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)

                                                              Issue Date
                                                                   September 23, 2005
                                                              Audit Report Number

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


 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

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.

                            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

   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

                      BACKGROUND AND OBJECTIVES


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.


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.

                                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

              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

First Magnus Did Not Follow HUD Requirements When Underwriting Five
                 Federal Housing Administration Loans

 One Loan Was
 Approved with False

         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

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.

          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

          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

          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

           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

           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

           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.

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.


             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


          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.

                          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.

                             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.


Appendix A


 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

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.

Appendix B


Ref to OIG Evaluation   Auditee Comments

Comment 1

Comment 2

Comment 3

                         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:

            • 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

            •   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.

   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