Issue Date
September 23, 2005
Audit Report Number
2005-LA-1010
TO: Brian D. Montgomery, Assistant Secretary for Housing, Federal Housing
Commissioner, H
FROM: Joan S. Hobbs, Regional Inspector General for Audit, Region IX, 9DGA
SUBJECT: First Magnus Financial Corporation Did Not Comply with Federal Housing
Administration Guidelines When Underwriting Five Mortgage Loans and
Implementing Its Quality Control Program
HIGHLIGHTS
What We Audited and Why
We reviewed five Federal Housing Administration loans sponsored by First
Magnus Financial Corporation’s (First Magnus) branch office in Las Vegas,
Nevada. During an audit of a Federal Housing Administration-approved loan
correspondent, we identified loans sponsored by First Magnus that did not appear
to be originated according to U.S. Department of Housing and Urban
Development (HUD) regulations. Because the sponsor is ultimately responsible
for approving the loans, we reviewed the underwriting deficiencies with First
Magnus to determine whether it complied with HUD requirements.
What We Found
First Magnus did not comply with HUD requirements when underwriting the five
Federal Housing Administration-insured mortgages as the sponsoring lender.
First Magnus approved the loans for borrowers who were ineligible for the
insured mortgages because the loan files contained false and otherwise
questionable documentation. In addition, First Magnus did not perform quality
control reviews during the time that four out of five loans in our sample were
closed. Therefore, the quality control plan at that time was not fully implemented.
As a result, it improperly placed the insurance fund at risk.
What We Recommend
We recommend that the assistant secretary for housing - federal housing
commissioner take appropriate administrative action against First Magnus. This
action, at a minimum, should include requiring First Magnus to repay $204,826 in
claims and losses incurred on four loans, and, indemnify HUD $127,893 for any
future losses associated with one loan that is presently in foreclosure.
We also recommend that First Magnus require its branch offices to respond in
writing to quality control review findings, and establish timeframes for completion
of corrective actions.
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
We provided First Magnus with the discussion draft report on August 24, 2005,
and held an exit conference on September 8, 2005. First Magnus provided written
comments on September 13, 2005. First Magnus agreed with our report findings.
The complete text of First Magnus’ response, along with our evaluation of that
response, can be found in appendix B of this report.
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TABLE OF CONTENTS
Background and Objectives 4
Results of Audit
Finding 1: First Magnus did not follow HUD requirements when underwriting 5
five mortgage loans and implementing its quality control program
Scope and Methodology 11
Internal Controls 12
Appendixes
A. Schedule of Questioned Costs and Funds to Be Put to Better Use 13
B. Auditee Comments and OIG’s Evaluation 14
C. Schedule of Deficiencies and Related Claim Amounts 19
3
BACKGROUND AND OBJECTIVES
Background
The First Magnus Financial Corporation (First Magnus) is a wholesale lender that was incorporated
and approved by the U.S. Department of Housing and Urban Development (HUD) as a
nonsupervised lender in 1996. Its corporate office is located in Tucson, Arizona. First Magnus
currently has 251 active branch offices and sponsors 1,870 Federal Housing Administration-
approved loan correspondents. As a wholesale lender, First Magnus underwrites and funds loans
received by its loan correspondents and other brokers.
First Magnus’ Las Vegas branch office sponsored 283 HUD loans that were originated by First
Source Financial USA (First Source) of Henderson, Nevada, between April 1, 2001, and March 31,
2003. The chart below shows the current status of those loans.
Description Number Percentage Amount
HUD loans sponsored 262 $30,018,096
Defaults reported 16 6.1% $1,950,599
Loans to claim 5 1.9% $638,813
We reviewed five of the 283 loans originated during this period.
Objectives
Our objectives were to determine if First Magnus complied with HUD requirements when
underwriting the five loans originated by its loan correspondent First Source Financial USA
(First Source), and, to determine whether First Magnus’ current and past quality control plans
complied with HUD requirements and were adequately implemented.
4
RESULTS OF AUDIT
Finding 1: First Magnus Did Not Follow HUD Requirements When
Underwriting Five Mortgage Loans and Implementing Its Quality
Control Program
First Magnus did not comply with HUD regulations, procedures, and instructions in the
processing of five Federal Housing Administration-insured single-family mortgages. The lender
did not adequately support the borrowers’ eligibility by verifying income and clarifying
questionable documentation. We reviewed five loans processed by First Magnus and found
instances where borrowers were approved for loans with false documents, overstated income, or
questionable loan documentation. In addition, First Magnus did not perform quality control
reviews during the time that four of the five loans reviewed were closed. Therefore, the quality
control plan at the time was not fully implemented. As a consequence, HUD incurred an
unnecessary risk to the Federal Housing Administration insurance fund and suffered losses
associated with the loans totaling $204,826.
General HUD Handbook
Requirements
Paragraph 2-5 of HUD Handbook 4000.4, REV-1, requires the lender to obtain and
verify information with at least the same care that would be exercised in originating
a loan in which the lender would be entirely dependent on the property as security to
protect its investment.
HUD Handbook 4155.1, REV-4, describes the basic mortgage credit underwriting
requirements for single-family mortgage loans insured under the National Housing
Act. For each loan HUD insures, the lender must establish that the borrower has the
ability and willingness to repay the mortgage debt. This decision must be predicated
on sound underwriting principles consistent with the guidelines, rules, and
regulations described throughout the handbook and must be supported by sufficient
documentation.
5
First Magnus Did Not Follow HUD Requirements When Underwriting Five
Federal Housing Administration Loans
One Loan Was
Approved with False
Documentation
Loan Number 332-3619948
First Magnus did not verify the borrower’s loan documentation and approved the
loan based on false documents. The loan file contained false employment
verifications, Internal Revenue Service W-2 forms, and pay stubs. The
borrower’s alternative credit documentation was also false. The First Magnus
loan file contained a faxed copy of a telephonic verification of employment for a
company for which the borrower never worked.
Mortgagee Letter 2001-01 holds lenders responsible for verifying the authenticity
of faxed loan documentation. The letter states that among other things, the
documentation must contain a telephone number of an individual who can verify
the accuracy of the information provided. First Magnus did not comply with this
requirement.
Three Loans Were Approved with
Overstated Income and High Debt-
to-Income Ratios
For three of the five loans we reviewed, the borrower’s income was overstated. In
addition, the debt-to-income ratios in four of the loans exceeded the HUD
benchmark ratios of 29/41. For three loans, either the underwriter gave no
compensating factors, or the compensating factors provided were not sufficient to
warrant loan approval.
Loan Number 332-3709163
First Magnus improperly used income that the borrower had received for only five
months to calculate the borrower’s debt-to-income ratios. The borrower’s
monthly income before loan approval averaged at least $1,000 less than the
income used to calculate debt-to-income ratios. If the borrower’s actual income
had been considered, First Magnus would have calculated the borrower’s ratios at
56/57, far exceeding the HUD benchmark ratios of 29/41. At the time of our
audit fieldwork, the property had gone into foreclosure twice.
6
On June 1, 2005, the property went into foreclosure for the third time ($127,893).
Loan Number 332-3690171
First Magnus disregarded the lower income stated on the borrower’s previous two
years’ tax returns and used a higher income taken from a budget letter supplied by
the self-employed borrower. The borrower’s income was overstated by $194 per
month. Using the lower income from the borrower’s tax returns resulted in debt-
to-income ratios of 40/40. These ratios exceeded HUD’s benchmark ratios of
29/41.
This loan was a 12-payment default and is in claim status ($138,969).
Loan Number 332-3690901
The underwriter included undocumented overtime as effective income, and as a
result, income was overstated by $812 per month. The overtime was not
documented over two years as is required and should not have been included in
the underwriter’s calculations. Using the overtime, the underwriter calculated
debt-to-income-ratios of 33/33. However, if overtime pay had been omitted from
the calculation, the ratios would have increased to 43/43.
This loan was a one-payment default, and a claim was paid ($27,748).
No Compensating Factors or
Insufficient Justifications Were
Provided
For three of the five loans we reviewed, either no compensating factors were
provided when the borrower’s ratios exceeded HUD’s benchmark ratios or the
compensating factors given were not sufficient to justify loan approval.
HUD Handbook 4155.1, REV-1 states that compensating factors may be used in
justifying approval of mortgage loans with ratios exceeding HUD benchmark
guidelines. The underwriter must state the compensating factors used to support
loan approval on the remarks section of the HUD 92900-WS.
Loans 332-3709163 and 332-3690901 had no compensating factors to offset the
borrowers’ excessive ratios. The compensating factors used for loan 332-
3690171 were not plausible. One compensating factor stated that the borrower’s
housing expense would only be a minimal increase over his present rent expense.
However, we calculated the increase to the borrower’s housing expense to be as
much as 33 percent. Another compensating factor stated that the borrower was a
7
minimal user of credit. The borrower’s credit report reflected only six accounts;
however, four had gone into collection.
Loan Was Approved with
Inappropriate Third Party
Intervention
HUD Handbook 4155.1 REV-4 prohibits verification documents from passing
through the hands of a third party.
Loan Number 332-3688870
We found evidence in the file that loan documents including a pay stub passed
through the hands of the seller as indicated by the seller’s name in the fax line of
the document. We located and interviewed the borrower, who told us she never
met the loan officer, all business was conducted with one of the sellers, and she
signed the paper work at the sellers’ home. In addition, the loan was submitted
for late endorsement without evidence of current payment on the part of the
borrower.
The loan was a zero-payment default and a claim was paid ($8,932).
First Magnus Performed Partial
Quality Control Reviews in 2001
First Magnus’ quality control program was not consistent and not fully performed
during calendar year 2001. Based on our review of quality control documents, we
determined that First Magnus performed quality control reviews for the period
January 2001 through May 2001. Four of the five loans in our sample closed later
in 2001, when reviews were not performed. Management explained that some
reviews were not performed during the time of an office move, and that they
hoped to complete them, but never did.
8
Branch Offices Did Not
Respond to Identified
Deficiencies resulting from
Quality Control Reviews
First Magnus has established a written plan for on-site quality control reviews that
complies with the latest revision to HUD Handbook 4060.1, REV-1. However,
we reviewed documentation for 69 on-site reviews that were conducted by First
Magnus’ risk management department between February 2004 and December
2004 and determined that of the 69 branches reviewed, 17 branches had
significant findings that were noted, but only two (12 percent) provided responses
back to the risk management department. There were no final resolutions to the
significant findings identified for the other 15 branches.
In addition, First Magnus had not fully implemented its early payment default
program. We reviewed four quarters of early default reports between July 22,
2003, and July 6, 2004, and found that the overall response rate was less than 60
percent. Therefore, we concluded that the quality control review program has not
been fully implemented.
Conclusion
Due to lack of due diligence during the underwriting process and a lack of quality
controls, First Magnus underwrote the five loans in our sample with false
documentation, overstated income, high debt-to-income ratios, and inadequate
compensating factors. Compensating factors either were not provided or were not
adequate to support approval of the loans. These deficiencies caused an
unnecessary risk to the Federal Housing Administration’s insurance fund and
caused HUD to suffer losses associated with the loans totaling $204,826.
In addition, First Magnus performed quality control reviews for the first five months
of 2001 there was no evidence reviews performed for the remaining seven months of
the year. Four of the five loans in our sample closed during the time that no reviews
were performed.
First Magnus’ branch offices frequently did not respond to significant deficiencies
identified by its corporate risk management department. As a result, First Magnus’
quality control process has not been fully implemented and in practice is not
sufficiently effective in ensuring that loans are processed in accordance with HUD
requirements.
9
Recommendations
We recommend that the assistant secretary for housing – federal housing
commissioner require First Magnus to
1A. Repay $204,826 in claims and losses that HUD incurred on four loans.
1B. Indemnify HUD for any future loss associated with one loan in foreclosure
status for $127,893.
1C. Require its branch offices to respond in writing to quality control findings,
and establish timeframes for completion of corrective actions.
10
SCOPE AND METHODOLOGY
We performed audit work from April through July 2005. The audit period covered April 2001
through December 2004.
To accomplish our review objectives, we
• Reviewed five Federal Housing Administration-insured loans that were underwritten by
First Magnus during the period April through September 2001,
• Interviewed First Magnus’ Las Vegas branch management and its corporate office
management in Tucson, Arizona, and
• Performed a review of First Magnus’ present and 2001 Quality Control plan.
We relied on computer-processed data contained in HUD’s Neighborhood Watch system. During
the audit of the loan correspondent, we assessed the reliability of the data, including relevant general
and application controls, and found them to be adequate. 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.
We performed our review in accordance with generally accepted government auditing standards.
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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:
• Underwriting – Policies and procedures that management has in place to
reasonably assure that the loan underwriting process complies with HUD
program requirements.
• Quality Control Process – Policies and procedures established by
management to ensure the quality control plan has been implemented and
related reviews are performed.
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.
Significant Weaknesses
First Magnus did not underwrite five loans in accordance with all applicable HUD
requirements, and based on our review, we believe that the quality control process,
as it relates to implementation of the auditee’s prior and current quality control
plans, is a significant weakness.
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APPENDIXES
Appendix A
SCHEDULE OF QUESTIONED COSTS
AND FUNDS TO BE PUT TO BETTER USE
Recommendation Ineligible 1/ Unsupported Unreasonable or Funds to be put
number 2/ unnecessary 3/ to better use 4/
1A $204,826
1B $127,893
1/ Ineligible costs are costs charged to a HUD-financed or HUD-insured program or activity
that the auditor believes are not allowable by law; contract; or federal, state, or local
polices or regulations.
2/ Unsupported costs are those costs charged to a HUD-financed or HUD-insured program
or activity when we cannot determine eligibility at the time of audit. Unsupported costs
require a decision by HUD program officials. This decision, in addition to obtaining
supporting documentation, might involve a legal interpretation or clarification of
departmental policies and procedures.
3/ Unreasonable/unnecessary costs are those costs not generally recognized as ordinary,
prudent, relevant, and/or necessary within established practices. Unreasonable costs
exceed the costs that would be incurred by a prudent person in conducting a competitive
business.
4/ “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.
13
Appendix B
AUDITEE COMMENTS AND OIG’S EVALUATION
Ref to OIG Evaluation Auditee Comments
Comment 1
14
Comment 2
Comment 3
15
16
OIG Evaluation of Auditee Comments
Comment 1 First Magnus Financial Corporation (First Magnus) agreed with our
recommendation to reimburse the insurance fund for claims paid on four loans
and agreed to remit $204,826. First Magnus also agreed to execute an
indemnification agreement for a fifth loan ($127,893), which is presently in
foreclosure. However, the response also stated, “…First Magnus understands that
there will be no other reviews completed on any loan originated by First Source as
they relate to First Magnus and that all loan level issues are resolved with First
Magnus’ payment.” The OIG makes no such agreement and in fact at the exit
conference, we explained that we plan to return and follow up on issues found
during the audit that did not specifically relate to only the five loans reported in
this audit. We also told First Magnus that our follow-on work would not be
limited to only transactions dealing with First Source.
Comment 2 The term “significant findings” is not a term that was used by the OIG to describe
the results of branch office report reviews First Magnus conducted at its branches.
The term significant issues was used by First Magnus in a statement contained in
its “On-Site HUD Compliance Review” reports to describe items that its Risk
Management department said needed to be addressed and response obtained
within 45 days. The statement reads as follows:
“In pursuing a constructive audit process, Risk Management requests your
response in increasing compliance levels as it pertains to ensuring that loan files
contain complete and accurate borrower disclosure and First Magnus’ policy-
required information. Please respond to Risk Management within 45 days,
from the date of this report, covering significant issues noted above (if any).”
As stated in our draft report, we found that of 69 branch office reviews, 17 had
issues that were identified as significant by First Magnus. The issues were either
contained on the on-site compliance review report or in appendices that were
attached to the report. In the 69 reviews that were provided to us, only two
contained responses to the significant findings identified in the reports.
At the exit conference when we were asked to provide examples of “significant
issues” we responded that they used this term in their correspondence, not us. We
did not bring copies of their correspondence with us to the exit conference since
they were the originator of the information. At the exit conference the one
example we recalled was where the underwriters did not sign mortgage credit
analysis worksheets. Other issues identified by First Magnus in its compliance
reviews included:
17
• Loan documents that were signed by borrowers when they were blank and
filled in later.
• Loan applications that were not signed by applicants, loan officers or
brokers.
• Files contained no copy of the mortgage credit analysis worksheets.
• Good Faith Estimates and Truth in Lending statements were not issued to
borrowers within three days of the loan application.
• Calculated borrower income was either overstated or unsupported.
The items above violated HUD and/or RESPA requirements. In each of the
above cases, First Magnus requested that the reviewed branch office respond
to the Risk Management department within 45 days from the date of the report
covering significant issues that were either noted on the report or in
appendices attached to the report. However, there was no evidence that
responses to the above issues were provided by their branches.
Comment 3 HUD Handbook 4060.1, REV-1, paragraph 6-3G states that a site review of
branch offices must be conducted to determine if they are in compliance with the
department’s requirements. The handbook goes on to list which review items, at
a minimum, must be included in reviews. In addition, the handbook states that
the review is not necessarily limited to confirmation of the items listed in the
handbook. Paragraph 6-3E, states “…the file review must evaluate the accuracy
and adequacy of the information and documentation used in reaching decisions
either the origination process or servicing processes.”
In its verbal and written responses, First Magnus indicated that in addition to the
stated minimum handbook requirements, it is performing file reviews during on-
site branch visits, and although it agreed to take steps to improve the response
rate amongst its branches, First Magnus also indicated that it considers a
discussion of the findings with branch personnel during an exit interview as
sufficient resolution of findings. However, it is our belief that if there is no
requirement to document resolution of findings, there is no assurance that
resolution of the identified issues occurred. As stated by the handbook, the goals
of quality control is to assure compliance with HUD's and the mortgagee's own
origination or servicing requirements throughout its operations, protect the
mortgagee and HUD from unacceptable risk, guard against errors, omissions and
fraud, and, assure swift and appropriate corrective action.
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Appendix C
SCHEDULE OF DEFICIENCIES AND RELATED CLAIM AMOUNTS
Questionable Loan Documentation
False W-2, Insufficient/No Loan Late
VOE, Compensating Endorsed w/o
URLA, Factors When Evidence of 3rd Party
Paystubs & Ratios Earnest Current Handling of
Case Credit Overstated Excessive Debt Exceeded Money Alternative Expired Profit & Mortgage Loan
No. Loan Amount Claims Paid Loan Status Report Income to Income Ratios Guidelines Deposit Credit VOEs Loss Stmt. Payments Documentation
332- $29,177 X
3619948 Claim
332- 138,969 X X X X X
3690171 Claim(1)
332- 27,748 X X X X X
3690901 Claim(2)
332- 8,932 X X X X
3688870 Claim
332- $127,893 X X X
3709163 Foreclosure
Totals $127,893 $204,826 1 3 4 3 1 1 1 1 2 1
(1) Still in HUD's REO Inventory for resale as of March 4, 2005
(2) Partial Claim as result of Pre-foreclosure sale program May 23, 2002
19
First Magnus Financial Corporation Did Not Comply with Federal Housing Administration Guidelines When Underwriting Five Mortgage Loans and Implementing Its Quality Control Program
Published by the Department of Housing and Urban Development, Office of Inspector General on 2005-09-23.
Below is a raw (and likely hideous) rendition of the original report. (PDF)