transferring
Oversight               loans to SMG for servicing, the regional offices continued to submit
                        noncash adjustments to SMG to change the outstanding loan balances of
                        borrowers’ accounts. In ordinary business practice of financial
                        institutions, noncash adjustments are unusual events that require an
                        explanation by the person making the adjustment and the approval of a
                        supervisor. Yet VA regional staff were permitted to forward noncash
                        adjustments regularly, causing principal balances to go up and down,
                        without proper approvals or documentation. For example, during
                        October 1997, SMG recorded approximately $250,000 in noncash
                        adjustments requested by the regional offices. As a result, VA lacked
                        assurance that changes were legitimate and that funds were not being
                        misdirected. When we advised VA management of these activities, it
                        promptly instituted a formal review process for all changes, which
                        required documentation, supervisory approval, and PLOU authorization.

                        Three times a year, VA selects marketable loans from its direct loan
VA Lacked               portfolio, packages them, and sells them to investors through an
Accountability and      underwriter in order to recoup costs for the HCA program. These loans are
Control Over Its Loan   sold with a guarantee of payment of principal and interest and are backed
                        by the full faith and credit of the United States. Since fiscal year 1992, the
Sale Activity           funding for this type of guarantee has been subject to the Credit Reform

                        Page 18                       GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

Act and OMB’s guidance but, until recently, VA had not complied with the
requirement to estimate the future liability related to these loan sales and
to include the estimated cost of the liability in its annual budget request to
the Congress. VA also had not been disclosing and properly accounting for
these sales and the associated liability created by the guarantees in its
financial statements as required by federal accounting standards.
Furthermore, VA had not established an effective control environment for
monitoring the servicing on these loans.

Since the mid-1980’s, VA has engaged the services of an investment banking
firm to sell securities backed by marketable loans in the direct loan
portfolio.9 Each of the sales has a separate trust agreement, which calls for
a separate cash reserve associated with each trust based on the size of the
portfolio sold and the terms of the sales agreement. Initially, VA funded
these cash reserves from a portion of the proceeds VA received from the
sale of loans as stipulated in the sales agreement.

Each trust has a loan servicer to collect monthly payments from the
borrowers and perform other traditional loan servicing functions,
including handling defaults, foreclosures, and routine payoffs. VA has hired
the trust department of a major bank10 to serve as the trustee/custodian for
all of these trusts. (See figure 2.) The trustee/custodian manages the trusts,
maintains the custody of all funds (including VA’s cash reserves), pays the
certificate holders, reports to taxing authorities, and provides investors
relevant data needed for filing their annual tax returns.

In practice, the servicer deposits receipts from the servicing activities in a
depository account managed by the trustee/custodian. The
trustee/custodian subsequently transfers these funds to its distribution
account to pay investors. When funds in the distribution account are
insufficient to pay investors, the trustee/custodian transfers funds from
VA’s cash reserve account into the distribution account.

Because the loans are sold with guarantees to maximize the sales yield, VA
has a contingent liability to the certificate holders as long as these loans
remain outstanding. To the extent that loans default and aggregate cash
flows are inadequate to pay investors and trust expenses, the guarantee
feature comes into play. Because of this guarantee, VA has a responsibility
and vested interest in monitoring the servicer and trustee/custodian

 Purchasers buy certificates representing a percentage of ownership in the trust. The certificates are
collateralized collectively by all of the loans in the portfolio and guaranteed by the U.S. government.
    Banker’s Trust of California is the trustee/custodian for all of the trusts.

Page 19                                     GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

                                 activities to maximize the cash flow from loan servicing operations and to
                                 minimize expenses.

Little Oversight Over Loan       Although the sales contract requires VA to replenish cash reserves when
Servicers and the                needed, in our opinion, an effective control environment requires on-site
Trustee/Custodian                monitoring of contractors to ensure that the transactions reported are
                                 reasonable and appropriate. OMB provides guidance to credit agencies to
                                 evaluate and enforce servicers’ performance. This guidance states that
                                 agencies should undertake biennial on-site reviews of their contractors
                                 where possible, but recommends annual on-site reviews for all lenders and
                                 servicers with substantial loan volume.11 The OMB guidance states that
                                 agencies are to manage federal credit programs to ensure that federal
                                 assets are protected and that losses are minimized in relation to the social
                                 benefits provided by credit programs.

                                 VA  did not comply with OMB guidance, and the trustee/custodian and the
                                 four servicers used by VA operated with little oversight. For example,
                                 although VA had been selling loans in a trust structure since the late 1980’s,
                                 it did not begin monitoring its servicers until 1994. As of October 1998, it
                                 had only reviewed three of its four servicers, and no servicer had been
                                 reviewed more than once. Further, VA had never reviewed the

                                 At one servicer, VA found procedural problems it characterized as not
                                 resulting in any significant cost to the government. However, the other two
                                 servicers had servicing inefficiencies and had engaged in unauthorized
                                 practices. VA’s reports on those servicers estimated that the two most
                                 serious findings cited had cost VA more than $6 million over the period of
                                 the trusts they were servicing. Specifically,

                             •   Servicers were not reporting cash receipts resulting from loan
                                 liquidations12 in a timely manner to the trustee/custodian. As a result, the
                                 trustee/custodian was not aware that principal and interest payments to
                                 investors were to be correspondingly reduced. Another salient factor is
                                 that servicer fees are calculated as a percentage of outstanding loan
                                 principal being serviced. Thus, any delays in reporting liquidations would
                                 result in both excessive payments to investors as well as servicer fees

                                  OMB Circular A-129 (as revised 1/11/93), Policies for Federal Credit Programs and Non-Tax
                                   Loan liquidations are the proceeds of the sale of property from a defaulted mortgage.

                                 Page 20                                GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

                            unless they were timely detected and appropriate adjustments made to
                            both investor payments and servicer fees.
                        •   One servicer was charging certain sales management and referral fees to
                            realtors who listed foreclosed properties for sale. Such practices were not
                            authorized under the servicing agreement. In its monitoring report, VA
                            stated that the realtors who paid the fee to the servicer had, in effect,
                            agreed to sell the property for a lesser net commission than VA actually
                            paid. The servicer received the increment, which, according to VA’s report,
                            ranged from 1 percent to 1.3 percent, thus increasing VA costs and
                            reducing net sale proceeds.

                            In response to these monitoring efforts, VA officials told us that they are
                            negotiating recovery of estimated losses of federal revenues with the
                            servicers involved. They also told us that while VA had not realigned any of
                            the existing servicing responsibilities, it was channeling all new servicing
                            work to the entity for whom monitoring efforts had not revealed any
                            significant problems.

Inadequate Management       One trustee handles the custodial arrangements for all 31 of the trusts
Involvement in              originated from loan sales dating back to 1988, with reported outstanding
Relationship With           balances of approximately $7 billion as of September 1998. Through the
                            conclusion of our fieldwork, VA management had taken little action to
Trustee/Custodian           oversee the relationship with the trustee/custodian, including management
                            of the cash reserves and the flow and sharing of critical financial and
                            budgetary data associated with trust operations. In essence, the loan sale
                            activity functioned as a stand-alone project, removed from input and
                            oversight by management, accounting, or budget staff. Financial data were
                            not adequately shared with staff who needed to review and record them in
                            VA’s accounting and budget records.

                            One individual at VA was in charge of all operational and administrative
                            phases of the loan sale activity, which included preparing the loan sale
                            documents, calculating the value of the loan portfolio to be sold,
                            authorizing payments to the trustee/custodian for requested amounts
                            when cash reserves fell below contractual levels, and receiving financial
                            reports the contractors generated. In our opinion, such a broad scope of
                            authority without a strong supervisory presence exposes VA to excessive
                            risk that improprieties could occur and not be detected, and that
                            important activities could be neglected. Our 1983 Standards for Internal
                            Controls in the Federal Government, issued pursuant to the Federal
                            Financial Managers’ Integrity Act of 1982 to be followed by federal

                            Page 21                      GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

                               agencies, outlines key control objectives and explains specific techniques
                               for achieving those objectives. Not achieving the goals for two of these
                               objectives, separation of duties and supervision, contributed to the
                               observed weaknesses in loan sale activities and reporting.

                               This situation was a factor in VA not detecting or reversing a key decision
                               that authorized the trustee/custodian to report financial data within the
                               trusts on a consolidated basis. The contract with the trustee/custodian
                               required that the reports to VA provide details for each trust that would
                               satisfy data requirements for both credit program administration and
                               financial reporting considerations. A report on the internal controls in the
                               loan sale activity by a consultant cited the trustee/custodian’s
                               consolidation of financial reporting for the 12 trusts originated between
                               1992 and 1996 as a key factor in VA not having the level of detail required to
                               comply with credit reform requirements. Consolidated, rather than trust
                               by trust, reporting masked the performance of individual trusts and
                               eliminated critical data for reasonably estimating program costs under the
                               Credit Reform Act as well as for reliably reporting on financial statements.

VA Did Not Properly            In addition, VA did not have processes in place to ensure that relevant
Account for Loan Sales         reporting from servicers and the trustee/custodian was channeled to
and Subsequent Financial       appropriate VA offices. Since all reporting from the trustee/custodian came
                               to one individual, there needed to be a process for the individual to
Activity                       provide the reported information to other VA officials who needed the
                               information for accounting, budgeting, and other purposes. However, we
                               determined that the accounting staff did not have copies of any of the loan
                               sales agreements and that the information they had on the loan sale
                               activity was incomplete because it had either not been forwarded to them
                               or they had not requested it.

                               This lack of data on loan sales and related transactions was a factor in
                               accounting and financial reporting errors. Our review of the accounting
                               treatment of the loan sale transactions showed that the entries were not in
                               accordance with adopted federal accounting standards and related
                               guidance. Specifically:

                           •   VA incorrectly calculated and classified gains and losses on loan sales,
                           •   VA was not estimating and recording the liability for the guarantee on the
                               loans sold at the time of sale, and
                           •   the reserves held by the trustee/custodian were not recorded in VA’s
                               general ledger.

                               Page 22                      GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

                            This accounting treatment indicated a lack of familiarity with some
                            elements of proper accounting for credit transactions. Not recording the
                            liability and reserves would suggest that VA had no further responsibility
                            for these loans or a continuing interest in the appropriate servicing of the
                            loans and maintenance of the cash reserves, which is not the case.

                            After we advised VA that its accounting and budgetary reporting did not
                            accurately reflect the loan sales or the contingent liability, VA, in
                            consultation with OMB, estimated a subsidy and recorded an additional
                            expense as an aggregate adjustment for future losses and related liability
                            for the loan sales not recorded between 1992 and 1997. Because the
                            adjustment was made to the financial statement line item for the direct
                            loan activity and was aggregated with other adjustments related to direct
                            loans, we were unable to determine what portion of this $376 million
                            adjustment was related to the loan sale activity.13

                            In September 1998, VA contracted with a private-sector firm to develop a
                            model for estimating the liability for the loan sales, and to reconstruct all
                            necessary historical information. The firm agreed to research and correct
                            the missing or improperly recorded financial information and produce
                            auditable records supporting the information recorded.

Replenishment of Reserves   Periodically, the trustee/custodian asked VA to replenish the cash balances
Not Financed Properly       for the individual trusts to designated levels. VA did not follow the Credit
                            Reform Act and related requirements when identifying the sources of the
                            funds to satisfy the underlying federal guarantees. As noted above, VA had
                            been initially funding the reserve for each trust from the proceeds of the
                            loan sale transaction. It had not accounted for the source of the cash used
                            to fund the reserves or estimated and recognized the liability associated
                            with the federal guarantee. Also, VA was not reporting subsequent
                            replenishment of the cash reserves or disclosing the funding source.

                            Under the Credit Reform Act, in order to fund the guarantees, VA should
                            have estimated its future liability for satisfying guarantees on the loans
                            sold and included it in annual budget requests to the Congress. In addition,
                            VA should have notified both OMB and Treasury to set up program and
                            financing accounts for guarantees made beginning October 1, 1991. These

                              The subsidy cost related to these trusts was recorded as part of the direct loan program. However,
                            OMB Circular A-11 requires that the related subsidy cost for loans sold with a guarantee be included as
                            part of the loan guarantee program. For fiscal year 1999, VA plans to include the subsidy cost for the
                            loans sold in the appropriate program.

                            Page 23                                GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

accounts are used to record the appropriation for the net cost to the
government for the guarantee, record the sale transactions, and track the
subsequent activity for the loans sold. Annually, VA should have
reestimated the liability and included any reestimate in its budget and
financial statements.

Instead, VA had been financing those replenishments off the books.
Specifically, VA did not record the interest income or the replenishments of
the reserve in its accounting records. For several precredit reform loan
sales, VA reported that it had retained investments valued at $318 million as
of September 30, 1997. We found that VA had been improperly using the
income from those investments to finance replenishment of the reserves
for trust agreements initiated after 1991 (those subject to credit reform
requirements). VA officials told us that since the income from all of the
trusts flowed to the same trustee/custodian, they had instructed the
trustee/custodian to use the investments to finance replenishments for the
post-1991 trusts. The Credit Reform Act clearly stipulates that income
arising from pre-1992 credit activities must be used only to offset expenses
arising from those same activities. Such income is not to be used to offset
expenses for post-1991 activities, which is what VA routinely did.

VA exclusively relied on income from the pre-1992 investments to replenish
the reserves of post-1991 trusts until fiscal year 1997, when income from
that source became insufficient. At that juncture, VA started using funds
from the direct loan financing account to replenish the trust reserves in
fiscal years 1997 and 1998.

For fiscal year 1997, VA transferred $14 million to the trustee/custodian to
augment cash reserves from the 1997 cohort14 of its direct loan financing
account15 because, as described above, it had not set up the appropriate
financing mechanism to finance those losses. In 1998, VA transferred
another $40 million from the 1998 cohort in its direct loan financing
account to replenish the reserves.

  As described in OMB Circular No. A-34, a cohort applies to post-1991 direct loans and loan
guarantees committed by a program in the same fiscal year even if disbursements occur in subsequent
fiscal years. Accounting and other records must be maintained separately for each cohort within the
program’s financing account. Any payment for losses from the financing account must be applied to
the cohort in which the original loan was disbursed.
 Under the Federal Credit Reform Act of 1990, a financing account is the nonbudgetary account or
accounts associated with each credit program account, which holds balances, receives the subsidy
cost payment from the credit program account, and includes all other cash flows to and from the
government resulting from post-1991 direct loans or loan guarantees.

Page 24                              GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

                      While VA had started to shift to post-credit-reform financing sources for the
                      post-1991 trusts replenishments, it did not have the information that would
                      enable charging the cost of replenishing the related reserves to the proper
                      fiscal years (cohorts). Financing all the losses incurred for any particular
                      year from just one cohort is contrary to the basic concept outlined in OMB’s
                      Circular A-11, implementation guidance for the Credit Reform Act, which
                      attempts to accurately account for costs by the fiscal year in which the
                      activity was originated. VA officials are currently in discussion with
                      Treasury officials on establishing the appropriate funding mechanism for
                      the guarantee on loans sold.

                      The purpose of the loan sale and direct loan activities discussed in this
Conclusions           report is to provide opportunities for mitigating losses on defaulted
                      VA-guaranteed loans in the HCA program, where reported guarantees
                      outstanding total $69 billion. VA has not been successful in moving to
                      outsourcing arrangements for these activities. It has not yet instituted
                      adequate safeguards over either the assets or the cash flows managed by
                      private contractors. Until it establishes an adequate evaluation base and
                      more stringent monitoring activities, it will provide little assurance to
                      others that the HCA programs are being run prudently. Instituting the kinds
                      of controls employed by major owners of housing loan portfolios is
                      necessary and would help in forming the basis for good program
                      management and reliable data for reporting financial and budgetary

                      In order to effectively manage loan assets and the cash flows associated
Recommendations       with VA’s direct loans, we recommend that the Secretary of Veterans
                      Affairs direct the Under Secretary for Benefits to:

                  •   Provide a basis for monitoring and controlling loan and property assets
                      and any related cash flows managed by contractors by establishing a
                      database for direct loans, through the development of a complete
                      inventory of all loans originated. The database should be similar to the
                      information systems in place at major owners of housing loan portfolios.
                      Benchmarking with major owners of housing loan portfolios should offer
                      perspective in the data requirements and capabilities offered by such
                      systems for creating an adequate control environment for overseeing both
                      in-house activities as well as outsourced functions.
                  •   Implement processes to allow immediate improvements in VA’s capability
                      to monitor contractor servicing of direct loans and disbursements related

                      Page 25                      GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

    to VA-owned properties. These improvements would include periodically
    obtaining tax bills for VA-owned properties from independent sources and
    comparing this information to that in its Property Management System to
    validate servicer requests for reimbursement of expenses.
•   Develop a centralized database to immediately record loans in the process
    of being assumed by VA in order to establish timely and thorough visibility
    over those assets and to facilitate transferring such information to the
    contract servicer expeditiously.
•   Reconcile all loan records in the contractor’s database to VA’s general
    ledger on a monthly basis, by the end of the following month.
•   Continue to develop standardized policies and procedures intended to
    ensure completeness, consistency, and accuracy of data obtained and
    recorded concerning individual loans and properties. Implement quality
    assurance steps to ensure the accuracy of this data.
•   Adhere to federal legislation and guidance regarding cash management.
    Servicers should be instructed to remit all proceeds to VA’s Treasury
    accounts daily upon receipt. Further, VA should recoup the total interest
    earned on SMG’s account balances from the inception of VA’s contract with
•   Establish suspense accounts, and a control account in VA’s general ledger,
    to record all collections that cannot be allocated to specific loan accounts.

    Regarding gaining operational and accounting control over loan sale
    activities, the Secretary of Veterans Affairs should direct the Under
    Secretary for Benefits to:

•   Complete the reconstruction of the historical data for the loan sales, the
    resulting trusts, and financing for the required reserve accounts for each
•   Establish adequate separation of duties and supervision over VA staff
    involved in all loan sale operational and administrative activities.
•   Develop and implement procedures to ensure that relevant data from
    servicers and the trustee/custodian are provided promptly to VA offices
    responsible for managing or recording trust activities and transactions.
•   Record loan sale transactions and all subsequent activity associated with
    the trusts consistent with federal accounting standards and any related
    guidance. This would include:
    • making appropriate accounting adjustments to accurately reflect the
       results of prior years’ transactions and
    • recording all financial transactions relating to trust activities, including
       those associated with the original sale, the establishment of the
       reserves, drawdowns to satisfy the federal guarantee, subsidy

    Page 26                       GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

                           reestimates, and replenishments to satisfy trust agreement provisions as
                           well as revenue from trust investments and assets.

                         Finally, we recommend that the Secretary of Veterans Affairs direct the
                         Under Secretary for Benefits to:

                     •   Establish and implement adequate monitoring activities of outsourced
                         activities to include both direct loans and VA property servicing as well as
                         activities associated with the loan sales. These efforts should be designed
                         to comply with OMB Circular A-129 and be stringent, given the risks
                         inherent in the existing servicing environment.
                     •   Disclose cash flows related to loan sales and related guarantees in VA’s
                         budget records, calculate and report the cost of direct loans and loan
                         guarantees, and budget for the subsidy and administrative cost of the loans
                         and guarantees in accordance with the Credit Reform Act and OMB Circular

                         In commenting on a draft of this report, VA concurred with 11 of our 13
Agency Comments          recommendations and agreed to implement them as part of its current
and Our Evaluation       effort to correct direct loan and loan sale records. Of the remaining two
                         recommendations, VA disagreed with one, and reserved agreement pending
                         a legal opinion on the other.

                         VA characterized the financial management weaknesses presented in this
                         report as being relatively minor. We disagree. By any measure, the
                         problems we identified are material financial and management control
                         weaknesses. The problems discussed in this report are so pervasive that
                         they resulted in qualified opinions by VA’s Office of the Inspector General
                         on VA’s financial statements for both fiscal years 1997 and 1998. The
                         $3 billion in loans and VA-owned property and $9 billion in potential
                         liability on loan sales represent guaranteed loans previously serviced by
                         private lenders that went into default and were acquired by VA. VA now
                         bears the primary responsibility for insuring prudent management of these
                         assets, in an effort to recoup losses and to preclude additional losses on
                         the properties for which loans were originally guaranteed.

                         VA stated that it had initiated a number of corrective actions. In our report,
                         we recognize that VA is taking good first steps to correct these problems,
                         and our recommendations for improvements are intended to assist the
                         agency in attaining the level of accountability and control envisioned in
                         the growing body of financial and program management legislation.

                         Page 27                      GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

VA did not concur with our recommendation that it test the validity of
contractor billings for property taxes paid on VA’s behalf. VA stated that its
Portfolio Loan Oversight Unit uses the Property Management System to
verify these payments. We agree that verifying VA ownership of property in
order to determine whether VA had any responsibility for taxes on
individual properties is a good first step. However, the thrust of our
recommendation is that VA verify that amounts paid for property taxes
were accurate. As pointed out in our report, VA could accomplish this by
obtaining tax data through readily available means. The verification could
be accomplished efficiently by testing selected transactions that provided
a statistically valid sample. Verifying the amounts in sample transactions
would provide adequate assurance that the billings from the contractor
were reasonable.

Finally, VA pledged to modify its processes to adhere to cash management
principles established in federal legislation and other guidance. It did not
take issue with our view that federal law does not authorize VA to
contractually or otherwise permit the contractor to retain interest earned
by depositing federal collections in the contractor’s account. Regarding
the matter of recouping of interest earned by the contractor, VA neither
concurred nor disagreed with our recommendation, stating that its
General Counsel is reviewing the issue of recoupment.

We are sending copies of this report to Senator Arlen Specter, Senator Ted
Stevens, Senator Robert C. Byrd, Senator Fred Thompson, Senator Joseph
Lieberman, Senator John D. Rockefeller IV, Representative C. W. Bill
Young, Representative Lane Evans, III, Representative Bob Stump,
Representative David Obey, Representative Dan Burton, and
Representative Henry A. Waxman in their capacities as Chairmen or
Ranking Minority Members of Senate and House Committees. We are also
sending copies to Togo D. West, Jr., Secretary of Veterans Affairs, the
Honorable Jacob J. Lew, Director of the Office of Management and
Budget, and the Honorable Joseph Thompson, Under Secretary for
Benefits of the Department of Veterans Affairs. Copies will be made
available to others upon request. If you have any questions or wish to
discuss the issues in this report, please contact me at (202) 512-4476.
Major contributors to this report are listed in appendix II.

Gloria L. Jarmon
Director, Health, Education and Human Services,
  Accounting and Financial Management Issues
Page 28                      GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities
Page 29   GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

Letter                                                                                                  1

Appendix I                                                                                             32
Comments From the
Department of
Veterans Affairs
Appendix II                                                                                            39
Major Contributors to
This Report
Glossary                                                                                               40

Figures                 Figure 1: Processes Supporting VA Guaranteed Loans in the                       6
                          Housing Credit Assistance Program
                        Figure 2: Contractors Involved in VA’s Direct Loan and Loan Sale               10


                        CDSI        Computer Data Systems, Incorporated
                        CDSI/SMG    Computer Data Systems, Incorporated/Seasons Mortgage
                        COTR        Contracting Officer’s Technical Representative
                        FMFIA       Federal Managers’ Financial Integrity Act
                        GAO         General Accounting Office
                        OIG         Office of Inspector General
                        OMB         Office of Management and Budget
                        HCA         Housing Credit Assistance Program
                        LGY         Loan guaranty activity
                        LSAMS       Loan Servicing Automated Management System
                        PLOU        Portfolio Loan Oversight Unit
                        PLS         Portfolio Loan System
                        PMS         Property Management System
                        SFFAS       Statement of Federal Financial Accounting Standards
                        SMG         Seasons Mortgage Group
                        USC         United States Code
                        VA          Department of Veterans Affairs
                        VBA         Veterans Benefits Administration

                        Page 30                     GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities
Page 31   GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities
Appendix I

Comments From the Department of
Veterans Affairs

Note: GAO comments
supplementing those in the
report text appear at the
end of this appendix.

                             Page 32   GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities
                 Appendix I
                 Comments From the Department of
                 Veterans Affairs

See comment 1.

                 Page 33                       GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities
                 Appendix I
                 Comments From the Department of
                 Veterans Affairs

See comment 2.

See comment 3.

                 Page 34                       GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities
                 Appendix I
                 Comments From the Department of
                 Veterans Affairs

See comment 4.

                 Page 35                       GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities
Appendix I
Comments From the Department of
Veterans Affairs

Page 36                       GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities
Appendix I
Comments From the Department of
Veterans Affairs

Page 37                       GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities
               Appendix I
               Comments From the Department of
               Veterans Affairs

               The following are GAO’s comments on the Department of Veterans Affairs’
               letter dated February 24, 1999.

               1. See “Agency Comments and Our Evaluation” section.
GAO Comments
               2. When VA uses the term “refunded” loans, it is describing a transaction
               more commonly known as “assumed” loans. We chose to use the term
               most understandable to readers outside of VA.

               3. Reconciliations are a basic control for financial management and
               accountability. The failure of VA to achieve timely and complete
               reconciliations of its direct loan records with the contractor’s indicates a
               systemic problem with the flow of accounting information. The dollar
               amount involved is less significant than the fact that the reconciliations
               cannot be performed successfully. VA has the responsibility to its
               borrowers to ensure that their loan balances are accurate.

               4. VA is responsible for ensuring the propriety and legality of services it
               contracts for, and the practices to be employed.

               Page 38                       GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities
Appendix II

Major Contributors to This Report

                       Alana Stanfield, Assistant Director
Accounting and         Elizabeth Kreitzman, Audit Manager
Information            Mel Mench, Senior Assistant Director
Management Division,   Maria Zacharias, Communications Analyst
                       Christina Quattrociocchi, Senior Auditor
Washington, D.C.       Suzanne Lightman, Auditor

                       Jeffrey A. Jacobson, Assistant General Counsel
Office of General

                       Page 39                    GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

           Assumed loans - Loans which were originally guaranteed by VA and held
           by private lenders. After the lenders notified VA of intent to foreclose, VA
           took over the loans from the lender and became the creditor to the
           veterans involved. VA may modify the terms of the loan with the veteran
           during the assumption.

           Cash reserve fund - The fund created during a loan sale and financed by
           VA. VA retains ownership of cash in the fund. The fund is used to pay VA’s
           guarantee of principal and interest as well as other expenses.

           Cohort - As described in OMB Circular No. A-34, a cohort includes all loans
           obligated or loan guarantees committed by the program in the same fiscal
           year, even if disbursements occur in subsequent fiscal years. Cohort
           accounting applies to post-1991 direct loans and loan guarantees.
           Accounting and other records must be maintained separately for each
           fiscal year within the program’s financing account. Any payment for losses
           from the financing account must be applied to the fiscal year in which the
           original loan was disbursed.

           Computer Data Systems, Incorporated (CDSI) - The primary
           contractor that services VA’s direct loan portfolio. It provides computer
           facilities and the servicing programs.

           Credit reform - Refers to the collective requirements as set forth in
           (1) the Federal Credit Reform Act of 1990, which generally requires that
           agencies calculate and record the net present value for credit programs
           and include the cost to the government in the budget, (2) Statement of
           Federal Financial Accounting Standard No. 2, Accounting for Direct Loans
           and Loan Guarantees, and (3) OMB Circulars A-11 and A-34.

           Direct loan activity - Actions relating to the creation, recording, and
           servicing of VA’s direct loan portfolio. The majority of direct loans are
           classified as either assumed or vendee loans. (See these terms for further

           Established loan - An assumed loan for which VA has a modification
           agreement with the veteran and has received all necessary documents
           pertaining to the loan.

           Financing account - The nonbudget account or accounts associated with
           a credit program account, which holds balances, receives the subsidy cost
           payment from the credit program account, and includes all other cash

           Page 40                      GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

flows to and from the government resulting from post-1991 direct loans or
loan guarantees.

Housing credit assistance program - A function of VA concerned with
housing credit activities. Its objectives are to assist veterans, certain
reservists, and active duty personnel in obtaining mortgage loans; assist in
avoiding foreclosures; and deliver the loan guarantee benefit as efficiently
as possible.

Loan guaranty activity - Actions related to providing a partial guaranty
of loans made by private lenders to veterans and service members to
purchase and retain homes, including claim payments, loan assumptions,
and property acquisition and management.

Loan sale activity - Actions related to the sale by VA of loans from its
direct loan portfolio. The loans are packaged into a trust and sold with a
guarantee of repayment of principal and interest.

Loan Servicing Automated Management System (LSAMS) - Loan
servicing program provided by CDSI that processes and accounts for
mortgage loans for VA’s direct loan portfolio.

Pre-1992 loan sale investments - Investments VA holds from loan sales
prior to 1992 which continue to generate income.

Outsourcing - The process of contracting for performance of a function
previously performed in-house, such as direct loan servicing.

Portfolio Loan Oversight Unit (PLOU) - A VA entity that oversees the
direct loan portfolio servicer’s functions and reconciles the general ledger
accounts related to the direct loan portfolio.

Qualified opinion - A opinion which states that, except for the effects of
the matter(s) to which the qualification relates, the financial statements
present fairly, in all material respects, the financial position, results of
operations, and cash flows of the entity in conformity with generally
accepted accounting principles.

Seasons Mortgage Group - A subcontractor to CDSI that services VA’s
direct loan portfolio.

Page 41                      GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities

           Servicer - A private sector entity that performs servicing functions for VA’s
           loan sale and direct loan activities. For the direct loans, the servicer
           collects and allocates mortgage payments from borrowers, pursues
           delinquent borrowers, maintains custody of escrow accounts, and pays
           taxes on VA-owned properties. The servicers for the loan sale activity are
           responsible for managing the loan portfolio of sold loans, accounting for
           individual loans in the portfolio, collecting mortgage payments,
           maintaining escrow accounts, foreclosing on delinquent borrowers,
           maintaining and selling foreclosed property, and reporting financial results
           of these activities to the trustee/custodian.

           Subsidy cost - The government’s estimated net costs, in present value
           terms, of direct or guaranteed loans over the entire period the loans are
           outstanding. For direct or guaranteed loans disbursed during a fiscal year,
           a subsidy expense is recognized. The amount of the subsidy expense
           equals the present value of estimated cash outflows over the life of the
           loans minus the present value of estimated cash inflows.

           Trust - A structure in which investors are issued certificates that
           represent shares in the cash flows from loans sold by VA. The trust is
           administered by a trustee/custodian.

           Trustee/custodian - A financial institution VA contracts with in
           connection with the loan sale activity. The trustee/custodian manages the
           trusts created by the sale and is responsible for maintaining the custody of
           all funds (including VA’s cash reserves), paying certificate holders, and
           filing with taxing authorities. The trustee/custodian is also responsible for
           reporting to VA financial activity within the trusts and other information as
           requested by VA.

           Vendee loan - A mortgage loan made by VA for the purchase of VA-owned

(919300)   Page 42                      GAO/AIMD-99-24 VA Direct Loan and Loan Sale Activities
Ordering Information

The first copy of each GAO report and testimony is free.
Additional copies are $2 each. Orders should be sent to the
following address, accompanied by a check or money order
made out to the Superintendent of Documents, when
necessary. VISA and MasterCard credit cards are accepted, also.
Orders for 100 or more copies to be mailed to a single address
are discounted 25 percent.

Orders by mail:

U.S. General Accounting Office
P.O. Box 37050
Washington, DC 20013

or visit:

Room 1100
700 4th St. NW (corner of 4th and G Sts. NW)
U.S. General Accounting Office
Washington, DC

Orders may also be placed by calling (202) 512-6000
or by using fax number (202) 512-6061, or TDD (202) 512-2537.

Each day, GAO issues a list of newly available reports and
testimony. To receive facsimile copies of the daily list or any
list from the past 30 days, please call (202) 512-6000 using a
touchtone phone. A recorded menu will provide information on
how to obtain these lists.

For information on how to access GAO reports on the INTERNET,
send an e-mail message with "info" in the body to:


or visit GAO’s World Wide Web Home Page at:


United States                       Bulk Rate
General Accounting Office      Postage & Fees Paid
Washington, D.C. 20548-0001           GAO
                                 Permit No. G100
Official Business
Penalty for Private Use $300

Address Correction Requested