oversight

American Mortgage Services, Inc., Non-supervised Loan Correspondent, Millington, Tennessee

Published by the Department of Housing and Urban Development, Office of Inspector General on 2004-05-03.

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

                                                                 Issue Date
                                                                         May 3, 2004
                                                                Audit Case Number
                                                                         2004-AT-1008




TO:           John C. Weicher, Assistant Secretary for Housing – Federal Housing
                 Commissioner, H




FROM:         James D. McKay
              Regional Inspector General for Audit, 4AGA

SUBJECT:      American Mortgage Services, Inc.
              Non-supervised Loan Correspondent
              Millington, Tennessee


                                     INTRODUCTION

We have completed an audit of the loan origination activities of American Mortgage Services,
Inc. We selected American Mortgage for review mainly due to its high default rate. Our
objective was to determine whether: (1) American Mortgage acted in a prudent manner and
complied with the Department of Housing and Urban Development (HUD) regulations,
procedures, and instructions in the origination of Federal Housing Administration (FHA) insured
single-family mortgages; and, (2) American Mortgage’s quality control plan, as implemented,
met HUD requirements.

To accomplish our objectives we tested compliance with HUD’s requirements for the origination
of FHA-insured loans. We reviewed a sample of 15 FHA-insured loans that were in default (14
of 15) or had been at some time during our audit period (1 of 15). American Mortgage
originated the loans between May 1, 2001, and April 30, 2003. We interviewed officials and
staff at HUD’s Atlanta Single Family Homeownership Center, American Mortgage officials and
staff, 11 of the 15 borrowers, closing attorneys, and other interested parties. In addition, we
reviewed HUD, FHA, American Mortgage, and the closing attorneys’ files and documents.

Our review generally covered the period May 1, 2001, through April 30, 2003. We extended the
audit period as necessary to achieve the audit objectives. We conducted our fieldwork from
July 7, 2003, through December 12, 2003. We conducted our audit in accordance with generally
accepted government auditing standards.
We discussed our review results with American Mortgage officials during the audit and at an exit
conference on March 19, 2004. We provided a copy of the draft report to American Mortgage
officials on March 9, 2004, for their comments. American Mortgage provided written comments
on March 29, 2004, which are summarized in the finding and included in their entirety as
Appendix A. As discussed in the Finding, we removed some issues from the draft report and
revised some recommendations based on American Mortgage’s comments.

In accordance with HUD Handbook 2000.06 REV-3, within 60 days please provide us, for each
recommendation without a management decision, a status report on: (1) the corrective action
taken; (2) the proposed corrective action and the date to be completed; or (3) why action is
considered unnecessary. Additional status reports are required at 90 days and 120 days after
report issuance for any recommendation without a management decision. Also, please furnish us
copies of any correspondence or directives issued because of the audit.

Should you or your staff have any questions, please contact me at (404) 331-3369 or
Gerald Kirkland, Assistant Regional Inspector General for Audit at (865) 545-4368.

                                           SUMMARY

Our review showed American Mortgage did not always follow prudent lending practices or
always demonstrate responsibility when it originated FHA-insured loans. For 5 of the 15 cases
we reviewed, American Mortgage did not exercise due diligence or fully consider all factors in
its review of borrowers' liabilities, credit, assets, and income. While the borrowers may have
met minimum requirements to qualify for loan approval, we question whether American
Mortgage originated the loans with the same care that it would have exercised if the loans were
entirely dependent on the properties as security. This occurred because American Mortgage’s
quality control plan did not meet HUD requirements and its quality control review process was
ineffective. Further, by American Mortgage’s own admission, it was concerned that applicants
would file suits if their applications were denied and subsequently approved by another
mortgagee. As a result, American Mortgage originated loans for borrowers who were, at best,
marginally qualified for FHA-insured loans. American Mortgage’s questionable loan origination
practices resulted in its high loan default rate of 12.88 percent, well above the national average of
2.99 percent for the 2-year period ending December 31, 2002. Further, HUD paid claims
totaling $170,636 for three of the five loans. We recommend you uphold American Mortgage’s
suspension under Credit Watch until such time as your office performs a quality assurance
review to assess American Mortgage’s ability to properly originate loans in accordance with all
HUD requirements.

                                        BACKGROUND

HUD grants FHA insurance on mortgages made by private lending institutions under Title II,
Section 203(b) of the National Housing Act as governed by regulations in Title 24 Code of
Federal Regulations (CFR) Part 203. HUD designates these institutions as supervised,
non-supervised, loan correspondent or investing lenders and mortgagees. Depending upon their
respective designation, the institutions have the authority to originate, purchase, sell, or service



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HUD FHA-insured mortgages. Specifically, a loan correspondent can only originate loans for
approved non-supervised mortgagees/sponsor.

American Mortgage was incorporated on June 26, 1992, in the state of Tennessee, and received
approval from HUD as a Title II non-supervised loan correspondent on November 19, 1992.
American Mortgage was formed for the purpose of originating residential mortgage loans with
FHA, the Department of Veterans Affairs, and conventional financing resources for borrowers in
the Memphis and Millington, Tennessee, area. As a non-supervised loan correspondent
mortgagee, American Mortgage only originated loans and did not underwrite them. We
reviewed the documentation in both American Mortgage’s and FHA’s case files as they related
to the origination function. American Mortgage had 25 sponsoring mortgagees that performed
the underwriting of its loans. The sponsoring mortgagees approved or rejected the loans based
on information in the loan package received from American Mortgage. Therefore, it was critical
American Mortgage exercise prudent lending practices during the loan origination process.

On June 23, 2003, HUD terminated American Mortgage from originating FHA-insured loans due
to its high default rate. HUD permitted American Mortgage to re-apply for a new loan
origination approval agreement at the completion of a 6-month exclusion period. On December
23, 2003, American Mortgage requested reinstatement.

American Mortgage originated 391 FHA-insured loans totaling $35,103,749 between May 1,
2001, and April 30, 2003. As of April 30, 2003, 42 of the 391 loans were in default and 2 had
claims paid on them. American Mortgage’s central office is located at 8086 Highway 51 North,
Millington, Tennessee.      American Mortgage has one branch office located at
5719 Raleigh-LaGrange #7, Bartlett, Tennessee.




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Finding 1 – American Mortgage Did Not Always Follow Prudent Lending Practices

American Mortgage did not always follow prudent lending practices or always demonstrate
responsibility when it originated FHA-insured loans. For 5 of the 15 cases we reviewed,
American Mortgage did not exercise due diligence or fully consider all factors in its review of
borrowers' liabilities, credit, assets, and income. While the borrowers may have met minimum
requirements to qualify for loan approval, we question whether American Mortgage originated
the loans with the same care that it would have exercised if the loans were entirely dependent on
the properties as security. This occurred because American Mortgage’s quality control plan did
not meet HUD requirements and its quality control review process was ineffective. Further, by
American Mortgage’s own admission, it was concerned that applicants would file suits if their
applications were denied and subsequently approved by another mortgagee. As a result,
American Mortgage originated loans for borrowers who were, at best, marginally qualified for
FHA-insured loans. American Mortgage’s questionable loan origination practices resulted in its
high loan default rate of 12.88 percent, well above the national average of 2.99 percent for the 2-
year period ending December 31, 2002. Further, HUD paid claims totaling $170,636 for 3 of the
5 loans. We recommend you uphold American Mortgage’s suspension under Credit Watch until
such time as your office performs a quality assurance review to assess American Mortgage’s
ability to properly originate loans in accordance with all HUD requirements.

Criteria

HUD Handbook 4000.4, REV-1, Single Family Direct Endorsement Program, Paragraph 2-1,
requires mortgagees to develop FHA-insured loans in accordance with accepted sound lending
practices, ethics, and standards. Paragraph 2-5 provides that mortgagees must obtain and verify
information with at least the same care that would be exercised if originating a mortgage entirely
dependent on the property as security to protect its investment.

Paragraph 2-13 states that a loan correspondent may participate in Direct Endorsement in a
limited manner within the HUD Field Office jurisdiction where it is approved to originate loans,
provided its sponsor is approved for Direct Endorsement. Under this arrangement, the loan
correspondent will take the initial application, handle the appraisal assignment with HUD,
procure verifications of deposit and employment and the credit report, close the loan after it has
been underwritten and submit the loan package to HUD for insurance endorsement.

HUD Handbook 4060.1, Mortgagee Approval Handbook, Paragraph 2-23D, and
24 CFR 202.5(j)(4), state that to be approved and to maintain mortgagee approval, neither the
mortgagee nor any officer, partner, director, principal, or employee shall be engaged in business
practices that do not conform to generally accepted practices of prudent mortgagees or that
demonstrate irresponsibility.

HUD Handbook 4155.1, REV-1, CHG-1, Section 2, paragraph 2-6, provides guidance for
determining borrowers' employment stability. While HUD does not impose an arbitrary
minimum length of time a borrower must have held a position to be eligible, the lender must
verify the borrower's employment for the most recent 2 full years.




                                                4
To analyze the probability of continued employment, lenders must examine the borrower’s past
employment record, qualifications for the position, previous training and education, and the
employer's confirmation of continued employment. A borrower who changes jobs frequently
within the same line of work, but continues to advance in income or benefits should be
considered favorably. In some cases, a borrower may have recently returned to the work force
after an extended absence. In these circumstances, the borrower's income may be considered
effective and stable provided: (1) the borrower has been employed in the current job for 6
months or more, and the borrower can document a 2-year work history prior to the absence from
the work force. This can be accomplished by providing traditional employment verifications.

Chapter 2, Section 1, Paragraph 2-3, provides guidance for originating loans for prospective
borrowers that have not established a credit history. For those borrowers, and those who do not
use traditional credit, the lender must develop a credit history from utility payment records,
rental payments, automobile insurance payments, or other means of direct access from the credit
provider, or may elect to use a non-traditional mortgage credit report developed by a credit
reporting agency. Neither the lack of credit history nor the borrower's decision not to use credit
may be used as a basis for rejection.

Paragraph 2-3A states the payment history of the borrower’s housing obligations is of significant
importance in evaluating credit. The lender must determine the borrower's payment history of
the housing obligations through either the credit report, directly from the landlord or mortgage
servicer, or through canceled checks covering the most recent 12-month period.

Chapter 2, Section 5, Paragraph 2-12, provides requirements for assessing whether borrowers
can reasonably be expected to meet the expenses involved in homeownership, and otherwise
provide for the family. If the total mortgage payment (principal and interest, escrow deposits,
homeowners' association dues, ground rent, and any special assessments, and payments for any
acceptable secondary financing) does not exceed 29 percent of gross effective income, the
relationship of the mortgage payment to income is considered acceptable. A ratio exceeding 29
percent may be acceptable if significant compensating factors are presented.

Loan Origination Deficiencies

We performed a detailed review of 15 FHA-insured loans originated by American Mortgage.
For 5 of the 15 cases we reviewed, American Mortgage did not exercise due diligence or fully
consider all factors in its review of borrowers' liabilities, credit, assets, and income. HUD paid
claims totaling $170,636 on 3 of the loans.

                          Inadequate     Inadequate        Unstable       Inadequate
           FHA Case         Credit         Rental         Income or      Consideration
            Number         Analysis        History       Employment      of All Factors
         482-3484186          X              X                X                 X
         482-3398943          X              X                                  X
         482-3406626          X                                                 X
         482-3428473          X
         482-3446816          X               X                                 X



                                                  5
FHA Case Number: 482-3484186

At the time of the initial application, December 2, 2001, the borrower had not demonstrated a
stable employment or income history. The borrower had been employed by the current
employer, a tire and alignment company, since September 6, 2001, or about 4 months. The only
other reported period of employment was with a tree trimming company from December 28,
1999, until the end of August 2001.

According to employment verifications, the borrower currently earned about $290 weekly. The
borrower had previously earned $323 weekly at the prior place of employment. Thus, the
borrower’s income had declined by $33 a week, or about 10 percent. Also, the jobs were not in
the same line of work (tire and alignment versus tree trimming). A borrower who changes jobs
frequently within the same line of work, but continues to advance in income or benefits should
be considered favorably. However, this borrower not only changed lines of work, but the income
declined. Further, because of the lower income, the borrower’s ratio of mortgage payment to
income was 30.7 percent, slightly above HUD’s threshold of 29 percent. Exceeding the ratio
was technically justified because the borrower’s monthly housing payment was reportedly
declining about $100 per month.

At the time of the initial application, the borrower had minimal traditional credit history. The
credit report only showed one small installment loan of $44 per month. The only other reported
monthly payment was for rent (one other person was included on the lease).

The borrower was renting the property he wished to purchase. The property owner signed a
rental verification form reporting the borrower began renting the property on April 1, 2001.
However, a rental agreement obtained at the closing agent's office shows that the borrower began
renting the property on June 1, 2001. Thus, the rental history only covered a period of 6 to
8-months. American Mortgage did not verify the borrower’s housing obligations for the most
recent 12-month period as required.

A limited credit and rental history does not necessarily disqualify the borrower from obtaining a
loan. However, because of the limited credit history, American Mortgage was required to
develop a credit history based on other information. American Mortgage did not develop the
credit history.

The borrower may have technically met FHA requirements for loan approval; however, the
Mortgage should have considered all factors relevant to the loan. In addition to the borrower’s
unstable employment and income, high mortgage payment to income ratio, limited credit, and
lack of rental history, the borrower had to obtain a gift of $2,650 to pay closing costs. Further,
following closing, the borrower only had $58 in reserves. We question whether it was prudent
for American Mortgage to approve the loan and place the FHA insurance fund at increased risk.
The borrower defaulted on the loan after making one payment. The mortgage was foreclosed
and the property was conveyed to HUD on October 1, 2003. HUD paid claims of $60,667.




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FHA Case Number: 482-3398943

The borrower had a history of bad credit, including collection accounts, charged off accounts,
and bad checks. A May 2, 2001, credit report showed the borrower had four collection accounts.
Three of the accounts were in collection as of September 2000. No payments had been made on
the three accounts from September 2000 through May 2, 2001. American Mortgage was aware
of the derogatory credit. In fact, American Mortgage obtained numerous credit reports between
January 30, 2001, and July 13, 2001, all of which showed derogatory credit. Yet, American
Mortgage approved the loan.

American Mortgage was required to verify 12-months payment history for the borrower’s
housing obligations. American Mortgage obtained evidence supporting the borrower paid rent at
the current residence, the property being purchased, for 1-month. The only other evidence of a
rental history was a statement from an American Mortgage loan officer that the borrower
previously rented somewhere else. American Mortgage did not obtain sufficient evidence to
support the borrower’s ability to meet housing obligations.

Given the borrower’s poor credit and insufficient rental history, American Mortgage should have
denied the loan.

We question whether it was prudent for American Mortgage to approve the loan and place the
FHA insurance fund at increased risk. The borrower defaulted on the loan after making one
payment. The mortgage was foreclosed and the property was conveyed to HUD on May 1, 2003.
HUD paid claims of $65,644.

FHA Case Number: 482-3406626

The borrower had a minimal credit history. Thus, American Mortgage was required to develop
an alternative credit history based on the borrower’s ability to make monthly payments,
including utility payments. We did not find any evidence that American Mortgage developed the
required alternative credit history. In fact, according to a February 10, 2001, credit report, the
borrower had a past due debt to a phone company at the time of the initial application.

The borrower's monthly housing expense was increasing significantly. The borrower was paying
$275 per month rent. The proposed mortgage payment was $531 per month, an increase of 93
per cent.

Further, American Mortgage claimed to have verified the borrower’s ability to save funds based
on the borrower’s bank statements. However, our review of the bank statements showed a
significant, unexplained discrepancy between the ending balance of one bank statement and the
beginning balance of the next bank statement. American Mortgage was required to verify assets
needed to meet the borrower’s minimum required investment. Given the unexplained
discrepancy, we question whether American Mortgage adequately reviewed the bank statements.

Given the borrower’s minimal credit history, recent delinquent phone bill, significant increase in
housing expense, and questionable bank statements, we question whether it was prudent for
American Mortgage to approve the loan and place the FHA insurance fund at increased risk.

                                                7
The borrower defaulted on the loan after 13 payments. Foreclosure began on November 1, 2002.
As of January 30, 2004, HUD had not paid a claim.

FHA Case Number: 482-3428473

The borrower had a minimal credit history. Thus, American Mortgage was required to develop
an alternative credit history based on other monthly payments being made by the borrower (rent,
utilities, cable bill, phone bill, etc.). We did not find any evidence that American Mortgage
developed the required alternative credit history. Even if American Mortgage had developed a
history, it would have been inadequate to support loan approval. According to American
Mortgage’s records, the borrower only had two monthly bills, utilities and cable, both of which
were delinquent.

We question whether it was prudent for American Mortgage to approve the loan and place the
FHA insurance fund at increased risk. The borrower defaulted on the loan after making three
payments. The mortgage was foreclosed and the property was conveyed to HUD on
August 1, 2003. HUD paid claims of $44,325.

FHA Case Number: 482-3446816

The borrower had a minimal credit history. Thus, American Mortgage was required to develop
an alternative credit history based on other monthly payments. We did not find any evidence
that American Mortgage developed the required alternative credit history. Even if American
Mortgage had developed a history, it would have been inadequate to support loan approval. The
borrower had three unpaid collection accounts at the time of initial application.

The borrower reported that there was no monthly rent expense. Thus, American Mortgage had
no rental history to assess the borrower’s ability to pay housing obligations. The payment
history of the borrower’s housing obligations is of significant importance in evaluating credit.

The borrower’s monthly mortgage payment on the loan was $420. The underwriter wrote on the
Mortgage Credit Analysis Worksheet, “Payment shock, however housing is minimal.” Although
$420 per month may seem minimal, the borrower reportedly had not been paying a monthly
housing expense. Thus, the increase was significant. In fact, the monthly housing expense to
income ratio jumped from zero percent to 33 percent, which exceeds HUD’s threshold of 29 per
cent. Based on HUD guidance, American Mortgage should have concluded that the borrower
could not reasonably be expected to meet the expenses involved in homeownership, and
otherwise provide for the family.

Even though the borrower had a poor credit history, insufficient rental history, and the monthly
housing expense to income ratio exceeded HUD’s threshold, American Mortgage approved the
loan for underwriting.

We question whether it was prudent for American Mortgage to approve the loan and place the
FHA insurance fund at increased risk. The borrower defaulted on the mortgage after making 14
payments. As of January 30, 2004, the mortgage was current.



                                               8
American Mortgage’s Quality Control Plan Did not Include all Required HUD Elements

The HUD Handbook 4060.1, REV-1, outlines specific items required to be included in the
mortgagee’s quality control plan. American Mortgage’s quality control plan did not include all
HUD required elements. Specifically, it did not include requirements to: (1) document actions
taken by management to identify causes of deficiencies and initiate prompt action to notify
employees and correct the deficiencies, (2) assure that procedures existed for expanding the
scope of quality control reviews where fraudulent activity or patterns of deficiencies were
identified, (3) determine whether verifications of employment, verifications of deposit, and credit
reports were handled by any interested third party or the mortgagor, or (4) assure that escrow
funds received from mortgagors were not excessive or used for any purpose other than that for
which they were received. Because its quality control plan was inadequate, American Mortgage
originated ineligible or questionable loans that were subsequently insured by FHA. As a result,
the FHA insurance fund incurred losses of $170,636 for three loans, and faces potential losses of
$98,293 for two loans.

Although American Mortgage used an outside contractor to develop its quality control plan, and
perform its quality control reviews, American Mortgage remained responsible for ensuring HUD
requirements were met. It failed to ensure the quality control plan met requirements. Further,
the reviews proved to be inadequate to identify and correct deficiencies.

To reduce its default rate, American Mortgage took steps to correct its weaknesses. American
Mortgage implemented risk-layering procedures for analyzing borrower applications. Also,
during our audit, American Mortgage replaced its quality control contractor and implemented a
new quality control plan. We did not assess whether the new plan met HUD requirements or
whether the new contractor performed adequate reviews.

AUDITEE COMMENTS

American Mortgage explained that in 2 ½ years its prior contractor never identified any changes
that were needed from the original documentation submitted to underwriting. American
Mortgage changed contractors based on a suggestion from its Certified Public Accountant.
Subsequently, it identified the reasons for an increase in its defaults.

American Mortgage believed a very large portion of the findings were underwriter issues and
their responsibility, thus American Mortgage questioned why we did not interview the
underwriters during our audit.

American Mortgage provided a brief discussion to dispute each of the five loans we questioned.
Generally, American Mortgage claimed that it obtained the necessary documentation and
properly analyzed the borrowers’ credit history, income, assets, payment of housing obligations,
and other factors. As such, American Mortgage claimed it met requirements.

Further, American Mortgage stated that recommending it indemnify the loans would be an
injustice.




                                                9
OIG EVALUATION OF AUDITEE COMMENTS

As stated in the Finding, we recognized American Mortgage took steps to correct its weaknesses,
including replacing its contractor. We did not interview the underwriters because our objective
was to determine whether American Mortgage followed HUD policies and procedures and
prudent lending practices, not the underwriting/sponsoring mortgagees. The concerns we raise
are attributable to American Mortgage. It was American Mortgage’s responsibility during loan
origination, and prior to submitting for underwriting, to assess the borrowers’ credit, income,
payment of housing obligations, and other issues identified in the Finding.

We considered American Mortgage’s discussions on the five cases as well as comments we
received from HUD’s Quality Assurance Division. Based on the comments, we removed the
recommendations to require American Mortgage to indemnify the loans. However, we
recommended that HUD uphold American Mortgage’s suspension under Credit Watch until such
time as HUD performs a quality assurance review to determine whether American Mortgage can
originate loans in accordance with all HUD requirements. We also removed a discussion on loan
482-3406626 pertaining to the borrower’s lack of rental history and a discussion on loan
482-3446816 pertaining to the borrower’s ability to save funds. Further, we removed a
discussion on loan 482-3428473 pertaining to the borrower’s income.

We revised the Finding to emphasize that while the borrowers may have met minimum
requirements to qualify for loan approval, we question whether American Mortgage exercised
due diligence or fully considered all factors in its review of borrowers' liabilities, credit, assets,
and income. We questioned whether American Mortgage originated the loans with the same
care that it would have exercised if the loans were entirely dependent on the properties as
security.

RECOMMENDATIONS

We recommend the Assistant Secretary for Housing – Federal Housing Commissioner:

1A.    Perform a quality assurance review of American Mortgage.

1B.    Uphold American Mortgage’s suspension under Credit Watch until such time as a quality
       assurance review determines American Mortgage can originate loans in accordance with
       all HUD requirements.

1C.    Review American Mortgage’s implementation of its new quality control plan, and ensure
       its loan origination procedures and management controls process are fully implemented
       in conformity with HUD requirements.




                                                 10
                                MANAGEMENT CONTROLS

In planning and performing our audit, we considered American Mortgage’s management controls
relevant to the Section 203 Program to determine our auditing procedures and not to provide
assurance on the controls. Management is responsible for establishing effective management
controls to ensure that its goals are met. Management controls include the plan of the
organization, methods and procedures adopted by management to ensure that its goals are met.
Management controls include the processes for planning, organizing, directing, and controlling
program operations. They include systems for measuring, reporting, and monitoring program
performance.

We determined the following management controls were relevant to our audit objectives:

   1. Loan origination process.

   2. Quality Control process.

We assessed the relevant controls identified above by:

       Reviewing the regulations governing the program and procedures established by
       American Mortgage in originating FHA-insured loans;

       Interviewing HUD officials and staff, American Mortgage officials and staff, 11 of the 15
       borrowers, closing attorneys, and other interested parties; and,

       Reviewing American Mortgage’s and HUD’s records and related documents and controls
       for FHA-insured loans originated between May 1, 2001, and April 30, 2003.

A significant weakness exists if management controls do not provide reasonable assurance that
resource use is consistent with laws, regulations and policies; that resources are safeguarded
against waste, loss and misuse; and that reliable data are obtained, maintained and fairly
disclosed.

Based on our audit, we identified weakness in all relevant control areas. See Finding 1.




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                             FOLLOW-UP ON PRIOR AUDITS

This is the first Office of Inspector General Audit of American Mortgage’s origination of FHA-
insured loans. Cook, Greer, Huddleston, McLean, P.C. completed the most recent Independent
Auditor audit report for the 12-month period ended May 31, 2002. The report disclosed one
reportable condition, a lack of segregation of duties as they relate to cash, revenue/receipts and
disbursements. The finding did not impact our audit objectives.




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                   APPENDIX A

AUDITEE COMMENTS




       13
*   Borrower’s name has been deleted.




                                        14
*   Borrower’s name has been deleted.




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