AUDIT REPORT Fairfield Financial Mortgage Group, Inc., Danbury, Connecticut, Did Not Always Comply with Federal Housing Administration Requirements 2005-BO-1007 September 26, 2005 OFFICE OF AUDIT, REGION 1 Boston, MA Issue Date September 26, 2005 Audit Report Number 2005-BO-1007 TO: Brian D. Montgomery, Assistant Secretary for Housing-Federal Housing Commissioner, H FROM: For John A. Dvorak, Regional Inspector General for Audit, 1AGA SUBJECT: Fairfield Financial Mortgage Group, Inc., Danbury, Connecticut, Did Not Always Comply with Federal Housing Administration Requirements HIGHLIGHTS What We Audited and Why We audited Fairfield Financial Mortgage Group, Inc. (Fairfield Financial), a nonsupervised lender approved by the U.S. Department of Housing and Urban Development (HUD) to originate Federal Housing Administration-insured single- family mortgages. We selected Fairfield Financial for review because of risk factors associated with defaulted loans, including higher risk multiunit properties, early payment defaults, and income-excessive obligations cited for several defaulted loans, which suggested potential problems with the qualifying documentation. Our objectives were to determine whether Fairfield Financial complied with HUD regulations, procedures, and instructions in the origination of Federal Housing Administration loans and whether Fairfield Financial’s quality control plan, as implemented, met HUD requirements. 1 What We Found Fairfield Financial did not always comply with HUD regulations, procedures, and instructions in the origination of Federal Housing Administration loans. It improperly originated 4 of the 24 loans reviewed. These four loans contained deficiencies that affected the insurability of the loans, including unsupported income, underreported liabilities, excessive qualifying ratios, and derogatory credit information. As a result, HUD insured loans that placed the insurance fund at risk for $1,204,981. In addition, Fairfield Financial did not properly disclose to borrowers $11,390 for commitment fees in 20 of the 24 loans reviewed. Further, Fairfield Financial’s quality control plan, as implemented, did not meet HUD requirements. Its written quality control plan lacked required elements, and it did not implement procedures to ensure that reviews of early defaulted loans took place or that its operations complied with fair lending laws. As a result, HUD lacks assurance that Fairfield Financial is able to ensure the accuracy and completeness of its loan origination operations. What We Recommend We recommend that the assistant secretary for housing-federal housing commissioner require Fairfield Financial to (1) indemnify HUD against future losses on the four loans totaling $1,204,981 and (2) revise its procedures to ensure that each borrower charged a commitment fee is properly informed, in writing, of the fee, the amount of the fee, and the purpose of the fee, and that the actual fee charged coincides with the amount disclosed to the borrower. Additionally, HUD should require Fairfield Financial to implement controls to ensure that it follows HUD’s quality control requirements and verify that it has implemented proper controls. For each recommendation in the body of the report without a management decision, please respond and provide status reports in accordance with HUD Handbook 2000.06, REV-3. Please furnish us copies of any correspondence or directives issued because of the audit. 2 Auditee’s Response We provided Fairfield Financial a draft report on August 24, 2005, and held an exit conference with Fairfield Financial officials on August 31, 2005. Fairfield Financial provided written comments on September 21, 2005, in which it generally expressed disagreement with finding 1 and agreement with finding 2. The complete text of the auditee’s response, along with our evaluation of that response, is in appendix B of this report. 3 TABLE OF CONTENTS Background and Objectives 5 Results of Audit Finding 1: Fairfield Financial Did Not Follow HUD Requirements When 6 Originating Four Loans Finding 2: Fairfield Financial’s Quality Control Plan Did Not Comply with 11 HUD Requirements Scope and Methodology 14 Internal Controls 15 Appendixes A. Schedule of Questioned Costs and Funds to Be Put to Better Use 17 B. Auditee Comments and OIG’s Evaluation 18 C. Narrative of Loan Deficiencies 29 D. Commitment Fees Charged to Borrowers 36 E. Audit Criteria 37 4 BACKGROUND AND OBJECTIVES The National Housing Act, as amended, established the Federal Housing Administration, an organizational unit within the U.S. Department of Housing and Urban Development (HUD). The Federal Housing Administration provides insurance for lenders against loss on single-family home mortgages. HUD approved Fairfield Financial Mortgage Group, Inc. (Fairfield Financial), as a nonsupervised direct endorsement lender on September 4, 1998. As a HUD-approved direct endorsement lender, Fairfield Financial can underwrite and close Federal Housing Administration loans without prior HUD review or approval. Fairfield Financial originated 423 Federal Housing Administration-insured loans with mortgages totaling $79.6 million, which had beginning amortization dates (defined as one month before the first principal and interest payments are due) between January 1, 2003, and December 31, 2004. According to HUD’s Neighborhood Watch system, 14 of the loans defaulted within the first two years of origination, equating to an average default rate of roughly 3.3 percent. This default rate compared favorably to the national average default rate of 4.2 percent during that same two-year period. As of the latest reporting period ending June 30, 2005, Fairfield Financial’s two-year average default rate has declined to 3.1 percent, while the national two-year average default rate has increased to 4.6 percent. Fairfield Financial sells 100 percent of the loans it originates to the secondary market. The audit objectives were to determine whether Fairfield Financial complied with HUD regulations, procedures, and instructions in the origination of Federal Housing Administration loans and whether Fairfield Financial’s quality control plan, as implemented, met HUD requirements. 5 RESULTS OF AUDIT Finding 1: Fairfield Financial Did Not Follow HUD Requirements When Originating Four Loans Fairfield Financial did not follow HUD requirements when originating and approving 4 of the 24 loans reviewed. The loans contained deficiencies that affected the credit quality (insurability) of the loans. Fairfield Financial approved the loans based on unsupported income, underreported liabilities, excessive qualifying ratios, and derogatory credit information. The deficiencies occurred because Fairfield Financial did not exercise due care in originating and underwriting loans and did not adequately implement its quality control plan. As a result, HUD insured four loans that placed the Federal Housing Administration insurance fund at risk for $1,204,981. In addition, Fairfield Financial did not properly disclose to borrowers $11,390 for commitment fees in 20 of the 24 loans reviewed. Loans Did Not Comply with HUD Requirements Fairfield Financial originated four loans totaling $1,204,981 that contained significant loan origination deficiencies. These loans contained material errors, including unsupported income, underreported liabilities, inadequate qualifying ratios, and derogatory credit. Fairfield Financial’s quality control process contributed to the loan origination deficiencies (see finding 2). As of August 31, 2005, HUD’s data systems showed that all four of the loans were actively insured with Federal Housing Administration insurance. HUD has not incurred any claims associated with these loans. The following table summarizes the mortgage amounts and categories of loan deficiencies. Case # Mortgage Unsupported Underreported Excessive Derogatory amount income liabilities qualifying credit ratios 251-3097987 $446,067 X X 251-2928528 296,656 X X 251-3084029 265,828 X X 352-5211304 196,430 X X X Total $1,204,981 2 2 3 2 All four loans contained more than one deficiency. Descriptions of the deficiencies noted are presented below. Appendix C contains detailed narrative case presentations for each loan. 6 Unsupported Income Fairfield Financial relied on unsupported income for two loans, case numbers 251-3097987 and 251-2928528. The anticipated amount of income and the likelihood of its continuance must be established to determine a borrower’s capacity to repay mortgage debt. Lenders may not use income in evaluating the borrower’s loan that it cannot verify, is not stable, or will not continue. Overstating income affects the debt-to-income ratios. The use of incorrect income information could result in an invalid underwriting decision. For example, Fairfield Financial originated case number 251-3097987 using a calculated monthly income of $4,687, consisting of $2,542 in base pay and $2,145 in overtime income. Fairfield Financial calculated the monthly income using only one of the pay stubs provided by the borrower, although the borrower provided six pay stubs and Internal Revenue Service W-2 forms from the prior two years. HUD requires that lenders develop an average of overtime income over the last two years or otherwise justify and document the reason for using the income. A more accurate estimate of the borrower’s monthly income would have been an average of his 2003 earnings and year-to-date earnings. That calculation resulted in an average monthly income of $3,916, well below the income Fairfield Financial used to qualify the borrower. Underreported Liabilities Fairfield Financial did not consider all relevant liabilities when approving two loans, case numbers 352-5211304 and 251-2928528. HUD requires lenders to consider all recurring obligations, contingent liabilities, and projected obligations that meet HUD’s specific stipulations when evaluating a loan application. Underreported liabilities affect the debt-to-income ratios. The use of incorrect liability information could result in an invalid underwriting decision. For example, for case number 251-2928528, Fairfield Financial omitted liabilities for the borrower when evaluating the loan. It requested tax returns to support the borrower’s income. However, the borrower was self-employed and had neglected to prepare and submit federal tax returns. Although the borrower submitted proforma tax returns, Fairfield Financial did not consider more than $32,300 in federal taxes and penalties owed by the borrower for the prior two tax years, as indicated on the unfiled tax returns. It was Fairfield Financial’s obligation to consider this significant liability in evaluating the loan application and its impact on the borrower’s capacity to repay mortgage debt. 7 Excessive Qualifying Ratios Fairfield Financial allowed excessive qualifying ratios without valid compensating factors in three loans, case numbers 251-3084029, 352-5211304, and 251-3097987. HUD requires debt-to-income ratios not to exceed 29 and 41 percent (mortgage payment-to-effective income and total fixed payment-to- effective income ratio, respectively). Ratios exceeding 29 and 41 percent may be acceptable only if significant compensating factors are present. HUD identifies 10 compensating factors that may be considered to justify approving mortgage loans with qualifying ratios exceeding HUD’s established thresholds. The three loans approved by Fairfield Financial did not adequately document any of the 10 compensating factors recognized by HUD. For example, case number 352-5211304 had a mortgage payment-to-income ratio of 38.09 percent and a total fixed payment-to-income ratio of 43.50 percent. Fairfield Financial should have documented compensating factors to justify the excess ratios; especially considering that the borrower’s housing payment was increasing 600 percent from $300 per month to just over $2,100 per month. Derogatory Credit Fairfield Financial did not properly evaluate the borrowers’ past credit performance and ensure that the borrowers demonstrated financial responsibility in two of the four loans, case numbers 251-3084029 and 352-5211304. HUD considers past credit performance of the borrowers to be the most useful guide in determining the attitude toward credit obligations that will govern the borrowers’ future actions. If the credit history, despite adequate income to support obligations, reflects continuous slow payments, judgments, and delinquent accounts, strong compensating factors will be necessary to approve the loan. While minor derogatory information occurring two or more years in the past does not require explanation, major indications of derogatory credit—including judgments, collections, and any other recent credit problems—require sufficient written explanation from the borrower. For example, the borrower’s credit report for case number 251-3084029 identified six different accounts that went into collection. Shortly before the loan application, all six of these accounts were brought current, and they all had no balances. Derogatory credit, including accounts in collection, requires a sufficient written explanation from the borrower. The borrower provided a letter of explanation, citing a divorce as the reason for falling behind on payments. The letter further indicated that efforts had been made over the last several months to 8 settle and pay off the debts. The divorce cited by the borrower occurred approximately eight years before the loan application, and five of the six accounts in collection were opened after the divorce finalization. This does not constitute a sufficient written explanation. $11,390 Charged for Commitment Fees without Adequate Disclosure Fairfield Financial charged $11,390 for loan commitment fees, without adequate disclosure, in 20 of the 24 loans reviewed. Commitment fees are an allowable charge if there is a lock-in or commitment agreement, in writing, that guarantees the rate or discount points for a period of not less than 15 days before the anticipated closing date. Fairfield Financial did not provide adequate disclosure of written lock-in or commitment agreements to its borrowers as required. While these deficiencies did not affect the overall credit quality (insurability) of the individual loans, they do indicate a lack of full commitment to quality underwriting. Lenders need to ensure that they follow all facets of HUD requirements when originating Federal Housing Administration loans. We provided details of these deficiencies to Fairfield Financial during our review. Appendix D presents a table summarizing the commitment fees charged to borrowers for each of the 20 loans. Conclusion Fairfield Financial did not always exercise due care in originating and underwriting loans and did not adequately implement its quality control plan. As a result, Fairfield Financial originated four loans containing deficiencies that placed the Federal Housing Administration insurance fund at risk for $1,204,981. In addition, Fairfield Financial charged $11,390 for loan commitment fees, without adequate disclosure, in 20 of the 24 loans reviewed. 9 Recommendations We recommend that the assistant secretary for housing-federal housing commissioner 1A. Require Fairfield Financial to indemnify HUD against future losses on the four loans totaling $1,204,981. 1B. Require Fairfield Financial to revise its procedures to ensure that each borrower charged a commitment fee is properly informed, in writing, of the fee, the amount of the fee, and the purpose of the fee, and that the actual fee charged coincides with the amount disclosed to the borrower. 10 Finding 2: Fairfield Financial’s Quality Control Plan Did Not Comply with HUD Requirements Fairfield Financial did not establish and implement an adequate quality control process in accordance with HUD regulations. Fairfield Financial’s quality control plan did not include all of the HUD-required elements. In addition, its staff did not ensure that loans going into early payment default were reviewed as part of the quality control process or that its operations complied with applicable fair lending laws. Further, Fairfield Financial’s quality control plan lacks specific procedures regarding single-family loan servicing. These deficiencies existed because of Fairfield Financial’s lack of understanding concerning its responsibility to ensure that it met HUD requirements when contracting with an outside firm to perform quality control reviews. As a result, it was unable to ensure the accuracy and completeness of its loan origination operations, contributing to an increased risk of loss to the Federal Housing Administration insurance fund. Outside Firm Contracted to Perform Quality Control Reviews HUD provides that a lender may engage outside sources to perform the quality control function. 1 A lender contracting out any part of its quality control function is responsible for ensuring that the outside source meets HUD’s requirements. Fairfield Financial contracted with an outside firm to perform its quality control reviews. It relied on the quality assurance program prepared by the contractor (Fairfield Financial’s quality control plan). However, Fairfield Financial did not ensure that this program contained all HUD-required elements or that it completed quality control reviews in accordance with the plan. Written Quality Control Plan Did Not Contain Required Elements HUD provides that as a condition of HUD-Federal Housing Administration approval, lenders must have and maintain a quality control plan for the origination and servicing of insured mortgages. The quality control plan must be a prescribed function of the lender’s operations and assure that the lender maintains compliance 1 HUD Handbook 4060.1, REV-1, CHG-1, paragraph 6-3(B)(2). 11 with HUD-Federal Housing Administration requirements and its own policies and procedures. 2 Fairfield Financial’s quality control plan was not dated and did not include the following elements: • Determine whether there are sufficient and documented compensating factors if the debt ratios exceed Federal Housing Administration limits. • Determine whether all conditions were cleared before closing. • Determine whether the seller acquired the property at the time of or soon before closing, indicating a possible property “flip.” Additionally, Fairfield Financial’s quality control plan lacked specific procedures regarding single-family loan servicing. We recognize that Fairfield Financial intended to sell 100 percent of the loans it originated. However, from time to time and in varying degrees, it serviced the loans it originated, including Federal Housing Administration-insured loans. Early Default and Rejected Loans Not Reviewed Fairfield Financial did not fully implement its quality control plan. It did not ensure that quality control reviews were performed on all loans defaulting within six months of closing, as required and as outlined in its own quality control plan. This occurred because Fairfield Financial did not submit the required loan listing of early payment defaults to its quality control contractor. It mistakenly believed that this function was part of the quality control process of the secondary lending market in which it sells its loans. Accordingly, the contractor did not perform the required reviews. Further, Fairfield Financial did not provide a list of rejected loans to its quality control contractor to use in performing quality control reviews. Without these reviews, there was no assurance that Fairfield Financial’s operations complied with applicable fair lending laws. We noted that, with the exception of the four months between January and April 2004, Fairfield Financial did not provide the required rejected loan listing to its quality control contractor. Therefore, the contractor was unable to perform the required fair lending review. Fairfield Financial stated that this was an oversight. 2 HUD Handbook 4060.1, REV-1, CHG-1, paragraph 6-1. 12 Fairfield Financial, along with its quality control contractor, expressed an interest in ensuring that its quality control plan meets HUD requirements. Conclusion Fairfield Financial did not establish and implement a quality control process that complied with HUD requirements. Its quality control plan lacked required elements necessary to conduct proper quality control reviews, and it did not ensure that it routinely provided adequate information to its quality control contractor to ensure that it conducted reviews in accordance with HUD requirements. Without a properly implemented quality control process, Fairfield Financial cannot ensure that its loan originations comply with HUD requirements; that it is protecting itself and HUD from unacceptable risk; and that it is guarding against errors, omissions, and fraud. Recommendations We recommend that the assistant secretary for housing-federal housing commissioner 2A. Require Fairfield Financial to establish and implement an adequate quality control process. 2B. Verify that Fairfield Financial’s quality control process is fully implemented in accordance with HUD regulations. 13 SCOPE AND METHODOLOGY Fairfield Financial originated 423 Federal Housing Administration-insured loans, which had beginning amortization dates (defined as one month before the first principal and interest payments are due) between January 1, 2003, and December 31, 2004. To achieve our objectives, we chose a nonrepresentative method to select loans for review from that period. This method allowed us to select Federal Housing Administration-insured loans with certain characteristics, enabling us to focus our review efforts on Federal Housing Administration-insured loans in which there was a greater inherent risk to the Federal Housing Administration insurance fund and/or risk of noncompliance or abuse. We selected all 14 loans that defaulted within the first two years of loan origination for review and, based on the high percentage of defaulted loans that were multiunit, we selected an additional 10 multiunit loans for review. The results of our detailed testing only apply to the 24 loans reviewed and may not be projected to the universe of 423 Federal Housing Administration- insured loans. We reviewed HUD’s rules, regulations, and guidance for proper origination and submission of Federal Housing Administration loans. We interviewed HUD staff to obtain background information on HUD requirements and on Fairfield Financial, and we reviewed the HUD case binders for the 24 loans selected. We interviewed Fairfield Financial’s management and staff to obtain information regarding its policies, procedures, and management controls. We reviewed Fairfield Financial’s written policies and procedures to gain an understanding of how its processes are designed to function. We also reviewed Fairfield Financial’s quality control plan, as well as the quality assurance program of its quality control provider, and available quality control reports. Additionally, we reviewed Fairfield Financial’s origination binders for the 24 loans selected for review. We relied upon computer-processed data contained in HUD’s Single Family Data Warehouse system. We assessed the reliability of these data, including relevant general and application controls, and found them to be adequate for the data obtained. We also performed sufficient tests of the data, and based on the assessments and testing, we concluded that the data are sufficiently reliable to be used in meeting our objectives. The audit generally covered the period from January 1, 2003, through December 31, 2004. We expanded this period, when applicable, to include the most current data through August 31, 2005, while performing the audit. We performed our fieldwork from January through July 2005. We performed our review in accordance with generally accepted government auditing standards. 14 INTERNAL CONTROLS Internal control is an integral component of an organization’s management that provides reasonable assurance that the following objectives are being achieved: • Effectiveness and efficiency of operations, • Reliability of financial reporting, and • Compliance with applicable laws and regulations. Internal controls relate to management’s plans, methods, and procedures used to meet its mission, goals, and objectives. Internal controls include the processes and procedures for planning, organizing, directing, and controlling program operations. They include the systems for measuring, reporting, and monitoring program performance. Relevant Internal Controls We determined the following internal controls were relevant to our audit objectives: • Program operations. Policies and procedures that management has implemented to reasonably ensure that the loan origination process complies with HUD/Federal Housing Administration requirements and that the objectives of the program are met. • Validity and reliability of data. Policies and procedures that management has implemented to reasonably ensure valid and reliable data are obtained, maintained, and fairly disclosed in reports. • Compliance with laws and regulations. Policies and procedures that management has implemented to reasonably ensure that resource use is consistent with laws and regulations. • Safeguarding of resources. Policies and procedures that management has implemented to reasonably ensure that resources are safeguarded against waste, loss, and misuse. We assessed the relevant controls identified above. A significant weakness exists if management controls do not provide reasonable assurance that the process for planning, organizing, directing, and controlling program operations will meet the organization’s objectives. 15 Significant Weaknesses Based on our review, we believe the following items are significant weaknesses: • Compliance with laws and regulations. Fairfield Financial did not follow HUD requirements when originating four Federal Housing Administration- insured loans (see finding 1). • Compliance with laws and regulations. Fairfield Financial has not implemented its quality control plan in accordance with HUD requirements (see finding 2). 16 Appendix A SCHEDULE OF FUNDS TO BE PUT TO BETTER USE Recommendation Funds to be put number to better use 1/ 1A $1,204,981 1/ ”Funds to be put to better use” are quantifiable savings that are anticipated to occur if an Office of Inspector General (OIG) recommendation is implemented, resulting in reduced expenditures at a later time for the activities in question. This includes costs not incurred, deobligation of funds, withdrawal of interest, reductions in outlays, avoidance of unnecessary expenditures, loans and guarantees not made, and other savings. 17 Appendix B AUDITEE COMMENTS AND OIG’S EVALUATION Ref to OIG Evaluation Auditee Comments Comment 1 18 Comment 2 Comment 3 Comment 4 Comment 5 Comment 6 19 Comment 7 Comment 8 Comment 9 Comment 10 Comment 11 20 Comment 12 Comment 13 Comment 14 21 Comment 15 Comment 16 Comment 17 Comment 18 Comment 19 22 23 OIG Evaluation of Auditee Comments Comment 1 Fairfield Financial agreed to make the recommended changes, but noted that their Quality Control Plan (QCP) was not deficient. As detailed in this report, Fairfield Financial’s QCP is deficient, as it lacks HUD- required elements and procedures regarding single-family loan servicing. Comment 2 Fairfield Financial disagreed that the borrower’s income was incorrectly calculated. We agree that the loan file contained six pay stubs. The loan file also contained Internal Revenue Service W-2 forms for 2002 and 2003. Fairfield Financial, however, only used one of those pay stubs and none of the W-2 forms to calculate the borrower’s base income, as well as the borrower’s overtime income. This is not adequate and does not meet HUD/FHA requirements. Fairfield Financial stated that, an average of the borrower’s earnings prior to his elevated position, with its increased overtime demands, would have been inappropriate in the underwriters opinion. We agree, and that’s why we indicate in the report that a more accurate estimate of the borrower’s monthly income would have been an average of his 2003 earnings (the year of his promotion) and his year-to- date earnings; not a single a pay stub. Comment 3 We did not present this issue in the audit report. Fairfield Financial is referring to comments we made in an earlier OIG letter, dated June 9, 2005, in which we detailed our preliminary concerns and provided Fairfield Financial an opportunity to respond. Fairfield Financial did not revise its comments prepared in response to that letter to reflect only the issues presented in the audit report. As we did not carry this issue forward to the audit report, we offer no response. Comment 4 We agree that the loan closed in May 2004, and that it was completely acceptable to qualify the borrower at the first year bought-down rate. Regardless of whether the loan closed prior to, or subsequent to May 2004, Fairfield Financial was required to establish that the eventual increase in mortgage payments would not adversely affect the borrower and lead to default. Fairfield Financial did not establish, or document as required, that the eventual increase would not adversely affect the borrower. Comment 5 Fairfield Financial disagrees that the borrower’s income was not sufficiently established. Prior to his mortgage application, the borrower failed to prepare Federal tax returns for the prior two years and, most likely, for prior years as well. The Federal tax returns included in the loan file indicated that they were prepared by a “paid preparer” on March 26, 2003, but did not include the paid preparer’s signature. Further, the borrower did not sign and date the tax returns until the day of his loan closing. There is no indication that those returns were ever filed or 24 accurately reflect the borrower’s self-employment income. Our main concern lies with the $32,000 plus owed for taxes and penalties reflected on the 2001 and 2002 tax returns and not considered by Fairfield Financial during the underwriting process (see comment 10). Comment 6 The loan file does contain a conflicting Social Security number for the borrower. The loan file contains two separate certificates from the City of Brockton; one from 1998 and one from 2002. Both certificates include the borrower’s printed name and signature, but reflect two different Social Security numbers. There is nothing in the loan file indicating that the conflicting Social Security number is that of the borrower’s business partner. Comment 7 We do not dispute that the borrower appears to be self-employed. Comment 8 We agree that the loan file does not contain any other Social Security discrepancies and that the credit report did not contain a warning. Comment 9 We disagree that Fairfield Financial was unaware that the borrower had not filed previous tax returns or that he had not paid any tax liability to the Internal Revenue Service. The tax returns for 2001 and 2002 are both dated by the “paid preparer” on March 26, 2003, providing evidence that they were prepared at the time of the borrower’s application for a mortgage loan. The tax returns clearly indicate the tax liability and penalties of over $32,000 and there is no indication in the loan file that Fairfield Financial considered this, as required. Fairfield Financial correctly pointed out that the borrower would be eligible if the delinquent account was brought current, paid, or otherwise satisfied or a satisfactory repayment plan was made between the borrower and the Federal agency owed and verified in writing. There is no indication that Fairfield Financial made any effort to determine if this occurred. Further, our concern did not lie with the closing stipulations or instructions, but with the timeliness of the returns and the significant liability owed by the borrower that was not addressed by Fairfield Financial. Comment 10 Fairfield Financial did not consider the borrower’s significant liability in evaluating the loan application and its impact on the borrower’s capacity to repay mortgage debt, as required. Neither the loan file nor the HUD case binder provided any justification for moving forward with this loan or any evidence that the borrower brought current, paid, or otherwise satisfied the delinquent account. Further, Fairfield Financial presumes to know what the borrower’s liability with the Internal Revenue Service would be. In the absence of a repayment agreement, the borrower’s liability is unknown. The tax returns in question represent only two years and the borrower was self-employed prior to that. Therefore, it is likely 25 that the borrower’s liability to the Internal Revenue Service may far exceed the $32,000 owed for the 2001 and 2002 tax years. Comment 11 We agree with Fairfield Financial that, as of August 31, 2005, the loan does not appear in the early warning default section of HUD’s Neighborhood Watch system. This does not excuse Fairfield Financial from adhering to HUD/FHA regulations in the origination and underwriting of FHA-insured loans. Comment 12 Again, Fairfield Financial is referring to comments we made in an earlier OIG letter, dated June 9, 2005, in which we detailed our preliminary concerns and provided Fairfield Financial an opportunity to respond. Fairfield Financial did not revise its comments prepared in response to that letter to reflect only the issues presented in the audit report. We agree that the borrower had three months of reserves, as reflected in the audit report. The borrower’s fixed payment to effective income ratio, however, was 49.90, well above the HUD/FHA threshold. Comment 13 Fairfield Financial presented the argument that an additional compensating factor was present. The loan file, however, only included two compensating factors on the Mortgage Credit Analysis Worksheet (MCAW); “3-months reserves” and “job longevity.” We agree that the borrower had three months of reserves. Job longevity, though, is not recognized as a compensating factor. The loan file does not contain any other information or documentation regarding compensating factors present. If Fairfield Financial felt other compensating factors were relevant, they should have documented those factors on the MCAW as required. Comment 14 Fairfield Financial stated that five of the six accounts actually went into collection within 12-24 months of the borrower’s divorce. This is incorrect. In fact, four of the six accounts were not opened by the borrower until October 1999 or later, over three years after the divorce. Only one of the accounts was open prior to the divorce. This is why the borrower’s explanation that the divorce caused her to fall behind on payments was inadequate, as five of the six accounts were opened subsequent to the divorce. It was not until the borrower applied for a mortgage loan that she made an effort to clear her delinquent accounts. Comment 15 Fairfield Financial stated that the borrower sold the subject property on August 31, 2005 and that it would be inappropriate to indemnify the loan. A check of HUD’s Neighborhood Watch system, as of August 31, 2005, showed that foreclosure was started on the subject property. If the property was in fact sold, we would still recommend that Fairfield Financial indemnify HUD from paying any claims or costs associated with this loan. 26 Comment 16 Fairfield Financial stated they no longer employ the underwriter or the originator of this loan. Fairfield Financial believes that the file reflects the two properties, but concedes that the file documentation should be improved and that the analysis should have been contained in the file documentation. We did not find that the loan file reflected both properties. The initial application included both properties, whereas, the final application reflected only the FHA-insured property. There was no explanation regarding the discrepancy between the initial and final application, as required. The borrower stated that the originator was well aware of his intent to purchase both properties, but he could not recall why the final application did not reflect this. Comment 17 Fairfield Financial stated that the $190 debt was an installment loan with a balance of $520, based on a March 9, 2004, credit report. Fairfield Financial further stated that the loan would have been paid off prior to the first mortgage payment due August 1, 2004. This is incorrect. The credit report was ordered on March 9, 2004, but was revised as of June 7, 2004 and still reflected the $520 balance. We stand by our conclusion that the $190 monthly payment would have adversely affected the borrower’s ability to make his mortgage payment in consideration that his monthly housing payment was increasing 600 percent. Comment 18 Fairfield Financial stated that the property purchased was a three family dwelling and that, when the potential rental income is considered as an offset to the housing payment, the net increase to the borrower’s monthly housing expense is significantly less than the 600 percent cited in the report. We disagree. As Fairfield Financial correctly stated, the borrower’s previous monthly housing payment was $300. The new monthly housing payment was $2,120. This equates to over a 600 percent increase. Fairfield Financial is quick to point out that the potential rental income would reduce the burden on the borrower of meeting this increase, but neglects to mention the second property purchased by the borrower that also required a monthly housing payment. The fact remains that the borrower’s monthly housing payment was increasing from $300 a month to over $2,100 a month, regardless of any other potential income sources. Comment 19 Fairfield Financial provided twelve commitment letters evidencing that they locked in each borrower for a minimum of 15 days. For the remaining eight loans in question, Fairfield Financial provided copies of their investor locks showing the borrowers were locked in prior to or on the day of the issuance of their commitment letters. Fairfield Financial contends that the borrowers were properly informed of their lock in protection. 27 The commitment letters provided, in most cases, were not included in the loan files or the HUD case binders at the time of our review. We recognize that the borrowers received a rate lock for the commitment fees paid. We disagree, however, that the borrowers were properly informed. Of the twelve commitment letters, only seven included the correct commitment fee amount charged to the borrower. Furthermore, of the twelve commitment letters: two were not dated by the borrower; one was not signed or dated by the borrower; and the remaining nine were all signed on the date of the closing. We have no way of knowing whether the borrowers received any notification for the eight loans where Fairfield Financial was unable to provide commitment letters. Accordingly, we disagree that the borrowers were properly informed considering the inconsistent amounts listed on the commitment letters to what was actually charged and that the borrowers, in most cases, did not sign the commitment letters until the day of closing. As this was the first review of Fairfield Financial, and it appears that the borrowers received a rate lock for the commitment fees paid, we revised our recommendation. We revised the recommendation from requesting repayment of the $11,390 charged, to require Fairfield Financial to ensure it properly discloses the fee to each borrower. 28 Appendix C NARRATIVE OF LOAN DEFICIENCIES Case number: 251-3097987 Mortgage amount: $446,067 Date of loan closing: May 28, 2004 Current status Current (as of August 31, 2005): Cause of default: Not applicable Number of payments before Not applicable first default reported: Unpaid principal balance $439,634 (as of August 31, 2005): Summary: Unsupported Income The application indicated the borrower’s total monthly employment income was $4,687, which consisted of $2,542 in base income and $2,145 in overtime income. Fairfield Financial computed the income during its verification process by using one of the borrower’s pay stubs. While the year-to-date earnings reflected on the pay stub were sufficient to establish the borrower’s base income, considering a recent raise, they were not sufficient to establish the overtime income of the borrower. HUD allows overtime income in qualifying a borrower so long as the borrower has earned overtime income for approximately two years. Otherwise, the lender must adequately justify and document its reasons for using the income. The borrower’s historical income data revealed that the borrower averaged only $3,153 per month in 2002, the year of his last promotion. In 2003, the borrower averaged $3,626 per month. A more accurate estimate of the borrower’s monthly income would have been an average of his 2003 earnings and year-to-date earnings. That calculation resulted in an average monthly income of $3,916, including overtime, well below the $4,687 monthly income Fairfield Financial used to qualify the borrower. Using that income, the mortgage payment-to-effective income ratio increased from 39.10 to 43.78 percent, and the total fixed payment-to-effective income ratio increased from 44.00 to 49.20 percent. Excessive Qualifying Ratios 29 Fairfield Financial exceeded HUD’s allowable limits without compensating factors. The mortgage credit analysis worksheet showed the borrower’s mortgage payment-to- effective income ratio as 39.10 percent and total fixed payment-to-effective income ratio as 44.00 percent. The worksheet indicated “credit an isolated situation” and “job longevity” as compensating factors. These are not included in the 10 compensating factors recognized by HUD. Also, as pointed out above, we calculated the debt ratios to be 43.78 percent and 49.20 percent based on the revised income calculation, further illustrating the need for compensating factors. Other Deficiencies Contrary to HUD requirements, Fairfield Financial approved a buydown interest rate loan without establishing and documenting that the eventual increase in mortgage payment would not adversely affect the borrower’s ability to make higher mortgage payments in the future. As noted above, Fairfield Financial improperly calculated the borrower’s monthly income, resulting in lower debt-to-income ratios. The debt-to-income ratios were actually much higher, which would have an adverse impact on the borrower’s ability to make higher mortgage payments in the future. 30 Case number: 251-2928528 Mortgage amount: $296,656 Date of loan closing: April 18, 2003 Current status Reinstated by borrower who retains (as of August 31, 2005): ownership; December 1, 2003 Cause of default: Other Number of payments before Two first default reported: Unpaid principal balance $288,571 (as of August 31, 2005): Summary: Unsupported Income The application indicated the borrower was self-employed with total monthly employment income of $4,167. To support this income, Fairfield Financial requested federal tax returns for the past two years and learned that the borrower had not prepared the required tax returns. Fairfield Financial allowed the borrower to have the federal tax returns prepared. Although the borrower signed and dated the prepared tax returns, the preparer did not sign the tax returns, and there is no indication that the borrower ever filed the tax returns with the Internal Revenue Service. Further, the loan file contains a conflicting Social Security number for the borrower, as reported on the certificate he signed as the owner of the business. Fairfield Financial did not address this conflicting Social Security number and did not sufficiently establish the borrower’s reported self- employment income. Underreported Liabilities In addition, Fairfield Financial omitted liabilities for the borrower when evaluating the loan. As noted above, Fairfield Financial requested tax returns to support the borrower’s income. However, the borrower was self-employed and had neglected to prepare and submit federal tax returns. Although the borrower submitted proforma tax returns, Fairfield Financial did not consider more than $32,300 in federal taxes and penalties owed by the borrower for the prior two tax years, as indicated on the unfiled tax returns. 31 When a borrower is delinquent on any federal debt, HUD declares that the borrower is not eligible until the delinquent account is brought current, paid, or otherwise satisfied or a satisfactory repayment plan is made between the borrower and the federal agency owed and verified in writing. It was Fairfield Financial’s obligation to consider this significant liability in evaluating the loan application and its impact on the borrower’s capacity to repay mortgage debt. As there is no repayment agreement in place for the borrower’s tax liability, we were unable to calculate the effect on the debt-to-income ratios. 32 Case number: 251-3084029 Mortgage amount: $265,828 Date of loan closing: April 1, 2004 Current status Foreclosure started; August 1, 2005 (as of August 31, 2005): Cause of default: Inability to rent property Number of payments before Four first default reported: Unpaid principal balance $261,357 (as of August 31, 2005): Summary: Excessive Qualifying Ratios Fairfield Financial exceeded HUD’s allowable limits without compensating factors. The mortgage credit analysis worksheet showed the borrower’s mortgage payment-to- effective income ratio as 42.94 percent and total fixed payment-to-effective income ratio as 49.90 percent. The worksheet indicated “job longevity” and “3-months reserves” as compensating factors. HUD does not recognize job longevity as a compensating factor. Although the borrower did have three months of reserves, HUD requires that the lender judge the overall merits of the loan application when determining to what extent the ratios may be exceeded. Considering the excessive ratios and the derogatory credit detailed below, the one compensating factor cited by Fairfield Financial was not sufficient to qualify the borrower. Derogatory Credit The borrower’s credit report identified six different accounts that went into collection. Derogatory credit, including accounts in collection, requires a sufficient written explanation from the borrower. The borrower provided a letter of explanation, citing a divorce as the reason for falling behind on payments. The letter further indicated that efforts had been made over the last several months to settle and pay off the debts. The divorce cited by the borrower occurred approximately eight years before the loan application, and five of the six accounts in collection were opened after the divorce finalization. This did not constitute a sufficient written explanation. 33 Case number: 352-5211304 Mortgage amount: $196,430 Date of loan closing: June 14, 2004 Current status Reinstated by mortgagor who retains (as of August 31, 2005): ownership; December 31, 2004 Cause of default: Curtailment of borrower income Number of payments before One first default reported: Unpaid principal balance $194,304 (as of August 31, 2005): Summary: Underreported Liabilities The borrower’s initial loan application indicated rental income from a single-family residence suggesting that he owned another residence. The final loan application did not include the rental income from this single-family residence and further indicated that the borrower did not own any other real estate. HUD requires a satisfactory letter of explanation from the borrower addressing any significant variances between the initial application and final application. Fairfield Financial did not document how this discrepancy was resolved and should have asked the borrower about this potential other property so that it could consider the asset and corresponding liability in the qualifying process. We learned that the borrower purchased two properties from the same seller, including the Federal Housing Administration property. The borrower closed on the other single- family property in the month before closing on the Federal Housing Administration property. The borrower stated that Fairfield Financial was aware of his intent to purchase both properties, but he was supposed to close on the Federal Housing Administration property first. Regardless of the order of closings on the properties, Fairfield Financial was obligated to include this liability in its analysis. Additionally, the borrower’s credit report included a $190 monthly payment to one creditor. Fairfield Financial excluded the debt because there were fewer than 10 monthly payments left on the obligation. HUD requires that lenders include debts lasting less than 10 months if the amount of the debt will affect the borrower’s ability to make the mortgage payment during the months immediately after loan closing. In this instance, the borrower’s monthly housing payment was increasing from $300 per month to more than $2,100 per month, a 600 percent increase. The borrower also owned another property on which he was making mortgage payments. Considering this substantial increase and the 34 borrower’s obligations to his other property, the additional $190 monthly payment would adversely affect the borrower’s ability to make his mortgage payments. Excessive Qualifying Ratios Fairfield Financial exceeded HUD’s allowable limits without compensating factors. The mortgage credit analysis worksheet showed the borrower’s mortgage payment-to- effective income ratio as 38.10 percent, requiring compensating factors, and total fixed payment-to-effective income ratio as 40.10 percent. Including the $190 monthly payment excluded by Fairfield Financial (detailed above), we calculated the total fixed payment-to-effective income ratio at 43.50 percent, also requiring compensating factors. Fairfield Financial did not document compensating factors. We were unable to determine what effect the borrower’s other property would have on the debt-to-income ratios. Derogatory Credit The borrower’s credit report identified a past judgment, various late payments, and six different accounts that went into collection. Derogatory credit, including accounts in collection, requires a sufficient written explanation from the borrower. The borrower provided a letter of explanation citing that the derogatory credit items were due to address changes and extended vacations and that he was a victim of identity theft. Address changes and extended vacations were not sufficient explanations, and there was nothing in the loan file or otherwise documented by Fairfield Financial substantiating that the borrower was a victim of identity theft. Other Deficiencies Fairfield Financial did not ensure the loan complied with HUD’s self-sufficiency requirements, as required. As a result, the monthly mortgage payment exceeded the property’s monthly net rental income, resulting in an over-insured loan. 35 Appendix D COMMITMENT FEES CHARGED TO BORROWERS Case # Description of fee Fee charged 061-2594624 Commitment fee; inadequate disclosure $180 251-2948755 Commitment fee; inadequate disclosure 500 061-2662310 Commitment fee; inadequate disclosure 595 061-2672274 Commitment fee; inadequate disclosure 595 251-2877993 Commitment fee; inadequate disclosure 595 251-2928528 Commitment fee; inadequate disclosure 595 251-2978060 Commitment fee; inadequate disclosure 595 251-2987969 Commitment fee; inadequate disclosure 595 251-2992447 Commitment fee; inadequate disclosure 595 251-3040714 Commitment fee; inadequate disclosure 595 251-3041749 Commitment fee; inadequate disclosure 595 251-3059409 Commitment fee; inadequate disclosure 595 251-3066191 Commitment fee; inadequate disclosure 595 251-3084029 Commitment fee; inadequate disclosure 595 251-3097987 Commitment fee; inadequate disclosure 595 251-3099102 Commitment fee; inadequate disclosure 595 352-5211304 Commitment fee; inadequate disclosure 595 352-5303820 Commitment fee; inadequate disclosure 595 374-4333229 Commitment fee; inadequate disclosure 595 374-4399067 Commitment fee; inadequate disclosure 595 Total $11,390 36 Appendix E AUDIT CRITERIA HUD Handbook 4060.1, REV-1, CHG-1, “Mortgagee Approval Handbook,” Chapter 6, “Quality Control Plan,” provides guidelines and requirements to be implemented by all lenders. Paragraph 6-1 requires all Federal Housing Administration-approved lenders, including loan correspondents, to implement and continuously have in place a quality control plan for the origination and/or servicing of insured mortgages as a condition for receiving and maintaining Federal Housing Administration approval. The quality control plan must be a prescribed and routine function of the lender’s operations and assure that the lender maintains compliance with HUD-Federal Housing Administration requirements and its own policies and procedures. Paragraph 6-3 contains the basic elements that are required in all quality control programs. The lender must properly train its staff involved in quality control and provide them with access to current guidelines relating to the operations that they review. It is not necessary for lenders to maintain these guidelines in hard copy format if they are accessible in an electronic format. Many of the statutes, regulations, HUD handbooks, and mortgagee letters that establish the requirements for Federal Housing Administration programs may be accessed through HUD’s home page on the World Wide Web. Paragraph 6-6C, “Sample Size and Loan Selection,” states that a lender originating 7,000 or fewer Federal Housing Administration loans per year must review 10 percent of the Federal Housing Administration loans it originates. Paragraph 6-6D, “Early Payment Defaults,” provides that in addition to the loans selected for routine quality control reviews, lenders must review all loans going into default within the first six payments. Early payment defaults are loans that become 60 days past due. Paragraph 6-7 prescribes minimum elements for the production portion of a quality control program. The lender must address the following elements, among others: • Determine whether there are sufficient and documented compensating factors if the debt ratios exceed Federal Housing Administration limits (paragraph 6-7J). • Determine whether all conditions were cleared before closing (paragraph 6-7 L). • Determine whether the seller acquired the property at the time of or soon before closing, indicating a possible property “flip” (paragraph 6-7P). 37 HUD Handbook 4000.4, REV-1, CHG-2, “Single Family Direct Endorsement Program,” paragraph 2-1, states that a lender must conduct its business operations in accordance with accepted sound mortgage lending practices, ethics, and standards. Paragraph 2-4C states that lenders are expected to exercise due diligence in the underwriting of loans to be insured by the Federal Housing Administration. HUD Handbook 4155.1, REV-4, CHG-1 (September 1995) and HUD Handbook 4155.1, REV-5 (October 2003), “Mortgage Credit Analysis for Mortgage Insurance on One- to Four-Family Properties,” requires lenders to determine the borrowers’ ability and willingness to repay the mortgage debt and, thus, limit the probability of default or collection difficulties. Lenders should evaluate the stability and adequacy of income, funds to close, credit history, qualifying ratios, and compensating factors. Lenders must ensure the application package contains sufficient documentation to support their decision to approve the mortgage loan. Paragraph 1-8C imposes self-sufficiency requirements on three- and four-unit properties as follows: “THREE- AND FOUR-UNIT PROPERTIES, regardless of occupancy status, must be self-sufficient, i.e., the maximum mortgage is limited so that the ratio of the monthly mortgage payment divided by the monthly net rental income does not exceed 100 percent.” Paragraph 2-3 states that while minor derogatory information occurring two or more years in the past does not require explanation, major indications of derogatory credit, including judgments and collections, and any other recent credit problems require sufficient written explanation from the borrower. The borrower’s explanation must make sense and be consistent with other information in the file. Paragraph 2-5B states if the borrower, as revealed by public records, credit information, or HUD’s Credit Alert Interactive Voice Response System, is presently delinquent on any federal debt (e.g., U.S. Department of Veterans Affairs-guaranteed mortgage, Title I loan, federal student loan, Small Business Administration loan, delinquent federal taxes) or has a lien, including taxes, placed against his or her property for a debt owed to the United States, the borrower is not eligible until the delinquent account is brought current, paid, or otherwise satisfied or a satisfactory repayment plan is made between the borrower and the federal agency owed and verified in writing. Tax liens may remain unpaid provided the lien holder subordinates the tax lien to the Federal Housing Administration-insured mortgage. If any regular payments are to be made, they must be included in the qualifying ratios. Section 2 and paragraph 2-7 require the lender to establish the anticipated amount of income and the likelihood of its continuance to determine a borrower’s capacity to repay the mortgage debt. 38 Paragraph 2-7A states that overtime may be used to qualify if the borrower has received such income for approximately two years and the employment verification must not state categorically that such income is not likely to continue. Periods of less than two years may be acceptable provided the underwriter adequately justifies and documents his or her reasons for using the income. Paragraph 2-9B prescribes documentation requirements for self-employed borrowers as follows: 1. Signed and dated individual tax returns, plus all applicable schedules, for the most recent two years; 2. Signed copies of federal business income tax returns for the last two years with all applicable schedules if the business is a corporation, an “S” corporation, or a partnership; 3. A year-to-date profit-and-loss statement and balance sheet; and 4. A business credit report on corporations and “S” corporations. Paragraph 2-11A indicates the borrower’s liabilities include all installment loans, revolving charge accounts, real estate loans, alimony, child support, and all other continuing obligations. In computing the debt-to-income ratios, the lender must include the monthly housing expense and all additional recurring charges extending 10 months or more, including payments on installment accounts, child support, or separate maintenance payments, revolving accounts and alimony, etc. Debts lasting less than 10 months must be counted if the amount of the debt affects the borrower’s ability to make the mortgage payment during the months immediately after loan closing. Paragraph 2-11C states if a debt payment, such as a student loan, is scheduled to begin within 12 months of the mortgage loan closing, the lender must include the anticipated monthly obligation in the underwriting analysis unless the borrower provides written evidence that the debt will be deferred to a period outside this timeframe. Section 5, “Borrower Qualifying,” states that HUD does not set an arbitrary percentage that ratios may never exceed. However, it is left up to the lender to judge the overall merits of the loan application and determine what compensating factors apply and to what extent the ratios may be exceeded. Establishing that a loan transaction meets minimal standards does not necessarily constitute prudent underwriting. Paragraph 2-12 states that debt-to-income ratios are used to determine whether the borrower can reasonably be expected to meet the expenses involved in homeownership and otherwise provide for the family. The lender must compute two ratios: (1) mortgage payment expense-to-effective income, which is considered acceptable if it does not exceed 29 percent of gross effective income, and (2) total fixed payment-to-effective income, which is considered acceptable if it does not exceed 41 percent of gross effective income. However, these ratios may be exceeded if significant compensating factors are presented. 39 Paragraph 2-13 establishes the 10 compensating factors that may be used in justifying approval of the loan with ratios exceeding HUD benchmark guidelines. Underwriters must state on the “remarks” section of the mortgage credit analysis worksheet the compensating factors used to support loan approval. Paragraph 2-14 permits lenders to provide borrowers with interest rate buydowns. Interest rate buydowns are designed to reduce the borrower’s monthly payment during the early years of the mortgage. It also requires the lender to establish that the eventual increase in mortgage payments will not adversely affect the borrower and likely lead to default. The underwriter must document which of four criteria the borrower meets. 1. The borrower has a potential for increased income that would offset the scheduled payment increases, as indicated by job training or education in the borrower’s profession or by a history of advancement in the borrower’s career with attendant increases in earnings. 2. The borrower has a demonstrated ability to manage financial obligations in such a way that a greater portion of income may be devoted to housing expenses. This criterion also may include borrowers whose long-term debt, if any, will not extend beyond the term of the buydown agreement. 3. The borrower has substantial assets available to cushion the effect of the increased payments. 4. The cash investment made by the borrower substantially exceeds the minimum required. Paragraph 3-6 requires a satisfactory letter of explanation from the borrower addressing any significant variances between the initial application and final application. 40
Fairfield Financial Mortgage Group, Inc., Danbury, Connecticut, Did Not Always Comply with Federal Housing Administration Requirements
Published by the Department of Housing and Urban Development, Office of Inspector General on 2005-09-26.
Below is a raw (and likely hideous) rendition of the original report. (PDF)