oversight

Harry Mortgage Company Generally Complied with HUD Loan Origination Requirements but Did Not Perform Quality Control Reviews of All Early Defaults, Oklahoma City, OK

Published by the Department of Housing and Urban Development, Office of Inspector General on 2005-06-01.

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

                                                            Issue Date
                                                                     June 1, 2005
                                                            Audit Report Number
                                                                     2005-FW-1011




TO:         Frank L. Davis
            General Deputy Assistant Secretary for Housing, H



FROM:       Frank E. Baca
            Regional Inspector General for Audit, 6AGA

SUBJECT: Harry Mortgage Company Generally Complied with HUD Loan Origination
           Requirements but Did Not Perform Quality Control Reviews of All Early
           Defaults.


                                 HIGHLIGHTS

 What We Audited and Why

             We surveyed Harry Mortgage Company (lender), Oklahoma City, Oklahoma,
             because of its high default and claim rate. According to the U.S. Department
             of Housing and Urban Development’s (HUD) Neighborhood Watch system,
             6.01 percent of the loan originations by the lender resulted in defaults or
             claims during the two-year period ending September 30, 2004. For the same
             period, the Oklahoma City Metropolitan Statistical Area had a 2.67-percent
             default and claim rate, less than one-half of the lender’s rate.

             The survey objective was to determine whether the lender acted in a prudent
             manner and complied with HUD regulations, procedures, and instructions in
             the origination of Federal Housing Administration single family mortgages.
             An additional objective was to decide whether deficiencies warrant an in-
             depth audit.


 What We Found


             For 14 of the 15 loans reviewed, we found that the lender acted in a prudent
             manner and complied with HUD regulations, procedures, and instructions in
           originating Federal Housing Administration single family mortgages.
           However, one loan exhibited poor underwriting and warrants indemnification.
           In addition, the lender did not make required reviews of early defaults. HUD
           reported the deficiency in December 2002. The deficiencies do not warrant
           further audit work.

What We Recommend


           We recommend that the General Deputy Assistant Secretary for Housing
           require the lender to indemnify HUD for the deficient loan, ensure that the
           lender has procedures to monitor defaults, and take appropriate administrative
           action against the lender for not reviewing early payment defaults, a
           recurrence of a HUD finding.

           For each recommendation 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.

Auditee’s Response


           The lender provided a response to the report at our exit conference on May 10,
           2005. The lender generally disagreed with our recommendation regarding the
           deficient loan. It also indicated it has implemented new procedures for quality
           control.

           The complete text of the auditee’s response, along with our evaluation of that
           response, can be found in Appendix B of this report.




                                          2
                           TABLE OF CONTENTS

Background and Objectives                                                            4

Results of Audit
        Finding 1: Lender Generally Complied with HUD Requirements but Approved      5
        One Loan That It Should Have Rejected
        Finding 2: Lender Did Not Review Loans Going into Default within the First   7
        Six Payments

Scope and Methodology                                                                8

Internal Controls                                                                    9

Appendixes
   A.    Schedule of Funds to Be Put to Better Use                                   10
   B.    Auditee Comments and OIG’s Evaluation                                       11
   C.    Criteria                                                                    15




                                            3
                   BACKGROUND AND OBJECTIVES

Harry Mortgage Company’s (lender) main office is in Oklahoma City, Oklahoma, and it has
a branch office in Tulsa, Oklahoma. The lender is a nonsupervised direct endorsement
lender. The U.S. Department of Housing and Urban Development (HUD)/Federal Housing
Administration approved the main office on October 18, 1963, and the branch office on
September 12, 1977, to originate single family loans under section 203(b)(1) of the National
Housing Act. On May 28, 2004, the lender engaged a private firm to provide quality control
services. HUD terminated the lender as an approved Federal Housing Administration lender
on November 17, 2004, because of a high default and claim rate.




                                             4
                              RESULTS OF AUDIT

Finding 1: Lender Generally Complied with HUD Requirements but
Approved One Loan That It Should Have Rejected
Of the 15 loans reviewed, we found one that the lender’s underwriter should have rejected,
Federal Housing Administration number 421-3978468. The lender’s staff disregarded HUD
requirements when originating the loan. They did not obtain a reasonable explanation for
negative bank balances, a large deposit three days before closing, and the source of funds for
two money orders. As a result, the lender subjected HUD to unnecessary risk by approving
the HUD-insured loan of $138,061. The borrower defaulted without making a loan payment.



The borrower did not provide a reasonable explanation for his negative bank balances. He
submitted to the lender three months of bank statements, which had negative balances. In a
letter of explanation, the borrower stated the reason for the negative bank account balances
was that his employer had not deposited his payroll checks in a timely manner. However, the
deposit date identified on the pay statement is consistent with the deposit date on the bank
statement. Therefore, the borrower’s explanation is questionable and not sufficient to resolve
the issue. HUD Handbook 4155.1, REV 4, paragraph 2-3, states that the borrower’s
explanation for derogatory credit must make sense and be consistent with other credit
information in the file.

The borrower had an unexplained deposit of $460 three days before closing. This deposit
ensured the borrower had enough funds to close. HUD Handbook 4155.1, REV 4, states the
lender should verify large unexplained deposits. Based on the borrower’s negative bank
balances, $460 is a large deposit. The lender should have verified the source of the
unexplained deposit.

The borrower had unexplained money orders purchased with funds that did not come out of
his bank account. The borrower paid $400 in earnest money with two $200 money orders on
the same day. The borrower’s bank statements do not show that he withdrew the earnest
money payment from his bank account. HUD Handbook 4155.1, REV 4, states if the earnest
money appears excessive based on the borrower’s history of accumulated savings, the lender
must verify the source of funds. The lender’s underwriter disregarded HUD requirements to
obtain required verifications. Without the required verifications, the underwriter should have
rejected the loan.




                                              5
Recommendation



We recommend that the General Deputy Assistant Secretary for Housing:

1A. Require the lender to indemnify HUD for loss on Federal Housing Administration loan
    number 421-3978468.




                                           6
Finding 2: Lender Did Not Review Loans Going into Default within
the First Six Payments
Neither the lender’s staff nor its quality control contractor reviewed all early payment default
loans as required by HUD. Although the lender’s quality control plan included such reviews,
the lender had not implemented adequate controls to ensure its staff or contractor conducted
the reviews. As a result, the lender had no way to identify patterns or correctable causes of
early payment defaults.



We examined the lender’s quality control reports for evidence that the lender had reviewed
12 loans. For the remaining three loans in our sample, HUD no longer required the lender to
keep quality control reports, nor did the lender still have the reports.

Neither the lender’s staff nor its quality control contractor had reviewed any of the 12 loans
in our sample that defaulted after the borrowers made one or fewer payments. HUD requires
the lender to review all loans going into default within the first six payments (Handbook
4060.1, REV-1, CHG-1, Chapter 6, part B, paragraph 6-6D). In December 2002, the HUD
Quality Assurance Division reported, “Harry Mortgage failed to perform quality control
reviews of all early payment default loans as required. Specifically, on those loans that went
into default within the first six months, no quality control reviews were being performed as
required.”

HUD also requires lenders to take steps to identify the patterns of early defaults by location,
program, or loan characteristic (Handbook 4060.1, REV-1, CHG-1, Chapter 6, part B,
paragraph 6-5C). The lender’s quality control plan requires a review of all early payment
default loans. However, the lender had not implemented management controls or procedures
to monitor for defaults and to ensure its staff or contractor conducts the reviews. As a result,
the lender did not identify patterns or causes of early payment defaults.


Recommendations


We recommend that the General Deputy Assistant Secretary for Housing:

2A. Ensure that the lender has procedures to monitor defaults and ensure its staff or
    contractor conducts the required quality control reviews on early payment defaults
    before reinstating the lender as a direct endorsement lender for HUD.

2B. Take the appropriate administrative action, to include imposing civil monetary
    penalties, against the lender for not reviewing early payment default loans, a recurrence
    of a finding that HUD reported in December 2002.




                                               7
                         SCOPE AND METHODOLOGY

We divided the survey objective into mortgage credit analysis areas to determine whether the
borrower had available assets to close the loan, was creditworthy, and had adequate and
stable effective income. To accomplish the objective, we selected 15 loans for review from a
list of 155 of the lender’s defaulted loans in HUD’s Neighborhood Watch system1 from
January 1, 2001, through September 30, 2004. We selected all loans with one or fewer
payments before first default was reported. We reviewed relevant federal regulations, HUD
handbooks, title company closing files, and Federal Housing Administration and lender loan
origination files. Our review of the loan origination files included:

          1. Determining whether a pattern of defaults existed;
          2. Examining loan documents for inconsistent and derogatory information;
          3. Comparing the final application with the preliminary application, verifications
             of deposit and employment, credit reports, and any other relevant
             documentation available to establish consistency; and
          4. Examining the appraisal and comparing the subject and details with comparable
             properties for value consistency. This included a review of information
             maintained by the offices of the Oklahoma and Cleveland County tax assessors.

We interviewed HUD Quality Assurance Division staff and held an entrance conference with
the lender’s executives on November 16, 2004. We conducted our fieldwork through
March 16, 2005. We performed our fieldwork at the lender’s office and reviewed Federal
Housing Administration case binders in our office in Oklahoma City, Oklahoma. We
conducted our audit survey in accordance with generally accepted government auditing
standards.




1
    We did not perform procedures to assess the data contained in HUD’s Neighborhood Watch system. The
    survey did not include other computer-generated data.

                                                   8
                            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 survey
               objectives:

                  •    Loan origination process – Policies and procedures that management
                       has in place to reasonably ensure that the loan origination process
                       complies with HUD program requirements.

                  •    Quality control plan – Policies and procedures that management has in
                       place to reasonably ensure implementation of HUD quality control
                       requirements.

Significant Weakness


               Based on our survey, we believe the following item is a significant weakness:

                  •    The lender had not implemented adequate controls to ensure its staff or
                       contractor conducted the reviews of early defaults as discussed in
                       Finding 2.




                                              9
                                 APPENDIXES

Appendix A

    SCHEDULE OF FUNDS TO BE PUT TO BETTER USE



                        Recommendation          Funds to be Put
                            Number               to Better Use1

                                1A                 $138,061




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.




                                           10
Appendix B

      AUDITEE COMMENTS AND OIG’S EVALUATION


Ref to OIG Evaluation   Auditee Comments




                        Redacted



Comment 1




Comment 2




Comment 3




                        11
Comment 3




Comment 1


Comment 3




Comment 1

Comment 4




Comment 5




            12
13
                          OIG Evaluation of Auditee Comments

Comment 1 The lender stated HUD Handbook 4155.1 REV 4 Chapter 2-10 A does not
appear to be specifically applicable to this case. We stated in the report that if the earnest
money appears excessive based on the borrower’s history of accumulated savings, the lender
must verify the source of funds. This statement is from HUD Handbook 4155.1 REV 4
Chapter 2-10 A. We believe this is applicable based on the borrower’s history of negative
bank balances. The lender should have verified the source of the earnest money to ensure the
borrower used his funds.

Comment 2 Negative Bank Balances – The lender assumed the borrower’s explanation of
the negative bank balances was acceptable although documents contained in the file do not
support the explanation. The pay and bank statements in file show the employer deposited
the borrower’s paycheck without delays. The borrower’s explanation remains questionable
and insufficient to explain three months of negative balances.

Comment 3 Unexplained Large Deposit and Money Orders - The lender assumes that the
$460 deposit came from a re-deposit of borrower’s funds. The borrower’s bank statement
shows the borrower issued two checks that totaled $760. The lender stated it is “more than
likely” the two checks were cash withdrawals, and that the borrower probably later realized
he did not have sufficient funds to cover closing costs and re-deposited $460 of the $760 into
the bank account. The lender has no documentation to support these assumptions. In
addition, even if the lender’s assumptions were correct, the transactions still do not explain
where the borrower came up with $460 to re-deposit into his account since he paid $735 in
money orders (a $325 money order for the application fee and two money orders totaling
$400 for earnest money), leaving only $35 of the $760. The lender should make proper
verifications instead of unsupported assumptions.

Comment 4 The lender indicates rejecting the loan on the basis of excessive and unverified
earnest money would not have been justifiable since the underwriter excluded the $400 of
additional earnest money in the underwriting of the file. However, as stated in the finding,
we believe the loan should not have been approved because of three things: (1) no
reasonable explanation for negative bank balances; (2) unexplained deposit three days before
closing; and (3) unexplained money orders for funds not withdrawn from the bank account.
HUD requires the explanations to make sense and be consistent with other credit information
in the file. By approving the loan without adequate explanations as required, the lender
subjected HUD to unnecessary risk. According to HUD’s Neighborhood Watch System,
foreclosure is completed and the borrower never made a payment.

Comment 5 The lender indicates it has implemented new procedures in connection with its
quality control plan. HUD will need to review and ensure the plan’s adequacy.




                                              14
Appendix C
                                       CRITERIA
HUD Handbook 4060.1, REV-1, “Mortgagee Approval Handbook”
Paragraph 6-5C. Identify Patterns. Lenders must identify patterns of early defaults by
location, program, loan characteristic, loan correspondent, or sponsor. Lenders may use
HUD’s Neighborhood Watch - Early Warning system to identify patterns. Lenders must
identify commonalities among participants in the mortgage origination process to learn the
extent of their involvement in problem cases. Loans involving appraisers, loan officers,
processors, underwriters, etc., who have been associated with problems, must be included in
the review sample.

Paragraph 6-6D. Early Payment Defaults. In addition to the loans selected for routine
quality control reviews, lenders must review all loans going into default within the first six
payments. As defined here, early payment defaults are loans that become 60 days past due.

HUD Handbook 4155.1, REV-4, “Mortgage Credit Analysis for Mortgage
Insurance”
An excerpt from paragraph 2-3. The borrower’s explanation must make sense and be
consistent with other credit information in the file.

Paragraph 2-10A. Earnest Money Deposit. If the amount of the earnest money deposit
exceeds 2 percent of the sales price or appears excessive based on the borrower’s history of
accumulating savings, the lender must verify with documentation the deposit amount and the
source of funds. Satisfactory documentation includes a copy of the borrower’s cancelled
check. A certification from the deposit holder acknowledging receipt of funds and separate
evidence of the source of funds is also acceptable. Evidence of source of funds includes a
verification of deposit or bank statement showing that at the time the deposit was made, the
average balance was sufficient to cover the amount of the earnest money deposit.

Paragraph 2-10B. Savings and Checking Accounts. A verification of deposit, along with the
most recent bank statement, may be used to verify savings and checking accounts. If there is
a large increase in an account or the account was opened recently, the lender must obtain a
credible explanation of the source of those funds.




                                              15