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 Table of Contents 2 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. Table of Contents 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. Table of Contents 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. Table of Contents 6 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 Table of Contents 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. Table of Contents 8 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 Table of Contents 9 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. Table of Contents 10 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. Table of Contents 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. Table of Contents 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 Table of Contents 13 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. Table of Contents 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 Table of Contents 15 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. Table of Contents 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 Table of Contents 17 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- Table of Contents 18 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 Table of Contents 19 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. Table of Contents 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. Table of Contents 21 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. Table of Contents 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. Table of Contents 23 Appendix B AUDITEE COMMENTS AND OIG’S EVALUATION Ref to OIG Evaluation Auditee Comments Table of Contents 24 Table of Contents 25 OIG Evaluation of Auditee Comments Comment 1 Table of Contents 26 Comment 2 Comment 3 Table of Contents 27 Comment 4 Comment 4 Comment 4 Table of Contents 28 Comment 4 Comment 5 Table of Contents 29 Comment 5 Comment 5 Comment 6 Comment 7 Table of Contents 30 Comment 8 Comment 6 Comment 9 Table of Contents 31 Comment 9 Comment 10 Comment 10 Table of Contents 32 Comment 10 Comment 11 Comment 10 Table of Contents 33 Comment 12 Comment 13 Table of Contents 34 Comment 13 Comment 12 Table of Contents 35 Comment 12 Comment 14 Comment 12 Comment 6 Table of Contents 36 Comment 12 Comment 16 Comment 16 Comment 15 Table of Contents 37 Comment 16 Comment 16 Comment 16 Table of Contents 38 Comment 16 Comment 16 Comment 16 Comment 16 Table of Contents 39 Comment 16 Comment 16 Comment 16 Comment 16 Table of Contents 40 Comment 16 Comment 16 Comment 16 Table of Contents 41 Comment 16 Comment 16 Comment 16 Table of Contents 42 Comment 16 Comment 16 Comment 16 Comment 16 Table of Contents 43 Comment 16 Comment 16 Comment 16 Comment 17 Table of Contents 44 Comment 17 Comment 16 Comment 18 OIG Evaluation of Auditee Comments Comment 16 Comment 16 Comment 18 Comment 18 Table of Contents 45 Comment 16 Comment 16 Comment 16 Table of Contents 46 Comment 16 Comment 16 Comment 16 Comment 18 Table of Contents 47 Comment 16 Comment 19 Table of Contents 48 Comment 16 Comment 19 Comment 16 Table of Contents 49 Comment 16 Comment 18 Comment 16 Comment 16 Comment 16 Table of Contents 50 Comment 16 Comment 18 Comment 20 Comment 20 Comment 20 Table of Contents 51 Comment 20 Comment 20 Table of Contents 52 Comment 20 Comment 16 Comment 16 Table of Contents 53 Comment 16 Comment 16 Comment 16 Comment 18 Comment 21 Table of Contents 54 Comment 21 Comment 21 Comment 21 Table of Contents 55 Comment 16 Comment 2 Comment 22 Comment 21 Comment 22 Comment 21 Table of Contents 56 Comment 21 Comment 23 Comment 23 Comment 23 Table of Contents 57 Comment 23 Comment 23 Comment 23 Comment 23 Table of Contents 58 Comment 23 Comment 23 Comment 23 Table of Contents 59 Comment 23 Comment 23 Comment 24 Comment 24 Table of Contents 60 Comment 24 Comment 24 Comment 23 Comment 25 Comment 24 Comment 25 Table of Contents 61 Comment 23 Comment 23 Table of Contents 62 S AND OIG’S EVALUATION Comment 23 Comment 26 Table of Contents 63 S AND OIG’S EVALUATION Comment 26 Comment 16 Comment 27 Comment 27 Table of Contents 64 S AND OIG’S EVALUATION Comment 27 Comment 27 Comment 28 Comment 16 Comment 16 Comment 2 Comment 2 Comment 16 Table of Contents 65 S AND OIG’S EVALUATION Comment 16 Table of Contents 66 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 Table of Contents 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 Table of Contents 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 Table of Contents 69 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 Table of Contents 70 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 Table of Contents 71 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 Table of Contents 72 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. Table of Contents 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. Table of Contents 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. Table of Contents 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 Table of Contents 76 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 Table of Contents 77 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 Table of Contents 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. Table of Contents 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. Table of Contents 80 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. Table of Contents 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 Table of Contents 82 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. Table of Contents 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. Table of Contents 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. Table of Contents 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. Table of Contents 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. Table of Contents 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. Table of Contents 88 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. Table of Contents 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. Table of Contents 90 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. Table of Contents 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 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. 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. Table of Contents 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. Table of Contents 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. Table of Contents 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. Table of Contents 95 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. Table of Contents 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. Table of Contents 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 Table of Contents 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. Table of Contents 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. Table of Contents 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. Table of Contents 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 Table of Contents 104 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 Table of Contents 105 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. Table of Contents 106 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 Table of Contents 107 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. Table of Contents 108
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)