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
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)