oversight

Keystone Mortgage & Investment Company, Phoenix, Arizona

Published by the Department of Housing and Urban Development, Office of Inspector General on 2004-03-24.

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

           AUDIT REPORT




KEYSTONE MORTGAGE AND INVESTMENT COMPANY

            PHOENIX, ARIZONA

                2004-LA-1001

               March 24, 2004



               OFFICE OF AUDIT
            PACIFIC/HAWAII REGION
           LOS ANGELES, CALIFORNIA
                                                                   Issue Date
                                                                         March 24, 2004
                                                                  Audit Case Number
                                                                           2004-LA-1001




TO:            John C. Weicher, Assistant Secretary for Housing, Federal Housing
               Commissioner and Chairman Mortgagee Review Board, H

               Margarita Maisonet, Acting Director, Departmental Enforcement Center, CV




FROM:          Joan S. Hobbs, Regional Inspector General for Audit, 9DGA

SUBJECT:       Keystone Mortgage and Investment Company
               Non-Supervised Loan Correspondent
               Phoenix, Arizona

We completed an audit of Keystone Mortgage and Investment Company (Keystone), a non-
supervised loan correspondent mortgagee, based in Phoenix, Arizona. We selected Keystone for
audit based on the existence of identified risk factors and indications it originated loans at an
office that had its origination approval terminated under HUD’s Credit Watch authority. The
audit objective was to determine if Keystone originated Federal Housing Administration (FHA)
insured mortgages in accordance with prudent lending practices and HUD requirements.

Our report contains two findings with recommendations requiring action by your office. 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.

If you have any questions, please contact Charles Johnson, Assistant Regional Inspector General
for Audit at (602) 379-7243.
Management Memorandum




                        THIS PAGE LEFT
                            BLANK
                        INTENTIONALLY




2004-LA-1001              Page ii
Executive Summary
We completed an audit of Keystone Mortgage and Investment Company (Keystone), a non-
supervised loan correspondent mortgagee located in Phoenix, Arizona. The objective of our
audit was to determine if Keystone complied with prudent lending practices, and HUD
regulations, requirements, and instructions in the origination of FHA insured mortgage loans.




                                   Keystone used falsified borrower credit and employment
 48 Loan Files Contained           documents to originate FHA loans. Forty-eight of the
 Falsified Documents               sixty-five loans we reviewed (74%) contained false or
                                   altered documents including:

                                       •   Fabricated or altered Internal Revenue Service (IRS)
                                           W-2 forms, pay stubs, and verification of employment
                                           forms.
                                       •   Fabricated or altered credit reference letters
                                           showing invalid accounts or inaccurate credit
                                           history information.
                                       •   False credit reports listing invalid borrower credit
                                           history information.

                                   We identified a pattern of apparent mortgagee complicity in
                                   the loan origination process that allowed false documents to
                                   be used and a serious lack of due professional care by
                                   mortgagee personnel. Based upon information obtained
                                   during the audit, it appears one Keystone employee was
                                   primarily responsible for the false and fabricated documents.
                                   Further, Keystone’s failure to implement a quality control
                                   plan allowed the pervasive use of falsified loan origination
                                   documents to continue over a period of at least 3 years. As a
                                   result, loans were approved based on false information
                                   causing FHA to assume over $5 million in unnecessary
                                   insurance risk

                                   Keystone improperly originated FHA loans at its home
 Keystone improperly               office in Phoenix after HUD terminated this office’s
 originated FHA loans              origination approval under the Credit Watch program. In
 after HUD terminated the          our opinion, this occurred because Keystone intentionally
 origination approval.             failed to comply with the requirements of HUD’s
                                   termination. As a result, FHA was exposed to unnecessary
                                   risk on loans originated by a terminated mortgagee office.



                                       Page iii                                    2004-LA-1001
Executive Summary



                             Keystone’s comments are included as Attachment C and
  Auditee Comments.
                             summarized at the end of Findings one and two. Keystone
                             agreed that required quality control reviews were not
                             conducted, yet stated they believe Keystone employees did
                             not cause the use of false documents found in its loan files.
                             Keystone stated it did not originate loans at a Credit Watch
                             terminated office.

                             OIG’s evaluation of Keystone’s comments is included at the
 OIG Evaluation of Auditee
                             end of Findings one and two. We disagreed with several
 Comments
                             points in Keystone’s comments. As stated in the report, we
                             found a pattern of apparent mortgagee complicity in the loan
                             origination process and a serious lack of due professional care
                             by mortgagee personnel.         OIG also found Keystone
                             improperly originated FHA loans at a Credit Watch
                             terminated office.

                             We recommend that your office take appropriate action
 Recommendation              against Keystone, up to and including debarment and denial
                             of FHA loan approval authority, for not adhering to HUD’s
                             program requirements, and require Keystone to indemnify
                             HUD/FHA against past and future losses on the 48 loans
                             identified in Appendix B.

                             We discussed the findings with Keystone officials during
  Audit Results Discussed    the audit and at an exit conference held on February 5,
  With Auditee               2004. We also provided Keystone and HUD with a copy of
                             the draft audit report for comments on February 9, 2004.
                             We received their written responses on March 8, 2004.
                             Their responses and our evaluations are discussed in the
                             findings, and the full text of their responses is included as
                             Appendix C.




2004-LA-1001                     Page iv
Table of Contents
Management Memorandum                                                    i



Executive Summary                                                    iii



Introduction                                                             1



Findings

1. Keystone Used Falsified Documents When Originating FHA
   Insured Loans
                                                                     3
2. Keystone Originated FHA Loans at a Credit Watch Terminated
   Office                                                           11



Management Controls                                                  15



Follow Up On Prior Audits                                            17



Appendices
   A. Schedule of Questioned Costs and Funds Put to Better Use       19

   B. Schedule of FHA Loans Originated Using False Documents         21

   C. Auditee Comments                                               23




Abbreviations
                             Page v                         2004-LA-1001
Table of Contents




CFR            Code of Federal Regulations
FHA            Federal Housing Administration
HUD            The Department of Housing and Urban Development
OIG            Office of Inspector General




2004-LA-1001                      Page vi
Introduction
Section 203 (b) (1) of the National Housing Act, as amended, authorizes HUD to provide
mortgage insurance for single-family homes. A mortgagee that originates, purchases, holds or
sells FHA insured loans, must be formally approved, by HUD. Mortgagees must follow the
statutory and regulatory requirements of the National Housing Act and HUD instructions,
guidelines, and regulations when originating insured loans. Mortgagees that do not follow
these requirements are subject to administrative sanctions.

Keystone is a loan correspondent mortgagee and therefore may originate loans. However, the
loans must be sent to a HUD-approved Direct Endorsement sponsor for underwriting approval
prior to loan closing, and submission to HUD for insurance endorsement. The loan origination
process includes taking the initial loan application, initiating the appraisal assignment,
obtaining the credit report, and procuring verifications of deposit and employment. Based on
the information gathered by the loan correspondent, the sponsor mortgagee underwrites the
loan and makes a decision as to whether the borrower represents an acceptable credit risk for
HUD. Since the sponsor bases its underwriting approval, in large part, on information
gathered by the loan correspondent, it is critical that the loan correspondent exercises due care
and follows prudent lending practices when originating the loan.

Keystone has a home office located in Phoenix, Arizona, and one branch office located in
Mesa, Arizona. In January 2002, HUD terminated the FHA loan origination approval of
Keystone’s home office based on Keystone’s high default rate. In February 2002, shortly after
the home office was terminated, Keystone obtained approval from HUD to originate FHA
loans at a new branch office in Mesa, Arizona.




                                    The objective of our audit was to determine if Keystone
Audit Objectives                    complied with prudent lending practices and HUD
                                    regulations, requirements, and instructions when originating
                                    FHA insured single-family mortgages.

                                    We performed our audit during the period February 2003
Audit Scope and                     through October 2003. We selected Keystone for audit based
Methodology                         on several risk factors, including a high number of defaults,
                                    indications false borrower social security numbers were used,
                                    and information indicating the mortgagee originated loans at
                                    an office that had been terminated under HUD’s Credit
                                    Watch termination authority.




                                        Page 1                                      2004-LA-1001
Introduction


               To accomplish our audit objectives, we:

                  •   Selected and performed in depth reviews on 24 FHA
                      insured loans originated by Keystone during the
                      period March 2001 through May 2002.

                  •   Selected and performed limited reviews on 41
                      additional Keystone FHA insured loan files primarily
                      originated between May 2001 and October 2003.
                      These loans were reviewed because the documents
                      used in these files were similar to a pattern of falsified
                      loan origination documents identified in the initial
                      sample.

                  •   Interviewed Keystone management and employees.

                  •   Interviewed FHA borrowers, purported borrower
                      employers, and creditors to verify information
                      submitted to HUD/FHA as part of the FHA loan files
                      reviewed.

                  •   Verified purported borrower wage information.

                  •   Reviewed Keystone’s quality control plan and
                      determined if the plan was properly implemented.

               Since Keystone is a loan correspondent and therefore must
               use a HUD-approved sponsor mortgagee to underwrite its
               FHA loans, our review did not focus on the adequacy of
               loan underwriting. Although we did note deficiencies
               related to the sponsors’ underwriting in some cases, these
               will not be addressed as part of this audit report.

               The audit primarily covered loans originated during the
               period from March 2001 through October 2003. During
               this period, Keystone originated 268 FHA insured loans for
               amounts totaling approximately $30 million within the state
               of Arizona. We conducted our review in accordance with
               generally accepted government auditing standards.




2004-LA-1001       Page 2
                                                                                        Finding 1


     Keystone Used Falsified Documents When
          Originating FHA Insured Loans
Forty-eight of the sixty-five loans we reviewed, totaling approximately $5 million, were
originated and approved based upon falsified borrower information - falsified credit reports,
false credit history letters from utility companies, and/or falsified employment documents such
as pay stubs, W-2s, and verification of employment forms. This occurred because Keystone
apparently allowed the documents to be included in the files and failed to exercise due care
during the loan origination process. The scheme was allowed to continue over a period of at
least three years because Keystone management failed to implement a quality control plan to
monitor its loan origination activities and assure compliance with HUD requirements. As a
result, loans were approved based on false information, causing FHA/HUD to assume
unnecessary insurance risks. Four of these forty-eight loans have resulted in insurance claims to
HUD/FHA and three others are currently in foreclosure.




                                     Mortgagees must follow the statutory and regulatory
 Loan Origination                    requirements of the National Housing Act and HUD
 Requirements                        instructions, guidelines, and regulations when originating
                                     insured loans. HUD Handbook 4060.1 REV-1, Mortgagee
                                     Approval Handbook, requires that mortgagees conform to
                                     generally accepted practices of prudent mortgagees and
                                     demonstrate responsibility in order to maintain approval for
                                     participation in FHA insurance programs. This would
                                     include exercising due care when obtaining borrower credit
                                     and income verifications, and being alert to situations
                                     involving obvious use of falsified documents.

                                      As part of the loan origination process, mortgagees are
                                     required to obtain a credit report for each borrower. The
                                     credit report is used as a guide in the underwriting process
                                     to evaluate the borrower’s attitude toward credit
                                     obligations. If the credit report shows the borrower has
                                     made payments on previous or current obligations in a
                                     timely manner, the underwriter will find the borrower
                                     represents a reduced risk. If the borrower has not yet
                                     established a credit history with traditional credit accounts
                                     such as, credit cards, car loans or mortgages, the mortgagee
                                     can develop an “alternative” credit history using utility
                                     payment records, rental payments, automobile insurance
                                         Page 3                                      2004-LA-1001
Finding 1


                      payments, or other similar non-traditional credit sources.
                      The mortgagee itself may obtain this alternative credit
                      information, or the mortgagee may elect to use a credit-
                      reporting agency to develop and provide a non-traditional
                      mortgage credit report (reference HUD Handbook 4155.1
                      REV-5, Mortgage Credit Analysis for Mortgage Insurance
                      on One-to-Four Family Properties).

                      The mortgagee must also obtain documentation evidencing
                      the borrowers’ history of employment and income. The
                      anticipated amount of income and likelihood of its
                      continuance must be established to determine the
                      borrower's capacity to repay the mortgage debt.

                      The underwriter’s evaluation of a borrower’s credit and
                      income history (previously obtained during the loan
                      origination process) is used as a basis for determining if the
                      borrower represents an acceptable credit risk under HUD
                      guidelines, and accordingly, whether or not the loan should
                      be approved.

                      As a condition of HUD/FHA approval, HUD requires
                      mortgagees, including loan correspondents, to maintain a
                      written Quality Control Plan for the origination of FHA
                      insured mortgages. The plan must provide for independent
                      testing/sampling and evaluation of the significant
                      information gathered for use in the mortgage credit
                      decision. It must be sufficient in scope to enable the
                      mortgagee to evaluate the accuracy, validity and
                      completeness of its loan origination operations. Among
                      other things, the Quality Control Plan must provide for
                      written re-verification of the borrower’s employment and
                      ordering a new credit report to identify any discrepancies.
                      Mortgagees may choose to review the lesser of 10% of all
                      loans closed on a monthly basis, or a random sample that
                      provides a 95% confidence level with 2% precision
                      (reference HUD Handbook 4060.1 REV-1, Chapter 6).

                      Keystone did not adhere to the above HUD requirements.
                      Specifically, Keystone failed to exercise due care when
                      originating FHA insured loans and failed to implement a
                      quality control plan.

                      In total, we reviewed 65 FHA insured loan files. We
We Reviewed 65 Loan   initially selected a sample of 24 loans for in-depth review
Files                 of the loan origination process. This initial review
2004-LA-1001              Page 4
                                                                             Finding 1


                          identified the use of false non-traditional credit documents
                          associated with three specific credit sources. Based on this
                          identified pattern, we selected for review 41 additional
                          Keystone loan files where these three specific credit
                          sources were used.

                          Of the 65 loan files reviewed, 48 (74%) contained false
48 Loan Files Contained   borrower credit and/or employment documents. False
Falsified Documents       credit documents included credit reports and letters
                          purportedly from creditors listing invalid accounts or
                          inaccurate credit history information. False employment
                          documents included fabricated or altered IRS W-2 forms,
                          borrower pay stubs, and verification of employment forms.
                          In many of the loan files involving false employment, the
                          borrower’s income or length of employment was
                          overstated. In other cases, the borrower never worked for
                          the purported employer or the borrower worked as a
                          contract laborer rather than as a full time employee as
                          claimed. The falsified documents in Keystone’s files were
                          apparently intended to enhance the appearance of the
                          borrower’s credit and employment history, and thereby
                          unduly influence the loan underwriting process in order to
                          obtain loan approval. Those loans identified which
                          involved the use of false employment and/or credit
                          documents are detailed in Appendix B.

                          A close review of the 48 loan files involving false
Keystone Failed to        origination documents identified a pattern evidencing
Exercise Due Care and     apparent mortgagee complicity in the falsification,
Responsibility            involving primarily one Keystone employee, and a serious
                          lack of due care by mortgagee personnel involved in the
                          loan origination process. Specifically:

                          All but two of the 48 loan files containing false
                          documents involved the same Keystone employee.

                          Nearly all of the loan files containing false documents were
                          tied to the same Keystone employee. This employee was the
                          loan officer for 37 of the 48 loans involving the use of false
                          documents and participated in the origination of nine more of
                          these loans, acting as the loan processor or closely
                          supervising the origination process for loan officers in-
                          training.

                          This employee had extensive prior experience as an
                          underwriter and loan officer, yet claimed to have had no

                              Page 5                                      2004-LA-1001
Finding 1


               knowledge of the false documents used throughout the loan
               files. Loan officers in training who worked under this
               Keystone employee stated they questioned this employee
               about suspicious documents they found in the loan files,
               and the employee would either ignore the questions or
               become angry and confrontational. One of the loan officers
               in-training working under this employee stated on one
               occasion she observed the employee using white out to
               alter a verification of employment form.

               The same four credit sources were shown on falsified
               alternative credit documents in 42 different Keystone
               loan files.

               Forty-two of the forty-eight loan files containing false
               documents involved falsified credit references (letters and
               account history statements) from the same four utility
               companies - COX cable, Qwest telephone, SRP power and/or
               Southwest Gas. References for these same sources were used
               even for borrowers that did not reside in areas serviced by
               these utility companies. Keystone used these false credit
               documents to obtain alternative credit reports by faxing the
               falsified letters and account history statements to a credit
               reporting company who, without verification, would use the
               falsified accounts to create a credit report. In many instances,
               the credit reference letters and account statements were
               purged from Keystone’s loan files, leaving only the credit
               reports with the false account information.

               False credit and employment documents found
               throughout Keystone’s loan files were nearly identical.

               The 48 loans involving false documents were originated
               over a three year period and were associated with 1) many
               different borrowers, sellers and realtors, 2) properties
               located in different areas, and 3) borrowers living in
               different areas prior to purchasing their new homes. Yet
               many of the loan files contained nearly identical false credit
               and employment documents. In fact, it appears falsified
               documents in many of the loan files were fabricated using
               the same template. In these cases, the formatting of the
               falsified documents was the same, and even random ink
               markings on the documents were identical. The only
               common link identified between these loan files was the
               involvement of one Keystone employee. Examples of
               these commonalities include:
2004-LA-1001       Page 6
                                                   Finding 1



•   The same W-2 form (photocopy) was included in five
    separate loan files. The borrower name and employer
    information in each case was altered to make it appear as
    though it belonged to the borrowers for each loan.
    However, it was obvious that the documents were created
    from the same original photocopy. In all five cases,
    characters consistent with page header information
    typically printed by a fax machine appeared in the same
    position respective to the form. These five W-2 forms
    also contained several random ink markings that were
    also identically positioned respective to the form,
    confirming that each of the five falsified W-2 forms was
    fabricated using one original form as a template.

•   Nine additional instances were noted where loan files
    contained one or more documents which were used as
    templates to create false employment forms that were
    used in other loan files. This included pay stubs and
    additional W-2s. In several loan files we identified false
    employment documents matching those found in up to
    seven other Keystone loan files.

•   For six loans the same borrower credit history document
    with COX Cable was used to create false account history
    statements. Similar use of templates to create false
    documents was found for other alternative credit letters
    including letters from SRP power and Qwest Telephone.

•   Many of the false documents were altered in a similar
    manner. For example, in nine cases, income amounts
    shown on borrower W-2 forms were overstated by even
    dollar amounts.     In six separate loan files the
    borrower’s annual income was overstated by exactly
    $10,000 and in other cases the overstatement was
    exactly $4,000, $5,000 or $6,000. Also, in many cases
    the borrower’s personal information and other altered
    text on the false documents was printed in a similar
    manner indicating the documents were altered by the
    same source using the same method.

Those borrowers and employers we interviewed stated that
they provided the correct employment and credit
documents to Keystone. This is corroborated by our
review of Keystone’s loan files. For example, in one
instance Keystone’s loan file contained an Arizona Public
    Page 7                                      2004-LA-1001
Finding 1


                                  Service (APS) electric bill provided by a borrower, yet its
                                  file also contained a false letter from SRP, a different
                                  power company.        In this same case, documents in
                                  Keystone’s loan file, including pay stubs and its own
                                  employee’s notes, showed the borrower was a contract
                                  laborer paid without any tax withholdings. Yet, Keystone
                                  included a false W-2 form in the file showing the borrower
                                  was an employee with tax withholdings, and not a contract
                                  laborer. This false information was submitted to its
                                  sponsor for underwriting approval.       It is apparent that
                                  Keystone had the correct credit and employment
                                  information in this case, but chose to use falsified
                                  information in order to obtain loan approval.

                                  In summary, Keystone failed to exercise due care when
                                  obtaining borrower credit and income verifications and failed
                                  to prevent the persistent use of falsified documents. Based on
                                  the facts discussed above, it appears one Keystone employee
                                  was responsible for including the false documents in the loan
                                  files to obtain underwriting approval.           Because the
                                  underwriting process intended to limit HUD’s insurance risk
                                  was unduly influenced by inaccurate credit and employment
                                  information in 48 of Keystone’s loans, HUD was exposed to
                                  unnecessary risk.

                                  Keystone management failed to implement a quality
Failure to Implement a            control plan as required by HUD. As a result, the rampant
Quality Control Plan              use of false credit and employment documents discussed
                                  above was allowed to continue undetected by management
                                  over a period of at least three years. When we first
                                  requested documentation on recent quality control reviews,
                                  Keystone provided a one page document listing two loans
                                  that were supposedly reviewed. Upon further review, we
                                  found this list had been created only after OIG requested
                                  this, and no prior reviews had actually been conducted.
                                  Keystone management stated they will ensure the required
                                  quality control reviews are conducted in the future.

Auditee Comments

Keystone agreed that the required quality control reviews were not performed, and stated an
Executive Vice President for Keystone was fired because no loan files were subjected to
independent review. Keystone also stated a contractor was hired since September of 2003 to
perform quality control reviews.

2004-LA-1001                           Page 8
                                                                                         Finding 1


Keystone stated they believe no employees caused or allowed fraud in the loan files. Keystone
stated there is a possibility the falsified documents were created by an unknown party that
produces false documents “on the street” for a fee, rather than by a Keystone employee.
However, based on the strength of the information and documentation presented in our report,
Keystone terminated the loan officer associated with the falsified loans.

Keystone stated credit documents cited as false in the audit report might have been valid.




OIG Evaluation of
Auditee Comments
We agree with Keystone (as discussed in our audit report), that it did not conduct independent
quality control reviews as required by HUD. Further, Keystone’s response stated a senior loan
officer was assigned to its quality control function. This is prohibited by HUD Handbook
4060.1, which requires that quality control staff have no direct loan processing responsibilities.
It should be noted that this loan officer was the same individual that participated in originating
46 FHA loans using false documents.

Keystone noted it might have been difficult to detect the use of false documents. We disagree.
In fact, Keystone’s primary FHA loan officer claims she had indications false documents were
being used and states in a letter “When HUD first came to me to question several items of
documentation in the file and advised me that many of them were false I was not surprised or
alarmed because many times while originating loans over the past 3 years I had my own
suspicions”. This letter indicates that only “very questionable” documents were rejected, and
also states “…I am aware that I am responsible for the documentation in the file and I agree that
me and Keystone had some responsibility to ensure that what was in the loan file was true and
exact, I feel this is where I failed”. Also, as noted in the audit report, other Keystone employees
questioned the legitimacy of the loan documents. It is apparent Keystone, at a minimum, failed
to resolve obvious use of falsified documents and thus failed to exercise due professional care
when originating FHA insured loans.

Keystone claimed the falsified documents found in its files may have been created by an
unknown third party rather than by a Keystone employee. However, the audit report does not
conclude as to who physically created the false documents, but rather the report outlines a
Keystone employee’s apparent complicity in using the false documents within FHA loan files.
As stated in the audit report, the only common link identified between the files, often containing
identical false documents, was a single Keystone employee. In our opinion, it would have been
virtually impossible for the falsified documents to be used without the knowledge of this
employee.

Another comment in Keystone’s response appeared to imply borrower utility bills we concluded
were falsified may have been valid, yet only appeared false because they were not associated
with the borrowers’ current address. This point is not valid. Through direct verification with

                                          Page 9                                      2004-LA-1001
Finding 1


creditors (COX, Qwest, SRP and Southwest Gas) we confirmed the purported accounts were not
valid or not associated with the borrower.



Recommendations                   We recommend the Assistant Secretary for Housing – Federal
                                  Housing Commissioner and Chairman, Mortgagee Review
                                  Board:

                                  1A.      Require Keystone to indemnify HUD/FHA for any
                                           losses already incurred, and against future losses,
                                           on the 48 loans identified in Appendix B that were
                                           originated using false documents.

                                  1B.      Seek civil monetary penalties against Keystone for
                                           each loan identified in Appendix B that was
                                           originated using falsified documents.

                                  1C.      Take appropriate action against Keystone up to and
                                           including removal from participation in HUD’s
                                           Single Family Mortgage Insurance Programs.

                                  1D.      If HUD determines that Keystone can maintain their
                                           approval as a non-supervised loan correspondent, take
                                           appropriate monitoring measures to ensure Keystone
                                           Mortgage implements a quality control plan that
                                           meets HUD requirements.

                                  We recommend the Acting Director, Departmental
                                  Enforcement Center:

                                  1E.     Debar the Keystone employee apparently responsible
                                           for use of the falsified documentation.




2004-LA-1001                            Page 10
                                                                                        Finding 2




   Keystone Originated Loans at a Credit Watch
               Terminated Office
Keystone originated FHA insured loans at its Phoenix home office after HUD terminated this
office’s origination approval agreement pursuant to HUD’s Credit Watch termination authority.
In our opinion, Keystone intentionally failed to comply with the requirements of HUD’s
termination notice. Further, it appears Keystone circumvented HUD’s Credit Watch termination
by obtaining HUD approval for a new branch office, and using this office to submit loans to
HUD for insurance, when in fact, the loans were originated at least in part through the terminated
office. As a result, HUD’s Credit Watch Termination was effectively bypassed and FHA was
exposed to unnecessary risk on loans originated by a terminated mortgagee office that had not
taken the remedial steps needed to strengthen its loan origination controls and obtain
reinstatement of its loan origination approval.




                                     A mortgagee must be approved by HUD in order to
 Mortgagee Requirements              originate, purchase, hold or sell HUD-FHA insured
                                     mortgages (HUD Handbook 4060.1 ). In accordance with
                                     24 CFR 202.3 and HUD’s Mortgagee Letter 99-15, a
                                     mortgagee’s FHA origination approval agreement may be
                                     terminated if the mortgagee’s rate of defaults and claims on
                                     HUD/FHA insured mortgages endorsed during the
                                     preceding 24 months exceeds 200 percent of the default
                                     and claim rate for that geographic area, and also exceeds
                                     the national default and claim rate.

                                     On January 24, 2002, HUD terminated the FHA loan
 Keystone originated loans           origination approval of Keystone’s home office in Phoenix,
 after HUD terminated                Arizona, under the Credit Watch termination authority.
 approval                            This termination was based on Keystone’s default and
                                     claim rate of 8.10 percent, which was more than twice the
                                     HUD Phoenix Office rate of 2.24 percent, and greater than
                                     the national rate of 3.07 percent for the 24 months ending
                                     June 30, 2001. Nineteen days after HUD terminated
                                     Keystone’s Phoenix home office approval, Keystone
                                     submitted an application to HUD requesting approval of a
                                     new branch office in Mesa, Arizona (adjacent to Phoenix).
                                     HUD approved this request for a new branch office on
                                     February 28, 2002, and assigned it a separate HUD
                                     mortgagee identification number. All FHA insured loans
                                     originated by Keystone after the credit watch termination
                                         Page 11                                     2004-LA-1001
Finding 2


               date were submitted to HUD using the mortgagee
               identification number established for this newly created
               branch office in Mesa.

               In reality, Keystone continued to conduct FHA origination
               activities at its home office in Phoenix after this office’s
               origination approval was terminated. Based on interviews
               with the president of Keystone, the Mesa office branch
               manager and a Keystone loan processor, loan officers
               continued to take borrower FHA loan applications at the
               home office in Phoenix after the credit watch termination
               date. Additionally, Keystone staff stated that discussions
               with borrowers and loan document processing related to
               FHA loans were routinely performed at the home office
               after the Credit Watch termination.

               A review of six randomly selected loan files closed in mid
               to late 2002, and review of eight loan files closed between
               June and October 2003, identified documents in all 14 files
               indicating the loans were, at least in part, originated at
               Keystone’s home office.         For example, we found
               documents from title companies, miscellaneous fax memos,
               credit reports, verifications, and appraisal reports all
               showing the Keystone home office address and/or
               telephone number and/or fax number. Further, even the
               legitimacy of the branch office (used for submission of
               FHA loans to HUD for insurance endorsement) as a viable
               operating entity is questionable. When we made an
               unannounced visit to the branch office in February 2003,
               one year after this office was approved by HUD and had
               purportedly begun originating FHA insured loans,
               Keystone’s name did not appear on the sign in front of the
               building, and even the building directory did not list
               Keystone as a business operating in the center.
               Accordingly, it appears that the branch office was a front
               established primarily to allow Keystone to continue loan
               origination activities at its terminated branch office in
               violation of HUD’s termination notice.




2004-LA-1001       Page 12
                                                                                       Finding 2

Auditee Comments

Keystone disagreed with the finding and stated that HUD told Keystone they could open a new
branch in Mesa and that the Mesa office was not a front established to bypass HUD’s Credit
Watch termination.

Keystone stated they were not aware the Mesa branch office did not have a business sign.

Keystone acknowledged that loan officers occasionally met with borrowers and received loan-
processing documents at the Phoenix location after this office had its origination approval
terminated by HUD. Additionally, Keystone stated documents found in its loan files showing
the Phoenix office address were generated automatically on “preloaded” computer forms and
that the personnel assigned to the Mesa office did not have offices at Keystone’s Phoenix
location.




OIG Evaluation of
Auditee Comments
As stated in the report and affirmed in Keystone’s response, Keystone staff conducted face-to-
face meetings with borrowers, took loan applications and received loan processing documents at
Keystone’s Phoenix location after this office was terminated under HUD’s Credit Watch
program. These activities represent significant elements of the loan origination process and
should not have been performed at a Credit Watch terminated branch office. By effectively
circumventing HUD’s Credit Watch termination, Keystone exposed HUD to unnecessary risk.
This is demonstrated by the fact that the pattern of false FHA loan origination documents we
identified continued after Keystone opened its new office in Mesa, Arizona.

Keystone’s explanation of computer generated forms “preloaded’ with the Phoenix office
address raises additional doubts as to the legitimacy of the Mesa branch. It appears Keystone did
not even change the address on its forms for at least a full year after it supposedly ceased FHA
loan origination activities at this location.

Keystone’s claim that personnel assigned to the Mesa branch did not have offices at Keystone’s
Phoenix location is incorrect. On February 21, 2003, we conducted a face-to-face interview with
a Keystone loan officer and a Keystone loan processor supposedly assigned to the Mesa branch
while they were seated in their office at the Phoenix location. Further, these Keystone
employees specifically identified the desks in the Phoenix office as their own and when asked if
they had desks in both the Phoenix office and the Mesa Office they responded “yes”.




                                         Page 13                                    2004-LA-1001
Finding 2

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

                 2A.      Take appropriate administrative sanctions against
                          Keystone for not complying with HUD’s Credit
                          Watch termination of its Phoenix office.




2004-LA-1001           Page 14
Management Controls
In planning and performing our audit, we considered the management controls of Keystone to
determine our audit procedures, not to provide assurance on the controls. Management controls
include the plan of 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 its business operations. They include the systems for measuring, reporting and
monitoring business performance.



                                     We determined the following management controls were
 Relevant Management
                                     relevant to our audit objectives:
 Controls
                                     •   Validity and Reliability of Data – Policies and
                                         procedures management has implemented to reasonably
                                         ensure that valid and reliable data are obtained,
                                         maintained, and used during the loan origination
                                         process.

                                     •   Compliance with Laws and Regulations – Policies and
                                         procedures management has implemented to reasonably
                                         ensure its loan origination process is carried out in
                                         accordance with applicable laws and regulations.

                                     The following audit procedures were used to assess the
                                     relevant controls identified above:

                                     •   Reviewed Keystone’s policies and procedures for
                                         originating FHA loans,
                                     •   Interviewed Keystone management and staff, and
                                     •   Reviewed 65 FHA loan files primarily originated
                                         between March 2001 and October 2003.


                                     A significant weakness exists if management controls do not
 Significant Weaknesses              give 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 is
                                     obtained and maintained, and fairly disclosed in reports.

                                     Based on our review, we believe the following items are
                                     significant weaknesses:

                                     •   Keystone management’s policies and procedures, as
                                         implemented, were inadequate to ensure valid and reliable
                                         Page 15                                     2004-LA-1001
Management Controls


                          data was obtained during the loan origination process (see
                          finding 1).

                      •   Keystone’s policies and procedures were inadequate to
                          ensure compliance with HUD requirements and prudent
                          lending practices (see findings 1 and 2).




2004-LA-1001              Page 16
Follow Up On Prior Audits
This is the first HUD Office of Inspector General audit review of Keystone. Keystone’s last
independent audit report for the year ending December 31, 2002, did not contain any findings.




                                         Page 17                                   2004-LA-1001
Follow Up On Prior Audits




                            THIS PAGE LEFT
                                BLANK
                            INTENTIONALLY




2004-LA-1001                Page 18
                                                                                         Appendix A

Schedule of Questioned Costs
and Funds Put to Better Use
Finding Number                                Type of Questioned Cost                 Funds Put to
                                           Ineligible 1/    Unsupported 2/            Better Use 3/

       1                                      0                   0                    $4,307,344


1/   Ineligible costs are costs charged to a HUD-financed or HUD-insured program or activity that
        the auditor believes are not allowable by law, contract or Federal, State or local policies or
        regulations.

2/   Unsupported costs are costs charged to a HUD-financed of HUD-insured program or activity,
       and eligibility cannot be determined at the time of the audit. The costs are not supported by
       adequate documentation, or there is a need for a legal or administrative determination on the
       eligibility of the costs. Unsupported costs require a future decision by HUD program
       officials. This decision, in addition to obtaining supporting documentation, might involve a
       legal interpretation or clarification of Departmental policies and procedures.

3/   Funds put to better use are costs that will not be expended in the future if our recommendations
       are implemented; for example, costs not incurred, de-obligation of funds, withdrawal of
       interest, reductions in outlays, avoidance of unnecessary expenditures, loans and guarantees
       not made and other savings.




                                           Page 19                                      2004-LA-1001
Appendix A




               THIS PAGE LEFT
                   BLANK
               INTENTIONALLY




2004-LA-1001    Page 20
                                                                     Appendix B
Schedule of FHA Loans Originated Using False Documents



                                            Use of False Documents
                              Original
 FHA Case          Closing    Mortgage
  Number            Date      Amount        Employment    Credit

 023-0317715       8/23/00       100,320                     X
               1
 023-0639742        5/7/01       103,377         X
 023-0710858        6/6/01       100,424                     X
               2
 023-0712632        7/6/01       226,796         X
 023-0748637       7/20/01        96,485                     X
               2
 023-0678638        7/25/01      105,346         X           X
               1
 023-0785681        8/16/01       85,655         X           X
 023-0798111       8/31/01        82,603                     X
               1
 023-0809788        9/7/01        88,609         X           X
 023-0793297       10/4/01        91,563         X           X
 023-0884063       11/5/01        95,895                     X
 023-0942324       12/5/01       104,043                     X
 023-0928952       12/11/01       94,208         X           X
 023-0923109       12/19/01      109,940                     X
 023-0787000        1/9/02        95,589         X
 023-0846990       1/17/02       120,115         X           X
 023-0924984       1/22/02       118,065                     X
 023-0925095       1/23/02       128,612         X           X
 023-0986059        2/1/02       105,346         X           X
 023-0917625       3/19/02       137,390         X
 023-0931758       3/22/02       129,762         X
 023-1135867       4/29/02       114,326                     X
               2
 023-0927038        5/22/02      113,739         X
 023-1158658        6/6/02       104,362         X           X
 023-1126416        6/7/02       106,915                     X
 023-1166018       6/13/02       105,346         X           X
 023-1162407       6/17/02        86,640         X           X
 023-1189366        7/8/02       122,459         X           X
 023-1198339       7/12/02        99,113                     X
 023-1228397       8/26/02       103,377         X           X

                                  Page 21                          2004-LA-1001
Appendix B


Schedule of FHA Loans Originated Using False Documents
(Continued)


                                                    Use of False Documents
                                    Original
     FHA Case           Closing     Mortgage
      Number             Date       Amount          Employment            Credit
    023-1212351          8/27/02          104,362           X                    X
                    1
    023-1235612          8/28/02          102,393                                X
    023-1234804          9/24/02          107,808           X                    X
    023-1270801          10/2/02           97,470           X                    X
    023-1244013         10/10/02          107,539           X                    X
    023-1422221         12/20/02          102,393           X                    X
                    2
    023-1262597         12/27/02          103,870           X                    X
    023-1449511          1/1/03            88,609           X                    X
    023-1394193          1/3/03            97,470           X                    X
    023-1449382          2/13/03           87,132           X                    X
    023-1620555          5/14/03           99,439                                X
    023-1557814          6/4/03           100,424           X                    X
    023-1611235          6/11/03          114,527           X                    X
    023-1730711          7/8/03           112,140                                X
    023-1731609          7/9/03            93,335           X                    X
    023-1721472          7/28/03          120,115           X                    X
    023-1711787          8/7/03           118,342                                X
    023-1875334          10/3/03          101,408           X                    X

               Total                    5,135,196



1
    Loans not currently insured by FHA and not refinanced to another FHA loan.

2
    Loans that resulted in insurance claims to HUD with known loss amounts.




2004-LA-1001                              Page 22
Appendix C

Auditee Comments




                   Page 23   2004-LA-1001
Appendix C




2004-LA-1001   Page 24
          Appendix C




Page 25   2004-LA-1001
Appendix C




2004-LA-1001   Page 26
          Appendix C




Page 27   2004-LA-1001
Appendix C




2004-LA-1001   Page 28
          Appendix C




Page 29   2004-LA-1001
Appendix C




2004-LA-1001   Page 30