oversight

First Magnus Financial Corporation Did Not Comply with HUD Guidelines When Operating and Managing Net Branches

Published by the Department of Housing and Urban Development, Office of Inspector General on 2006-12-12.

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

                                                               Issue Date
                                                                     December 12, 2006
                                                               Audit Report Number
                                                                     2007-LA-1002




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




FROM:      Joan S. Hobbs, Regional Inspector General for Audit, Region IX, 9DGA

SUBJECT: First Magnus Financial Corporation Did Not Comply with HUD Guidelines
         When Operating and Managing Net Branches


                                   HIGHLIGHTS

 What We Audited and Why

             We audited First Magnus Financial Corporation’s (First Magnus) branch office
             operations, primarily the branch doing business as Great Southwest Mortgage,
             located at 17015 North Scottsdale Road, Suite 325, Scottsdale, Arizona. The
             objective of the audit was to determine whether First Magnus operated its net
             branches in accordance with U.S. Department of Housing and Urban
             Development (HUD) requirements.

 What We Found


             First Magnus did not follow HUD requirements when operating and managing its
             Great Southwest Mortgage “net branches.” It violated HUD requirements by
             allowing officers to enact noncompete clauses, requiring net branch managers to
             indemnify branch-related losses, allowing nonexclusive employment, and failing
             to execute office lease agreements and equipment lease agreements in First
             Magnus’ name. These arrangements resulted in the branch offices operating
             without the close supervisory control and oversight HUD requires lenders to
             maintain over their branch offices.
What We Recommend


           We recommend that the assistant secretary for housing take appropriate
           administrative action regarding First Magnus. This action should include
           imposing civil money penalties for operating its net branches outside HUD
           requirements.

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

Auditee’s Response


           We provided the draft report to First Magnus on November 9, 2006, and held an
           exit conference on December 6, 2006. First Magnus generally disagreed with our
           report. The complete text of the auditee’s response, along with our evaluation of
           that response, can be found in appendix A of this report.




                                            2
                          TABLE OF CONTENTS


Background and Objective                                                       4

Results of Audit
      Finding 1: First Magnus Did Not Follow HUD Requirements When Operating   5
                 and Managing Its Great Southwest Mortgage “Net Branches”

Scope and Methodology                                                          11

Internal Controls                                                              12

Appendixes
   A. Auditee Comments and OIG’s Evaluation                                    13




                                          3
                      BACKGROUND AND OBJECTIVE

Background

First Magnus Financial Corporation (First Magnus) is a direct endorsement lender that was
incorporated and approved by the U.S. Department of Housing and Urban Development (HUD)
as a nonsupervised lender in 1996. Its corporate office is located in Tucson, Arizona. As of
October 24, 2006, First Magnus had 343 active branch offices and sponsored 2,175 Federal
Housing Administration-approved loan correspondents. As a direct endorsement lender, First
Magnus underwrites and funds loans that it and its branches originate and loans received by its
loan correspondents and other brokers.

We reviewed the First Magnus branch office doing business as Great Southwest Mortgage,
located at 17015 North Scottsdale Road, Suite 325, Scottsdale, Arizona. The Great Southwest
Mortgage branch office had been approved to originate and process Federal Housing
Administration loans since May 22, 2000. Based on data from HUD’s database system, the
Scottsdale, Arizona, branch office originated 1,220 Federal Housing Administration-insured
loans totaling more than $157 million between January 1, 2003, and September 30, 2006. The
chart below shows the current status of those loans.

         Description                Number                Percentage           Amount
       Loans originated              1,220                  100.0            $157,411,177
       Defaults reported              54                      4.4             $7,067,482
        Loans to claim                 11                     0.9             $1,422,913

Objective

Our objective was to determine whether First Magnus operated its net branches in accordance
with HUD requirements.




                                               4
                                    RESULTS OF AUDIT

Finding 1: First Magnus Did Not Follow HUD Requirements When
Operating and Managing Its Great Southwest Mortgage “Net Branches”
First Magnus did not comply with HUD rules, regulations, procedures, and instructions in operating
and managing its Great Southwest Mortgage net branches. It violated HUD requirements by
allowing officers to enact noncompete clauses, requiring net branch managers to indemnify branch-
related losses, allowing nonexclusive employment, and failing to execute office lease agreements
and equipment lease agreements in First Magnus’ name. Such arrangements create prohibited net
branches in violation of requirements set out in HUD Handbook 4060.1, REV-1, Mortgagee
Approval Handbook, and Mortgagee Letter 2000-151. As a result of this noncompliance, HUD’s
insurance funds and the public are exposed to an increased risk because First Magnus did not
provide close supervisory control of all of its branch offices and employees as required by HUD.


First Magnus operates its net branches under written net branch agreements. A review of the net
branch agreements (dated September 1999 and October 2004), relating to the operations of the
principal First Magnus net branch doing business as Great Soutwest Mortgage (located at 17015
North Scottsdale Road, Suite 325, Scottsdale, Arizona), identified the following provisions that
do net meet HUD requirements for bona fide branch office operations (Note: First Magnus’ net
branch agreements for its other Great Southwest Mortgage branches contain provisions similar to
those discussed below, and, accordingly, these other branch office agreements also violate HUD
requirements).

    First Magnus Allowed
    Officers to Enact
    Noncompete Clauses

                Both the September 1999 and October 2004 net branch agreements included
                noncompete clauses that allowed officers of Great Southwest Mortgage branch
                operations to dictate the growth of First Magnus in Maricopa County, Arizona.
                Although the September 1999 agreement resulted in the dissolution of Great
                Southwest Mortgage Corporation and the establishment of a Great Southwest
                Mortgage division within First Magnus, the officers of the Great Southwest
                Mortgage division had almost complete control over how First Magnus conducted
                its operations in Maricopa County. Both agreements allowed First Magnus to
                develop additional retail lending-related business ventures and relationships in
                Maricopa County but only with the consent of the Great Southwest Mortgage
                officers. If the officers consented and participated in the organization,
                management, and operation of such entities, First Magnus and the officers would

1
  HUD Handbook 4060.1, REV-1, CHG-1 and Mortgagee Letter 2000-15 were cancelled and replaced by HUD
Handbook 4060.1, REV-2 dated August 14, 2006. However, this revision resulted in no material changes with
regard to branch requirements that affected this finding.


                                                      5
           divide any profits generated by these new entities. The agreements allowed the
           Great Southwest Mortgage officers to exclusively control First Magnus’ ability to
           expand its business within Maricopa County, Arizona, which includes the
           Phoenix metropolitan area. In accordance with these agreements, First Magnus
           could not expand its business in Maricopa County without consent from the Great
           Southwest Mortgage officers. These arrangements, in which the employees, not
           the employer, dictate business expansion, raise concerns as to whether First
           Magnus has appropriate oversight and control over its net branches. In addition,
           this practice gives the appearance that Great Southwest Mortgage net branches
           operate as independent entities using First Magnus’ Federal Housing
           Administration-approved lender identification number solely as a means to
           originate and process Federal Housing Administration loans. This type of
           arrangement violates HUD requirements (see footnote 1), which does not allow a
           separate/independent entity to originate loans using a HUD-approved lender’s
           identification number.

First Magnus Required
the Indemnification of
Branch-Related Losses

           The October 2004 agreement contained provisions holding the Great Southwest
           Mortgage officers responsible for many of the legal penalties and loan losses
           resulting from net branch operations. For example, the agreement states
           “…FMFC [First Magnus] and Employees [Great Southwest Mortgage officers]
           agree that all loan losses, claims, lawsuits and settlements shall be allocated
           between FMFC and Employees by mutual agreement on a case by case basis. In
           such event that FMFC and Employees are unable to agree to the allocation of such
           loan losses, claims, lawsuits and settlements, then such items shall be allocated
           equally between the parties.” This provision shifts responsibility to the net branch
           managers/Great Southwest Mortgage officers and is not consistent with the
           supervision, control, and responsibility that a lender would have over a traditional
           branch office. HUD requirements (see footnote 1) consider “employment”
           agreement provisions in which branches are required to indemnify approved
           lenders for losses as violations of HUD branch requirements.

First Magnus Allowed
Nonexclusive
Employment

           The September 1999 and October 2004 net branch agreements allowed Great
           Southwest Mortgage officers to operate other business ventures in addition to
           their employment with First Magnus in violation of HUD requirements (see
           footnote 1).




                                            6
The September 1999 agreement, section H, Covenant Not to Compete, did not
allow the Great Southwest Mortgage officers to “directly or indirectly” provide
services to “any business, including, but not limited to mortgage broker or
mortgage banking business which is competing, directly or indirectly...” with First
Magnus. However, an additional condition was added to the agreement to allow
the officers “to conduct mortgage related seminars (for-profit) through-out the
United States. Employer [First Magnus] agrees that ‘the seminars’ would not be
in violation of the not to compete agreement.” This condition contradicted the
prior agreement and allowed Great Southwest Mortgage officers to conduct
outside for-profit businesses that could compete with First Magnus. Also, the
condition allowed the officers to operate outside businesses while employed as
full-time employees of First Magnus. The October 2004 net branch agreement
did not include a noncompete clause or conditions similar to the September 1999
net branch agreement.

The Great Southwest Mortgage officers took advantage of these agreements to
operate limited liability companies that provided various services, including but
not limited to recruiting loan officers for mortgage companies, office equipment
and office space leasing, and mortgage industry training. First Magnus used these
services and paid the Great Southwest Mortgage officers (through the officers’
limited liability companies) more than $5.4 million for the services during the
period January 1, 2003, to December 31, 2005. In addition to the payments to the
Great Southwest Mortgage employees for their outside business interests, First
Magnus also paid the Great Southwest Mortgage officers more than $12.6 million
in employee compensation during the same period.

HUD requirements (see footnote 1) require all employees of an approved lender
except receptionists, whether full time or part time, to be employed exclusively by
the lender at all times and conduct only the business affairs of the lender during
normal business hours. In addition, HUD requirements (see footnote 1) require a
lender’s senior corporate officers to spend their full time on the lender’s
operations.

First Magnus executed agreements that allowed Great Southwest Mortgage
officers to conduct outside businesses while employed by the lender. The
lender’s actions violated HUD requirements and give the appearance of a lack of
control and supervision by First Magnus over the Great Southwest Mortgage
division’s branch offices.




                                 7
First Magnus Failed to
Execute Office Lease
Agreements in Its Name


           First Magnus entered into office sublease agreements with companies, typically
           owned by its branch office managers, to rent office space for use by its Great
           Southwest Mortgage branch offices. In the sublease agreements, First Magnus
           was listed as the renter of the office, with the actual rental agreement with the
           property owner being retained by the branch office managers’ company. For
           example, First Magnus/Great Southwest Mortgage operated a branch office in
           Suite 325 of a building located at 17015 North Scottsdale Road in Scottsdale,
           Arizona. The Great Southwest Mortgage officers leased office space in this
           building, which included suite 325, from the building owners through their
           leasing company, Lender Support Services, LLC. Lender Support Services in
           turn subleased suite 325 to First Magnus for use as a branch office. According to
           the sublease agreement, First Magnus paid Lender Support Services a monthly
           rental of $64,000 for rental of office space and office equipment. The lease
           agreement between First Magnus and Lender Support Services was on a month-
           to-month basis, whereas Lender Support Services’ actual lease with the property
           owner was for 10 years.

           HUD requirements (see footnote 1) require all agreements, including office space
           leases, to be in the name of the lender. First Magnus’ practice of not executing
           primary lease agreements in its name resulted in the responsibility and control of
           the office space being born by Lender Support Services (and other companies of
           branch office managers), not First Magnus.

First Magnus Failed to
Execute Equipment Lease
Agreements in Its Name



           First Magnus also entered into agreements with leasing companies, typically
           owned by its branch office managers, to rent office equipment such as furniture
           and computers for use at its Great Southwest Mortgage branch offices. These
           agreements listed First Magnus as the renter of the office equipment with
           ownership of the equipment retained by companies owned by its branch office
           managers.

           For example, on December 28, 2004, Lender Support Services executed an
           equipment lease agreement with First Magnus dba Great Southwest to lease office
           furniture and equipment for use at 17015 North Scottsdale Road, Suite 325, in
           Scottsdale, Arizona. Lender Support Services is a leasing company owned and



                                            8
             operated by Great Southwest Mortgage officers. According to the agreement, the
             Great Southwest Mortgage branches were to rent office and computer equipment
             from Lender Support Services for a monthly fee of $20,123. The lease agreement
             term was on a month-to-month basis. The agreement listed Lender Support
             Services as the owner of the office and computer equipment and First Magnus dba
             Great Southwest Mortgage as the renter.

             HUD requirements (see footnote 1) require all agreements, including office space
             leases, to be in the name of the lender. First Magnus’ practice of not executing
             agreements in its name effectively resulted in the financial liability and control
             relating to its office and computer equipment being retained by a third party,
             Lender Support Services, not First Magnus, in violation of HUD requirements.

Conclusion


             First Magnus disregarded HUD requirements by allowing the use of noncompete
             clauses, requiring indemnification of branch-related losses, allowing nonexclusive
             employment, and failing to execute office lease agreements and equipment lease
             agreements in its name. These deficiencies exposed HUD’s insurance funds and
             the public to an increased risk through the origination of Federal Housing
             Administration-insured mortgages by branches and employees, the management
             of whose operations and activities were inconsistent with the close supervisory
             control mandated by HUD for all lender branch office origination activities.

             Further, allowing Great Southwest Mortgage branches to operate under executed
             branch and net branch agreement terms prohibited by HUD limited First Magnus’
             expected responsibility over and oversight of branch offices and personnel who
             originate and process Federal Housing Administration-insured loans. Essentially,
             as set out in its Web site advertisements, First Magnus offered franchise
             (mortgage broker) arrangements with its affiliates and not valid branch office
             operations as required by HUD rules and regulations.

Recommendations

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

             1A. Impose civil money penalties against First Magnus for Federal Housing
                 Administration-insured loans originated by its net branches that were being
                 operated in violation of HUD requirements during the period of January 1,
                 2003, to August 31, 2006. The closure of this recommendation is subject to
                 the consideration for administrative action and assessment of civil money
                 penalties by the Mortgagee Review Board.



                                              9
1B. Require First Magnus to either discontinue operations of all net branches
    that are being operated in a manner that violates HUD requirements or bring
    these branches into compliance with such requirements.




                               10
                        SCOPE AND METHODOLOGY

We performed audit work from May through September 2006. The audit period covered January
2003 through August 2006.

To accomplish our objective, we

   •   Reviewed the operations and agreements related to First Magnus’ net branch (dba Great
       Southwest Mortgage) located at 17015 North Scottsdale Road, Suite 325, Scottsdale,
       Arizona, for the period of January 2003 through August 2006;

   •   Reviewed net branch agreements of three other net branches operating in the Phoenix
       metropolitan area also doing business under the control of First Magnus/Great Southwest
       Mortgage;

   •   Interviewed First Magnus and Great Southwest Mortgage personnel;

   •   Interviewed government agency personnel and real estate development company
       personnel;

   •   Reviewed First Magnus’ financial records, employee personnel files, and employee
       benefits documents; and

   •   Reviewed public records and databases.

During the review, we identified information indicating Real Estate Settlement Procedures Act
violations by First Magnus involving the payment of marketing fees to real estate companies and
real estate developers in exchange for referrals of federally related mortgage loan business. We
plan to conduct followup work, and the results will be addressed in a later audit report.

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




                                                11
                             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,
   •   Compliance with applicable laws and regulations, and
   •   Safeguarding of assets.

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:

              •   Reliability of documents used to operate and manage net branches.

              •   Policies and procedures in place to ensure operation and management of net
                  branches in compliance with HUD rules and regulations.

              •   Safeguarding Federal Housing Administration-insured loans from high-risk
                  exposure through controls over net branch operations.

              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 item is a significant weakness:

              •   First Magnus disregarded applicable HUD rules and regulations in the
                  operation and management of its net branches.




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                        APPENDIX

Appendix A

        AUDITEE COMMENTS AND OIG’S EVALUATION


Ref to OIG Evaluation     Auditee Comments




Comment 1




                           13
Comment 2




Comment 3




Comment 4




            14
Comment 5




Comment 6




            15
16
17
                         OIG Evaluation of Auditee Comments

Comment 1   We agree that HUD’s guidance does not dictate any particular business model or
            structure that mortgagee net branch arrangements/operations must adhere to.
            However, HUD’s requirements do have the intent of ensuring that a mortgagee
            maintains full control and supervision over its “net branches” and that the branch
            office arrangements are not designed to maintain a distinct separation from the
            HUD/FHA approved mortgagee. The net branch agreements executed between
            First Magnus and its branch managers wherein the employees, not the employer,
            dictate how and where First Magnus can grow its business, specifically in
            Maricopa County, in our opinion, demonstrates a clear violation of these control
            standards.

            First Magnus also stated other industries, including the mortgage banking
            industry, engage in similar practices. However, when a mortgage company’s
            expansion is controlled by its “branch office employees,” the mortgagee does not
            have full control over the operations of the branch as intended by HUD’s
            requirements. If it was a true branch office, the company, not the employees,
            would have the ultimate decision-making role in determining whether to expand
            into or within a specific geographical area.

Comment 2   First Magnus contends it has “ultimate control” over its branch managers due to
            its ability to terminate them upon written notice for any reason. However, the
            executed agreements between First Magnus and the branch managers allow the
            branch managers to explicitly control the business growth and future opportunities
            of the company into markets such as Maricopa County, Arizona. This
            arrangement, as specified in detail under Section A of the 1999 agreement and
            Section 5 of the 2004 agreement clearly showed First Magnus did not have
            “ultimate control” over its branch managers. Further, the ability to terminate its
            “branch manager” for any reason, does not equate to control as contemplated by
            HUD requirements. Under First Magnus’ business relationships with the branch
            offices, it has no financial real responsibility for or investment in the “branch
            offices” operations (see comments 4, 5 and 6) and termination of its
            branches/branch managers and their respective branch offices would be no
            different than ceasing the purchase of loans originated by any other mortgage
            broker or loan correspondent.

Comment 3   First Magnus contends the exclusive sales territory arrangement does not result in
            Great Southwest Mortgage being an independent entity, separate and distinct from
            First Magnus Financial Corporation. In addition, First Magnus states that under
            its net branch agreements the branch managers are First Magnus employees paid
            under an alternative compensation program, i.e. First Magnus pays all branch
            expenses and then pays its branch managers a commission which equates to the
            remaining revenue (net profit) generated by the respective branch office.



                                            18
            However, in OIG’s opinion, the executed agreements that allow the branch
            managers to dictate the growth of First Magnus into the Maricopa County,
            Arizona market, and other provisions of the agreements relating to branch
            managers’ liability and branch office expenses (see comments 4, 5 and 6), do not
            provide complete control and supervision over its net branches as required by
            HUD guidelines.

Comment 4   First Magnus contends that it pays all loan losses, claims, lawsuits and
            settlements, but may allocate all or a portion of such expenses to the branch when
            calculating net profits, i.e. the branch office managers’ compensation. Further,
            First Magnus stated that OIG provided no evidence that First Magnus ever held
            any branch manager personally liable for branch-related expenses. However, in
            OIG’s opinion, in that the 2004 branch office agreement (Section 6) requires that
            in instances where “Net Profits are negative” the amount be carried forward and
            offset against future net profits, then the branch office managers are in effect
            being held responsible for loan losses, claims, etc. Under the terms of the branch
            office agreement such charges would reduce the net profit of the branch and the
            compensation/commission payable to the branch office manager. As discussed in
            the Finding, HUD has determined that branch office arrangements that require the
            “employee” indemnify the HUD/FHA approved lender if it incurs damage from
            any apparent, express, or implied agency representation by or through the
            “employee’s” actions are deemed a violation of HUD branch office requirements.
            Sections 6 and 13 of First Magnus’ 2004 branch office agreement and Section K
            of First Magnus’ 1999 branch office agreement clearly violate this requirement.

Comment 5   We disagree with First Magnus’ contention that its branch managers were only
            involved with their outside business interests on a passive basis and did not
            perform any individual or day-to day management duties related to these
            businesses. Discussions with the branch managers showed they actively
            participated in the operation of their equipment and office leasing companies and
            training company. According to the branch managers, Section H, in the 1999
            agreement allows them to provide real estate industry-related training without
            violating their agreement with First Magnus. Discussions with branch managers
            revealed that in 2004, they started and actively participated in a training company
            specializing in teaching real estate industry-related courses. On the training
            company’s website, the branch officers are listed as a corporate partner and
            national trainer, which explicitly demonstrates they are actively involved in a real
            estate industry-related entity.

            The state of Arizona Corporate Commission also showed that the branch
            managers are managers of an office leasing company and a real estate lending
            personnel recruitment company. OIG’s review noted the branch officers actively
            participated in their office space and equipment leasing and recruitment
            companies, including signing agreements granting approval of various business
            transactions such as the transfer of property.




                                             19
            Based on the discussions and documentation obtained directly from the branch
            managers, it is clear they were actively involved in real estate-related companies
            outside of their employment with First Magnus. Their active involvement in real
            estate industry-related entities outside of First Magnus violates HUD branch
            requirements, specifically, HUD Handbook 4060.1 REV-1, paragraphs 2-11 and
            2-14 that require all employees and senior corporate officers to be employed
            exclusively by the lender at all times and conduct only the business affairs of that
            lender during normal business hours.

Comment 6   Even though First Magnus pays the applicable office and equipment leases on a
            monthly basis, the underlying agreements are not in the name of the lender, First
            Magnus. Rather, OIG’s review found the underlying long term leases were
            executed in the name of branch managers’ limited liability companies, who in
            turn executed month to month leases with First Magnus. Mortgagee Letter 00-15
            requires “all” contractual relationships with vendors such as leases be in the name
            of the lender, not in the name of the branch employee. First Magnus’ practice of
            having the actual long term leases be placed in the name of its branch office
            managers, not in its name, serves to limit First Magnus’ responsibility and risk
            and violates the intent of HUD’s branch office requirements.




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