oversight

Pine State Mortgage Company, Atlanta, Georgia, Did Not Always Comply with Federal Housing Administration Underwriting and Quality Control Requirements

Published by the Department of Housing and Urban Development, Office of Inspector General on 2006-11-03.

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

                                                                  Issue Date
                                                                  November 3, 2006
                                                                  Audit Report Number
                                                                  2007-AT-1002




TO:        Brian D. Montgomery, Assistant Secretary for Housing-Federal Housing
            Commissioner, H




FROM:      James D. McKay
           Regional Inspector General for Audit, 4AGA


SUBJECT: Pine State Mortgage Company, Atlanta, Georgia,
         Did Not Always Comply with Federal Housing Administration
         Underwriting and Quality Control Requirements



                               HIGHLIGHTS

 What We Audited and Why

            We audited loans Pine State Mortgage Company (Pine State) underwrote
            at its Atlanta, Georgia, branch office. Pine State is a nonsupervised direct
            endorsement lender with headquarters located in Atlanta, Georgia. We
            selected the Atlanta branch office because its default rate was significantly
            higher than the Georgia average.

            Our audit objective was to determine whether Pine State acted in a prudent
            manner and complied with U.S. Department of Housing and Urban
            Development’s (HUD) regulations, procedures, and instructions in the
            underwriting process for cash assets, income, and general creditworthiness
            of its Federal Housing Administration-insured mortgages.


Table of Contents
What We Found

           Pine State did not always follow HUD’s underwriting and quality control
           requirements for Federal Housing Administration-insured loans. It
           improperly underwrote 21 of the 108 loans reviewed. The improperly
           underwritten loans contained deficiencies that affected the insurability of
           the loans, including improper assessment of borrowers’ income, debts,
           credit histories, and eligibility for interest rate buydowns. As a result,
           HUD insured 21 loans that placed the Federal Housing Administration
           insurance fund at risk for $151,687 in questioned costs and $713,495 in
           funds to be put to better use. Pine State also did not maintain proper
           quality controls over its underwriting process. The inadequate quality
           control procedures placed HUD’s insurance fund at risk for an additional
           15 loans. Our assessment of Pine State’s quality control reviews showed
           these loans involved material violations not recognized by Pine State and
           reported to HUD. The violations affected the loans’ insurability. These
           conditions exposed HUD’s insurance fund to unnecessary risk of default,
           claims, and foreclosure.

What We Recommend


           We recommend that the assistant secretary for housing-federal housing
           commissioner take appropriate administrative action against Pine State
           based on the information contained in this report. This action should, at a
           minimum, require Pine State to reimburse or hold HUD harmless against
           any losses for the 21 improperly underwritten loans in finding 1 that
           involve $151,687 in questioned costs and $713,495 in funds to be put to
           better use, and any of the 15 loans in finding 2 that involve material
           violations.

           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 discussed the findings with Pine State officials during the audit. We
           provided a copy of the draft report to Pine State on August 10, 2006, for
           their comments and discussed the report with the officials at the exit


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            conference held on August 28, 2006. Pine State provided written
            comments on August 28 and September 6, 2006.

            Pine State generally disagreed with our findings and case studies. The
            complete text of Pine State’s response (minus exhibits); along with our
            evaluation of that response, can be found in appendix B of this report.




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                                         3
                          TABLE OF CONTENTS

Background and Objectives                                                                5

Results of Audit
        Finding 1: Pine State’s Atlanta Branch Office Did Not Fully Comply with          6
        HUD’s Underwriting Requirements

        Finding 2: Pine State Did Not Effectively Implement Quality Controls for Early   13
        Payment Default Loans

Scope and Methodology                                                                    21

Internal Controls                                                                        22


Appendixes
   A.   Schedule of Questioned Costs and Funds to Be Put to Better Use                   23
   B.   Auditee Comments and OIG’s Evaluation                                            24
   C.   Loan Underwriting Deficiency Charts                                              74
   D.   Loans with Temporary Interest Rate Buydowns Inappropriately Approved             76
   E.   Material Quality Control Findings Not Reported to HUD                            80
   F.   Case Studies of Improperly Underwritten Loans                                    82




                                           4
                 BACKGROUND AND OBJECTIVES

Pine State Mortgage Corporation (Pine State) is a nonsupervised direct endorsement
lender, which operates from its home office in Atlanta, Georgia. The company has been
approved to originate loans since February 11, 1993. At the time of our audit, Pine State
did not sponsor any loan correspondents. Pine State had 12 Federal Housing
Administration-approved branch offices and is approved to operate in Georgia, Florida,
Alabama, Tennessee, and South Carolina. It also did business as Bowen Family
Mortgage at two of its branch offices.

We audited loans Pine State underwrote at its Atlanta branch office for properties located
in the metropolitan Atlanta area for the period August 1, 2003, through July 31, 2005.
The Atlanta branch originated 42 percent of Pine State’s 4,163 loans but accounted for 52
percent (183/349) of the company’s defaults. The branch had a 10.54 percent two-year
default rate compared to Pine State’s overall 8.4 percent rate. The 183 Atlanta branch
defaults included 81 loans that defaulted with six or fewer payments on mortgages that
totaled $11.5 million. The branch also had a 223 percent compare ratio. The branch
compare ratio exceeded the 200 percent level generally used by HUD to identify
branches that warrant further assessment or sanctions.

Our audit objective was to determine whether Pine State acted in a prudent manner and
complied with the U.S. Department of Housing and Urban Development’s (HUD)
regulations, procedures, and instructions in the underwriting process for cash assets,
income, and general creditworthiness of its Federal Housing Administration-insured
mortgages.




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                                            5
                                    RESULTS OF AUDIT

Finding 1: Pine State’s Atlanta Branch Office Did Not Fully
Comply with HUD’s Underwriting Requirements
Pine State did not follow HUD requirements when underwriting 21 of the 108 Federal
Housing Administration-insured loans reviewed. The loans contained deficiencies that
affected the credit quality (insurability) of the loans. The loan underwriting deficiencies
occurred because Pine State’s underwriters did not adequately assess borrower eligibility.
As a result, HUD insured 21 loans that placed the Federal Housing Administration
insurance fund at risk for $151,687 in questioned costs and $713,495 in funds to be put to
better use.



    Scope of Review


                   We reviewed 108 loans. The audit focused on early payment default loans
                   and loans that involved interest rate buydowns. The loans included 16 of
                   81 early payment default loans originated by Pine State’s Atlanta branch
                   office from August 1, 2003, to July 31, 2005. In addition, we examined
                   92 of 217 defaulted temporary interest rate buydown loans 1 originated by
                   Pine State, without regard to office location, between January 1, 2003, and
                   December 31, 2004. We limited the review to 92 loans that had defaulted
                   and had a debt to income ratio equal to or greater than 41 percent. We
                   identified significant underwriting violations for 11 of the 16 loans
                   reviewed for underwriting compliance and 10 of the 92 loans reviewed for
                   temporary interest rate buydowns.


    Loans Not in Compliance with
    HUD Requirements


                   Pine State underwrote 21 loans that contained significant loan
                   underwriting deficiencies. The deficiencies primarily involved




1
    We expanded the review to include the interest rate buydown loans due to violations noted in loans
    selected for underwriting review. We only reviewed these loans for compliance with underwriting
    requirements associated with the borrower’s eligibility for the buydowns.

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                                    Deficiency                                  Number of loans

Number of Loans             Interest rate buydown not properly assessed                  11 2
                            Income not properly assessed                                  5
                            Debts not properly assessed                                   6
                            Credit not properly assessed                                  4
                            Quitclaim transfers                                           2
                            Gifts not properly verified                                   7
                            Other                                                         6

                   These conditions occurred because underwriters did not adequately
                   evaluate borrower information for compliance with requirements before
                   approving the loans.

                   Each loan contained one or more significant deficiencies that are
                   summarized below. Appendix C summarizes the loan deficiencies for the
                   11 problem loans reviewed for overall underwriting, and appendix F
                   contains a detailed case study for each of these loans. Appendix D
                   summarizes the 10 loans reviewed for compliance with buydown
                   requirements.

    Interest Rate Buydowns Not
    Properly Assessed

                   Pine State inappropriately approved interest rate buydown loans for 11
                   borrowers (discussed in appendixes C and E). The files for the 11
                   borrowers did not show or document that Pine State assessed the
                   borrowers’ eligibility for the buydowns to assure that the eventual increase
                   in mortgage payments would not adversely affect the borrowers and likely
                   lead to default. The borrowers did not meet the buydown criteria. Thus,
                   Pine State inappropriately used the bought down monthly mortgage
                   amount rather than the full mortgage payment to qualify them for their
                   loans. Each of the 11 borrowers defaulted on their loans. The following
                   two examples demonstrate the conditions identified during the review.

                       •    105-0981353 - Pine State said they approved the buydown because
                            the borrower demonstrated an ability to devote a greater portion of
                            income to housing expense and the potential for increased income.
                            The credit report showed the borrower was over $20,000
                            delinquent on child support payments. That was not consistent
                            with Pine State’s justification for the buydown. Pine State based
                            the borrower’s increased earning potential on overtime pay. Pine
                            State did not assess or document that the potential increased

2
    This number includes one loan listed in appendix C, reviewed for overall underwriting compliance, and
    the 10 loans in appendix D, reviewed for borrower eligibility for temporary interest rate buydowns.

                                                     7
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                           overtime pay would be enough to pay the buydown increments.

                       •   105-1953205 - Pine State claimed the borrower was qualified
                           based on increased earning potential. We determined that Pine
                           State incorrectly estimated the borrower’s future earnings. The
                           income we projected for 2004 was less than the borrower earned in
                           2003. Thus, the borrower did not demonstrate the potential for
                           increased earning needed to pay the buydown increments.

                   HUD Handbook 4155.1, REV 5, paragraph 2-14B(2), provides that the
                   lender must establish that the eventual increase in mortgage payments will
                   not affect the borrower adversely and likely lead to default. The
                   underwriter must document that the borrower meets one of four criteria
                   that require borrowers to have (a) potential for increased income that
                   would offset the scheduled payment increases, (b) demonstrated ability to
                   manage financial obligations in such a way that a greater portion of
                   income may be devoted to housing expenses, (c) substantial assets
                   available to cushion the effect of the increased payments, or (d) cash
                   investment made that substantially exceeds the minimum required.

                   Although this issue was discussed in HUD’s February 2004 Quality
                   Assurance Division report, Pine State did not correct the documentation
                   problem for temporary interest rate buydown loans. Four of the ten
                   problem loans noted in appendix D closed after HUD completed its 2004
                   review 3.

    Income Not Properly Assessed

                   Pine State did not properly assess income for five borrowers (105-
                   1380870, 105-2032130, 105-17491989, 105-2020030, and 105-1548492).
                   As a result, it overstated the borrowers’ monthly income. The following
                   two examples demonstrate the conditions identified during the review.

                       •   For case 105-2020030, Pine State overstated the borrower’s
                           monthly income by $688. The overstatement included $478 for
                           overtime pay and $210 for child support. The overtime was not
                           allowable because the borrower had been employed at the job for
                           only 10 months before the loan closing and because Pine State did
                           not verify or document verification that the overtime would
                           continue. The $210 child support was not allowable because Pine
                           State did not properly verify the amount and resolve discrepancies

3
    Effective August 2004, HUD changed its rules to no longer allow lenders to qualify borrowers at bought
    down mortgage amounts. HUD changed the rule because this category of loans experienced a higher rate
    of default than other loans.


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                    associated with the payments before it approved the loan.
                    Adjustments for these and other items resulted in a 58.28 percent
                    debt-to-income ratio compared to the 40.61 percent rate Pine State
                    calculated.

               •    For case105-1741989, Pine State overstated the borrower’s
                    monthly income by at least $907. The overstatement included
                    $627 in supplemental Social Security income and $280 for
                    commission income. The supplemental Social Security income
                    ended about 18 months after the loan closed because the
                    borrower’s income exceeded the eligibility limit for the benefits.
                    Pine State did not verify the likelihood that the income would
                    continue, and it inappropriately increased the $545 monthly
                    payment shown on the verification by 15 percent to $627. It did
                    not document a reason for the increase. It also overstated the
                    borrower’s 2002 monthly commission income by $280 because it
                    did not deduct expenses that offset the commission. In addition,
                    Pine State overstated the borrower’s 2003 commission income by
                    an undetermined amount due to its failure to document and deduct
                    commission expenses. Adjustments for the $907 resulted in a
                    55.43 percent debt-to-income ratio compared to the 46.34 percent
                    rate Pine State calculated.

           Handbook 4155.1, REV 5, provides that anticipated amount of income and
           likelihood of its continuance must be established to determine the
           borrower’s capacity to repay the mortgage debt. Income from any source
           that will not continue may not be used in calculating the borrower’s
           income ratios.

Debts Not Properly Assessed


           Pine State did not consider and/or properly assess borrower debts before
           approving six loans (105-1380870, 105-1769305, 105-1741989, 105-
           1587099, 105-1524517, and 105-1728585). The following examples
           demonstrate this condition.

               •    For case 105-1769305, Pine State’s loan file contained no evidence
                    that it asked the borrower to explain a credit inquiry that resulted in
                    an additional $306 monthly debt for an automobile loan. The
                    borrower made the loan in March 2004, the same month Pine State
                    closed the borrower’s home loan. The additional debt was shown
                    on a credit report Pine State obtained during its quality control
                    review, but the reviewer did not detect and report the debt during
                    the quality control review. Adjustment for the debt and other items

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                    resulted in a 60.93 percent debt-to-income ratio compared to the
                    47.34 percent rate Pine State calculated.

               •    For case 105-1524517, Pine State’s loan file contained no evidence
                    that it asked the borrower to explain a credit inquiry that resulted in
                    an additional $211 monthly debt. The borrower made the loan in
                    October 2003. Pine State closed the borrower’s home loan on
                    November 7, 2003. The additional debt was shown on a credit
                    report Pine State obtained during its quality control review.
                    Adjustment for the debt resulted in a 53.42 percent debt-to-income
                    ratio compared to the 47.36 percent rate Pine State calculated.

            HUD Handbook 4155.1, REV-5, paragraph 2-3B, provides that the lender
            must determine the purpose of any recent debts. The borrower must
            explain in writing all inquiries shown on the credit report in the last 90
            days.

Credit Not Properly Assessed


            Pine State did not consider and/or properly evaluate borrower credit
            history before approving four loans (105-1380870, 105-2032130, 105-
            2020030, and 105-1531395). Each loan involved borrowers whose credit
            reports showed deragatory credit histories that involved collections,
            judgements, and/or delinquent accounts. The following case demonstrates
            this condition.

               •    105-2032130 - Pine State did not adequately consider the
                    borrower’s past disregard for child support payments. The credit
                    report showed the borrower had accumulated $58,143 in
                    delinquent child support. The file contained an “order/notice to
                    withhold income for support,” dated July 22, 2003. The loan
                    closed on August 13, 2004; thus, the order was not current, and
                    Pine State did not followup or document followup to determine
                    whether the order had been modified. Pine State should have
                    reviewed and considered this matter before it approved the loan.

            HUD Handbook 4155.1, REV-5, paragraph 2-3, states that past credit
            performance serves as the most useful guide in determining a borrower’s
            attitude toward credit obligations and predicting a borrower’s future
            actions. If the credit history, despite adequate income to support
            obligations, reflects continuous slow payments, judgments, and delinquent
            accounts, strong compensating factors will be necessary to approve the
            loan.



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    Quitclaim Transfers



             Pine State submitted two loans (105-1728585 and 105- 1817383) for
             insurance endorsement despite knowledge that at loan closing one or more
             of the coborrowers transferred their interest to individuals who were not
             listed on the loan applications. The borrowers used quitclaim deeds to
             make the transfers to individuals whose income, debts, and credit were
             required to be but were not assessed and approved to have ownership
             interest in the property.

             HUD Handbook 4155.1, REV-5, paragraph 3-10 (lender responsibility at
             closing), provides that the lender is required to resolve all problems
             regarding title to the real estate. The loan must close in the same manner
             in which it was underwritten and approved. Additional signatures on the
             security instruments and/or mortgage note of individuals not reviewed
             during mortgage credit analysis may be grounds for withholding
             endorsement. Paragraph 2-2A states that HUD does not permit an
             individual to take an ownership interest in the property at settlement
             without signing the mortgage note and all security instruments.

    Gifts Not Properly Verified



             Pine State did not properly verify gift funds paid to closing agents for
             seven borrowers (105-1380870, 105-1769305, 105-1587099, 105-
             1524517, 105-1531395, 105-1728585, and 105-1548492). In each case,
             the borrowers received gifts from nonprofit donors. Pine State
             subsequently verified receipt of the gift funds by obtaining copies of the
             wire transfers submitted by the nonprofit donors to the closing attorneys.
             However, the verification does not relieve Pine State of its responsibility
             to verify the transfer of gift funds to the closing attorneys before loan
             closing. The missing documentation was required to provide assurance
             that the gifts were paid by the nonprofit organizations and not by other
             interested parties to the loan transactions.

             HUD Handbook 4155.1, REV-4, paragraph 2-10C, requires that if the gift
             funds are not deposited to the borrower’s account before closing, the
             lender must obtain verification that the closing agent received funds from
             the donor for the amount of the gift.




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                                          11
 Other Less Significant Deficiencies


              Pine State also underwrote five loans that contained less significant
              underwriting deficiencies. The deficiencies involved some of the same
              violations cited for the cases discussed above. However, we considered
              the deficiencies less significant because they did not affect the overall
              credit quality (insurability) of the individual loans. Thus, the deficiencies
              would not support indemnification of the defaulted loans or repayment of
              losses on claims. This fact does not relieve Pine State from following all
              facets of HUD requirements when originating Federal Housing
              Administration loans. We provided details of these deficiencies to Pine
              State during our review. Appendix C summarizes the less significant
              deficiencies for the five loans.

 Conclusion


              Pine State’s underwriters did not adequately evaluate information
              presented by borrowers for compliance with requirements before
              approving 21 loans. This resulted in Pine State approving 21 loans that
              did not meet HUD requirements and submitting them to HUD for Federal
              Housing Administration endorsement. As a result, HUD insured 21 loans
              that placed the Federal Housing Administration’s insurance fund at risk
              for $151,687 in questioned costs and $713,495 in funds to be put to better
              use.

 Recommendations

              We recommend that the assistant secretary for housing-federal housing
              commissioner

              1A.    Take appropriate administrative action against Pine State for not
                     complying with HUD requirements.

              1B.    Require Pine State to indemnify $713,495 for 17 defaulted loans.

              1C.    Require Pine State to reimburse HUD $66,425 for actual loss
                     sustained on two claim-terminated loans that HUD sold.

              1D.    Require Pine State to reimburse HUD the actual losses incurred on
                     two claim-terminated loans that HUD has not resold. We estimate
                     $85,262 for the losses.

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                                            12
Finding 2: Pine State Did Not Effectively Implement Quality
           Controls for Early Payment Default Loans
Pine State did not implement effective quality controls over early payment default loans
despite HUD’s prior findings on this issue. HUD requires all nonsupervised lenders to
implement an effective quality control system to retain their HUD approval. Pine State’s
management did not take proper action to ensure compliance with this requirement.

                                           ___


       We assessed Pine State’s quality controls and found that it did not properly

           •   Assess and classify the severity of its quality control findings,
           •   Report material quality control findings to HUD,
           •   Document resolution of its quality control findings,
           •   Prepare and assess trends to identify areas that warranted expanded
               coverage,
           •   Assess underwriters with high default rates, and
           •   Assess branch offices with high default rates.

       These issues hampered Pine State’s ability to identify and correct performance
       issues and contributed to the high 10.54 percent default rate at its Atlanta branch.
       The conditions also allowed underwriting problems to continue without adequate
       measures to identify and correct them. For instance, 23 loans from Pine State’s
       quality control findings involved violations that should have been but were not
       reported to HUD. We reviewed eight of the loans as part of our sample discussed
       in finding 1. The remaining 15 loans involved $1.3 million in unpaid principal for
       defaulted loans, a $155,000 claim payment, and $155,000 in losses HUD incurred
       on foreclosed properties.

 Conditions Noted in HUD’s
 Past Reviews

       HUD Handbook 4060.1, paragraph 6-1, provides that all Federal Housing
       Administration-approved lenders must implement and continuously have in place
       a quality control plan for the origination of insured mortgages as a condition of
       receiving and maintaining Federal Housing Administration approval. Quality
       control must be a prescribed and routine function of each lender’s operations,
       whether performed by a lender’s staff or an outside source.

       HUD reviewed Pine State’s quality controls in February 2004. During our audit,
       we identified several violations of the same type as those identified during HUD’s


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     2004 review. The repeat issues include Pine State’s failure to (a) classify the
     severity of its quality control findings, (b) take and document corrective actions,
     (c) prepare and use trend results to determine the focus of quality control work,
     and (e) expand its quality control review to follow up on commonalities in the
     review.

     We reviewed Pine State’s quality controls over loans that defaulted with six or
     fewer payments (early default loans). We primarily focused on activity for Pine
     State’s Atlanta branch office and its overall assessment of patterns and trends to
     identify areas that might require increased quality control attention. We assessed
     all Pine State quality control report findings for all early payment default loans
     reviewed between May and December 2005. We noted that Pine State had
     improved its quality control reviews of early payment default loans since HUD’s
     2004 review. We found that Pine State was conducting the required reviews and
     had gone back and performed recent reviews of older loans not reviewed in the
     past.

Severity of Quality Control Violations
Not Identified

     Pine State did not classify the severity of violations identified by its quality
     control reviews as recommended by HUD. HUD’s Quality Assurance Division
     mentioned this matter in its 2004 report, but Pine State had not implemented
     corrective action. The classification would identify violations that required (a)
     reporting to HUD, (b) management action to address decline in the quality of
     loans, and (c) prompt corrective action. Pine State did not report material
     violations to HUD and had not taken adequate measures to identify patterns and
     trends from its quality control reviews nor adequately correct violations noted
     during its quality control reviews.

     HUD Handbook 4060.1, REV-1, paragraph 6-4, recommends that quality control
     reports to lender management include an assessment of risks to enable a lender to
     compare one month’s sample to previous samples so the lender may conduct trend
     analysis. Management can also use this tool to respond quickly to a sudden
     decline in the quality of its loans and help identify and correct the problem.
     Lenders may consider a ratings system such as (a) “low risk” for loans with no or
     minor problems, (b) “acceptable risk” for loans that do not involve issues material to
     creditworthiness or insurability, (c) “moderate risk” for loans that contained
     significant unresolved questions or missing documentation, and (d) “material risk”
     for loans that involve material violations of Federal Housing Administration or
     lender requirements and represent an unacceptable level of risk. Lenders must
     report material risk loans, in writing, to HUD.



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                                          14
Material Violations Not Identified
and Reported to HUD


     Pine State did not identify and report to HUD material violations included in its
     quality control reports. In some instances, Pine State’s quality control reports
     noted that major violations were found, but the reports did not reference specific
     case violations. We met with Pine State officials in January 2006, and they
     acknowledged they had not self-reported any loans to HUD. HUD officials also
     stated that Pine State had not self-reported any violations detected by the
     company’s quality control reviews. As of April 2006, Pine State had not
     identified and reported any material violations to HUD.

     We examined Pine State’s quality control findings and observed material
     violations for 23 loans that warranted reporting but were not reported to HUD
     (appendix E). The violations were included in quality control reports for early
     payment default loans for all Pine State offices conducted from May through
     December 2005. We examined eight of the loans during our underwriting review.
     The review confirmed the existence of the type of violations Pine State detected
     for seven of the loans, although in most instances, our review detected additional
     issues and details. We did not audit the other 15 loans to validate Pine State’s
     review findings. The 15 loans involved more than $1.3 million in unpaid
     principal for 10 loans, one claim totaling $155,193, and four loans resold by HUD
     at a loss that totaled $155,402. The violations associated with the 23 loans
     consisted of

          •   Ten loans with overstated or understated income that increased the debt-
              to-income ratios to levels that adversely affected the insurability of the
              loans;
          •   Seven loans with quitclaim deeds executed at closing to individuals who
              were not subjected to assessment of their income, debts, and
              creditworthiness; and
          •   Six loans with omitted liabilities or understated housing costs that
              increased the debt-to-income ratios to levels that adversely affected the
              insurability of the loans.

     This condition occurred because Pine State management did not meet its
     responsibility to identify and report material violations to HUD. This condition
     exposed HUD to increased risk for loans with violations that impacted their
     eligibility for insurance. In response to our assessment, Pine State officials
     commented that they did not agree with their quality control finding results for 11
     of the 23 loans.

     HUD Handbook 4060.1, paragraph 6-3(J), provides that findings of fraud or other
     serious violations must be referred, in writing (along with the supporting
     documentation), to the appropriate director of the Quality Assurance Division in
     the HUD Homeownership Center. A lender’s quality control program must
     ensure that findings discovered by employees during the normal course of

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     business and by quality control staff during reviews/audits of Federal Housing
     Administration loans are reported to HUD within 60 days of the initial discovery.

Corrective Action Not Properly
Taken on Quality Control Findings

     Pine State did not take or document adequate action to address and resolve
     findings included in its quality control reports. The reports did not contain or give
     reference to the required corrective actions and timetables for completing
     corrective actions. Although this information was requested, Pine State could not
     produce adequate written records supporting proper action to resolve quality
     control findings. In some instances Pine State officials stated that they took
     informal and/or undocumented actions such as sending e-mails advising staff to
     be alert for certain conditions detected by its quality control reviewer. They also
     stated that they discussed some of the issues with their staff. We found limited
     documentation of these discussions.

     Handbook 4060.1, paragraph 6-3(I), provides that review findings must be
     reported to the lender’s senior management within one month of completion of
     the initial report. Management must take prompt action to deal appropriately with
     any material findings. The final report or an addendum must identify actions
     being taken, the timetable for their completion, and any planned followup
     activities.

Trending Not a Consistent Part of
the Quality Control Process

     Pine State did not consistently identify patterns and commonalities among
     participants for early payment defaults that required further assessment to identify
     the cause and any needed corrective action and or targeted coverage in future
     quality control reviews. We only found two trend assessments by Pine State.
     One was dated August 2005; however, the other one was not dated, and we could
     not determine when Pine State performed the assessment. The assessments
     identified

     •   Two high default rate underwriters at its Atlanta branch office (dated August
         2005) and

     •   A 39 percent default rate for loans that involved temporary interest rate
         buydowns. As discussed in finding 1, Pine State did not properly document
         and review borrowers’ eligibility for interest rate buydowns. It produced no
         evidence that it initiated action to identify the cause for this high default rate
         and initiated action to resolve the matter.


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                                           16
     These conditions occurred because Pine State did not require and commit staff to
     identify and follow up on patterns and trends. Pine State officials said they
     considered patterns in informal one-on-one meetings and decided the patterns did
     not warrant further assessment or followup. Thus, Pine State missed the
     opportunity to identify and correct, in a timely manner, underwriting problems
     such efforts may have identified. Pine State’s failure to address the issues
     allowed underwriting problems to continue unabated.

Inadequate Action to Identify and
Address the Cause for High
Underwriter Defaults

     Pine State did not assess the performance of two of its highest default rate
     underwriters to determine why their default rates were so high and take action to
     address the matter.


                                                        Loans
                                                      defaulted                  Mortgages on
                         Loans closed       Total     within two     Default      defaulted
        Underwriter         between         loans       years       percentage      loans
            A         Dec. 2003 and June       217             55        25.35    $7,430,248
                             2004
                      July 2004 and Dec.        143           29        20.28       3,701,148
                             2004
                      Jan. 2005 and June        66             8        12.12       1,052,043
                             2005
         Subtotal                               426           92        21.60      12,183,439

            B         Dec. 2003 and June        93            26        27.96      $3,116,226
                             2005

           Total                                519          118        22.74     $15,299,665



     Underwriter A continued to underwrite for Pine State at the time of our review.
     The personnel file showed no record of concern about the underwriter’s high
     default rate. Underwriter B left Pine State to work for another lender. The
     personnel file showed the underwriter left Pine State in good standing. The file
     showed no record of concern about the underwriter’s high default rate.

     Pine State’s owner stated the high default rates were due to a higher risk market
     rather than poor quality underwriting. The data we obtained from HUD’s
     Neighborhood Watch system coupled with our file reviews did not support Pine
     State’s assessment. The system showed an 8.25 percent default rate for loans in
     Georgia that correspond to Pine State’s market. The default rate is 2.29 percent
     lower than the 10.54 default rate for Pine State’s Atlanta branch where most of

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     the underwriter’s default activity occurred. Furthermore, the 8.25 Georgia default
     rate was 17.10 percent lower than the highest default rate for Underwriter A and
     19.71 percent lower than the default rate for underwriter B.

     Further, the underwriting violations detected by our review (appendixes C and D)
     show poor underwriting performance contributed to the underwriters’ high default
     rate. For instance, we identified 21 loans with underwriting violations that
     impacted insurability. Underwriter A underwrote six or 28.6 percent of the loans,
     and Underwriter B underwrote three or 14.2 percent of the loans. The violations
     contributed to the underwriters’ high default rates. Pine State did not focus extra
     quality control attention on these underwriters to identify the cause for the high
     defaults and to initiate corrective measures where appropriate.

     HUD handbook 4060.1, paragraph 6-5C, provides that lenders must identify
     patterns of early defaults by location, program, and loan characteristic. Lenders
     must identify commonalities among participants in the mortgage origination
     process to learn the extent of their involvement in problem cases. For instance,
     loans involving underwriters who have been associated with problems must be
     included in the review sample.

Inadequate Action to Identify and
Address the Cause for High Branch
Office Defaults

     Pine State’s quality control process did not assess or document its assessment of
     performance by its Atlanta branch office, which had a high 10.54 percent default
     rate. The high default rate caused a 223 percent compare ratio for the Atlanta
     branch. The compare ratio exceeded the 200 percent benchmark used by HUD to
     consider branch offices for possible sanction. The branch had 183 defaults for the
     period August 1, 2003, through July 31, 2005, underwritten by 16 different
     underwriters. Underwriters A and B, discussed above, underwrote 116 or 63.3
     percent of the defaulted loans.

                    Total                          Percentage of      Mortgage amounts
                    branch      Defaults by        defaults by       associated with the
      Underwriter   defaults    underwriter        underwriter       underwriter defaults

          A               183              72                39.34            $ 9,897,155
          B               183              44                24.04              6,573,135
         Total                            116                63.38            $16,470,290

     Pine State’s owner stated the high branch default rate was due to its primary focus
     on higher risk loans for new construction. However, our assessment shows other
     factors also played a part. For instance, as of September 30, 2005, the branch had
     an 11.55 percent default rate for new construction loans. That rate exceeded Pine
     State’s overall 9.03 percent rate and the 8.83 percent default rate for all HUD-

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     insured new construction loans in Georgia. As previously mentioned, the high
     default rate was due in part to the underwriting activity by underwriters A and B.
     Pine State did not review and assess the reason for the underwriters’ high default
     activity. The explanation Pine State provided was not consistent with the
     underwriting violations we noted for loans the two underwriters approved.

     Regulations at 24 CFR [Code of Federal Regulations] 202.3 provide that lenders
     are responsible for monitoring their default and claim rate performance. The
     HUD secretary may notify a lender that its origination approval agreement will
     terminate 60 days after notice is given, if the lender had a rate of defaults and
     claims on insured mortgages originated in an area, which exceeded 200 percent of
     the normal rate and exceeded the national default and claim rate for insured
     mortgages. Further, HUD Handbook 4060.1, paragraph 6-5C, provides that
     lenders must identify patterns of early defaults by location, program, and loan
     characteristic. They must identify commonalities among participants in the
     mortgage origination process to learn the extent of their involvement in problem
     cases. For instance, loans involving underwriters who have been associated with
     problems must be included in the review sample.

Conclusion

     Since HUD’s 2004 review, Pine State has not implemented effective quality
     controls for early payment default loans. Pine State conducted the required
     reviews but it did not (a) classify quality control violations based on risk, (b)
     report material risk loans to HUD, (c) properly take and document actions to
     resolve quality control findings, (d) conduct frequent trending to identify patterns
     that warrant followup in its quality control reviews and corrective action, (e)
     conduct expanded reviews of high default rate underwriters, and (f) review and
     assess the reason for the high default rate at its Atlanta branch. Thus, Pine State’s
     quality controls were not adequate to identify and correct problems that adversely
     affected the quality of its loans. These conditions contributed to the violations
     discussed in finding 1 and to the high default rate for Pine State’s Atlanta branch
     office.

Recommendations

     We recommend that the assistant secretary for housing-federal housing
     commissioner

     2A.     Take appropriate administrative action against Pine State for not
             implementing proper quality controls over its early payment default loans.
             This action is justified based on Pine State’s failure to correct or document
             corrective action on identified quality control findings, risk rank quality
             control findings, report material violations to HUD, and conduct and


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           consider trending in the performance of its quality control reviews.

     2B.   Require Pine State to implement proper quality controls over its early
           payment default loans.

     2C.   Require Pine State to reimburse HUD for losses or claims and/or
           indemnify HUD for any of the loans listed in appendix E that involve
           material violations Pine State should have reported to HUD.




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                                        20
                          SCOPE AND METHODOLOGY

We performed the audit between October 2005 and May 2006. We conducted the audit
fieldwork at Pine State’s Atlanta, Georgia, office and HUD’s Office of Inspector General
(OIG) and program offices in Atlanta, Georgia. The audit covered the period August 1,
2003, through July 31, 2005, but we extended the period as necessary. We conducted the
audit in accordance with generally accepted government auditing standards.

To achieve our objective, we reviewed HUD’s rules, regulations, and guidance for proper
origination and submission of Federal Housing Administration loans. We also reviewed
previous HUD reviews of Pine State and HUD case binders. In addition, we interviewed
HUD staff to obtain background information on HUD requirements and Pine State.

We interviewed Pine State’s management and staff to obtain information regarding its
policies, procedures, and management controls. We reviewed Pine State’s written
policies and procedures to gain an understanding of how its processes are designed to
function. We also reviewed Pine State’s quality control review of early payment defaults
related to our scope. Additionally, we reviewed Pine State’s case binders for 16 of 81
early-payment default loans and 92 of 217 cases Pine State approved for interest rate
buydowns. We limited the review to 92 loans that had defaulted and had a debt-to-
income ratio equal to or greater than 41 percent. We obtained origination default and
other loan information from HUD’s Neighborhood Watch system for loans included in
our review.

The amounts shown for questioned costs and funds to be put to better use apply only to
loans reviewed during the audit. The ineligible cost represents the actual loss HUD
incurred on the resale of affected properties. The unsupported cost represents 29 percent
of the claim paid based on information provided by HUD. We estimated funds to be put
to better use at 29 percent of the unpaid principal balance. HUD provided information
that shows its loss on sales average 29 percent of the claim paid. We also used 29
percent of the unpaid principal balance because HUD had not paid claims for these loans.




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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:

               •    Controls over underwriting of Federal Housing Administration loans.

               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

               Based on our review, we believe the following items are significant
               weaknesses:

               •    Pine State did not follow HUD requirements when underwriting 21
                    Federal Housing Administration-insured loans.

               •    Pine State did not implement its quality control plan in accordance
                    with HUD requirements.




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                                             22
                                 APPENDIXES

Appendix A

           SCHEDULE OF QUESTIONED COSTS
          AND FUNDS TO BE PUT TO BETTER USE



          Recommendation                                       Funds to be put to
              number            Ineligible 1/   Unsupported 2/   better use 3/
                  1B                                                    $713,495
                  1C               $66,425
                  1D                               $85,262




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, federal, state,
     local policies or regulations. The amount shown represents the actual loss HUD
     incurred when it sold the affected properties.

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. In this
     instance, we estimated unsupported cost to be 29 percent of the claim paid based
     on information provided by HUD.

3/   “Funds to be put to better use” are quantifiable savings that are anticipated to
     occur if an 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. In this instance, we estimated funds to be put to better use at 29 percent
     of the unpaid principal balance. HUD provided information that shows its loss on
     sales averages 29 percent of the claim paid. We used 29 percent of the unpaid
     principal balance because HUD has not paid claims for these loans.



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                                           23
Appendix B

     AUDITEE COMMENTS AND OIG’S EVALUATION

Ref to OIG Evaluation    Auditee Comments




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                    OIG Evaluation of Auditee Comments




Comment 1




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Comment 2




Comment 3




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Comment 4




Comment 4




Comment 4




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Comment 4




Comment 5




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Comment 5
Comment 6




Comment 7




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Comment 8
Comment 6




Comment 9




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Comment 10




Comment 10




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Comment 11




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Comment 12




Comment 13




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Comment 12




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Comment 12



Comment 14




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Comment 6




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Comment 16




Comment 16




Comment 15




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Comment 16




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Comment 17

Comment 16
Comment 18

                     OIG Evaluation of Auditee Comments


Comment 16


Comment 16




Comment 18


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Comment 16




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Comment 2




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                    S AND OIG’S EVALUATION


Comment 23




Comment 26




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Comment 26




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Comment 27




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Comment 16




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Comment 2




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                    S AND OIG’S EVALUATION

Comment 16




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                     OIG Evaluation of Auditee Comments


Comment 1   We provided Pine State the opportunity to informally respond to our
            tentative finding during the course of the audit. We considered its
            comments and revised our conclusions where appropriate. We then
            prepared the final draft report and provided Pine State an opportunity to
            respond to the report in writing. We included its written response (minus
            supporting exhibits) in this report along with our assessment of the
            response. Pine State will have further opportunity to provide comments
            and supporting documentation to HUD program staff, who will work with
            Pine State and our office to resolve the audit recommendations.

Comment 2   We revised the report in several instances to reflect valid issues raised by
            Pine State. See comments 3, 4, and 27. However, the revisions did not
            materially affect the overall accuracy of the report.

Comment 3   We revised the number shown in the summary schedule of finding 1 for
            cases with less significant deficiencies to agree with the number of loans
            listed in appendix C.

Comment 4   We assessed and accepted Pine State’s position that 1 of the 12 questioned
            buydown cases met requirements (case number 105-1380870). We
            revised the report to delete all reference to this condition. The information
            Pine State provided did not support its claim that the remaining 11
            buydown cases met requirements. Pine State’s comments included
            substantial justification for the buydowns that it prepared in response to
            the audit. The justification should have been but was not prepared and
            documented at the time Pine State approved the buydowns.

Comment 5   Buydown for case number 105-1587099 - This buydown was not
            allowable for the reasons cited in the report. We agree with Pine State’s
            reference to HUD requirements that allow lenders to consider training
            when assessing a borrower’s potential for increased earning. In this case,
            the borrower obtained the training as a nursing assistant and then obtained
            a job in that field. We assessed the borrower’s income after the indicated
            training and subsequent employment as a nursing assistant. Our
            assessment did not support an earning pattern or potential needed to justify
            the buydown. The file and Pine State’s comments contained no support
            that the borrower had taken and completed any other training that would
            further increase her earning potential. As for the coborrower, we agree
            that the documents Pine State provided support a projected 2 percent raise
            or approximately 20 cents per hour. The borrower needed a 45-cent per
            hour raise to offset the first buydown increment. The file contained no
            documentation that the borrowers’ combined earning potential was


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                                         67
              sufficient to pay the buydown increment.

Comment 6     Pine State did not recognize its responsibility to determine the adequacy of
              borrowers’ earning capacity to justify buydowns. HUD’s buydown
              requirements were designed to ensure that the eventual increase in
              mortgage payments would not affect the borrowers adversely and likely
              lead to default.

Comment 7     Buydown for case number 105-1953205 - This buydown was not justified
              for the reasons cited in the report. Contrary to Pine State’s claim, the
              borrower’s 2004 income was $227 less than the 2003 amount. Pine State
              incorrectly estimated the borrower’s 2004 income. We contacted the
              employer and determined that our 2004 estimate was only $41 less than
              the 2004 amount we confirmed with the employer.

Comment 8     Buydown for case number 105-1956571 - This buydown was not justified
              for the reasons cited in the report. The document Pine State obtained
              from the employer contained a general comment that the borrower, and
              independent contractor, was a hard worker with a potential for increased
              earnings. Pine State did not determine or show how much of a pay
              increase the borrower would receive. Also, it did not show whether the
              borrower’s past earning supported projected increases sufficient to pay the
              buydown increments.

Comment 9     Buydown for case number 105-1386555 - This buydown was not justified
              for the reasons cited in the report. Pine State provided a copy of the
              borrower’s employment contract that indicated the possibility of bonuses.
              However, the contract only guaranteed the borrower a basic salary
              amount. Pine State provided no information to show when and how much
              of a pay increase or bonus the borrower would receive.

Comment 10 Buydown for case number 105-1606248 - This buydown was not justified
           for the reasons cited in the report. Pine State said it properly excluded the
           $145 monthly payment because the debt had less than 10 months
           remaining when the loan closed. Handbook 4155.1, REV-4, provides that
           debts lasting less than 10 months must be counted if the amount of the
           debt affects the borrower’s ability to make mortgage payments during the
           months immediately after loan closing. This was the case considering that
           the payment increased the borrower’s debt-to-income ratio from 43.10 to
           49.42 percent. Pine State also made an unsupported claim that the
           borrower qualified for the buydown based on increased earning. To
           support its position Pine State provided joint income tax data that showed
           the borrower’s and his wife’s combined income increased from 2001 to
           2002. However, the borrower’s wife was not a party to the loan. Thus,
           her income and credit were not assessed to determine eligibility for the


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                                           68
              loan and are not relevant to the borrower’s qualification for the buydown.

Comment 11 Buydown for case number 105-1696401 - This buydown was not justified
           for the reasons cited in the report. The borrower had worked as a police
           officer for 19 months. We determined that the officer’s earning rate for
           2003 was less than the rate for 2002. We did not determine the reason for
           this condition. However, Pine State should have obtained and considered
           an explanation as part of its buydown assessment. HUD’s Neighborhood
           Watch system shows the borrower defaulted due to a curtailment of
           income. Pine State was responsible for assessing the adequacy of
           potential pay increases to cover the buydown increments.

              In its response, Pine State also said the borrower qualified for the
              buydown because of a $242 monthly debt that would be paid off within 20
              months and before the buydown period ended. The liquidation of this debt
              20 months into the buydown period was not relevant to the borrower’s
              eligibility for the buydown.

Comment 12 Buydowns for case numbers 105-1072865, 105-1751832, and 105-
           1969307 - We assessed Pine State’s comments and supporting documents.
           They provided no new information for our consideration. The buydowns
           are not justified for the reasons cited in the report.

Comment 13 Buydown for case number 105-0981353 - This buydown was not justified
           for the reasons cited in the report. The collection accounts, increasing
           housing cost, and the delinquent child support payments were not
           consistent with Pine State’s claim concerning the borrower’s ability to
           manage increased housing expense. We consider it unreasonable to accept
           that the borrower accumulated more than $20,000 in delinquent child
           support due to an address mix-up. The borrower was or should have been
           aware of the child support obligation.

              In addition, Pine State claimed the borrower was qualified for the
              buydown because of an increased earning potential associated with
              overtime pay not included as effective income. We agree with Pine
              State’s comment that HUD criteria do not require lenders to document
              overtime earnings for a two-year period for the purpose of satisfying the
              buydown requirement. However, Pine State was responsible for but did
              not assess or document its assessment of the adequacy of potential pay
              increases to pay the buydown increments.

Comment 14 Buydown for case number 105-1644709 - This buydown was not justified
           for the reasons cited in the report. The documents Pine State provided
           understated the borrower’s 2002 income it used to compare against the
           2003 amount. The loan file showed the borrower worked for three
           different employers in 2002 and earned $35,796 versus the $27,635


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              claimed by Pine State. The borrower worked for one employer in 2003 at
              an hourly pay rate that equated to $35,360 in regular pay or $436 less than
              the amount earned in 2002. The borrower started work for the employer
              in February 2002 and continued in the job through the September 2003
              date reflected in Pine State’s comments. The verification of employment
              indicated no past pay increases. The employer entered question marks in
              the boxes on the verification form that inquired about the projected date
              and amount of the next pay increase. The verification of employment did
              not show whether overtime would continue. The borrower’s September
              2003 pay stub showed only $485 in year-to-date overtime pay.

Comment 15 We disagree with Pine State’s comments that compensating factors exist
           that would offset its omission of a $142 monthly payment from the
           borrower’s credit assessment (FHA case number 105-1969307). The
           omitted debt contributed to a 47.59 debt-to-income ratio with the buydown
           and a 52.54 percent ratio without the buydown.

Comment 16 We disagree with Pine State’s assessment that the reported violations are
           not valid and should be removed from the report. The report provides an
           accurate presentation of the conditions found and the HUD criteria
           designed to regulate those conditions. Pine State provided no new
           information for our consideration.

Comment 17 The Fannie Mae underwriting finding, item 17, required Pine State to
           include new debt payments resulting from material inquiries listed on the
           credit report in the debt ratio. Item 21 of the finding contained a similar
           requirement. Thus, we disagree with Pine State’s assessment that it was
           not required to follow up on the inquiry and that we should remove this
           issue from the report.

Comment 18 The recommendation for indemnification was based on our consideration
           of all violations detected for each loan versus individual violations. We
           further assessed the violations giving consideration to Pine State’s
           comments and supporting documents. We found no justification to
           change the recommendation.

Comment 19 We disagree with Pine State’s comment that the file documented an
           explanation for insufficient fund charges listed on the borrower’s June
           2003 bank statement. The borrower’s explanation, dated June 18, 2003,
           explained derogatory credit information listed on the credit report.
           However, the credit report in the file was dated July 25, 2003, over a
           month after the letter of explanation. Notwithstanding this discrepancy,
           item 6 of the explanation attributes a delinquent Blockbuster account to
           two returned checks that resulted from fraudulent activity in the
           borrower’s account. The credit report did not show a Blockbuster
           account. The report did show two unpaid collection accounts for another


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              video company that did not appear to be recent. The balances had been
              outstanding long enough to be transferred from the video company to a
              collection agency. Thus, the two checks mentioned did not appear to be
              related to the three returned checks shown on the borrower’s June 2003
              bank statement. The borrower’s June bank statement showed no evidence
              of the account being frozen due to fraudulent activity. Thus, the
              comments and documents Pine State provided did not resolve issues we
              raised concerning returned checks.

Comment 20 We recognize the positive actions Pine State indicated to prevent and
           identify future quitclaim transfers. However, Pine State should have had
           such measures in place already to ensure compliance with HUD’s
           requirements. Pine State either knew or should have known about the
           quitclaim transfers before it submitted the loans for HUD’s endorsement.
           We disagree with Pine State’s position that indemnification of the cases
           would be inappropriate.

Comment 21 We recognize Pine State’s disagreement with the method we used to
           calculate potential losses for loans that have not been resold by HUD. The
           calculations represent the effect for loans that do not meet HUD’s
           underwriting requirements whether or not they go into default. These
           decisions increased risk to HUD for insurance losses.

Comment 22 Pine State objected to OIG’s making its report public before the
           Department makes a final determination on the recommendations. We
           recognize but disagree with Pine State’s categorization of the process and
           the way it suggests the process works. The OIG policy requires public
           disclosure of issued audit reports. HUD management officials are
           responsible for taking action to resolve reported findings and
           recommendations.

Comment 23 We recognize Pine State’s claimed actions to improve its quality control
           program. However, we disagree with its assertion that it consistently
           complied with HUD guidelines regarding the areas cited as violations in
           finding 2. The finding accurately describes the conditions detected by the
           audit, the HUD requirements involved, and the impact associated with the
           violations. Pine State did not provide adequate documentation during or
           subsequent to the audit to support its claimed compliance and objection to
           the finding.

Comment 24 Pine State’s comment misrepresents the meaning of material risk defined by
           HUD Handbook 4060.1, REV-1, paragraph 6-4. The handbook defines
           material risk as material violations of FHA or mortgagee requirements and
           represents an unacceptable level of risk; for example, a significant
           miscalculation of the insurable mortgage amount or the applicant’s capacity
           to repay, failure to underwrite an assumption or protect abandoned property


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               from damage, or fraud. Mortgagees must report these loans, in writing, to
               HUD. We relied on this criterion to determine which loans Pine State should
               have reported to HUD. Contrary to Pine State’s comments, the report never
               stated or implied that lenders report to HUD every underwriting issue raised
               by their quality control reviews. Also, if Pine State disagreed with its own
               quality control findings, it should have but did not document the basis for the
               disagreement and resolution of the disagreement(s).

Comment 25 Contrary to Pine State’s claim, the issues cited in the report comply with
           auditing standards and provide a balanced presentation of the facts. Pine
           State should have but did not evaluate its quality control findings and report
           material risk loans to HUD. We tested the accuracy of Pine State’s quality
           control findings for 8 of the 23 loans listed in appendix E. The review
           confirmed the type of violations detected by the quality control reviewer for
           seven of the loans (appendix E, notes a and b). We also asked Pine State to
           review the quality control finding, and it agreed with the results for 11 of the
           23 loans. It disagreed with the results for the remaining loans even though in
           three cases our underwriting review confirmed the type of violations
           detected by the quality control review. We appropriately requested that HUD
           review and determine whether Pine State should indemnify the loans in
           appendix E.

Comment 26 Pine State provided no support for the claim that it performed monthly
           reviews of the Neighborhood Watch report to assess underwriter and branch
           office performance. It also did not provide support to show when its review
           identified high defaults for interest rate buydown loans. As cited in the
           report, Pine State produced only one instance to support trending that
           identified a high default rate for buydown loans. The analysis was not dated,
           and we could not determine when it was performed.

               Furthermore, the March 2004 guidelines included in Pine State’s response
               were not specifically designed to address buydown loans. The guidelines
               provided specific instructions for automated underwritten loans that
               warranted referral for manual underwriting. The guidelines included, among
               other provisions, review considerations for buydowns. The guidelines did
               not mention the default rate for buydown loans, nor did the guidelines
               require staff to document the files to include the type of information we
               found to be missing.

Comment 27 The report does not ignore Pine State’s justification for the high default rate
           at its Atlanta branch office. We simply disagree with Pine State’s
           explanation. We revised the report to clarify that Pine State primarily made
           loans for new construction. Pine State commented “ …the Report’s statistics
           do not represent the ‘higher risk market’ that Pine State identified as the
           cause of the branch office’s higher-than-average default rate. …” We
           disagree. The supporting information Pine State included with its comments


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              was dated September 30, 2004, and was not current. We updated the June
              30, 2005, statistics in our report through September 30, 2005. The updated
              information continued to support the conditions cited in the report. The
              report accurately describes Pine State’s loan market and how the branch
              office’s high default rate compared to Pine State’s overall default rate and the
              default rate associated with that market for all lenders in the state of Georgia.

Comment 28 Pine State provided no documentation to support its claim that the
           company’s overall and its Atlanta branch’s high default rates resulted solely
           from the company’s focus on new construction loans. The data we obtained
           from Neighborhood Watch as of September 30, 2005, showed Pine State’s
           Atlanta branch default rate (11.55 percent) and Pine State’s overall default
           rate (9.03 percent) for new construction loans exceeded the Georgia average
           (8.83 percent). Thus, as cited in the report, the company’s lack of proper
           underwriting practices further contributed to the high default rates.




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                                             73
Appendix C
Page 1 of 2

         LOAN UNDERWRITING DEFICIENCY CHARTS

                   Loans with deficiencies that affected insurability
                                      Credit not properly assessed

                                                                     Debts not properly assessed




                                                                                                                             Gifts not properly assessed

                                                                                                                                                           Interest rate buydown not
                                                                                                   Unauthorized quitclaims
                Income not properly




                                                                                                                                                               properly assessed




                                                                                                                                                                                               Total errors per loan
                     assessed




Case number                                                                                                                                                                                                            Questioned       Funds put to better


                                                                                                                                                                                       Other
                                                                                                                                                                                                                         costs                 use
                                                                                                                                                                                                                       Ineligible
105-1380870        X                       X                                           X                                             X                                                         4                                              $39,728
105-2032130        X                       X                                                                                                                                                   2                                              $46,530
105-1769305                                                                            X                                             X                                                 X(1)    3*                                             $41,651
105-1741989        X                                                                   X                                                                                               X(2)    3*                                             $50,516
105-2020030        X                       X                                                                                                                                           X(1)    3                                              $45,918
105-1587099                                                                            X                                             X                           X                     X(1)    4*                                             $50,510
105-1524517                                                                            X                                             X                                                         2*                       $33,603
105-1531395                                X                                                                                         X                                                 X(1)    3                                              $40,309
105-1817383                                                                                        X                                                                                   X 1)    2                                              $41,171
105-1728585                                                                            X           X                                 X                                                         3                                              $47,162
105-1548492        X                                                                                                                 X                                                         2                                              $45,641
   Total           5                           4                                           6       2                                 7                            1                    6       31                      $33,603**    $       $449,136 **

* These were automated underwritten loans. The other loans were manually underwritten.
** These calculations are based on 29 percent of the insured loan amount in recognition that this is the
   average percentage of net loss HUD eventually experiences on loans that enter its inventory.

    (1) Housing costs understated.
    (2) Outdated verification documents.




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                                                                                                                                                             74
Appendix C
Page 2 of 2



                      Loans with less significant deficiencies



                                                                 Buydown requirement




                                                                                                                                         signed by all required
                                                                                                                                          Loan application not
                                                                                                                   Understated housing
                     Income not properly




                                                                  met but Pine State’s
                                           Credit not properly




                                                                                              Gifts not properly




                                                                                                                                                                  Total violations
                                                                    assessment not
                                                                     documented
                          assessed


                                                assessed




                                                                                                   assessed




                                                                                                                                                parties
                                                                                                                          costs
      Case number

      105-2074685       X                                                                            X                                          X                         3
      105-1353324       X                     X                                                      X                                                                     3*
      105-1565006       X                                                                            X                X                                                   3
      105-1794657       X                                                 X                                           X                                                   3
      105-1676147                             X                           X                          X                X                                                   4
         Total           4                    2                           2                          4                3                          1                        16


* Loan terminated.

Not all errors pertaining to income, credit, or liabilities were considered material
deficiencies. Only those errors that could have changed the underwriting decision were
considered material. For instance, some errors in income or liabilities did not
significantly affect the housing and debt ratios.




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                                                                                         75
Appendix D

         LOANS WITH TEMPORARY INTEREST RATE
                      BUYDOWNS
             INAPPROPRIATELY APPROVED

                        The deficiencies affected insurability
                         Debt-to-Income
                             Ratio                       Questioned Cost
                                                                  Funds put
                       With Without Closing Ineligible Unsupported to better
         Case number buydown buydown date      cost       cost        use                  Notes

               Manual underwritten loans
     1   105-1953205 44.45        49.75     05/28/04              $44,503                  a, b, d
     2   105-1956571 44.20        48.93     06/21/04                          $42,554      a, b, e
     3   105-1386555 43.00        48.00     07/23/03                          $28,154      a, b, f
     4   105-1606248 43.10        49.42     10/02/03                          $37,544      a, b, g
     5   105-1696401 42.15        47.64     12/18/03                          $33,323      a, b, h
     6   105-1072865 43.59        49.01     04/28/03                          $29,421      a, b, i
     7   105-0981353 44.48        47.79     03/21/03 $32,822                               a, b, j
     8   105-1751832 41.64        47.40     05/24/04                           $46,066     a, b, k
     9   105-1644709 49.21        55.86     10/31/03                           $47,297     a, b, l

             Automated underwritten loan
    10 105-1969307 47.59      52.54 07/15/04 ______               $40,759      ______      a, c, m
                                             $32,822              $85,262     $264,359
               Total



  Note
  a      Pine State did not determine or document the required determinations needed to justify the
         use of an interest rate buydown to qualify the borrower for the loan. The file did not show or
         document that Pine State assessed the buydown to assure that the eventual increase in
         mortgage payments would not adversely affect the borrower and likely lead to default. We
         reviewed the file and determined that the borrower did not meet at least one of the four
         buydown criteria. Thus, Pine State inappropriately used the monthly bought down mortgage
         amount rather than the full payment to qualify the borrower for the loan. Adjustment for the
         buydown resulted in substantial increases in the debt-to-income ratio for each borrower.

         HUD Handbook 4155.1, REV 5, paragraph 2-14B(2), provides that the lender must establish
         that the eventual increase in mortgage payments will not affect the borrower adversely and
         likely lead to default. The underwriter must document that the borrower meets one of these
         four criteria: (a) the borrower has a potential for increased income that would offset the
         scheduled payment increases, (b) the borrower has a demonstrated ability to manage
         financial obligations in such a way that a greater portion of income may be devoted to
         housing expenses, (c) the borrower has substantial assets available to cushion the effect of


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       the increased payments, or (d) the cash investment made by the borrower substantially
       exceeds the minimum required.
  b    The revised debt-to-income ratio exceeded HUD’s limit for loan approval.
  c    Pine State’s inappropriate approval of the buydown caused it to enter an understated
       mortgage payment amount into its automated underwriting system to assess the borrower’s
       eligibility for the loan.
  d    Pine State’s representative stated that the borrower had a potential for increased income to
       offset the increased mortgage payments required by the buydown. We determined that Pine
       State incorrectly estimated the borrower’s future earning capacity. Based on information
       contained in the loan file, the borrower’s projected effective income for 2004 would be $220
       less than the prior 2003 income amount. Thus, the borrower did not demonstrate the
       potential for increased earning needed to pay either the first $1,122 or the second $1,175
       annual buydown increment.
  e    Pine State’s representative stated that the borrower had a potential for increased income to
       offset the increased mortgage payments required by the buydown. Pine State stated that the
       borrower’s historical income showed increases each year and indicated that the borrower’s
       fiancée would contribute to paying housing expense. The borrower’s fiancée was not a party
       to the loan, and her income was not relevant to this assessment. The loan closed in 2004.
       The file showed the borrower’s income increased only $873 from 2002 to 2003 and deceased
       by $439 from 2003 to 2004. Thus, the borrower’s income history did not support the
       potential for salary increases sufficient to pay either the first $1,071 or the second $1,131
       annual buydown increment.
  f    Pine State’s representative stated that the borrower had a potential for increased income from
       bonus and overtime pay to offset the increased mortgage payments. The total effective
       income included the employer’s confirmed standard provision for a 62.5-hour week to allow
       for overtime. The file showed the borrower had worked for the employer less than four
       months and was a trainee. That was not long enough to establish a pattern of job and income
       stability. The employer did not answer the question on the verification of employment
       concerning the borrower’s prospect for continued employment. We recognize that the
       verification of employment showed the borrower would receive various bonuses. However,
       the verification did not indicate how much the payments would be or how often the
       payments would occur. The file did not contain sufficient evidence of job and income
       stability or future pay increases large enough to pay either the first $735 or the second $774
       annual buydown increment.
  g    Pine State’s representative stated that the borrower demonstrated an ability to manage
       financial obligations in such a way that a greater portion of income may be devoted to
       housing expenses. Pine State incorrectly claimed that the borrower had one debt with a
       monthly payment of $291 that would not extend beyond the term of the buydown. The debt
       extended well into if not beyond the last term of the last buydown increment. Pine State did
       not verify the remaining terms of the debt with the creditor. Pine State also inappropriately
       excluded a $145 monthly payment from its assessment of the borrower’s credit. We accept
       Pine State’s position that the debt had less than 10 months remaining. However, the
       payment was high enough to affect the borrower’s ability to make mortgage payments during
       the months immediately after loan closing. The added payment would have increased the
       debt-to-income ratio from 43.10 to 49.42 percent. The credit report showed the borrower
       had serious and recent delinquencies.
  h    Pine State’s representative stated that the borrower had a potential for increased income to
       offset the increased mortgage payments. Pine State stated that the borrower was a police
       officer and was likely to receive annual income increases. The loan closed in December
       2003. The file showed the borrower’s average monthly income decreased approximately
       $236 from 2002 to 2003. The file did not contain sufficient evidence of future pay increases
       large enough to pay either the first $871 or the second $915 annual buydown increment.
  i    Pine State’s representative stated that the borrower demonstrated an ability to manage
       financial obligations in such a way that a greater portion of income could be devoted to
       housing expense. Pine State also stated that the borrower would receive a tax deduction due

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       to mortgage interest. The loan closed on April 28, 2003, with a 43.59 percent debt-to-
       income ratio. The credit report showed several collection accounts including two that were
       settled or paid in 2003 just prior to loan closing. The collection accounts were not consistent
       with Pine State’s comments concerning the borrower’s ability to devote a greater portion of
       income to housing expense. The borrower’s housing cost for the new loan, giving
       consideration to the buydown, was slightly less than the borrower’s prior rent. However, the
       collections accounts did not support Pine States justification for the buydown.
 j     Pine State’s representative stated that the borrower demonstrated an ability to manage
       financial obligations in such a way that a greater portion of income could be devoted to
       housing expense. The representative also stated that the borrower had a potential for
       increased income to offset the increased mortgage payments. We disagree with Pine State’s
       assessment. The credit report showed recent collection accounts and a $20,090 delinquency
       on child support payments. The total mortgage payments (at the bought down amount)
       exceeded the borrower’s prior rent amount. The collections, delinquent child support, and
       increased housing costs were not consistent with Pine State’s claim concerning the
       borrower’s ability to manage increased housing expense.

       In addition, the file did not support Pine State’s claim concerning the borrower’s increased
       earning capacity. Pine State’s calculation included overtime pay based on the borrower’s
       current pay stubs. The file did not contain documentation needed to assess overtime pay
       over the required two-year trend period to determine whether the amount was stable enough
       to warrant such consideration in projecting the borrower’s future earning capacity. The file
       contained no verification stating whether overtime was likely to continue. We requested but
       Pine State could not produce documentation needed to assess the borrower’s prior year
       income for comparison to later years. Thus, the file did not contain adequate documentation
       to support that the borrower would receive pay increases sufficient to pay either the first
       $1,307 or the second $1,380 annual buydown increment.
 k     Pine State’s representative stated that the borrower demonstrated an ability to manage
       financial obligations in such a way that a greater portion of income could be devoted to
       housing expense. Pine State commented that the borrower was able to make timely monthly
       payments with a rental expense comparable to the proposed housing expense. The loan
       closed on May 24, 2004. Pine State’s position appeared plausible except that the file showed
       the borrower issued 18 insufficient fund checks between March 19 and May 5, 2004. The
       borrower provided a written explanation blaming the insufficient fund checks on a variation
       in pay dates from those the borrower was use to. The borrower’s comments did not make
       sense. The borrower, despite any variation in pay dates, either knew or should have known
       the actual pay dates and should not have written any checks against funds not on deposit at
       the bank. Pine State’s position concerning the borrower’s ability to manage financial
       obligations was not supported by what the file showed.
 l     Pine State’s representative stated that the borrower had a potential for increased income to
       offset the increased mortgage payments. Pine State based its position on its estimate of the
       borrower’s 2003 income that included consideration for overtime. The borrower had worked
       for the current employer 20 months before loan closed on October 31, 2003. The
       verification of employment did not identify overtime or past or future pay increases and did
       not contain a response to a question regarding whether overtime would continue. Based on
       the borrower’s pay stubs, the 2003 income without consideration to overtime would be $436
       less than the income for 2002. The file contained no basis for determining whether the
       borrower would receive salary increases sufficient to pay either the first $1,247 or the second
       $1,309 annual buydown increment.
 m     Pine State’s representative stated that the borrower had a potential for increased income to
       offset the increased mortgage payments. Pine State claimed that the borrower’s income
       increased from 2001 to 2004 and that the borrower received a car allowance that was not
       included in effective income. Generally, Pine State’s position concerning increased income
       appeared correct. The file showed the borrower’s 2004 annual income increased by $902
       without regard to the car allowance. The $902 salary increase was not sufficient to pay
       either the first $1,015 or the second $1,064 annual buydown increment. Pine State did not

                                                 78
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      document how much of the car allowance (net of expenses) represented effective income.
      During our assessment, we noticed that Pine State did not enter a $142 monthly revolving
      account debt into its automated underwriting system that assessed the borrower’s eligibility
      for the loan. The omitted debt brings into question whether the loan should have been
      approved.




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                                               79
               Appendix E

                       MATERIAL QUALITY CONTROL FINDINGS NOT
                                 REPORTED TO HUD


                                 The deficiencies could or did affect insurability
                                                                                                             Did
                                                                          Unpaid                 HUD’s       Pine
                                                                         mortgage     Claim      loss on     State
         Case number     Description                                     amount        paid       resale    agree?   Notes
                         Income overstated
1        105-1187781     Debt ratio increased from 46.7 to 49 percent     $120,669                           No        a, c
2        105-1428807     Debt ratio increased from 43.2 to 50 percent       99,021                           No        a, c
3        105-1720581     Debt ratio increased from 38.2 to 48 percent      119,772                           No        a, c
4        105-1741989     Debt ratio increased from 46.34 to 51 percent                                       No        b, e
                         Unsupported income
5        105-1236876     Debt ratio increased from 42.3 to 49 percent      108,863                           No        a, c
6        105-0793308     Debt ratio increased from 32.6 to 60 percent            0                 36,457    No        a, c
7        105-0684284     Debt ratio increased from 43.2 to 47 percent      148,271                           No        a, c
8        105-0637652     Debt ratio increased from 42 to 60 percent                                41,541    No        a, c
9        105-1548492     Debt ratio increased from 39.59 to 57 percent                                       No        b, e
10       105-1676147     Debt ratio increased from 44.43 to 47 percent                                                  b,

                         Quitclaim transfer at closing
11       105-1530774     No underwriting assessment of transferee          149,135                           Yes       a, d
12       105-1290106     No underwriting assessment of transferee          144,935                           Yes       a, d
13       105-0107916     No underwriting assessment of transferee          124,268                           Yes       a, d
14       105-1317601     No underwriting assessment of transferee                      155,193               Yes       a, d
15       105-0306702     No underwriting assessment of transferee                                  23,364    Yes       a, d
16       105-1728585     No underwriting assessment of transferee                                            Yes       b, f
17       105-1817383     No underwriting assessment of transferee                                            Yes       b, f
                         Liability omitted
18       105-0365985     Debt ratio increased from 47.7 to 53 percent                              54,040    No        a, c
19       105-1380870     Debt ratio increased from 43.03 to 46 percent                                       No        b, e
20       105-1524517     Debt ratio increased from 47.36 to 57 percent                                       Yes       b, f
                         Housing expenses understated
21       105-0703913     Debt ratio increased from 43.9 to 46 percent      109,734                           Yes       a, d
22       105-2008495     Debt ratio increased from 44.5 to 46 percent      189,347                           Yes       a, d
23       105-1769305     Debt ratio increased from 47.34 to 50 percent                                       Yes       b, f
         Total                                                           $1,314,015   $155,193   $155,402




Notes
     a      These 15 loans were not included in our audit sample.




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b      We reviewed these remaining eight loans. Our review substantiated the general finding issues raised by Pine
       State’s reviewer for seven loans with mortgages that totaled more than $1 million (see appendix C). Our review did
       not substantiate the finding issue Pine State raised for the eighth loan (105-1676147).
c      Pine State reviewed the case during the course of our audit and disagreed with the finding cited in its quality control
       report. Pine State claimed that the borrowers’ correct debt-to-income ratios were lower than cited in the quality
       control report and were within HUD’s limit for approval. We did not audit Pine State’s reassessment of its quality
       control results.
d      Pine State reviewed these seven loans during the course of our audit and agreed with the material findings cited in
       its quality control report. We did not audit Pine State’s reassessment of its quality control results.
e      Pine State reviewed these three loans during the course of our audit and disagreed with the material finding cited in
       its quality control report. Pine State claimed that the borrowers were within HUD’s requirements for approval.
       However, our review (appendix C) confirmed the general nature of the violations cited in the Pine State quality
       control report although the scope of violations we detected was broader than those indicated by the Pine State
       review.
f      Pine State reviewed these four loans during the course of our audit and agreed with the material findings cited its
       quality control report.




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                                                               81
Appendix F

    CASE STUDIES OF IMPROPERLY UNDERWRITTEN
                      LOANS


Case number:                         105-1380870
Loan purpose:                        Purchase
Underwriter type:                    Manually underwritten
Date of loan closing:                July 25, 2003
Insured amount:                      $141,500
Debt-to-income ratio:                43.60 percent
Status:                              Reinstated
Default reason:                      Excessive obligations


Credit Not Properly Assessed

The file did not contain an explanation for three insufficient fund charges shown on the
borrower’s June 2003 bank statement. At the time, the borrower had been employed for
only five months following a four-month gap in employment to care for sick family
members. HUD’s system showed the borrower defaulted due to excessive obligations.
The credit report Pine State obtained for the quality control review showed the borrower
filed for bankruptcy protection in April 2004, about nine months after the loan closed.
The bankruptcy was dismissed in July 2004, but the borrower filed for bankruptcy
protection again in August 2004. These conditions indicate the borrower may have
bought the house before fully recovering from the gap in employment.

HUD Requirements

HUD Handbook 4155.1, REV-4, paragraphs 2-3 and 2-3B, states that past credit
performance serves as the most useful guide in determining a borrower’s attitude toward
credit obligation and predicting a borrower’s future actions. When analyzing the
borrower’s credit record, it is the overall pattern of credit behavior that must be
examined. The handbook further states that if the credit history reflects continuous slow
payments, judgments, and delinquent accounts, strong compensating factors will be
necessary to approve a loan.

Income Not Properly Assessed

Pine State approved the loan based on a $1,734 monthly effective income although the
borrower had not held the job long enough to support stability of the income amount.
The borrower had only been employed for five months in his job, not the required six
months needed to support income stability. The employment immediately followed a


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four-month employment gap, during which time the file showed the borrower was taking
care of sick relatives. We question whether Pine State should have included the $1,734
as effective income, but we did not deduct the amount.

HUD Requirements

HUD Handbook 4155.1, REV-4, CHG-1, section 2 provides that income from any source
that is not stable may not be used in calculating the borrower’s income ratios. Paragraph
2-6 provides that in some cases, a borrower may have recently returned to the workforce
after an extended absence. In these circumstances, the borrower’s income may be
considered effective and stable, provided the borrower has been employed in the current
job for six months or more.

Debts Not Properly Assessed

Pine State’s loan file contained no evidence that it asked the borrower to explain two
credit inquiries that resulted in two new loans. The first inquiry, dated April 21, 2003,
resulted in a new loan in September 2003 with a $358 monthly payment. The second
inquiry, dated May 14, 2003, resulted in a new loan in August 2003 with a $21 monthly
payment. Both loans were shown on the credit report Pine State obtained more than a
year later on November 7, 2004, during its quality control review of the loan. Pine State
did not resolve issues related to the inquiries before it approved the loan. Pine State
agreed with our adjustment to include the new $21 monthly payment. However, it stated
that the $358 debt replaced a prior car loan it included in its analysis at $462 per month
and that we should use the lower $358 payment in our assessment. We did not make the
adjustment because Pine State’s approval decision was based on information it possessed
at the time and without conducting the required followup.

HUD Requirements

HUD Handbook 4155.1, REV-4, CHG-1, paragraph 2-3B, provides that the lender must
determine the purpose of any recent debts. The borrower must explain all inquiries
shown on the credit report.

Gift Funds Not Properly Verified

The loan file contained no documentation that Pine State verified receipt of a $4,321 gift
paid at closing by a nonprofit donor. Thus, Pine State allowed the loan to close without
support that the closing agent received the nonprofit gift used to pay the borrower’s
required investment in the property. The HUD-1 settlement statement shows the gift was
paid. The missing document was required to provide assurance that the gift was paid by
the nonprofit organization and not by some other interested party to the loan transaction.
We discussed this matter with Pine State officials, and they followed up and obtained the
documents needed to confirm receipt of the gift.


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                                            83
HUD Requirements

HUD Handbook 4155.1, REV-4, paragraph 2-10C, requires that if the gift funds are not
deposited to the borrower’s account before closing, the lender must obtain verification
that the closing agent received funds from the donor for the amount of the gift.




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                                           84
Case number:                         105-2032130
Loan purpose:                        Purchase
Underwriter type:                    Manually underwritten
Date of loan closing:                August 13, 2004
Insured amount:                      $163,871
Debt-to-income ratio:                59.80 percent
Status:                              Default
Default reason:                      Curtailment of income


Income Not Properly Assessed

   Pine State included $1,343 as effective monthly income although it did not establish
   and document the amount to be stable and likely to continue. The coborrower had
   worked for the employer less than three months. The employer completed the
   verification but entered “N/A” to the question concerning the probability of continued
   employment. The file contained no evidence that Pine State followed up and
   obtained an answer to the question. The coborrower had a history of unstable
   employment in different lines of work broken by periods of unemployment. The
   coborrower was unemployed and looking for work for more than a month and a half
   before finding a job as a sheet metal worker. Previously, the coborrower worked for
   about two months as a sales person in a department store preceded by a month of
   unemployment. Before the department store job, the coborrower worked for about 14
   months as an assistant manager at a restaurant. HUD’s system shows the default
   resulted from a curtailment of income. The default reason was consistent with the
   coborrower’s inconsistent employment history. Adjustment for the $1,343 resulted in
   a 59.80 percent debt-to-income ratio compared to the 44.24 percent Pine State
   calculated.

   Pine State said the verification of employment confirmed that overtime was likely to
   continue, and it took this to also mean that the borrower’s employment was likely to
   continue. Confirmation that overtime will continue is not the same as confirmation of
   continued employment. Pine State should have obtained a response from the
   employer concerning the borrower’s likelihood of continued employment.

   We noted two other issues associated with Pine State’s assessment of the borrower’s
   income, but we did not deduct the amounts when we adjusted the debt-to-income
   ratio.

       •   Pine State allowed $389 per month for the borrower’s overtime pay without
           documenting how it calculated the amount. When asked to explain the
           calculation, it provided a different $415 overtime figure and said the $389 was
           a conservative amount. The files should have contained support for the actual
           overtime amount Pine State used to approve the loan.


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                                           85
       •   Pine State included $1,504 in monthly income for another coborrower, but it
           did not confirm or document confirmation with the employer that the income
           was likely to continue. The borrower had been employed in the position for
           about 19 months.

HUD Requirements

Handbook 4155.1, REV 5, section 2, provides that anticipated amount of income and the
likelihood of its continuance must be established to determine a borrower’s capacity to
repay mortgage debt. Income may not be used in calculating the borrower’s income
ratios if it comes from any source that cannot be verified, is not stable, or will not
continue. Paragraph 2-7A states that overtime income may be used to qualify if the
borrower has received such income for the past two years and it is likely to continue. The
lender must develop an average of overtime income for the past two years, and the
employment verification must not state that such income is unlikely to continue. Periods
of less than two years may be acceptable, provided the lender justifies and documents in
writing the reason for using the income for qualifying purposes.

Credit Not Properly Assessed

Pine State’s credit analysis did not adequately consider the borrower’s consistent
disregard for child support obligations. The August 6, 2004, credit report showed the
borrower had accumulated $58,143 in delinquent child support payments. The file
contained an “order/notice to withhold income for support,” dated July 22, 2003. The
order required the borrower to pay $420 per month. The payment consisted of $150 for
current support and $270 for past due support or $210 biweekly. The loan closed on
August 13, 2004; thus, the order was not current. Pine State did not follow up or
document followup to determine whether the order had been modified before it approved
the loan.

Pine State officials stated they accepted the borrower’s explanation concerning credit
issues although it did not specifically address the child support. We considered the
borrower’s explanation to be inadequate.

Further, Pine State did not properly assess the borrower’s poor credit performance
evidenced by three other delinquent collection accounts. The credit report showed the
borrower owed $4,669 on the three accounts, but the creditors were willing to settle the
accounts for $2,427. Pine State required the borrower to pay off one of the collections as
a condition to the loan closing. However, in view of the delinquent accounts and the
delinquent child support payments, Pine State should have documented specific
compensating factors to support its processing and approval of the loan. Pine State
officials stated that HUD does not require collection accounts to be paid and considered
the borrower to be working to improve his credit and to honor his responsibilities. We
maintain that the borrower’s poor credit history warranted further assessment and
consideration, given the significant issues involved.

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                                            86
HUD Requirements

HUD Handbook 4155.1, REV-5, paragraph 2-3, states that past credit performance serves
as the most useful guide in determining a borrower’s attitude toward credit obligations
and predicting a borrower’s future actions. A borrower who has made payments on
previous and current obligations in a timely manner represents reduced risk. Conversely,
if the credit history, despite adequate income to support obligations, reflects continuous
slow payments, judgments, and delinquent accounts, strong compensating factors will be
necessary to approve the loan.




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                                           87
Case number:                           105-1769305
Loan purpose:                          Purchase
Underwriter type                       Automated underwritten
Date of loan closing:                  March 19, 2004
Insured amount:                        $147,175
Debt-to-income ratio:                  60.93 percent
Status:                                Default
Default reason:                        Curtailment of income

Debts Not Properly Assessed

Pine State’s loan file contained no evidence that it asked the borrower to explain a credit
inquiry that resulted in an additional $306 monthly debt. The borrower made the loan in
March 2004, the same month Pine State closed the borrower’s home loan. The credit
report showed the inquiry, dated December 17, 2003. The additional debt was for an auto
loan shown on a credit report Pine State obtained on February 20, 2005, during its quality
control review. However, Pine State’s quality control review did not detect the additional
debt. The borrower had a responsibility to report all credit obligations. However, Pine
State was required to ask the borrower to explain the reason for the inquiry and whether it
resulted in an additional debt. Thus, Pine State missed the opportunity to identify the
debt and to input the debt into its automated underwriting system for consideration in
determining the borrower’s eligibility. Adjustment for the debt and housing cost
(discussed below) resulted in a 60.93 percent debt-to-income ratio compared to the 47.34
percent rate Pine State calculated.

Pine State officials stated that they did not follow up on the inquiry because it occurred
more than 90 days before their loan approval. Pine State’s position was not consistent
with the requirement to follow up on inquiries that occurred within 90 days of the credit
report date.

HUD Requirements

HUD Handbook 4155.1, REV-5, paragraph 2-3B, states that inquiries shown on the credit
report within the last 90 days are to be considered when analyzing the borrower’s credit
worthiness.

Gift Not Properly verified

Pine State’s file contained no documentation that it verified a $4,395 gift paid to the
closing agent by a nonprofit donor. Thus, Pine State allowed the loan to close without
support that the closing agent received the nonprofit gift used to pay the borrower’s
required investment in the property. We discussed this matter with Pine State officials,
and they followed up and obtained the documents needed to confirm receipt of the gift.
However, their verification does not relieve Pine State of its responsibility to verify the
transfer of gift funds before loan closing.


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HUD Requirements

HUD Handbook 4155.1, REV-5, paragraph 2-10C, provides that if the gift funds are not
deposited to the borrower’s account before closing, the lender must obtain verification
that the closing agent received funds from the donor for the amount of the gift.

Other - Understated Liabilities (Housing Cost)

Pine State understated the borrower’s monthly housing cost by $59. We used the
amounts reflected on the HUD-1 settlement statement for housing costs. The $59 is the
net of a $72 understatement for taxes and an ($13) overstatement for insurance. The
understated amount contributed to the borrower’s high debt-to-income ratio. Pine State
also noted this condition during its quality control review.

HUD Requirement

Handbook 4155.1, REV 5, paragraph 2-11A, provides that in computing the debt-to-
income ratios, the lender must include the monthly housing expense and all other
additional recurring charges extending 10 months or more.




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                                           89
Case number:                         105-1741989
Loan purpose:                        Purchase
Underwriter type:                    Automated underwritten
Date of loan closing:                February 3, 2004
Insured amount:                      $178,690
Debt-to-income ratio:                55.43 percent
Status:                              Default
Default reason:                      Other – not specified


Income Not Properly Assessed

Pine State overstated the borrower’s monthly income by at least $907. The overstatement
included $627 for Social Security and $280 for commissions. Pine State

   •   Allowed $627 in Social Security pay without verifying the likelihood that the
       income would continue for the first three years of the loan. We contacted the
       Social Security Administration and determined that it terminated the payments in
       August 2005, 18 months after the loan closed. It terminated the payments
       because the borrower’s income exceeded the eligibility limit. In addition, Pine
       State did not document why it increased the $545 shown on the verification by 15
       percent to $627. The increase was not justified based on our reconfirmation of
       the payment.

   •   Overstated the borrower’s 2002 monthly commission income by $280 because it
       did not deduct $6,728 in expenses that offset commissions. In addition, Pine State
       overstated the borrower’s 2003 commission income by an undetermined amount
       due to its failure to document and deduct commission expenses.

Pine State agreed with our assessment that the income was overstated by at least $907.
Adjustment for overstatement and debts discussed below resulted in a 55.43 percent debt-
to-income ratio compared to the 46.34 percent rate Pine State calculated.

HUD Requirements

Handbook 4155.1, REV 5, section 2, provides that the anticipated amount of income, and
the likelihood of its continuance, must be established to determine a borrower’s capacity
to repay mortgage debt. Income may not be used in calculating the borrower’s income
ratios if it comes from any source that cannot be verified, is not stable, or will not
continue. Paragraph 2-7 provides that the income obligated for the mortgage debt must
be analyzed to determine whether it can reasonably be expected to continue through at
least the first three years of the mortgage loan. Paragraph 2-7D requires lenders to
subtract unreimbursed business expenses from gross income. The automated underwriter
findings report required Pine State to consider business expenses when underwriting the
loan.

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Debts Not Properly Assessed

Pine State’s loan file contained no evidence that it asked the borrower to explain a credit
inquiry that resulted in an additional $3,430 debt. The borrower made the loan in
November 2003. The credit report showed the inquiry, dated October 22, 2003. The
additional debt was shown on a credit report Pine State obtained on February 18, 2005,
during its quality control review. The credit report did not show the monthly payment
amount. The borrower had a responsibility to report all credit obligations. However,
Pine State was required to ask the borrower to explain the reason for the inquiry and
whether it resulted in or might result in an additional debt. The debt further contributed
to the borrower’s already high 59.47 percent debt-to-income ratio.

HUD Requirements

HUD Handbook 4155.1, REV-5, paragraph 2-3B, provides that the lender must
determine the purpose of any recent debts. The borrower must explain in writing all
inquiries shown on the credit report in the last 90 days. The automated underwriter
finding (17) required the lender to include new debt resulting from material inquiries
listed on the credit report.

Other - Outdated Income Verification

Pine State relied on an outdated February 20, 2002, verification for the borrower’s Social
Security income. The verification was more than 120 days old when the loan closed on
February 3, 2004.

HUD Requirements

Handbook 4155.1, REV 5, paragraph 3-1, provides that all documents may be up to 120
days old at the time the loan closes (180 days for new construction). Updated, written
verifications must be obtained when the age of the documents exceed these limits.




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                                            91
Case number:                          105-2020030
Loan purpose:                         Purchase
Underwriter type:                     Manually underwritten
Date of loan closing:                 July 30, 2004
Insured amount:                       $161,283
Debt-to-income ratio:                 58.28 percent
Status:                               Default
Default reason:                       Other – not specified


Income Overstated

Pine State overstated the borrower’s monthly income by $688. The overstatement
included $478 for employment and $210 for child support. Pine State

ƒ    Allowed $478 in monthly overtime pay that did not meet requirements. The borrower
     had been employed at the job for only 10 months before the loan closing. This was
     not long enough to demonstrate the two-year pattern generally required to justify
     including overtime as effective income. Also, Pine State did not verify that the
     overtime was likely to continue. The file did not contain a written explanation for
     including overtime earned for less than the required two-year period.

ƒ    Allowed $210 per month for child support without documenting the file to show that
     it identified and considered discrepancies associated with the payment. The file
     showed the borrower had three children. The file did not contain a copy of a final
     divorce decree, legal separation agreement, or voluntary payment agreement, setting
     forth the legal basis for the payments, payment amount, which was responsible for the
     payment, and for how long the payments would continue. The file contained a copy
     of a divorce decree that dissolved a prior marriage between the borrower and the
     father of two of the children. The divorce decree did not mention child custody or
     child support and the payments received were not from the borrower’s prior husband.
     The file did not identify the father of the third child and did not contain any
     documentation that stipulated an obligation for anyone to pay child support for the
     child. The underwriting findings requested evidence that the payments would
     continue for at least three years. The file contained no evidence that Pine State
     followed up to obtain the requested information.

     Further, for the period January 1, 2003, to May 17, 2004, the support payments varied
     from a low of $210 to a high of $441. The most recurring payments amounted to
     $280 and $210 (latest three payments), but several months had irregular highs of
     $350, $420, and $441. The file contained no evidence that Pine State attempted to
     identify why the payments fluctuated.


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                                            92
We adjusted the borrower’s income to omit the $688 and other amounts discussed below.
The adjustments resulted in a 58.28 percent debt-to-income ratio compared to the 40.61
percent rate Pine State calculated.

HUD Requirements

HUD Handbook 4155.1, REV-5, paragraph 2-7, provides that the income of each
borrower to be obligated for the mortgage debt must be analyzed to determine whether it
can reasonably be expected to continue through at least the first three years of the
mortgage loan. Paragraph 2-7A, provides that overtime income may be used to qualify if
the borrower has received such income for the past two years and it is likely to continue.
The lender must develop an average of overtime income for the past two years, and the
employment verification must not state that such income is unlikely to continue. Periods
of less than two years may be acceptable, provided the lender justifies and documents in
writing the reason for using the income for qualifying purposes.

Paragraph 2-7F discusses child support income. The handbook provides that income in
this category may be considered as effective if such payments are likely to be consistently
received for the first three years of the mortgage. The borrower must provide a copy of
the final divorce decree, legal separation agreement, or voluntary payment agreement, as
well as evidence that payments have been received during the last 12 months. Periods
less than 12 months may be acceptable, provided the payer’s ability and willingness to
make timely payments is adequately documented by the lender.

Credit Not Properly Assessed

Pine State did not properly assess or document its assessment of the borrower’s poor
credit performance following a release from a bankruptcy on May 29, 2001. Between
January and June 2001, the borrower opened three accounts that were $1,556 delinquent
when Pine State pulled its credit report. The delinquencies consisted of accounts with
balances of $932, $334, and $290. Pine State required the borrower to pay off the
accounts as a condition to its approval of the loan. The HUD-1 settlement statement
showed the amounts were paid. However, the files did not document compensating
factors Pine State considered to offset the borrower’s poor credit performance.

HUD Requirements

HUD Handbook 4155.1, REV-5, paragraph 2-3, states that past credit performance serves
as the most useful guide in determining a borrower’s attitude toward credit obligation and
predicting a borrower’s future actions. It further states that if the credit history, despite
adequate income to support obligations, reflects continuous slow payments, judgments,
and delinquent accounts, strong compensating factors will be necessary to approve the
loan.



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                                             93
Other - Understated Liabilities (Housing Cost)

Pine State understated the borrower’s monthly housing cost by $88. We used the
amounts reflected on the HUD-1 settlement statement for housing costs. The
understatement includes $50 for taxes and $38 for insurance. Adjustment for the
understatement contributed to the borrower’s high 58.28 percent debt-to-income ratio.
Pine State also noted this condition during its quality control review.

HUD Requirement

HUD Handbook 4155.1, REV-5, paragraph 2-11A, provides that lenders must include the
monthly housing expense and all other additional recurring charges extending 10 months
or more.




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                                           94
Case number:                         105-1587099
Loan purpose:                        Purchase
Underwriter type:                    Automated underwritten
Date of loan closing:                October 20, 2003
Insured amount:                      $179,200
Debt-to-income ratio:                54.14 percent
Status:                              Default
Default reason:                      Other


Interest Rate Buydown Not Properly Assessed

Pine State did not make or document the required determinations needed to justify the use
of an interest rate buydown to qualify the borrower for the loan. The file did not show or
document that Pine State assessed the buydown to assure that the eventual increased
mortgage payments would not adversely affect the borrower and likely lead to default.
We reviewed the file and determined that the borrower did not meet at least one of the
four buydown criteria. Thus, Pine State inappropriately used the $935 monthly bought
down mortgage amount rather than the full $1,162 payment to qualify the borrower.
Adjustment for the buydown and the other issues discussed below resulted in a 54.14
percent debt-to-income ratio compared to the 46.97 percent ratio Pine State calculated.

HUD Requirements

HUD Handbook 4155.1, REV 4, paragraph 2-14B(2), provides that the lender must
establish that the eventual increase in mortgage payments will not affect the borrower
adversely and likely lead to default. The underwriter must document that the borrower
meets one of four criteria that require borrowers to have (a) potential for increased
income that would offset the scheduled payment increases, (b) demonstrated ability to
manage financial obligations in such a way that a greater portion of income may be
devoted to housing expenses, (c) substantial assets available to cushion the effect of the
increased payments, or (d) cash investment made that substantially exceeds the minimum
required.

Pine State officials stated that the borrower and coborrowers had the potential for
increased earnings to offset the buydown amount. The files did not support Pine State’s
position. The first monthly buydown increment amounted to $111. The file showed the
coborrower was to receive a $37 per month raise. The raise was $74 less than the amount
needed to offset the buydown. The borrower was to receive an unspecified raise within
two months of closing. The borrower’s prior raise amounted to 10 cents per hour. The
file and the borrower’s past pay increase provided no grounds to anticipate that the next
raise would amount to the 45 cents per hour needed to offset the $74 balance of the
buydown increment. Pine State also stated the coborrower earned overtime that was not
counted as effective income. We did not recognize the overtime because the file did not
contain documents needed to determine overtime pay for the required two-year period.
The overtime paid during the past seven and a half months totaled only $284.


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Debts Not Properly Assessed

Pine State’s loan file contained no evidence that it asked the borrower to explain a credit
inquiry that resulted in an additional $39 monthly debt. The borrower made the loan in
August 2003, and Pine State closed the borrower’s home loan on October 20, 2003. The
credit report showed the inquiry, dated August 17, 2003. The additional $1,634 debt was
shown on the credit report Pine State obtained on October 9, 2005, during its quality
control review. The borrower had a responsibility to report all credit obligations.
However, Pine State was required to ask the borrower to explain the reason for the
inquiry and whether it resulted in an additional debt. The debt contributed to the
borrower’s high 54.14 percent debt-to-income ratio.

HUD Requirements

HUD Handbook 4155.1, REV-4, paragraph 2-3B, provides that the borrower must
explain all inquiries shown on the credit report. Paragraph 2-11A requires the lender to
consider all recurring obligations extending 10 months or more. The automated
underwriter findings report required the lender to include all new debt payments resulting
from material inquiries listed on the credit report.

Gift Not Properly Verified

Pine State’s file contained no documentation that it verified receipt of a $5,482 gift paid
to the closing agent by a nonprofit donor. Thus, Pine State allowed the loan to close
without verifying that the closing agent received the nonprofit gift used to pay the
borrower’s required investment in the property. Pine State also noted this condition
during its quality control review of the loan. We discussed this matter with Pine State
officials, and they followed up and obtained the documents needed to confirm receipt of
the gift.

HUD Requirements

HUD Handbook 4155.1, REV-4, paragraph 2-10C, provides that if the gift funds are not
deposited to the borrower’s account before closing, the lender must obtain verification
that the closing agent received funds from the donor for the amount of the gift.

Other - Understated Liabilities (Housing Cost)

Pine State understated the borrower’s monthly housing insurance cost by $26. We used
the insurance amount reflected on the HUD-1 settlement statement. The understatement
contributed to the borrower’s high 54.14 percent debt-to-income ratio.




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                                             96
HUD Requirement

Handbook 4155.1, REV 4, paragraph 2-11A, provides that in computing the debt-to-
income ratios, the lender must include the monthly housing expense and all other
additional recurring charges extending 10 months or more.




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                                         97
Case number:                                 105-1524517
Loan purpose:                                Purchase
Underwriter type:                            Automated underwritten
Date of loan closing:                        November 7, 2003
Insured amount:                              135,600
Debt-to-income ratio:                        53.42 percent
Status:                                      Default
Default reason:                              Excessive obligations


Debts Not Properly Assessed

Pine State’s loan file contained no evidence that it asked the borrower to explain a credit
inquiry that resulted in an additional $211 monthly debt. The borrower made the loan in
October 2003, and Pine State closed the borrower’s home loan on November 7, 2003.
The credit report showed the inquiry, dated September 30, 2003. The additional $6,174
debt was shown on a credit report Pine State obtained on July 29, 2005, during its quality
control review. The borrower had a responsibility to report all credit obligations.
However, Pine State was required to ask the borrower to explain the reason for the
inquiry and whether it resulted in an additional debt. Thus, Pine State missed the
opportunity to identify the debt and enter it into its automated underwriting system for
consideration in determining the borrower’s eligibility. Pine State’s quality control
review also identified the new debt. Adjustments for the debt resulted in a 53.42 4 percent
debt-to-income ratio compared to the 47.36 percent rate Pine State calculated.

Pine State officials stated that they did not follow up on the credit inquiry because they
did not think they were required to do so based on wording contained in the automated
underwriting finding report. We reviewed the wording and determined that it intended
for Pine State to follow up on the inquiry.

HUD Requirements

HUD Handbook 4155.1, REV-4, paragraph 2-3B, provides that the borrower must
explain all inquiries shown on the credit report. Paragraph 2-11A requires the lender to
consider all recurring obligations extending 10 months or more. Also, debts lasting less
than 10 months must be counted if the amount of the debt affects the borrower’s ability to
make the mortgage payment during the months immediately after the loan closing. The
Fannie Mae underwriter findings report required the lender to include all new debt
payments resulting from material inquiries listed on the report in the debt ratios.




4
    Pine State overstated the borrower’s monthly housing cost by $57. We made an adjustment for the
    overstatement when we recalculated the debt-to-income ratio.

                                                    98
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Gift Not Properly Verified

Pine State’s file contained no documentation that it verified receipt of a $4,100 gift paid
to the closing agent by a nonprofit donor. Thus, Pine State allowed the loan to close
without confirming that the closing agent received the nonprofit gift used to pay the
borrower’s required investment in the property. Pine State obtained a copy of the wire
transfer during the course of our audit. However, the later verification does not relieve
Pine State of its responsibility to verify the transfer of gift funds before loan closing.

HUD Requirements

HUD Handbook 4155.1, REV-4, paragraph 2-10C, requires that if the gift funds are not
deposited to the borrower’s account before closing, the lender must obtain verification
that the closing agent received funds from the donor for the amount of the gift.




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                                             99
Case number:                         105-1531395
Loan purpose:                        Purchase
Underwriter type:                    Manually underwritten
Date of loan closing:                November 21, 2003
Insured amount:                      $142,950
Debt-to-income ratio:                45.25 percent
Status:                              Partial reinstatement
Default reason:                      Excessive obligations


Credit Not Properly Assessed

Pine State did not properly assess or document its assessment to justify why it approved
the loan despite the borrower’s poor credit. The automated underwriting finding report
referred the loan for manual underwriting because the loan exceeded the risk threshold
for automated approval. The credit report showed that the borrower had serious
delinquencies and derogatory public records or collections and that the length of time
since derogatory public records or collection was too recent or unknown. Pine State did
not properly assess or document its assessment of

   •   The borrower’s collection accounts and a judgment. The credit report showed
       five collection accounts that totaled $2,467 and one $4,652 judgment that had
       been satisfied. The collection accounts each occurred within 8 to 19 months of
       the loan closing, and the judgment was within 11 months of closing. The file did
       not contain a written explanation for the judgment. Further, in some instances,
       the borrower’s written explanation for the collections did not make sense. For
       instance, the borrower stated that most of the collections occurred before
       obtaining stable employment and salary increases. The credit report showed the
       judgment and four of the collection accounts occurred after July 2002. This was
       after the borrower started work for the employer in 2001 and established a stable
       earning pattern. The file showed three 2002 collections (one each in August,
       November, and December) resulted from insufficient fund checks. The
       insufficient fund checks were not consistent with the borrower’s generalized
       explanation for the collection accounts. The file contained no evidence that Pine
       State questioned the inconsistencies and the missing explanation for the judgment.

   •   The reason for a 60-day delinquency shown on the credit report for an auto loan.

   •   The borrower’s explanation for 16 credit inquiries (none mortgage lender related)
       within three months of loan closing. The borrower’s letter of explanation stated,
       “I have not opened any new accounts.” Pine State could not locate and produce
       the credit report it was supposed to obtain for the borrower to assess why the loan
       defaulted with fewer than six payments. Thus, we did not determine whether the
       inquiries resulted in additional debts. HUD’s system showed the borrower
       defaulted due to excessive obligations.



Table of Contents                          100
HUD Requirements

HUD Handbook 4155.1, REV-4, paragraphs 2-3 and 2-3B, states that past credit
performance serves as the most useful guide in determining a borrower’s attitude toward
credit obligations. If the credit history reflects continuous slow payments, judgments,
and delinquent accounts, strong offsetting factors will be necessary to approve the loan.
When delinquent accounts are revealed, the lender must determine whether the late
payments were due to a disregard for or an inability to manage financial obligations or
other factors beyond the borrower’s control. While minor derogatory information
occurring two or more years in the past does not require explanation, major indications of
derogatory credit, including judgments and collections, require written explanations. The
explanations must make sense and be consistent with other credit information in the file.
Paragraph 2-3B provides that the borrower must explain all inquiries shown on the credit
report.

Gift Not Properly Verified

Pine State’s file contained no documentation that it verified receipt of a $4,293 gift paid
at closing by a nonprofit donor. Thus, Pine State allowed the loan to close without
support that the closing agent received the nonprofit gift used to pay the borrower’s
required investment in the property. Pine State obtained a copy of the wire transfer
during the course of our audit. However, their later verification does not relieve Pine
State of its responsibility to verify the transfer of gift funds before loan closing. Pine
State also noted this issue during its quality control review of the loan.

HUD Requirements

HUD Handbook 4155.1, REV-4, paragraph 2-10C, requires that if the gift funds are not
deposited to the borrower’s account before closing, the lender must obtain verification
that the closing agent received funds from the donor for the amount of the gift.

Other - Understated Liabilities (Housing Cost)

Pine State understated the borrower’s monthly housing cost by $40. We used the
amounts reflected on the HUD-1 settlement statement for housing costs. The
understatement consists of $24 for taxes and $16 for insurance. Adjustment for the
understatement increased the borrower’s debt-to-income ratio from 44.19 to 45.25
percent.

HUD Requirement

Handbook 4155.1, REV-4, paragraph 2-11A, provides that the lender must include the
monthly housing expense and all other additional recurring charges extending 10 months
or more.


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                                            101
Case number:                          105-1817383
Loan purpose:                         Purchase
Underwriter type                      Manually underwritten
Date of loan closing:                 March 31, 2004
Insured amount:                       $146,007
Debt-to-income ratio:                 34.43 percent
Status:                               Default
Default reason:                       Excessive obligations


Inappropriate Quitclaim

Pine State submitted the loan for insurance endorsement knowing that the coborrower
had inappropriately transferred by quitclaim deed an interest in the property to his wife.
The borrower’s wife was not listed on the loan application, and Pine State did not identify
and assess the wife’s income and credit. Pine State’s representatives stated they did not
learn of the quitclaim until after they received the closing documents from the closing
attorney. Pine State either knew or should have known about the transfer before it
submitted the loan to HUD for endorsement. The loan closed on March 31, 2004. Pine
State successfully completed the insurance application on May 3, 2004. It was required
to resolve all problems regarding title to the real estate and to ensure that the loan closed
in the same manner in which it was underwritten and approved. Pine State did not
include the quitclaim in the documents sent to HUD for the Federal Housing
Administration case file. HUD’s system showed the borrower defaulted due to excessive
obligations.

HUD Requirements

HUD Handbook 4155.1, REV-5, paragraph 3-10 (lender responsibility at closing),
provides that the lender is required to resolve all problems regarding title to the real
estate. The loan must close in the same manner in which it was underwritten and
approved. Additional signatures on the security instruments and/or mortgage note of
individuals not reviewed during mortgage credit analysis may be grounds for withholding
endorsement. Paragraph 2-2A states that HUD does not permit an individual to take an
ownership interest in the property at settlement without signing the mortgage note and all
security instruments.

Other - Understated Liabilities (Housing Cost)

Pine State understated the borrower’s monthly housing cost by $58. We used the
amounts reflected on the HUD-1 settlement statement as the correct statement of the
borrower’s housing costs. The $58 is the sum of a $47 understatement for taxes and an
$11 understatement for insurance. Pine State also noted this condition during its quality
control review. Adjustment for the understatement increased the debt-to-income ratio
from 32.68 to 34.43 percent.


Table of Contents                           102
HUD Requirement

Handbook 4155.1, REV 5, paragraph 2-11A, provides that the lender must include the
monthly housing expense and all other additional recurring charges extending 10 months
or more.




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                                         103
Case number:                           105-1728585
Loan purpose:                          Purchase
Underwriter type:                      Manually underwritten
Date of loan closing:                  January 15, 2004
Insured amount:                        $167,322
Debt-to-income ratio:                  44.51 percent
Status:                                Default
Default reason:                        Excessive obligations

Inappropriate Quitclaim

Pine State submitted the loan for insurance endorsement knowing that both coborrowers
had inappropriately quitclaimed their interest in the property to the borrower and her
husband. The coborrowers were the borrower’s mother and father. The borrower’s
husband was not listed on the loan application, and Pine State did not identify and assess
the husband’s income and credit. Pine State’s representatives stated they did not learn of
the quitclaim until after they received the closing documents from the closing attorney.
Pine State either knew or should have known about the transfer before it submitted the
loan to HUD for endorsement. The loan closed on January 15, 2004. Pine State
successfully completed the insurance application on February 10, 2004. It was required
to resolve all problems regarding title to the real estate and to ensure that the loan closed
in the same manner in which it was underwritten and approved. Pine State did not
include the quitclaim in the documents sent to HUD for the Federal Housing
Administration case file.

HUD Requirements

HUD Handbook 4155.1, REV-5, paragraph 3-10 (lender responsibility at closing),
provides that the lender is required to resolve all problems regarding title to the real
estate. The loan must close in the same manner in which it was underwritten and
approved. Additional signatures on the security instruments and/or mortgage note of
individuals not reviewed during mortgage credit analysis may be grounds for withholding
endorsement. Paragraph 2-2A states that HUD does not permit an individual to take an
ownership interest in the property at settlement without signing the mortgage note and all
security instruments.

Debts Not Properly Assessed

Pine State understated the borrower’s monthly debts by $680 because it either omitted
debts shown on credit reports or did not use the payment terms shown on the most recent
credit reports. Pine State officials reviewed our calculations and said we double counted
one debt with a $127 monthly payment. The credit report showed two $127 monthly
payments to the same creditor for different accounts. We also observed that the credit
report indicated the borrowers had experienced some credit problems. For instance, Pine
State required the borrower to pay $1,794 for a delinquent account and a judgment as a


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condition to its approval of the loan. Adjustments for the understated debts and income
(discussed below) resulted in a 44.51 percent back ratio compared to the 34.93 percent
ratio Pine State calculated. HUD’s system showed the loan went into default due to
excessive obligations.

HUD Requirements

HUD Handbook 4155.1, REV-5, paragraph 2-11A, requires the lender to consider all
recurring obligations extending 10 months or more. Paragraph 2-3 states that past credit
performance serves as the most useful guide in determining a borrower’s attitude toward
credit obligations and predicting a borrower’s future actions. A borrower who has made
payments on previous and current obligations in a timely manner represents reduced risk.
Conversely, if the credit history, despite adequate income to support obligations, reflects
continuous slow payments, judgments, and delinquent accounts, strong compensating
factors will be necessary to approve the loan.

Income Discrepancy

Pine State did not include $804 in monthly retirement income for a coborrower. We did
not add the amount because the coborrower transferred her interest in the property at
closing.

HUD Requirement

HUD Handbook 4155.1, REV-5, paragraph 2-7, provides that the income of each
borrower to be obligated for the mortgage debt must be analyzed to determine whether it
can reasonably be expected to continue through at least the first three years of the
mortgage loan. If the borrower intends to retire during this period, the effective income
must be the amount of documented retirement benefits payments expected to be received
in retirement.

Gift Not Properly verified

Pine State’s file contained no documentation that it verified a $5,060 gift paid to the
closing agent by a nonprofit donor. Thus, Pine State allowed the loan to close without
support that the closing agent received the nonprofit gift used to pay the borrower’s
required investment in the property. Pine State obtained a copy of the wire transfer
during its quality control review of the loan. However, their later verification does not
relieve Pine State of its responsibility to verify the transfer of gift funds before loan
closing.

HUD Requirements

HUD Handbook 4155.1, REV-5, paragraph 2-10C, provides that the lender must
document the transfer of the funds from the donor to the borrower. If the funds are not

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deposited to the borrower’s account before closing, the lender must obtain verification
that the closing agent received funds from the donor for the amount of the gift.




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Case number:                         105-1548492
Loan purpose:                        Purchase
Underwriter type:                    Manually underwritten
Date of loan closing:                November 21, 2003
Insured amount:                      $162,300
Debt-to-income ratio:                Unknown
Status:                              Default
Default reason:                      Other


Unsupported Income

Pine State underwrote the loan with no support for how it calculated and verified the
borrower’s effective income. The file showed the borrower worked as a contractor and
as an employee for different clients or employers at different times. The current
employment verification showed the borrower had been employed as a contract worker
for 10 weeks before loan closing and that the borrower’s continued employment
depended on the availability of assignments. Pine State could not support the effective
income it used to approve the loan. In response to our request for support, Pine State
provided a different and lower effective income that used an unsupported 25 percent
factor to estimate the borrower’s business expense deductions. The recalculation resulted
in a 45.21 percent debt-to-income ratio compared to the 39.59 percent Pine State used to
approve the loan.

Pine State should have required the borrower to provide documentation of actual business
expenses incurred for determination of effective income. The borrower’s 2002 federal
tax return showed business expenses amounted to 66 percent of gross contract revenue.
The 66 percent factor is substantially higher than the unsupported 25 percent factor Pine
State used. The 66 percent factor would result in a 60.30 percent debt-to-income ratio
compared to the 45.21 percent ratio Pine State calculated. However, the determination of
effective income should not involve assumption. HUD does not allow income from any
source that cannot be verified or will not continue. Thus, the borrower’s actual debt-to-
income ratio is not known. Pine State’s quality control review also identified a problem
with the borrower’s income.

HUD Requirement

Handbook 4155.1, REV-4, CHG-1, section 2, provides that the anticipated amount of
income and likelihood of its continuance must be established to determine the borrower's
capacity to repay the mortgage debt. Income from any source that cannot be verified, is
not stable, or will not continue may not be used in calculating the borrower’s income
ratios. Paragraph 2-6 requires lenders to analyze and document the probability of
continued employment and states that lenders must examine the borrower’s past
employment and the employer’s confirmation of continued employment. Paragraph 2-7
provides that the income obligated for the mortgage debt must be analyzed to determine

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whether it can reasonably be expected to continue through at least the first three years of
the mortgage loan. Paragraph 2-9C discusses employee business expenses and requires
determination of actual cash expenses that must be deducted from the borrower’s
adjusted income.

Gift Not Properly Verified

Pine State's file contained no documentation that it verified receipt of a $4,909 gift paid
at closing by a nonprofit donor. Thus, Pine State allowed the loan to close without
support that the closing agent received the nonprofit gift used to pay the borrower’s
required investment in the property. The HUD-1 settlement statement showed the gift
was paid. At our request, Pine State obtained a copy of the wire transfer. However, the
later verification does not relieve Pine State of its responsibility to verify the transfer of
gift funds before loan closing. The missing documentation was required to provide
assurance that the gift was paid by the nonprofit organization and not by some other
interested party to the loan transaction.

HUD Requirements

HUD Handbook 4155.1, REV-4, paragraph 2-10C, requires that if the gift funds are not
deposited to the borrower’s account before closing, the lender must obtain verification
that the closing agent received funds from the donor for the amount of the gift.




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