oversight

Capital Mortgage Associates, LLC (North Haven, Connecticut), Did Not Always Comply with HUD Requirements Regarding Its Single-Family Loan Originations and Quality Control Plans

Published by the Department of Housing and Urban Development, Office of Inspector General on 2006-06-02.

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

                                                                 Issue Date
                                                                              June 2, 2006
                                                                 Audit Report Number
                                                                          2006-BO-1007




TO:        Brian Montgomery, Assistant Secretary for Housing–Federal Housing
              Commissioner, H

FROM:      John Dvorak, Regional Inspector General for Audit, 1AGA

SUBJECT: Capital Mortgage Associates LLC (North Haven, Connecticut), Did Not Always
           Comply with HUD Requirements Regarding Its Single-Family Loan
           Originations and Quality Control Plan


                                   HIGHLIGHTS

 What We Audited and Why

             We audited Capital Mortgage Associates LLC (Capital Mortgage), a
             nonsupervised loan correspondent approved by the U.S. Department of Housing
             and Urban Development (HUD) to originate Federal Housing Administration-
             insured single-family loans. We selected Capital Mortgage based on a lender risk
             analysis, which showed that the loans it originated had a higher default percentage
             than those of other lenders in the area. Our objectives were to determine whether
             Capital Mortgage acted in a prudent manner and complied with HUD regulations,
             procedures, and instructions in the origination of the Federal Housing
             Administration-insured single-family mortgages selected for review and whether
             its quality control plan as implemented met HUD requirements.


 What We Found

             Capital Mortgage did not always comply with HUD requirements regarding its
             single-family loan originations. It engaged in a prohibited net branch
             arrangement. There was also material loan origination deficiencies with two of
             the loans originated from this branch. These deficiencies affected the credit
             quality of the loans and represented a risk of loss to the Federal Housing
           Administration insurance fund. Capital Mortgage also charged ineligible fees to
           borrowers because it was not fully aware of HUD-allowable fees or written
           disclosure requirements regarding certain closing fees. This resulted in borrowers
           paying excessive and/or unreasonable fees. In addition, Capital Mortgage did not
           establish or implement a quality control plan that met all of HUD’s requirements.
           As a result, it may not identify and correct potential deficiencies in a timely
           manner, resulting in an unnecessary risk to the Federal Housing Administration
           insurance fund.


What We Recommend

           We recommend that HUD’s assistant secretary for housing–federal housing
           commissioner require Capital Mortgage to (1) revise its branch agreements to
           comply with HUD requirements or cease originating Federal Housing
           Administration-insured loans from the affected branch office, (2) refund the
           ineligible fees, and (3) update and fully implement its quality control plan. We
           also recommend that the assistant secretary refer Capital Mortgage to the
           Mortgagee Review Board for consideration of administrative sanctions and/or
           civil money penalties for the violation of HUD requirements disclosed in this
           report.

           For each recommendation in the body of the report without a management
           decision, please respond and provide status reports in accordance with HUD
           Handbook 2000.06, REV-3. Please also furnish us copies of any correspondence
           or directives issued because of the audit.


Auditee’s Response

           We provided Capital Mortgage draft finding details throughout the course of the
           audit. We also provided Capital Mortgage with a draft audit report on May 11,
           2006, and held an exit conference on May 16, 2006. Capital Mortgage provided
           us with formal written comments on May 17, 2006. 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:   Capital Mortgage Engaged in a Prohibited Net Branch Arrangement        6
   Finding 2:   Capital Mortgage Charged Borrowers Ineligible Fees                    10
   Finding 3:   Capital Mortgage’s Quality Control Plan and Its Implementation Were   12
                Deficient

Scope and Methodology                                                                 15

Internal Controls                                                                     16

Followup on Prior Audits                                                              18

Appendixes

   A. Schedule of Questioned Costs                                                    19
   B. Auditee Comments and OIG’s Evaluation                                           20
   C. Loans Originated from the Prohibited Net Branch                                 24
   D. Narrative Case Presentations                                                    25
   E. Schedule of Ineligible Fees Charged to Borrowers                                27




                                             3
                      BACKGROUND AND OBJECTIVES

The National Housing Act as amended established the Federal Housing Administration, an
organizational unit within the U.S. Department of Housing and Urban Development (HUD). The
Federal Housing Administration provides insurance to private lenders against loss on mortgages
financing homes. The basic home mortgage insurance program is authorized under Title II,
Section 203(b) of the National Housing Act and governed by regulations in 24 CFR [Code of
Federal Regulations] Part 203.

There are two types of HUD-approved lenders—supervised and nonsupervised. Additionally,
HUD authorizes and approves a separate class of lenders called loan correspondents. The loan
correspondent, which can be either a supervised or a nonsupervised lender, can originate and
process Federal Housing Administration-insured loans, but the correspondents’ sponsor lender
must conduct the final underwriting and approval of the loan. The loan correspondent, unless it
is a supervised lender, cannot hold, purchase, or service Federal Housing Administration-insured
mortgages.

Capital Mortgage Associates LLC (Capital Mortgage) is a nonsupervised loan correspondent.
HUD granted Capital Mortgage approval to originate loans in July 1996. Capital Mortgage is a
loan correspondent for 26 different sponsoring lenders. Its home office is in North Haven,
Connecticut, and it has one approved branch in Miami, Florida. Capital Mortgage also operates
several satellite offices, which forward all Federal Housing Administration loans originated to
the home office for final loan processing. Capital Mortgage’s principal market area is
Connecticut. Capital Mortgage originated 98 percent of its loans for properties located in
Connecticut.

Based on HUD’s latest available data, Capital Mortgage originated 174 Federal Housing
Administration loans from October 1, 2003, through March 31, 2006, with a total original
mortgage amount of more than $29.4 million. As of March 31, 2006, Capital Mortgage’s
Federal Housing Administration loan default rate on loans for properties located in Connecticut
that went into default within the first two years of origination was 7.21 percent. The average for
all lenders originating loans for properties in Connecticut for the same period was 3.44 percent.
Capital Mortgage has consistently had a higher default rate during the early loan repayment
period as compared to the average for all lenders (see table 1 on the following page).




                                                4
 Table 1. Comparison of early payment loan default percentages, Capital Mortgage and all lenders originating
 loans in Connecticut
                                          Loan defaults (%)
 Quarter end date           Capital Mortgage        All Lenders in Connecticut      Compare ratio (%)*
 Mar. 31, 2006                    7.21                         3.44                         210
 Dec. 31, 2005                    7.81                         3.33                         235
 Sept. 30, 2005                   7.84                         3.30                         238
 June 30, 2005                    7.34                         3.04                         241
 Mar. 31, 2005                    5.76                         3.01                         191
 Dec. 31, 2004                    5.58                         2.82                         198
 Sept. 30, 2004                   6.36                         2.43                         262
 June 30, 2004                    6.10                         2.38                         256
 Mar. 31, 2004                    4.98                         2.44                         204
 Dec. 31, 2003                    5.15                         2.38                         216
 Sept. 30, 2003                   4.48                         2.49                         180
 June 30, 2003                    4.57                         2.69                         170
 Mar. 31, 2003                    3.51                         3.05                         115
 * A compare ratio is the percentage of originations that went into default or were claim terminated divided by
 the percentage of originations that went into default or were claim terminated for the selected geographic area.
 Compare ratio is the value that reveals the largest discrepancies between the subject’s default and claim
 percentage and the default and claim percentage to which it is being compared.



The audit objectives were to determine whether Capital Mortgage acted in a prudent manner and
complied with HUD regulations, procedures, and instructions in the origination of the Federal
Housing Administration-insured single-family mortgages selected for review and whether its
quality control plan as implemented meets HUD requirements. We also assessed other general
aspects of Capital Mortgage’s operations as they relate to continued lender approval.




                                                        5
                                    RESULTS OF AUDIT

Finding 1: Capital Mortgage Engaged in a Prohibited Net Branch
Arrangement
Capital Mortgage operated a branch office under a prohibited branch arrangement. There was
also material loan origination deficiencies with 2 of the 17 loans reviewed. These two loans
were originated from this branch. Capital Mortgage used this branch because the relationship
was financially beneficial to both parties. By using a prohibited branch arrangement, Capital
Mortgage does not have direct control and supervision over those involved with the origination
of loans. The lack of direct control and supervision, coupled with quality control deficiencies,
increases the risk to the Federal Housing Administration insurance fund in the form of defaults
and claims.



    Prohibited Branch
    Arrangement

                  Capital Mortgage maintains several offices that it has not registered as approved
                  branch offices in HUD’s data systems. Capital Mortgage considers these branches
                  to be satellite offices because it forwards all Federal Housing Administration loans
                  originated at these locations to the HUD-approved home office for final loan
                  processing. However, one branch, operating under the name of Integrated Finance
                  Services, was created as a separate entity, and it pays all of its own operating
                  expenses. This is the only branch arrangement that Capital Mortgage established in
                  this manner.

                  HUD permits the use of satellite offices under certain conditions. 1 One of the
                  conditions is that the satellite offices be staffed with employees of the approved
                  lender. Another condition is that the lender pays all of the operating expenses of
                  its satellite offices. Thus, the branch arrangement with Integrated Finance
                  Services is in violation of HUD requirements, and loans originated by this branch
                  constitute third-party originations. This arrangement is also known as a
                  prohibited “net branch” because the approved lender is taking on a separate
                  mortgage company or broker as a branch and allowing that separate entity to
                  originate insured mortgages under the approved lender’s HUD lender number. 2




1
    HUD Mortgagee Letter 94-39.
2
    HUD Mortgagee Letter 00-15.


                                                    6
    Service Agreements Violate
    HUD Requirements

                   In July 2004, Capital Mortgage entered into services agreement contracts with
                   two loan officers. One of the provisions in these contracts required the loan
                   officers to establish a separate entity as a mortgage broker (Integrated Finance
                   Services). Another provision requires the separate entity to pay for any expenses
                   that it may incur. In addition, the separate entity is required to indemnify Capital
                   Mortgage from any risk associated with the loans originated by the independent
                   contract loan officers. These provisions in the agreements violate HUD branch
                   requirements. 3 HUD regulations also prohibit lenders from contracting out
                   customary loan officer functions. 4

                   Following the execution of the services agreement for each loan officer in July
                   2004, Capital Mortgage originated 53 Federal Housing Administration loans
                   between August 2004 and December 2005. The branch in question originated 26
                   loans (49 percent). See appendix C for the loans originated from this branch.
                   This branch produced the largest volume of Federal Housing Administration loans
                   for Capital Mortgage.

                   The branch (Integrated Finance Services) received Internal Revenue Service 1099
                   forms for all commissions earned for originating loans. Businesses use 1099
                   forms for payments for services performed by people not treated as its employees
                   (such as subcontractors).

                   The agreements between Capital Mortgage and the independent contract loan
                   officers were financially beneficial to both parties. For Capital Mortgage, it was
                   financially beneficial because it reduced operating costs and increased loan officer
                   retention. For the independent contract loan officers, it was financially beneficial
                   because they received higher commissions for loan originations. However, HUD
                   prohibits this type of branch arrangement.


    Material Origination
    Deficiencies Identified

                   Of the 17 loans selected for a detailed loan origination analysis, two had material
                   deficiencies that affected the credit quality of the loans and represented a loss risk
                   to the Federal Housing Administration insurance fund. Both of these loans were
                   originated from the branch in question, but only one of the loans poses a risk to
                   the Federal Housing Administration insurance fund because the borrower paid the


3
    Mortgagee Approval Handbook, 4060.1 REV-1, CHG-1, paragraphs 2-13, 2-14, and 2-17.
4
    HUD Mortgagee Letter 95-36.


                                                       7
                 other loan 5 in full in during our audit. However, the repaid loan had a material
                 origination deficiency that went undetected. Appendix D contains a detailed
                 narrative for these loans, and the loan that poses a risk is summarized below.

                 For the loan that poses a risk (case number 061-2767801), the underwriter
                 approved the loan for the borrower whose total debt-to-income ratios significantly
                 exceeded program guidelines without the support of adequate compensating
                 factors. HUD uses the ratios to determine whether it can reasonably expect the
                 borrower to meet the expenses involved in homeownership and otherwise provide
                 for the family. When the underwriter approved the loan, the maximum mortgage
                 payment expense-to-effective income ratio was set at 29 percent, and the
                 maximum total fixed payment-to-effective income ratio was 41 percent. 6 The
                 borrower’s ratios were 42.4 and 50.5 percent, respectively. The underwriter did
                 not document any strong compensating factors supporting the approval of the
                 loan. The loan went into default after only one payment because of excessive
                 obligations, and HUD paid a claim in March 2006. The sponsoring lender is
                 ultimately responsible for the underwriting and the actions of its loan
                 correspondents.


    Similar Underwriting
    Deficiencies Found During Last
    Lender Review

                 In November 2000, HUD’s Quality Assurance Division performed a lender
                 review of Capital Mortgage. Of the 21 loans reviewed, five had serious
                 underwriting violations relating to excessive debt ratios without significant
                 compensating factors that would justify approval of the loan. Because Capital
                 Mortgage’s sponsors are ultimately responsible for the final approval of the loan
                 and the actions of its loan correspondents, HUD required the sponsors to enter
                 into indemnification agreements with HUD for each of these loans.



    Conclusion

                 Capital Mortgage’s relationship with this separate entity represents a prohibited
                 branch arrangement and prohibited third-party originations. In addition, there was
                 material loan origination deficiencies with two loans originated from this entity.
                 HUD regulations require lenders to exercise direct control and supervision over
                 their employees and pay all operating expenses, including the expenses of their

5
  The loan that was paid in full was case number 061-2837347, and HUD terminated the Federal Housing
Administration insurance status.
6
  “Mortgage Credit Analysis for Mortgage Insurance on One-to-Four Family Properties,” 4155.1 REV-5, section 2-
12.


                                                       8
                  branches. HUD regulations also prohibit lenders from contracting out customary
                  loan officer functions. The lack of direct control and supervision, coupled with
                  quality control deficiencies (see finding 3), increases the risk to the Federal
                  Housing Administration insurance fund in the form of defaults and claims.
                  Because of the violations, Capital Mortgage is subject to a range of HUD
                  sanctions. 7


    Recommendations

                  We recommend that HUD’s assistant secretary for housing–federal housing
                  commissioner

                  1A. Require Capital Mortgage to revise its branch agreements to comply with
                      HUD requirements or cease originating Federal Housing Administration-
                      insured loans from the affected branch office.

                  1B. Refer Capital Mortgage to the Mortgagee Review Board for consideration of
                      administrative sanctions and/or civil money penalties for the violation of HUD
                      requirements disclosed in this finding.




7
    HUD Mortgagee Letter 00-15.


                                                   9
Finding 2: Capital Mortgage Charged Borrowers Ineligible Fees
Capital Mortgage charged ineligible fees totaling $3,875 to borrowers on 12 of the 17 loans
reviewed. This occurred because Capital Mortgage was not fully aware of HUD-allowable fees
and written disclosure requirements regarding certain closing fees. Capital Mortgage also relied
on the sponsoring lenders for the fee listings on the settlement statements. As a result, borrowers
paid for excessive and/or unreasonable fees.


    Improperly Disclosed
    Commitment Fees

                Capital Mortgage and its sponsors received ineligible commitment fees for eight
                loans totaling $2,695 (see appendix E). These charges were ineligible because the
                lenders did not provide the required written disclosures to the borrowers. HUD
                requires that any lock-in or commitment agreement for which a fee is charged be in
                writing and guarantee the rate and/or discount points for a period of not less than 15
                days before the anticipated closing date.8 Because the lenders did not provide the
                required written disclosures, borrowers may not have been guaranteed a rate and/or
                discount points for a period of at least 15 days before closing. In addition, borrowers
                were not protected from abusive practices such as charging a fee for a commitment
                signed the day of closing, not honoring a commitment as agreed to, or not providing
                something of value in exchange for the fee.



    Other Ineligible Fees

                Capital Mortgage and its sponsors charged borrowers other ineligible fees for four
                additional loans totaling $1,180 (see appendix E). The ineligible fees included
                underwriting fees, tax-related servicing fees, courier fees, and document
                preparation fees. HUD rules prohibit underwriting and tax-related servicing fees.
                Two loans included document preparation fees payable to the lender, not a third
                party. Lenders can only charge a document preparation fee if a third party
                prepares the documents and the lender does not control the entity. The lender
                may not charge these fees if it prepares documents itself. One loan included a
                courier fee on a purchase transaction. Courier fees are only allowable on
                refinance transactions. When HUD endorsed these loans, its rules prohibited
                lenders from charging the fees described above to borrowers. Lenders could only
                collect fees from HUD’s list of customary and reasonable fees. 9




8
  “Mortgagees Handbook, Application through Insurance (Single Family),” 4000.2 REV-3, paragraphs 1-9A and 5-
2P, and HUD Mortgagee Letter 94-7.
9
  Ibid., section 5-2.


                                                     10
Repeat Finding

             In November 2000, HUD’s Quality Assurance Division performed a lender
             review of Capital Mortgage. It found that Capital Mortgage charged borrowers
             similar fees not permitted (including commitment fees) on 9 of the 21 loans
             reviewed. HUD required Capital Mortgage to refund the charges totaling more
             than $3,700.



Conclusion

             Borrowers paid for excessive and/or unreasonable fees because Capital Mortgage
             and its sponsors charged ineligible fees. These charges occurred because Capital
             Mortgage was not fully aware of the HUD-allowable fees and relied on the
             sponsoring lenders for the fee listings on the settlement statements. Capital
             Mortgage should refund these fees to the respective parties. It also needs to
             develop a process to ensure that it only charges and collects customary and
             reasonable costs from borrowers and that it provides the required written
             disclosures for loan transactions.


Recommendations

             We recommend that HUD’s assistant secretary for housing–federal housing
             commissioner require Capital Mortgage to

             2A. Refund $3,875 in ineligible fees. If the loan is in default, refund the amount to
                 the servicer for a principal reduction. If the holding lender files a claim, refund
                 the amount to HUD.

             2B. Establish procedures to ensure that it only charges and collects customary
                 and reasonable costs from borrowers and that it provides the required
                 written disclosures regarding certain closing fees.




                                               11
Finding 3: Capital Mortgage’s Quality Control Plan and Its
Implementation Were Deficient
Capital Mortgage did establish or implement a quality control plan that met all of HUD’s
requirements. This occurred because the quality control staff at Capital Mortgage was not fully
aware of all of HUD’s quality control plan requirements. The failure to implement a quality
control plan and perform sufficient reviews prevents Capital Mortgage from ensuring the
accuracy, validity, and completeness of its loan origination operations. As a result, Capital
Mortgage may not identify and correct potential deficiencies in a timely manner, resulting in an
unnecessary risk to the Federal Housing Administration insurance fund.



     Deficient Quality Control Plan


                  Capital Mortgage’s quality control plan is missing important and required elements
                  typically found in a sound quality control plan, some of which include the following:
                      •   Performing site reviews of its branches;
                      •   Performing quality control file reviews for all loans going into default within
                          the first six payments;
                      •   Obtaining new credit reports for all borrowers whose loans are included in a
                          quality control review (except streamline refinances or loans processed using
                          an automated underwriting system);
                      •   Performing desk reviews of the property appraisals for all loans chosen for a
                          quality control review (except streamline refinances and HUD real estate
                          owned properties) and additional field reviews by licensed appraisers on 10
                          percent of the loans selected during the sampling process;
                      •   Determining conditions requiring occupancy reverification; and
                      •   Including all elements listed in section 6-7 of the “Mortgagee Approval
                          Handbook,” 4060.1 REV-1, CHG-1, which apply to the functions of Capital
                          Mortgage.

                  Capital Mortgage’s quality control plan did not require reviews of its branches,
                  and it had not completed any site reviews of its branches. This deficiency, in
                  particular, is a weakness in the plan that allowed the prohibited branch
                  arrangement deficiency to go undetected (see finding 1). Also, in response to our
                  initial quality control plan review, Capital Mortgage added that it would use
                  HUD’s Neighborhood Watch system to identify and review all loans that were in
                  default status. However, HUD requires that lenders review all loans going into
                  default within the first six payments. 10 The difference between Capital
                  Mortgage’s plan and HUD requirements is that the Neighborhood Watch system
                  would not show the loans that went into default within the first six payments in
                  current default status listing if borrowers brought their loans current.

10
     “Mortgagee Approval Handbook,” 4060.1 REV-1, CHG-1, paragraph 6-6D.


                                                     12
     Poor Quality Control
     Implementation

                  Capital Mortgage’s implementation of its quality control plan has several major
                  deficiencies. Capital Mortgage did not complete the following:
                      •   Perform quality control file reviews for 10 percent of the Federal Housing
                          Administration loans it originated on at least a quarterly basis;
                      •   Perform quality control file reviews within 90 days of loan closing for
                          randomly selected loans;
                      •   Perform quality control file reviews for all loans going into default within the
                          first six payments;
                      •   Order new credit reports for each borrower whose loan was included in a
                          quality control review (except for non-Federal Housing Administration
                          streamline refinance or automated underwriting system loans); or
                      •   Require field reviews of appraisals by licensed appraisers.

                  HUD requires that lenders perform quality control reviews within 90 days of
                  closing on at least a quarterly basis. Capital Mortgage had only completed four
                  quality control loan reviews since January 2004, did not complete three of the
                  four reviews within the required 90 days after closing, and conducted two of the
                  four reviews on January 30, 2006, in response to our audit. The quality control
                  reports indicated that the review was primarily a desk review that required a
                  simple checklist of required documents to be in the file with proper signatures and
                  dates. Capital Mortgage noted only minor findings, such as missing truth-in-
                  lending and lead paint disclosures, and a large unexplained bank deposit by the
                  borrower. However, there is no indication that corrective action was completed.
                  We did not find any new credit reports or any indications of field reviews of
                  appraisals by licensed appraisers.

                  HUD also requires that lenders perform quality file reviews for 10 percent of all
                  Federal Housing Administration loans it originates on at least a quarterly basis. 11
                  Capital Mortgage’s sampling methodology states that it uses a 10 percent random
                  sampling each month to include all Federal Housing Administration, U.S.
                  Department of Veterans Affairs, and/or conventional loans and that a minimum of
                  one loan from each is included. If Capital Mortgage selects a 10 percent sample
                  from all loans originated, its sampling methodology is inadequate because it is not
                  ensuring that it is selecting at least 10 percent of just Federal Housing
                  Administration loans. This is especially important since Capital Mortgage
                  originates substantially more conventional loans than Federal Housing
                  Administration or U.S. Department of Veterans Affairs loans.

                  In addition, HUD requires that lenders obtain new credit reports for all borrowers
                  whose loans are included in a quality control review (except streamline refinances

11
     “Mortgagee Approval Handbook,” 4060.1 REV-1, CHG-1, paragraph 6-6C.


                                                     13
                   or loans processed using an automated underwriting system) and that licensed
                   appraisers perform additional field reviews on 10 percent of the loans selected
                   during the sampling process. 12 According to Capital Mortgage’s quality control
                   plan, Capital Mortgage requires ordering only a sample of new credit reports
                   during the quality control process. Also, it only performed appraisal reviews on a
                   case-by-case basis.


     Repeat Finding

                   This is a repeat finding from a HUD review. In November 2000, the HUD
                   Quality Assurance Division completed an on-site review of the operations of
                   Capital Mortgage. It found that Capital Mortgage did not have a comprehensive
                   quality control plan that complied with HUD requirements. HUD required
                   Capital Mortgage to take corrective action.


     Conclusion

                   Capital Mortgage did not establish or implement a quality control plan that meets
                   all of HUD’s requirements. Although Capital Mortgage has taken some initial
                   action with regard to this finding, it needs to address the remaining deficiencies to
                   ensure the accuracy, validity, and completeness of its loan origination operations.
                   Also, a failure to comply with quality control plan requirements may result in
                   sanctions and the imposition of civil money penalties by the Mortgagee Review
                   Board.


     Recommendations


                   We recommend that HUD’s assistant secretary for housing–federal housing
                   commissioner

                   3A. Require Capital Mortgage to update its quality control plan to ensure that all
                       the minimum HUD requirements are included.

                   3B. Ensure that Capital Mortgage fully implements the new plan.

                   3C. Refer Capital Mortgage to the Mortgagee Review Board for consideration of
                       administrative sanctions and/or civil money penalties for the repeated violation
                       of HUD requirements disclosed in this finding.


12
     “Mortgagee Approval Handbook,” 4060.1 REV-1, CHG-1, section 6-6E.


                                                     14
                         SCOPE AND METHODOLOGY

Our audit primarily covered the period of October 1, 2003, through September 31, 2005, and
included loans originated by Capital Mortgage during this period. We extended the audit period
as necessary through March 31, 2006. We conducted our audit work from December 2005
through April 2006. We primarily carried out our audit work at the home office of Capital
Mortgage in North Haven, Connecticut, and the local HUD Hartford (Connecticut) field office.
We focused the audit on Capital Mortgage’s loan origination and quality control operations.

To achieve our objectives, we identified, obtained, and reviewed relevant rules, regulations, and
guidance pertaining to the origination of single-family mortgages, including the Code of Federal
Regulations, HUD handbooks, mortgagee letters, and the United States Code. We also obtained
and analyzed critical documents from the loan origination files maintained by Capital Mortgage
and HUD. We interviewed appropriate lender and HUD officials. In addition, we obtained an
understanding of controls significant to the audit objectives and considered whether the lender
designed and placed specific control procedures in operation.

We relied on information from HUD’s data systems. We reviewed existing information about
the data and performed sufficient tests to determine whether the data were reliable. Based on our
assessments, we determined that the data was sufficiently reliable for our purposes.

We selected a nonrepresentative sample of nine Federal Housing Administration-insured loans
that defaulted within the first two years of origination and eight loans that exhibited other
significant problems for a detailed loan origination analysis. This method allowed us to focus on
certain loans that had a greater inherent risk to the Federal Housing Administration insurance
fund and/or of noncompliance or abuse. Thus, the results of our detailed testing only relate to
the 17 loans reviewed.

We performed our review in accordance with generally accepted government auditing standards.




                                               15
                             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:
              •       Controls over program operations - Policies and procedures that
                      management has implemented to reasonably ensure that the HUD single-
                      family insurance program meets its objectives and that unintended actions do
                      not result.
              •       Controls over the validity and reliability of data - Policies and procedures
                      that management has implemented to reasonably ensure that valid and
                      reliable data (including computer-processed data) are obtained, maintained,
                      and fairly disclosed in reports and HUD computer systems.
              •       Controls over compliance with laws and regulations - Policies and
                      procedures that management has implemented to reasonably ensure that the
                      single-family program implementation is consistent with laws, regulations,
                      and provisions of contracts or grant agreements.

              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.




                                               16
Significant Weaknesses

           Based on our review, we believe the following items are significant weaknesses:
           •      Controls over program operations - Capital Mortgage did not develop or
                  implement a quality control program in accordance with HUD requirements
                  (see finding 3).
           •      Controls over compliance with laws and regulations - Capital Mortgage
                  engaged in a prohibited net branch arrangement (see finding 1). Capital
                  Mortgage also did not follow other HUD requirements when originating the
                  loans reviewed (see finding 2).


Separate Communication of
Minor Deficiencies

           We reported minor internal control and compliance issues verbally to the auditee on
           January 19, 2006, and March 21, 2006.




                                            17
                       FOLLOWUP ON PRIOR AUDITS

This was the first HUD Office of Inspector General audit of Capital Mortgage. However, in
November 2000, HUD’s Quality Assurance Division performed a lender review of Capital
Mortgage (review file number 11345). The purpose of the review was to ensure that practices
and procedures employed by Capital Mortgage were consistent with HUD regulations and
polices governing Federal Housing Administration single-family programs. The HUD review
resulted in six findings. HUD and Capital Mortgage resolved and closed the findings, but three
of the findings resurfaced during our audit.

HUD found five loans that the lender approved with total fixed payment-to-effective income
ratios exceeding HUD guidelines without significant compensating factors. HUD required
Capital Mortgage’s sponsor lenders to indemnify HUD should HUD pay a claim on these loans.
This HUD finding relates to our finding 1.

HUD also found that Capital Mortgage charged borrowers fees not permitted (including
commitment fees) on 9 of the 21 loans reviewed, totaling $3,732. HUD required Capital
Mortgage to refund the charges. This HUD finding relates to our finding 2.

Finally, HUD found that Capital Mortgage did not have a written comprehensive quality control
plan that complied with HUD requirements. HUD required Capital Mortgage to submit a plan that
was in compliance. This finding relates to our finding 3.




                                              18
                                   APPENDIXES

Appendix A

                SCHEDULE OF QUESTIONED COSTS

                           Recommendation            Ineligible 1/
                                  number
                                         2A               $3,875


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.




                                            19
Appendix B

        AUDITEE COMMENTS AND OIG’S EVALUATION


Ref to OIG Evaluation   Auditee Comments




Comment 1

Comment 2

Comment 3



Comment 4




                         20
Ref to OIG Evaluation   Auditee Comments




Comment 4

Comment 4

Comment 5



Comment 6




                         21
                         OIG Evaluation of Auditee Comments

Comment 1   We acknowledge that the loan officers received W-2 forms from Capital
            Mortgage for certain non-loan origination services rendered to the company such
            as training and accept that Integrated Finance Services actually received the 1099
            forms from Capital Mortgage for commissions on loans originated from this
            branch. We clarified this in the report on page 7.

Comment 2   Many of the fees charged were payable to Capital Mortgage. Consistent with
            HUD’s last lender review finding, we are recommending that Capital Mortgage
            refund the ineligible fees. Although Capital indicated that the ineligible fees were
            “passed through” by sponsoring lenders our audit scope was limited to a review of
            the loan origination and quality control operations of Capital Mortgage.
            Therefore, the finding remained unchanged. Capital Mortgage should address this
            concern specifically with HUD management officials during the resolution of the
            recommendations in the report. See also Comment 5 below.

Comment 3   We reviewed the default average for Capital Mortgage and determined that the
            comparison to other lenders nationwide would not be appropriate because 98
            percent of its loans were on properties located in Connecticut. It is more
            appropriate to compare Capital Mortgage to other lenders originating loans on
            properties in Connecticut. We made this change to the background section of the
            report.

Comment 4   We agreed to limit the finding to a discussion on the engagement of the prohibited
            net branch arrangement and eliminated the discussion on the independent contract
            loan officers. See Comment 1 above. However, the condition is still in material
            violation of HUD rules and the recommendations remained substantially
            unchanged.

Comment 5   Our scope was limited to a review of the loan origination and quality control
            operations of Capital Mortgage. It is not appropriate for the OIG to address the
            concern that the sponsoring lenders may also be in violation of HUD regulations
            at this time. Therefore, the finding and recommendations remained unchanged.
            Capital Mortgage should address this concern specifically with HUD management
            officials during the resolution of the recommendations in the report. See also
            Comment 2 above.

Comment 6   We commend Capital Mortgage for taking some initial actions with regard to the
            quality control plan finding. The Mortgagee Approval Handbook, 4060.1 REV-1,
            requires all Federal Housing Administration approved lenders, including loan
            correspondents, to implement and continuously have in place a quality control
            plan for the origination and/or servicing of insured mortgages as a condition of
            maintaining approval. Engaging outside sources to perform the quality control
            function is acceptable as long as the engagement agreement adheres to HUD’s
            requirements. In addition, it is acceptable to use HUD’s Neighborhood Watch



                                             22
system to identify loans that went into early payment default status. The finding
and recommendations remained unchanged.




                                23
Appendix C

               LOANS ORIGINATED BY
       INDEPENDENT CONTRACT LOAN OFFICERS


         Case number   Original mortgage amount     Date endorsed
      061-2809953                        $124,540      Nov. 3, 2004
      061-2822178                        $236,292     Jan. 19, 2005
      061-2817030                        $103,790     Jan. 28, 2005
      061-2826498                        $189,033     Jan. 28, 2005
      061-2835448                        $159,608     Feb. 17, 2005
      061-2830008                        $137,738     Feb. 23, 2005
      061-2837347                        $192,971    Mar. 10, 2005
      061-2831502                         $96,628    Mar. 29, 2005
      061-2840419                        $221,523      Apr. 8, 2005
      061-2852288                        $160,065    Apr. 22, 2005
      061-2841420                        $172,550      May 2, 2005
      061-2845915                        $221,523      May 6, 2005
      061-2856136                        $201,883    May 13, 2005
      061-2855097                        $177,219    May 20, 2005
      061-2840758                        $184,300    May 23, 2005
      451-0867364                        $278,183    May 27, 2005
      061-2854815                        $190,246      June 1, 2005
      061-2845909                        $170,063      June 9, 2005
      061-2838313                        $182,141     July 12, 2005
      061-2867802                        $122,084      Aug. 3, 2005
      061-2824518                        $300,287    Sept. 20, 2005
      061-2884347                        $251,060      Nov. 1, 2005
      061-2898425                        $159,253    Nov. 28, 2005
      061-2888457                        $167,373       Jan. 9, 2006
      061-2883834                        $195,433     Jan. 10, 2006
      061-2918673                        $231,420     Jan. 11, 2006




                                24
Appendix D

                       NARRATIVE CASE PRESENTATIONS


Case number:                                                                                              061-2767801
Original mortgage amount:                                                                                     $120,434
Section of the Housing Act:                                                                                     203(b)
Date of loan closing:                                                                                    June 11, 2004
Status as of March 31, 2006:                                                             Preforeclosure sale completed
Payments before first default:                                                                                     One
Reason for default:                                                                              Excessive obligations
Claims paid by HUD:                                                                                            $22,119
Summary:
In addition to being originated by an independent contract loan officer (a third-party origination violation – finding
1), the underwriter approved this loan for the borrower, whose total debt-to-income ratios exceeded program
guidelines, without the support of adequate compensating factors. The file documented monthly income for the
borrower of $3,102, monthly debts of $250, and monthly mortgage payments of $1,317. The mortgage payment-to-
effective income ratio was 42.4 percent ($1,317 / $3,102) and exceeded the 29 percent* allowable by HUD. The
total fixed payment-to-effective income ratio was 50.5 percent ([$250 + $1,317]) / $3,102) and exceeded the 41
percent* allowable by HUD.

The underwriter used the following compensating factors on the mortgage credit analysis worksheet (form HUD-
92900-PUR):
                  1.   Borrower took prepurchasing counseling course.
                  2.   Willingness to pay off debts.
                  3.   Conservative attitude toward accruing new credit since divorce.
                  4.   Contributed 5 percent toward purchase.

Factors 1 and 2 are inadequate and are not included in HUD’s list of compensating factors that lenders may use in
HUD Handbook 4155.1, REV-5, “Mortgage Credit Analysis for Mortgage Insurance on One-to-Four Family
Properties.” Factor 3 is not an adequate compensating factor because the borrower completed the divorce in
September 2003 and the loan closed in June 2004, only nine months later. Finally, factor 4 is not adequate because
it should be 10 percent or more according to HUD guidelines.

The loan went into default after only one payment because of excessive obligations. The holding lender completed a
preforeclosure sale in October 2005, and HUD paid a claim of $22,119 in March 2006. The sponsoring lender is
ultimately responsible for the underwriting and the actions of its loan correspondents.

* Effective with the April 13, 2005, Mortgagee Letter 2005-16, HUD raised the qualifying ratios to 31/43. This
policy change was not in effect for these cases. However, the ratios exceed these limits.




                                                         25
                       NARRATIVE CASE PRESENTATIONS


Case number:                                                                                             061-2837347
Original mortgage amount:                                                                                    $192,971
Section of the Housing Act:                                                                                    203(b)
Date of loan closing:                                                                                February 9, 2005
Status as of March 31, 2006:                                                                    Terminated/paid-in-full
Payments before first default:                                                                                    N/A
Reason for default:                                                                                               N/A
Claims paid by HUD:                                                                                              $0.00
Summary:
In addition to being originated by an independent contract loan officer (a third-party origination violation – finding
1), we identified a material conflict-of-interest deficiency. An employee of the branch was involved in the
processing of this loan for Capital Mortgage and was the real estate agent. This employee may have received both
the real estate commissions and the lender origination commissions for originating this loan. This practice violates
HUD’s conflict-of-interest policies, which prohibit payments to individuals who have received other payments for
services related to a transaction. HUD also requires that all employees, except receptionists, work exclusively for
the lender at all times, whether full time or part time, and conduct only the business affairs of the lender during
normal business hours (“Mortgagee Approval Handbook,” 4060.1 REV-1, CHG-1). The same real estate
agent/employee is listed as the real estate agent on the purchase and sales agreement and the loan officer on the
verification of rent, verification of deposit, request for appraisal, and other miscellaneous correspondence in the loan
origination files.

Additionally, the settlement agent is the husband of the real estate agent/employee involved with this loan and is
listed as a real estate agent for the same real estate agency according to the company Web site. This may also be a
conflict-of-interest violation. There were no affiliated business arrangement disclosures in the origination files.

The underwriter also approved this loan for the borrowers, whose total debt-to-income ratios exceeded program
guidelines, without the support of adequate compensating factors. The file documented monthly income for the
borrowers of $3,958, monthly debts of $80, and monthly mortgage payments of $1,633. The mortgage payment-to-
effective income ratio was 41.3 percent ($1,633 / $3,958) and exceeded the 29 percent allowable by HUD. The total
fixed payment-to-effective income ratio was 43.3 percent ([$80 + $1,633] / $3,958) and exceeded the 41 percent
allowable by HUD. The underwriter used the following compensating factors:
                  1.   Borrowers have limited use of revolving credit.
                  2.   Borrowers completed a HUD-approved first-time homebuyer program.
                  3.   Borrowers have demonstrated an ability to save.

Factor 2 is inadequate and is not included in HUD’s list of compensating factors that lenders may use in HUD
Handbook 4155.1, REV-5, “Mortgage Credit Analysis for Mortgage Insurance on One-to-Four Family Properties.”
The borrowers had shown a conservative use of credit (factor 1), but they had not demonstrated the ability to save
significantly (factor 3). The borrowers’ bank statements for the three months before the closing indicated they had a
monthly bank balance of about $5,400. However, the amount was steady from month to month, the borrowers had
no additional savings accounts listed, and $4,800 was due from the borrowers at closing. Stronger factors would
have been necessary to approve the loan.

The sponsoring lender is ultimately responsible for the underwriting and the actions of its loan correspondents.
Although this loan no longer poses a risk to the Federal Housing Administration insurance fund because the
borrower paid the loan in full in February 2006 and HUD terminated the Federal Housing Administration insurance
status, it represents a material origination deficiency that went undetected.




                                                          26
Appendix E

                SCHEDULE OF INELIGIBLE FEES
                  CHARGED TO BORROWERS


                Case number         Ineligible fee         Amount
             061-2670789      Commitment fee                 $225
             061-2690080      Commitment fee                 $425
             061-2703654      Document prep fee              $225
             061-2721092      Document prep fee              $190
             061-2721092      Tax-related service fee          $69
             061-2721092      Underwriting fee                $150
             061-2729304      Commitment fee                 $225
             061-2752944      Commitment fee                 $225
             061-2767801      Tax service fee                  $79
             061-2772331      Commitment fee                 $450
             061-2817030      Commitment fee                 $225
             061-2822178      Underwriting fee                $442
             061-2822178      Courier fee                      $25
             061-2830355      Commitment fee                 $425
             061-2837347      Commitment fee                 $495
                                                  Total:    $3,875




                                   27