oversight

Peoples Bank Did Not Follow HUD's Requirements When Underwriting Nine FHA Loans and Implementing Its Quality Control Program

Published by the Department of Housing and Urban Development, Office of Inspector General on 2008-08-20.

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

                                                                 Issue Date
                                                                        August 20, 2008
                                                                 Audit Report Number
                                                                        2008-KC-1004




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

           //signed//
FROM:      Ronald J. Hosking, Regional Inspector General for Audit, 7AGA

SUBJECT: Peoples Bank Did Not Follow HUD’s Requirements When Underwriting Nine
           FHA Loans and Implementing Its Quality Control Program


                                   HIGHLIGHTS

 What We Audited and Why

            We reviewed 23 Federal Housing Administration (FHA) loans underwritten by
            Peoples Bank of Overland Park, Kansas. Our audit objectives were to determine
            whether Peoples Bank followed U.S. Department of Housing and Urban
            Development (HUD) requirements for (1) borrower eligibility and
            creditworthiness and property eligibility when underwriting loans and (2)
            implementing a quality control program.

            We audited Peoples Bank because of its high 30-day delinquency rate. From
            January 2006 through December 2007, Peoples Bank originated 571 FHA loans,
            valued at $65.5 million. During this same period, 112 of the loans (19.6 percent)
            had been at least 30 days delinquent (past due) during our audit period.

 What We Found

            Peoples Bank did not follow HUD’s requirements when underwriting nine FHA
            loans. These loans had material underwriting deficiencies that affected the
            insurability of the loans. In addition, Peoples Bank’s quality control plan did not
           contain all of HUD’s required elements, and Peoples Bank did not fully
           implement the elements in its quality control program.

What We Recommend

           We recommend that the Assistant Secretary for Housing – Federal Housing
           Commissioner require Peoples Bank to indemnify HUD for eight actively insured
           loans with unpaid principal balances totaling $905,908 and reimburse HUD for
           one loan for which HUD incurred losses totaling $41,938 when it sold the
           property. We also recommend that HUD verify that Peoples Bank has
           implemented an adequate supervisory structure and adequately trained its
           underwriters regarding HUD requirements for FHA loans. Further, we
           recommend that HUD ensure that Peoples Bank implements a revised quality
           control plan that meets HUD requirements and develops and implements
           procedures to monitor its quality control contractor.

           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


           Peoples Bank generally agreed that deficiencies existed in its underwriting, loan
           documentation, and quality control program but considered the deficiencies
           minor. Therefore, it disagreed with the recommendations related to the
           underwriting deficiencies and stated that it had begun to make changes to its
           quality control program. We provided the draft report to Peoples Bank on June
           10, 2008, and requested a response by July 15, 2008. It provided written
           comments on July 15, 2008.

           The complete text of the auditee’s response, along with our evaluation of that
           response, can be found in appendix B of this report.




                                            2
                             TABLE OF CONTENTS

Background and Objectives                                                     4

Results of Audit
        Finding 1: Peoples Bank Did Not Follow HUD Requirements When          5
                      Underwriting Nine FHA Loans
        Finding 2: Peoples Bank’s Quality Control Program Did Not Meet HUD    9
                      Requirements

Scope and Methodology                                                        11

Internal Controls                                                            12

Appendixes
   A.   Schedule of Questioned Costs and Funds to Be Put to Better Use       13
   B.   Auditee Comments and OIG’s Evaluation                                14
   C.   Criteria                                                             34
   D.   Schedule of Significant Underwriting Deficiencies                    40
   E.   Case Studies for Nine Questioned Loans                               41




                                              3
                     BACKGROUND AND OBJECTIVES

Peoples Bank is a Federal Housing Administration (FHA)-approved direct endorsement lender
based in Overland Park, Kansas. It became an authorized FHA loan originator in March 1994.
Peoples Bank has branch offices in Lawrence, Louisburg, Ottawa, and Paola, Kansas, and in
Albuquerque and Taos, New Mexico.

Peoples Bank participates in HUD’s Lender Insurance program. The Lender Insurance program
enables high-performing FHA-approved direct endorsement lenders with acceptable default and
claim rates to endorse FHA loans without a preendorsement review being conducted by FHA.
The program also eliminates the lender’s submission of case binders to FHA.

From January 2006 through December 2007, Peoples Bank originated 571 FHA loans, valued at
$65.5 million. During this same period, 112 of the loans (19.6 percent) were at least 30 days
delinquent. There were also two claims against the FHA insurance fund during this period.

Our audit objectives were to determine whether Peoples Bank followed HUD requirements for
(1) borrower eligibility and creditworthiness and property eligibility when underwriting loans
and (2) implementing a quality control program.




                                               4
                               RESULTS OF AUDIT

Finding 1: Peoples Bank Did Not Follow HUD Requirements When
            Underwriting Nine FHA Loans
Peoples Bank did not follow HUD’s requirements when underwriting nine FHA loans. This
occurred because Peoples Bank senior management did not adequately supervise underwriters
approving FHA loans or ensure that underwriters were adequately trained regarding HUD
requirements. As a result HUD insured nine loans that unnecessarily placed the FHA insurance
fund at risk.



 Underwriting Did Not Meet
 HUD Standards


              Peoples Bank did not follow HUD’s requirements when underwriting nine FHA
              loans. FHA-approved lenders must follow HUD Handbook 4155.1, REV-5,
              Mortgage Credit Analysis for Mortgage Insurance, One- to Four-Family Properties,
              and HUD mortgagee letters when underwriting FHA loans. Appendix C provides
              details of HUD underwriting requirements.

              The underwriting deficiencies primarily involved the following:

              Overstated/Unsupported Income
              Peoples Bank did not always properly assess income for borrowers. Borrower
              income was either overstated or not adequately supported in five loans. Lenders
              must accurately assess borrower income to make informed decisions on income
              stability and the borrower’s ability to repay the mortgage.

              For example, in case number 183-0055148, Peoples Bank overstated the
              borrower’s income by $638 per month when it used income of $4,818 to evaluate
              the borrower’s ability to repay the mortgage. The borrower supported income of
              only $4,180 per month. The supported monthly income resulted in the borrower’s
              total debt ratio increasing to 48.3 percent, well above HUD’s limit of 43 percent,
              and increased the risk that the borrower would be unable to repay the mortgage.

              Unpaid Judgments
              Peoples Bank did not always adequately assess borrower credit histories. Borrower
              credit histories reflected unpaid judgments in two loans. HUD requires judgments to
              be paid in full for a loan to be eligible for FHA insurance. HUD makes an exception
              if the borrower has agreed with the creditor to make regular and timely payments on
              the judgment and the borrower provides evidence that he or she has made required
              payments in accordance with the agreement.


                                               5
           For example, in case number 181-2179272, Peoples Bank did not adequately assess
           the documentation for a borrower who had an unpaid judgment of $2,556 on his
           credit report. About three years before the FHA loan closing, the borrower’s
           nonpurchasing spouse agreed to make monthly payments to the creditor to repay the
           judgment. However, the spouse had missed about 20 payments during those three
           years, with six of the missed payments being in the year before the FHA loan
           closing. Therefore, the homeowners had not met their commitment to repay the
           judgment as agreed.

           Missing Verification of Mortgage Payments
           Peoples Bank did not obtain a verification of prior mortgage payments for two loans
           in which the borrowers refinanced from conventional loans to FHA loans. HUD
           generally requires lenders to obtain a verification of previous rental or mortgage
           payment history for all FHA loan packages, except certain streamline refinances. In
           addition, HUD does not allow refinanced loans to include delinquent interest, late
           charges, or escrow shortages.

           For example, in case number 183-0053891, Peoples Bank did not obtain a
           verification of payments for the borrower’s prior mortgage although there was
           evidence in the loan file that the borrower was past due on the mortgage being
           refinanced. The borrower’s bank statement reflected that the borrower had made
           three monthly mortgage payments in the month before the FHA loan closing. Also,
           the prior mortgage was listed as a derogatory account on the borrower’s credit
           report. Further, the borrower’s credit report reflected a principal balance of $26,576
           for the prior mortgage. However, the payoff statement from the prior lender showed
           a payoff amount of $34,737, indicating that there may have been delinquent interest,
           late charges, or escrow shortages included in the payoff of the prior mortgage.

Underwriters Were Not
Adequately Supervised or
Trained

           Peoples Bank senior management staff did not adequately supervise their
           underwriters. During our audit period, the senior underwriter was also the
           operations manager for the entire mortgage department, overseeing the processing
           of all mortgage loans (conventional and government). She also directly
           supervised a junior underwriter and four loan processors. Because of this
           management structure, no one reviewed the senior underwriter’s work, and she
           had no other person to consult when evaluating compliance with HUD
           underwriting requirements.

           Senior management staff told us that they began planning operational changes in
           July 2007. They also told us that they planned to have a contractor perform an
           underwriting review on the bank’s FHA loans in addition to the conventional



                                             6
           loans that the contractor was already reviewing. Peoples Bank began making the
           planned operational changes affecting its underwriting processes in February
           2008, about the same time as we began our audit work.

           Senior management staff also told us that FHA loan volume had recently
           increased and the managers had identified a need for the senior underwriter to
           concentrate her efforts solely on underwriting. As a result, Peoples Bank hired a
           new operations manager with underwriting experience to supervise the senior
           underwriter.

           Peoples Bank also did not adequately train its underwriters regarding HUD
           requirements. HUD requires lenders to ensure that underwriters are adequately
           trained and have completed a direct endorsement training program. The senior
           underwriter told us that she had participated in various FHA training classes.
           However, she did not know that she was required to manually underwrite loans
           with full documentation when the automated underwriting systems rejected or
           referred loans. She also told us that she was not aware of the HUD requirement to
           verify rental or mortgage payment history as part of a borrower’s credit history.

           Although senior management staff had identified and changed the inadequate
           supervisory structure, they were unaware that the senior underwriter was
           underwriting FHA loans that did not meet HUD’s standards. However, the
           mortgage operations manager told us that Peoples Bank had scheduled the senior
           underwriter for upcoming FHA training.

Loans Containing Material
Deficiencies Were Submitted
for FHA Insurance

           HUD cannot be assured that borrowers are eligible for FHA insurance on their
           loans when lenders do not properly monitor their underwriting efforts.

           Peoples Bank had submitted for FHA insurance nine loans with material
           deficiencies that had unpaid principal balances of about $1 million as of May
           2008. Therefore, HUD insured nine loans that should not have been insured. The
           loans unnecessarily placed the FHA insurance fund at risk for more than $350,000
           in potential losses and nearly $42,000 in losses already incurred.

Recommendations



           We recommend that the Assistant Secretary for Housing – Federal Housing
           Commissioner




                                            7
1A. Require Peoples Bank to indemnify HUD for eight actively insured loans
    with unpaid principal balances totaling $905,908. The projected loss is
    $353,304 based on the FHA insurance fund average loss rate of 39 percent
    for fiscal year 2007 (see appendix D).

1B. Require Peoples Bank to reimburse HUD for one loan for which HUD
    incurred losses totaling $41,938 when it sold the property (see appendix D).

1C. Verify that Peoples Bank has implemented an adequate supervisory
    structure that allows managers to identify and mitigate underwriting
    problems and prevents Peoples Bank from submitting loans for insurance
    endorsement that do not meet HUD requirements.

1D. Verify that Peoples Bank has adequately trained its underwriters regarding
    HUD requirements for FHA loans, including requiring it to provide HUD
    with evidence that its underwriters have received recent, acceptable training.




                                 8
Finding 2: Peoples Bank’s Quality Control Program Did Not Meet
            HUD Requirements
Peoples Bank’s quality control program did not meet HUD requirements. This occurred because
its managers were not aware of all HUD requirements and did not monitor their quality control
contractor. As a result, Peoples Bank could not ensure the accuracy, validity, and completeness
of its loan originations.



 Quality Control Process Did
 Not Meet HUD Standards


              Peoples Bank’s quality control program did not meet HUD requirements. HUD
              Handbook 4060.1, REV-2, states that all FHA-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 FHA approval. Further,
              the handbook establishes several basic elements that are required in all quality
              control programs (appendix C, items 3-15, provide the detailed HUD quality
              control requirements).

              Peoples Bank’s quality control plan lacked six required elements. The plan did
              not require the scope of quality control reviews to include all loan originators,
              appraisers, or FHA loan programs. The plan also did not require the lender to

                  •   Use the reporting feature in HUD’s Neighborhood Watch database when
                      notifying HUD of material deficiencies or fraud;
                  •   Retain quality control review reports, including actions taken, for a period
                      of two years and have the reports available to HUD upon request;
                  •   Verify the identity of the loan applicant;
                  •   Review all early payment defaults (loans that defaulted within the first six
                      payments due); and
                  •   Conduct an occupancy reverification for cases in which the occupancy of
                      the subject property was suspect.

              Further, Peoples Bank did not fully implement the elements in its quality control
              plan. The lender did not provide FHA loan files to its quality control contractor in
              a timely manner. As a result, the contractor was not able to review loans within
              90 days of the month of closing, and not all of the quality control reports that
              should have been available for our review were available. Peoples Bank also did
              not ensure that its quality control contractor performed reviews of its branch
              offices or that the contractor reviewed 10 percent of its FHA-insured loans.




                                                9
Managers Were Unaware of All
HUD Requirements and Did
Not Monitor Their Contractor

           Peoples Bank managers were not aware of all HUD requirements and did not
           monitor their quality control contractor. The operations manager for the period of
           our audit told us that she was unaware that the quality control plan did not contain
           all of HUD’s required elements and that she relied on the contractor to follow
           HUD requirements.

           Without a properly implemented quality control program, the lender could not
           ensure that it

              •   Complied with HUD requirements when originating loans;
              •   Protected itself and HUD from unacceptable risk; and
              •   Guarded against errors, omissions, and fraud.

           As a result, HUD lacked assurance that Peoples Bank identified and corrected
           potential deficiencies in its loan origination process before submitting loans for
           FHA insurance.

Recommendations



           We recommend that the Assistant Secretary for Housing – Federal Housing
           Commissioner

           2A. Ensure that Peoples Bank implements a revised quality control plan that
               contains all of the elements that HUD requires.

           2B. Ensure that Peoples Bank develops and implements procedures to monitor its
                quality control contractor.




                                            10
                         SCOPE AND METHODOLOGY

To accomplish our objectives, we reviewed HUD and Peoples Bank’s underwriting policies and
procedures. We interviewed Peoples Bank management and staff and HUD staff. We also
reviewed Peoples Bank’s quality control plan and quality control reports.

Our audit period was January 1, 2006, through December 31, 2007. During this timeframe,
Peoples Bank originated 571 FHA loans. Of the 571 loans, 112 became at least 30 days
delinquent during our audit period, and 25 of the 112 reached a 90-day defaulted status. We
reviewed Peoples Bank’s loan files for 23 of the 25 defaulted loans. We did not review two
loans for which the FHA insurance was terminated and the loans no longer posed a risk to the
FHA insurance fund.

When identifying underwriting deficiencies, we assessed whether the deficiencies were material and
should have caused the lender to disapprove the loan. We considered any deficiencies that affected
the approval and insurability of the loans as significant and recommend that HUD take appropriate
action on these loans. When identifying underwriting deficiencies that we considered minor, we
informed Peoples Bank of the deficiencies but have not recommended that HUD take action on
these loans.

We relied on computer-processed data contained in HUD’s Single Family Data Warehouse
system. During the audit, we assessed the reliability of the data and found the data to be
adequate. We also performed sufficient tests of the data, and based on the assessments and
testing, we concluded that the data were sufficiently reliable to be used in meeting our
objectives.

We assigned a value to the potential savings to HUD if it implements our recommendations to
require Peoples Bank to indemnify loans with material deficiencies. For those loans for which
HUD had not yet incurred a loss, we applied FHA’s average loss experience for fiscal year 2007
provided by HUD. We calculated the savings value at $353,304 for those properties currently
actively insured, which is 39 percent of the unpaid principal balance of $905,908.

We performed audit work from February through May 2008 at the Peoples Bank mortgage
operations branch office in Stanley, Kansas. We conducted our audit in accordance with
generally accepted government auditing standards. Those standards require that we plan and
perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our
findings and conclusions based on our audit objectives. We believe that the evidence obtained
provides a reasonable basis for our findings and conclusions based on our audit objectives.




                                                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, 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 to ensure that direct endorsement underwriters are adequately
                      trained.
              •       Controls to ensure adequate supervision of direct endorsement
                      underwriters.
              •       Controls to ensure that the quality control program has been implemented
                      and the quality control contractor is adequately monitored for compliance
                      with HUD requirements.

              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:

              •       Peoples Bank did not adequately supervise and train its direct endorsement
                      underwriters (finding 1).
              •       Peoples Bank did not have adequate controls in place to ensure that it
                      followed HUD requirements when implementing its quality control program
                      (finding 2).


                                               12
                                   APPENDIXES

Appendix A

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

                 Recommendation            Ineligible 1/   Funds to be put
                        number                              to better use 2/

                        1A                                       $ 353,304
                        1B                    $ 41,938

1/   Ineligible costs are costs charged to a HUD-financed or HUD-insured program or activity
     that the auditor believes are not allowable by law; contract; or federal, state, or local
     polices or regulations.

2/   Recommendations that funds be put to better use are estimates of amounts that could be
     used more efficiently if an Office of Inspector General (OIG) recommendation is
     implemented. This includes reductions in outlays, deobligation of funds, withdrawal of
     interest subsidy costs not incurred by implementing recommended improvements,
     avoidance of unnecessary expenditures noted in preaward reviews, and any other savings
     which are specifically identified.

     Implementation of our recommendations to require Peoples Bank to indemnify HUD for
     materially deficient loans will reduce the risk of loss to the FHA insurance fund. The
     amount above reflects that, upon sale of the mortgaged property, FHA’s average loss
     experience is about 39 percent of the unpaid principal balance based upon statistics
     provided by HUD.




                                            13
Appendix B

        AUDITEE COMMENTS AND OIG’S EVALUATION


Ref to OIG Evaluation                         Auditee Comments




            ** We provided HUD officials with the attachments that Peoples Bank included with its written
               response. Due to the sensitive nature and volume of the attachments, we have not included
               them in the report but can provide them upon request. In addition, we redacted borrower’s
               names from the auditee comments to protect their privacy.



                                                 14
Comment 1




            15
16
17
Comment 2




            18
Comment 3




Comment 4




            19
20
Comment 5




Comment 6




            21
Comment 7




Comment 8




            22
Comment 9




Comment 10




             23
Comment 11




Comment 12




             24
25
Comment 13




             26
Comment 14




Comment 15




             27
Comment 16




Comment 17




             28
29
                         OIG Evaluation of Auditee Comments


Comment 1   We used Peoples Bank’s delinquency rate only to select a lender to review that
            indicated potential for deficiencies in its FHA loan underwriting and quality
            control processes that could cause unnecessary risk to the FHA insurance fund.

Comment 2   Peoples Bank did not adequately verify and document whether the Social Security
            income was expected to continue during the first three years of the mortgage, as
            HUD requires. The dependent was 17 years old and his survivor benefit would
            have ended at age 18. The loan file contained only an underwriter and borrower
            note indicating that the dependent was going to receive Social Security disability
            when the survivor benefit ended. However, these notes were not sufficient
            documentation to include the unconfirmed disability income when underwriting
            the loan.

Comment 3   The compensating factors provided in Peoples Bank’s response (i.e.
            nonpurchasing spouse income and the borrower’s efforts to increase potential
            earnings) were not sufficient to offset a 74 percent total debt ratio. Further, the
            nonpurchasing spouse had a $5,000 judgment listed on his credit report.
            According to a loan officer’s note in the loan file, Peoples Bank did not include
            the spouse on the loan because of the spouse’s credit problems and the
            borrower(s) would have had to pay off the judgment or be participating in an
            acceptable repayment plan before being considered for an FHA loan.

Comment 4   HUD Handbook 4155.1, REV-5, points out 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. Further, HUD requires
            borrowers to pay court-ordered judgments before a loan is eligible for FHA
            insurance. An exception is made when the borrower has agreed to make regular
            and timely payments. The borrower and nonpurchasing spouse agreed to make
            monthly payments but in the three years before the FHA loan closed the borrower
            and spouse made less than half of the agreed-upon monthly payments. Further,
            the absence of garnishments or court orders to force repayment does not confirm
            that the payment history was acceptable to the creditor, but serves only to show
            that the creditor had not pursued further actions to collect the debt.

Comment 5   The recommendation for indemnification was based on our conclusion that
            Peoples Bank substantially overstated the borrowers’ income and should not have
            approved the loan. The borrower’s income discrepancy was material and the
            lender should have resolved the discrepancy before approving the loan. The
            borrower’s supported income was $2,204 per month, or $518 per month less than
            calculated by the underwriter. Also, the extra duty income was minimal and not
            sufficient to offset the excessive financial ratios.




                                             30
            The coborrower’s earnings record demonstrated that he did not consistently work
            full time. In the ten weeks just before the FHA loan closed, the coborrower
            worked only one 40-hour week. A better measurement of his income would have
            been an entire year, which would have taken into consideration fluctuations in
            hours worked. His 2004 average monthly income was $2,086 and 2005 average
            monthly income was $2,098. The loan closed March 15, 2006, and the
            coborrower was still at the same employer. Because his monthly income changed
            only $12 per month over two year period of 2004 and 2005, the monthly average
            of $2,098 from 2005 was the most prudent estimate of his income.

Comment 6   We did not include, nor should the lender include, the seasonal employment in
            income or consider it a compensating factor because it was not reflected on the
            uniform residential loan application as additional employment for the coborrower.
            While the income may have been available for the borrowers in 2005, the
            borrowers did not indicate that they would have this income in future periods.
            Further, the underwriter did not include the income when underwriting the loan in
            2006. Therefore, we maintain that the coborrower’s supported income was only
            $2,098 per month.

Comment 7   HUD requires borrowers to pay court-ordered judgments before the loan is
            eligible for FHA insurance, regardless of the amount. Also, as explained in
            comment 4, 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. Failure to pay a court-ordered judgment does not show
            that the borrower was committed to paying financial obligations.

Comment 8   HUD requires lenders to validate Social Security numbers and resolve
            discrepancies revealed during processing and underwriting. HUD also requires
            the underwriter to be aware of the warning signs that may indicate irregularities,
            to have the ability to detect fraud, and to take the responsibility that their
            underwriting decisions are performed with due diligence and in a prudent manner.
            We maintain that validating Social Security numbers is a critical part of
            underwriting that is intended to ensure that the borrowers have not provided a
            fraudulent identity to obtain the FHA loan and the underwriter should have
            positively verified the Social Security number.

Comment 9   HUD requires a lender to establish a two year earnings trend before including
            overtime in effective income. The only overtime income that the lender verified
            was 5.5 months shown on the borrower’s pay stub. Using only the Internal
            Revenue Service Form W-2 did not establish a history of overtime income
            because the W-2 did not distinguish between base pay and overtime pay. Further,
            the employer did not confirm that the borrower was likely to incur overtime in the
            future.

            Based on the Social Security Administration information provided with Peoples
            Bank’s response, we agree that the lender provided sufficient evidence that the



                                            31
              Social Security income was going to continue through at least the first three years
              of the mortgage. Therefore, we removed the related information from the case
              study in appendix E and recalculated the ratios. Total supported income for the
              borrower was $2,025 ($1,813 + $212), resulting in financial ratios of 49 percent
              ($993 / $2,025) and 53.4 percent ($1,082 / $2,025), well above HUD’s limits.

Comment 10 We used the same liability amount that the underwriter used to calculate the
           qualifying ratios on the mortgage credit analysis worksheet. As explained in
           comment 9, the financial ratios greatly exceeded HUD’s limits.

Comment 11 Peoples Bank agreed that its loan documentation did not support the income
           claimed when underwriting the loan and stated that it had additional information
           that supported the income used to underwrite the loan. However, Peoples Bank
           did not provide the support and therefore, we continue to consider the income
           overstated.

Comment 12 The mortgagee letter that Peoples Bank referred to in its response is Mortgagee
           Letter 2006-14, which states that if the seller has not owned the property for at
           least 90 days the property is not eligible for insurance. However, Mortgagee
           Letter 2006-14 rescinded Mortgagee Letter 2003-07, which also included the
           same requirement. Therefore, the “anti-flipping” rule had been in effect well
           before Mortgagee Letter 2006-14. We maintain that this property was not eligible
           for FHA insurance and is a material deficiency.

Comment 13 HUD requires lenders to include debts in the qualifying financial ratios if the
           amount of the debt affects the borrower’s ability to make the mortgage payment
           during the months immediately after closing. In this case, the car payment debt
           raised the total debt ratio from 38.7 percent to 54.7 percent, which was well above
           HUD’s limit, and the car payment was to continue for at least nine months. The
           total debt ratio greatly exceeded HUD’s limit and the borrowers did not
           demonstrate the ability to accumulate cash assets, as demonstrated by minimal
           balances on the two months of bank statements provided. The bank statements
           also showed 25 insufficient funds charges, demonstrating that the borrowers were
           not adequately handling their financial obligations.

Comment 14 Peoples Bank agreed during the audit that the loan was manually underwritten by
           the junior underwriter, just as it was reflected in HUD’s systems. In addition, the
           automated underwriting system approved the loan with a 30 year term. However,
           Peoples Bank closed the loan with a 20 year term. The lender invalidated the
           automated underwriting system approval when it closed the loan with a
           significantly shorter term and significantly higher mortgage payments.

Comment 15 Although HUD allows lenders to evaluate borrowers’ housing payment history
           through credit reports or verifications of rent or mortgages, Peoples Bank should
           have performed more due diligence on the borrowers’ payment history when it
           received a payoff amount that was significantly higher than shown on the credit



                                               32
              history. As explained in the report, HUD does not allow refinanced mortgages to
              include late interest, late fees, or escrow shortages. Without a payment history
              (verification of mortgage) from the prior lender, Peoples Bank could not be
              assured that the higher payoff had not resulted from missed payments or other
              costs not allowed by HUD.

              Further, the prior lender confirmed to us that the loan was not structured in a way
              that would allow accrual of interest outside of the monthly payments. The prior
              lender indicated that the mortgage balance included more than principal and
              interest. The underwriter should have also questioned the borrower about the
              large payment made two months before closing to determine whether the payment
              was to bring the loan current in order to obtain the FHA loan, as this should have
              been considered by the underwriter when evaluating the potential FHA loan.

Comment 16 We maintain that the borrower’s income was overstated, as the lender should have
           used a more prudent calculation of monthly income. The earnings and leave
           (payroll) statement supported annual salary of only $50,155 ($4,180 per month)
           and the borrower had earned only one hour of overtime through May 2007 of the
           current year. The lender based the calculated income on $22,886 earnings to date,
           which equated to $4,818 per month. The payroll statement gave no indication of
           what the extra pay was for, or if it would continue in the future.

Comment 17 As explained in comment 15, Peoples Bank should have performed more due
           diligence and obtained the borrowers’ payment history when it received a payoff
           amount on a refinance loan for which the credit report showed no outstanding
           mortgage. The underwriter should have required a payment history from the prior
           lender to evaluate the borrower’s willingness and ability to pay previous housing
           expenses and also questioned why the mortgage balances were not reflected on
           the borrower’s credit report.




                                              33
Appendix C

                                         CRITERIA


Criterion 1
HUD Handbook 4000.2, REV-3, paragraph 1-7C, states that a property acquired by the seller is
not eligible for a mortgage to be insured by FHA for the buyer unless the seller has owned that
property for at least 90 days. If a property is resold 90 days or fewer following the date of
acquisition by the seller, the property is not eligible for a mortgage insured by FHA. FHA
defines the seller’s date of acquisition as the date of settlement on the seller’s purchase of that
property. The resale date is the date of execution of the sales contract by a buyer intending to
finance the property with an FHA-insured loan.

Criterion 2
HUD Handbook 4000.4, REV-1, CHG-2, paragraph 2-4C, states that HUD looks to the
underwriter as the focal point of the direct endorsement program. The underwriter must assume
the following responsibilities:

   •   Compliance with HUD instructions, the coordination of all phases of underwriting, and
       the quality of decisions made under the program.
   •   The review of appraisal reports, compliance inspections and credit analyses performed by
       fee and staff personnel to ensure reasonable conclusions, sound reports, and compliance
       with HUD requirements.
   •   The decisions relating to the acceptability of the appraisal, the inspections, the buyers
       capacity to repay the mortgage, and the overall acceptability of the mortgage loan for
       HUD insurance.
   •   The monitoring and evaluation of the performance of fee and staff personnel used for the
       direct endorsement program.
   •   Awareness of the warning signs that may indicate irregularities and an ability to detect
       fraud, as well as the responsibility that underwriting decisions are performed with due
       diligence in a prudent manner.

Criterion 3
HUD Handbook 4060.1, REV-2, section 7-3, states that there are several basic elements that are
required in all quality control programs that apply to both origination and servicing. Paragraph
7-3F states that all aspects of the mortgage operation, including but not limited to all branch
offices or sites, FHA-approved loan correspondents, authorized agents, loan officers or
originators, processors, underwriters, appraisers, closing personnel, and all FHA loan programs,
must be subject to the lender’s quality control reviews.

Criterion 4
HUD Handbook 4060.1, REV-2, paragraph 7-3G, states that lender offices, including traditional,
nontraditional branch, and direct lending offices engaged in origination or servicing of FHA-



                                                 34
insured loans, must be reviewed to determine that they are in compliance with HUD’s
requirements.

Criterion 5
HUD Handbook 4060.1, REV-2, paragraph 7-3J, states that findings of fraud or other serious
violations must be immediately referred to HUD using the lender reporting feature in the
Neighborhood Watch early warning system.

Criterion 6
HUD Handbook 4060.1, REV-2, paragraph 7-3K, states that the quality control review report
and followup, including review findings and actions taken, plus procedural information must be
retained by the lender for a period of two years and these records must be made available to
HUD on request.

Criterion 7
HUD Handbook 4060.1, REV-2, paragraph 7-5A, states that lenders should monitor the
application process and must verify the identity of the loan applicant.

Criterion 8
HUD Handbook 4060.1, REV-2, paragraph 7-6A, states that loans must be reviewed within 90
days from the end of the month in which the loan closed. This requirement is intended to ensure
that problems left undetected before closing are identified as early after closing as possible.

Criterion 9
HUD Handbook 4060.1, REV-2, paragraph 7-6B, states that for lenders closing more than 15
loans monthly, quality control reviews must be conducted at least monthly and must address one
month’s activity.

Criterion 10
HUD Handbook 4060.1, REV-2, paragraph 7-6C, states that a lender who originates and/or
underwrites 3,500 or fewer FHA loans per year must review 10 percent of the FHA loans it
originates.

Criterion 11
HUD Handbook 4060.1, REV-2, paragraph 7-6C(1)a, states that loans must be reviewed from all
branch office and all sources including authorized agents and loan correspondents.

Criterion 12
HUD Handbook 4060.1, REV-2, paragraph 7-6C(1)b, states that lenders must review the work of
each of the loan processors, loan officers, and underwriters based on the sample selected. In
addition, lenders must review the work of roster appraisers, real estate companies, and builders
with whom they do a significant amount of business.




                                              35
Criterion 13
HUD Handbook 4060.1, REV-2, paragraph 7-6C(1)c, states that the sample must include all
FHA programs in which the lender participates, including but not limited to 203(b), 203(k),
234(C), and home equity conversion mortgages.

Criterion 14
HUD Handbook 4060.1, REV-2, paragraph 7-6D, states that in addition to loans selected for
routine quality control reviews, lenders must review all loans going into default within the first
six payments. Early payment defaults are loans that become 60 days past due.

Criterion 15
HUD Handbook 4060.1, REV-2, paragraph 7-6E(4), states that in cases in which the subject
property is suspect, lenders must attempt to determine whether the borrower is occupying the
property.

Criterion 16
HUD Handbook 4155.1, REV-5, paragraph 1-11A(2), states that in refinances, the amount of the
existing first mortgage may not include delinquent interest, late charges, or escrow shortages.

Criterion 17
HUD Handbook 4155.1, REV-5, paragraph 1-11B, states that “cash out” refinances for debt
consolidation represent considerable risk, especially if the borrowers have not had an attendant
increase in income. Such transactions must be carefully evaluated.

Criterion 18
HUD Handbook 4155.1, REV-5, section 2-2, states 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.

Criterion 19
HUD Handbook 4155.1, REV-5, paragraph 2-3A, states that the lender must pay particular
attention to the borrower’s previous rental or mortgage payment history. The payment history of
the borrower’s housing obligations holds significant importance in evaluating credit. The lender
must determine the borrower’s payment history of housing obligations through either the credit
report, verification of rent directly from the landlord (with no identity of interest with the
borrower), verification of mortgage directly from the mortgage servicer, or canceled checks
covering the most recent 12-month period.

Criterion 20
HUD Handbook 4155.1, REV-5, paragraph 2-3C, states that court-ordered judgments must be
paid off before the mortgage loan is eligible for FHA insurance endorsement. An exception may
be made if the borrower has agreed with the creditor to make regular and timely payments on the
judgment and documentation is provided that the payments have been made in accordance with
the agreement.




                                                 36
Criterion 21
HUD Handbook 4155.1, REV-5, section 2-7, states 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, Social Security payments, or other payments expected to be received in
retirement.

In most cases, the borrower’s income will be limited to salaries or wages. Income from other
sources can be included as effective income with proper verification by the lender. Procedures
for analyzing other acceptable income sources besides salaries and wages are described below.

   A. Overtime and bonus income. Both overtime and bonus 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 bonus or 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.

       An earnings trend also must be established and documented for overtime and bonus
       income. If either type shows a continual decline, the lender must provide a sound
       rationalization in writing for including the income for borrower qualifying. If bonus
       income varies significantly from year to year, a period of more than two years must be
       used in calculating the average income.

   E. Retirement and Social Security income. Retirement and Social Security income require
      verification from the source (i.e., former employer, Social Security Administration) or
      federal tax returns. If any benefits expire within the first full three years, the income
      source may be considered only as a compensating factor.

Criterion 22
HUD Handbook 4155.1, REV-5, paragraph 2-11A, states that the borrower’s liabilities include
all installment loans, revolving charge accounts, real estate loans, alimony, child support, and all
other continuing obligations. In computing the debt-to-income ratios, the lender must include
the monthly housing expense and all other recurring charges extending 10 months or more,
including payments on installment accounts, child support or separate maintenance payments,
revolving accounts, alimony, etc. 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 loan closing. This is especially true if the borrower will have limited
or no cash assets after loan closing.

Criterion 23
HUD Handbook 4155.1, REV-5, section 2-13, states that compensating factors that may be used
in justifying approval of mortgage loans with ratios exceeding the guidelines include those listed
below. Underwriters must state on the “remarks” section of the Form HUD-92900WS the
compensating factors used to support loan approval.



                                                 37
   A. The borrower has successfully demonstrated the ability to pay housing expenses equal to
      or greater than the proposed monthly housing expense for the new mortgage. If the
      borrower over the past 12 to 24 months has met his or her housing obligation as well as
      other debts, there should be little reason to doubt the borrower’s ability to continue to do
      so despite having ratios in excess of those prescribed.
   B. The borrower makes a large downpayment toward the purchase of the property.
   C. The borrower has demonstrated a conservative attitude toward the use of credit and an
      ability to accumulate savings.
   D. Previous credit history shows that the borrower has the ability to devote a greater portion
      of income to housing expenses.
   E. The borrower receives compensation or income not reflected in effective income but
      directly affecting the ability to pay the mortgage, including food stamps and similar
      public benefits.
   F. There is only a minimal increase in the borrower’s housing expense.
   G. The borrower has substantial documented cash reserves (at least three months of
      mortgage payments) after closing. In determining whether an asset can be included as
      cash reserves or cash to close, the lender must judge whether the asset is liquid or readily
      convertible to cash and can be so converted absent retirement or job termination.
   H. The borrower has substantial nontaxable income (if no adjustment was made previously
      in the ratio computations).
   I. The borrower has potential for increased earnings, as indicated by job training or
      education in the borrower’s profession.
   J. The home is being purchased as the result of relocation of the primary wage earner, and
      the secondary wage earner has an established history of employment, is expected to
      return to work, and has reasonable prospects for securing employment in a similar
      occupation in the new area. The underwriter must address the availability of such
      possible employment.

Criterion 24
HUD Handbook 4155.1, REV-5, section 3-1, states that a payment history of present mortgages
must be in the form of a direct verification from the landlord or mortgage servicer or through
information shown on the credit report.

Criterion 25
HUD Handbook 4155.1, REV-5, paragraph 3-1C, states that the lender is required to document a
valid Social Security number for each borrower, coborrower, and cosigner on the mortgage. All
individuals eligible for legal employment in the United States must have a Social Security
number. Each borrower must provide the lender with evidence of his or her own valid Social
Security number as issued by the Social Security Administration. This requirement applies to
purchase money loans and all refinances, including streamline refinances. While the actual
Social Security card is not required, the lender is required to validate the Social Security number.
Lenders may use various means for validating the Social Security numbers, including examining
the borrower’s pay stubs, passport, and valid tax returns and may use service providers including
those with direct access to the Social Security Administration. The lender is also required to




                                                38
resolve any inconsistencies or multiple Social Security numbers for individual borrowers that are
revealed during loan processing and underwriting.

Criterion 26
Mortgagee Letter 2005-16 states that FHA’s benchmark payment-to-income and debt-to-income
ratios of 29 percent and 41 percent, respectively, were promulgated before Congress enacted
recent federal tax cuts. Consequently, most borrowers seeking FHA mortgage insurance have
enjoyed a reduction to their federal income tax during the last several years, thus increasing their
buying power and disposable income.

Therefore, for manually underwritten mortgages in which the direct endorsement underwriter
must make the credit decision, the qualifying ratios are raised to 31 percent and 43 percent. This
change will allow a larger number of deserving families to purchase their first home while not
increasing the risk of default. As always, if either or both ratios are exceeded on a manually
underwritten mortgage, the lender must describe the compensating factors used to justify
mortgage approval.

Criterion 27
Mortgagee Letter 2005-27 states that although FHA provides validation checks on Social
Security numbers, lenders are reminded that it is their responsibility, not FHA’s, to verify each
borrower’s Social Security number as well as each borrower’s identity. FHA provides this
validation process to protect the insurance funds it manages.

Criterion 28
Mortgagee Letter 2006-14 states that if the owner sells a property within 90 days after the date of
acquisition, that property is not eligible security for a mortgage insured by FHA unless it falls
within one of the exceptions to the time restrictions on resales set forth in paragraph 203.37a(c)
of the regulations. FHA defines the seller’s date of acquisition as the date of settlement on the
seller’s purchase of that property. The resale date is the date of execution of the sales contract by
the buyer that will result in a mortgage to be insured by FHA.




                                                 39
Appendix D

                  SCHEDULE OF SIGNIFICANT
                 UNDERWRITING DEFICIENCIES


                                                                            Deficiency area




                                                                                                                                       number discrepancy
                                        Overstated income




                                                                            Ineligible property




                                                                                                                    Missing mortgage
                                                                                                  Unpaid judgment


                                                                                                                    payment history

                                                                                                                                       Social Security
                                                            Underreported
                               Actual




                                                            liabilities
                  Unpaid      loss on
     FHA case    principal    sale of
      number      balance    property
   181-2156090               $ 41,938     x
   181-2179272   $    94,762                                                                        x
   182-0814658   $   187,616              x                                                         x                                        x
   182-0821834   $   111,285              x
   182-0823672   $   142,036              x                                    x
   182-0824524   $    85,247                                    x
   183-0053891   $    64,582                                                                                             x
   183-0055148   $   167,641              x
   291-3457668   $    52,739                                                                                             x
   Totals        $   905,908 $ 41,938




                                        40
Appendix E

          CASE STUDIES FOR NINE QUESTIONED LOANS


Case number: 181-2156090                      Insured amount: $93,345

Section of Housing Act: 203(b)                Status upon selection: Claim - defaulted on 1st
                                                  payment

Date of loan closing: March 31, 2006          HUD costs incurred: Loss on sale of property
                                                as a result of foreclosure $41,938

Underwriter type: Manual

Overstated Income/Excessive Ratios
Peoples Bank overstated the borrower’s overtime and Social Security income by $1,153 per
month, resulting in excessive qualifying financial ratios of 51 percent and 74 percent ($751 /
$1,473 and $1,092 / $1,473). The borrower provided one pay stub that showed $242 in overtime
compensation in January and February 2006. HUD requires a two-year history of overtime
earnings, and the lender did not obtain a two-year history. Therefore, the lender should not have
included overtime pay in the income calculation. Further, the borrower’s base pay was $8.50 per
hour and equated to $1,473 per month ($8.50 x 40 hours x 52 weeks / 12 months), not the $1,579
in year-to-date earnings on the pay stub ($3,159 / 2).

Peoples Bank also overstated the borrower’s Social Security survivor benefit income by $926 per
month. This income was for the borrower’s 17-year-old son, and the monthly income was not
expected to continue during the first three years of the mortgage, which HUD requires. The
borrower’s son could only qualify for the income until he was 19, if it took him that long to
graduate from high school, but would discontinue at 18 if he had finished high school.

HUD Requirements – Appendix C
HUD Handbook 4000.4, REV-1, CHG-2, paragraph 2-4C (criterion 2)
HUD Handbook 4155.1, REV-5, section 2-2 (criterion 18)
HUD Handbook 4155.1, REV-5, section 2-7 (criterion 21)
HUD Handbook 4155.1, REV-5, paragraphs 2-7A and E (criterion 21)
Mortgagee letter 2005-16 (criterion 26)




                                               41
Case number: 181-2179272                    Insured amount: $96,536

Section of Housing Act: 203(b)              Status upon selection: Defaulted on 4th
                                            payment

Date of loan closing: September 20, 2006    Current status: Foreclosure sale held in April
                                                2008 – loss not yet determined

Underwriter type: Manual

Unpaid Judgment
Peoples Bank did not obtain a satisfactory pay history for an open judgment on the borrower’s
credit report. The borrower’s credit report showed an unpaid judgment of $2,556 that was filed
in May of 2002. Although court-ordered judgments are supposed to be paid before a mortgage
loan is eligible for FHA insurance, HUD makes an exception if the borrower has agreed with the
creditor to make regular and timely payments on the judgment and documentation is provided
that payments have been made in accordance with that agreement.

The borrower’s nonpurchasing spouse agreed to repay the debt at $10 to $20 per month
beginning September 8, 2003. The payment ledger indicated that the borrower missed about 20
payments during the three years between the agreement and the FHA loan closing. Further, the
nonpurchasing spouse missed 6 of the 20 monthly payments in the year before the FHA loan
closing.

HUD Requirements – Appendix C
HUD Handbook 4000.4, REV-1, CHG-2, paragraph 2-4C (criterion 2)
HUD Handbook 4155.1, REV-5, paragraph 2-3C (criterion 20)




                                              42
Case number: 182-0814658                      Insured amount: $192,479

Section of Housing Act: 203(b)                Status upon selection: Defaulted on 4th
                                                  payment

Date of loan closing: March 15, 2006          Current status: Foreclosure sale held in April
                                                  2008 – loss not yet determined

Underwriter type: Manual

Unsupported Income/Excessive Ratios
Peoples Bank overstated the total household income by $598 per month. The borrower’s income
was overstated by $518 per month, as the lender calculated the monthly income at $2,722. The
borrower’s pay stubs reflected a salary of $1,361 bimonthly for all of the pay stubs provided
(November 2005-February 2006). This bimonthly salary equated to $32,668 per year ($1,361 x
24 pay periods). However, the December 2005 year-to-date salary and 2005 Internal Revenue
Service (IRS) Form W-2 reflected a salary of $26,447, which equaled $2,204 per month
($26,447 / 12 months). The loan closed in March of 2006, and the IRS Form W-2 for 2005 was
a reasonable calculation for her income because her pay stubs indicated that she was still making
the same bimonthly salary in February 2006.

The borrower was a teacher and stated on the loan application that she had worked at the same
school for seven years. The difference in annual income could reflect that the borrower received
her salary during the nine-month school year only and not in June, July, and August. If this were
the case, the borrower’s annual income would have been $24,501 ($1,361 x 18 pay periods),
which was more in line with her IRS Form W-2 from 2005. On the pay stubs provided, the
borrower received pay in the “other” pay category, which could account for the difference
between the 2005 IRS Form W-2 ($26,447) and the calculation for nine months ($24,501). The
lender should have obtained an explanation of the income discrepancies from the borrower.

Additionally, Peoples Bank overstated the coborrower’s income by $80 per month. The lender
qualified the coborrower using a monthly income of $2,178; however, it was unclear how the
lender calculated the income. Peoples Bank obtained an earnings record for the coborrower that
did not reflect full-time employment. The earnings record covered 10 weeks during November
2005, December 2005, and January 2006. Only 1 of the 10 weeks reflected a 40-hour work
week. Using the 2005 IRS Form W-2, the lender supported only $2,098 per month ($25,181 / 12
months). The 2005 IRS Form W-2 was recent income information when the loan was
underwritten (the mortgage credit analysis worksheet was dated March 9, 2006).

The decreased monthly income resulted in excessive qualifying financial ratios of 37.8 percent
and 47.4 percent. The mortgage credit analysis worksheet included a note by the underwriter
that the borrowers had reserves as a compensating factor for the excessive ratios. To be
considered a compensating factor, HUD requires reserves of at least three months of housing
payments. The mortgage credit analysis worksheet showed $1,181 in cash reserves. The
borrower’s bank statement showed a balance of $2,063; however, the $1,000 earnest money
check had not cleared the account, so actual reserves totaled $1,063. In addition, the borrowers


                                               43
needed $664 at closing, leaving $399 in reserves (less than one monthly payment). The
borrowers’ principal and interest payment was $1,185. The lender did not support that the
borrowers had at least three months of housing payments in reserves, and, therefore, this
compensating factor was not valid.

HUD Requirements – Appendix C
HUD Handbook 4000.4, REV-1, CHG-2, paragraph 2-4C (criterion 2)
HUD Handbook 4155.1, REV-5, section 2-2 (criterion 18)
HUD Handbook 4155.1, REV-5, section 2-13 (criterion 23)
Mortgagee Letter 2005-16 (criterion 26)

Unpaid Judgment
Peoples Bank did not require the borrower to pay a $100 unpaid judgment before the loan closed.
The borrower’s credit report listed the judgment as unpaid. Court-ordered judgments are
supposed to be paid before a mortgage loan is eligible for FHA insurance.

HUD Requirements – Appendix C
HUD Handbook 4000.4, REV-1, CHG-2, paragraph 2-4C (criterion 2)
HUD Handbook 4155.1, REV-5, paragraph 2-3C (criterion 20)

Social Security Number Discrepancy
Peoples Bank did not resolve a Social Security number discrepancy. The borrower’s credit
report and a Social Security number report obtained by the lender showed that at least two other
people were associated with the same Social Security number. HUD requires the lender to
resolve any Social Security number discrepancies. The lender should have obtained a Social
Security number verification from another source document or an acceptable explanation from
the borrower.

HUD Requirements – Appendix C
HUD Handbook 4000.4, REV-1, CHG-2, paragraph 2-4C (criterion 2)
HUD Handbook 4155.1, REV-5, paragraph 3-1C (criterion 25)
Mortgagee Letter 2005-27 (criterion 27)




                                               44
Case number: 182-0821834                     Insured amount: $113,354

Section of Housing Act: 203(b)               Status upon selection: Defaulted on 14th
                                                 payment

Date of loan closing: July 25, 2006          Current status: First legal action to commence
                                                 foreclosure in April 2008
Underwriter type: Manual

Overstated Income/Excessive Ratios
Peoples Bank overstated the borrower’s employment income by $604 per month when it
included unsupported overtime income. The only pay stub provided by the borrower (pay period
ending June 15, 2006) did not indicate the number of hours worked or number of days in the pay
period or specify a pay rate. The lender used year-to-date earnings for a $2,417 monthly average
($13,293 / 5.5 months). However, the 2005 Internal Revenue Service Form W-2 yielded a
$2,283 ($27,390 / 12 months) monthly average. In addition, the lender did not develop a two-
year earnings trend for overtime. Further, the employer did not address the likelihood of future
overtime in the verification of employment, which is especially important when the claimed
monthly income includes a significant amount of overtime. The year-to-date amount for base
pay was $9,972 or $1,813 per month ($9,972 / 5.5 months). Employment income was overstated
by $604 per month ($2,417 - $1,813).

Without the overtime income, the qualifying financial ratios increased to well above HUD’s
limit, to 49 percent and 53.4 percent.

HUD Requirements – Appendix C
HUD Handbook 4000.4, REV-1, CHG-2, paragraph 2-4C (criterion 2)
HUD Handbook 4155.1, REV-5, section 2-2 (criterion 18)
HUD Handbook 4155.1, REV-5, section 2-7 (criterion 21)
HUD Handbook 4155.1, REV-5, paragraphs 2-7A and E (criterion 21)
Mortgagee Letter 2005-16 (criterion 26)




                                              45
Case number: 182-0823672                     Insured amount: $144,645

Section of Housing Act: 203(b)               Status upon selection: Defaulted on 8th
                                                 payment

Date of loan closing: September 8, 2006      Current status: Active – 10 months delinquent

Underwriter type: Manual

Overstated Income/Excessive Ratios
Peoples Bank overstated the borrowers’ income by $1,084 per month. The lender qualified the
borrowers using $4,160 in monthly income ($2,080 each). Pay stubs for each of the borrowers
supported a pay rate of $12 per hour ($12 x 40 hrs x 52 weeks / 12 = $2,080). The year-to-date
amounts on the pay stubs did not support earnings of $2,080 per month for either borrower.

The year-to-date amount on the borrowers’ most recent pay stub, dated August 15, 2006, was
$11,897. Average monthly income based on this amount was only $1,586 ($11,897 / 7.5
months). The year-to-date amount on the coborrower’s most recent pay stub, dated August 11,
2006, was $11,000. Average monthly income based on this amount was only $1,490 ($11,000 /
32 weeks x 52 / 12 months). The 2004 and 2005 income documentation, if used for either the
borrower or coborrower, would have made their monthly incomes even lower.

The total monthly income supported by the pay stubs was $3,076. The lender obtained verbal
verifications of employment for both borrowers; however, neither included information on pay
rate, work hours, or overtime and bonuses. In addition, the coborrower’s verification did not
include a start date for employment. The lender did not establish and document earnings trends
for overtime or bonus income. Therefore, the lender overstated monthly income by $1,084.
Using only supported income, the financial ratios were to 37.4 percent and 51.5 percent.

HUD Requirements – Appendix C
HUD Handbook 4000.4 REV-1, CHG-2, paragraph 2-4C (criterion 2)
HUD Handbook 4155.1, REV-5, section 2-2 (criterion 18)
HUD Handbook 4155.1, REV-5, section 2-7 (criterion 21)
Mortgagee Letter 2005-16 (criterion 26)

Ineligible Property
Peoples Bank submitted an ineligible property for FHA insurance. The appraisal listed a married
couple as the owners of record. The sales contract named an investment company as the owner.
Loan file documentation indicated that the married couple sold the property to the investment
company on August 15, 2006, which was less than one month before the sale of the property to
the FHA borrowers. This property was not eligible for FHA insurance.

HUD Requirements – Appendix C
HUD Handbook 4000.2, REV-3, paragraph 1-7C (criterion 1)
HUD Handbook 4000.4, REV-1, CHG-2, paragraph 2-4C (criterion 2)
Mortgagee Letter 2006-14 (criterion 28)


                                              46
Case number: 182-0824524                      Insured amount: $86,813

Section of Housing Act: 203(b)                Status upon selection: Defaulted on 12th
                                                  payment

Date of loan closing: September 18, 2006      Current status: First legal action to commence
                                                  foreclosure in April 2008

Underwriter type: Manual

Underreported Liabilities/Excessive Ratios
Peoples Bank underreported the borrower’s liabilities by $324 per month. The lender did not
adequately consider a car payment that affected the borrower’s ability to repay the mortgage in
the months immediately after closing. The lender did not include the payment in the financial
ratios.

The loan file documentation was contradictory, as described below.

   •   The credit report, dated August 7, 2006, showed a monthly payment of $324 and a
       balance of $4,817, which yielded more than 14 months left to repay the loan.
   •   The creditor verification letter, dated August 14, 2006, listed the monthly payments at
       $300 and the balance of the loan at $4,724, which yielded more than 15 months to pay off
       the loan.
   •   A payment printout, dated August 15, 2006, showed bimonthly payments of $150 and a
       balance of $4,701.

On September 5, 2006 (two weeks before closing the FHA loan), the borrower made a $1,474
payment (in two installments) to reduce the loan balance to $3,000. The final loan application
listed the payment as $324 with a balance of $3,074, which yielded a 9.5-month payoff period.

Based on the information provided by the creditor, it appeared that the most current balance was
$3,000 and that the borrower was paying $150 bimonthly (an average of $324/mo.). The
borrower had 9.3 months of payments left to make, and, therefore, the liability should have been
included in the ratio calculation because this monthly payment was large enough to adversely
affect the borrower’s ability to make the mortgage payment immediately after closing. The
liability increased the total debt ratio from 38.7 percent to 54.7 percent, which was well above
HUD’s limit. The transactions on this loan before loan closing could be an indication that the
borrower’s intention was to pay down the loan so that the liability would not affect already high
ratios.

Additionally, the lender should have questioned the source of funds used to pay down the car
loan. To pay down the car loan, the borrower may have secured an additional loan that might not
have appeared on the credit report and not have been included in the financial ratio calculation.
The borrowers used only about $300 of their own assets in closing the loan. Their bank balance
was only $557 as of August 23, 2006 (three weeks before closing the loan). The balance for the


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month before was only $306. Both months showed a number of insufficient funds charges. The
mortgage credit analysis worksheet showed that the borrower had reserves of only $299, less
than one month of the $549 monthly principal and interest payment. The lender did not list
compensating factors on the mortgage credit analysis worksheet.

HUD Requirements – Appendix C
HUD Handbook 4000.4, REV-1, CHG-2, paragraph 2-4C (criterion 2)
HUD Handbook 4155.1, REV-5, paragraph 2-11A (criterion 22)
Mortgagee Letter 2005-16 (criterion 26)




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Case number: 183-0053891                      Insured amount: $65,975

Section of Housing Act: 203(b)                Status upon selection: Defaulted on 2nd
                                                  payment

Date of loan closing: May 11, 2007            Current status: Active – six months delinquent

Underwriter type: Manual

Missing Verification of Mortgage Payments
Peoples Bank did not obtain a verification of mortgage for the borrower although there was
evidence that the borrower was past due on refinancing the mortgage. The borrower’s bank
statements showed that she had made a payment on February 2, 2007, for more than three times
the monthly payment ($1,316 / 423 = 3.11). The prior lender verified that the borrower’s
monthly payment was $423. The mortgage credit analysis worksheet showed that the borrower’s
current housing expense was $468 per month.

Further, there was a significant difference between what the credit report showed as the principal
balance ($26,576) on the prior mortgage and the loan payoff amount paid at closing ($34,860).
This difference indicated that the borrower may have missed payments, accrued additional
interest, had escrow shortages, and been charged fees for late payments. Peoples Bank should
have questioned the large payment and obtained a verification of mortgage payment history from
the prior lender. HUD does not allow refinanced mortgages to include late interest, late fees, or
escrow shortages. Without the payment history, Peoples Bank was unable to verify that the
unallowable fees were not included in the FHA mortgage.

HUD Requirements – Appendix C
HUD Handbook 4000.4, REV-1, CHG-2, paragraph 2-4C (criterion 2)
HUD Handbook 4155.1, REV-5, paragraph 1-11A(2) (criterion 16)
HUD Handbook 4155.1, REV-5, paragraph 1-11B (criterion 17)
HUD Handbook 4155.1, REV-5, paragraph 2-3A (criterion 19)
HUD Handbook 4155.1, REV-5, section 3-1 (criterion 24)




                                               49
Case number: 183-0055148                     Insured amount: $169,099

Section of Housing Act: 203(b)               Status upon selection: Defaulted on 3rd
                                                 payment

Date of loan closing: June 23, 2007          Current status: Active – two months delinquent

Underwriter type: Manual

Unsupported Income/Excessive Ratios
Peoples Bank overstated the borrower’s income by $638 per month, resulting in excessive
qualifying financial ratios of 34 percent and 48 percent. The borrower’s statement of earnings
and leave showed the borrower’s annual salary as $50,155, which equaled $4,180 per month
($50,155 / 12 months). However, the lender listed the borrower’s monthly income on the
mortgage credit analysis worksheet as $4,818, which would be an annual salary of $57,818.
Therefore, the lender overstated the borrower’s monthly income by $638 ($4,818 - $4,180).

HUD Requirements – Appendix C
HUD Handbook 4000.4, REV-1, CHG-2, paragraph 2-4C (criterion 2)
HUD Handbook 4155.1, REV-5, section 2-2 (criterion 18)
HUD Handbook 4155.1, REV-5, paragraph 2-7A (criterion 21)
Mortgagee Letter 2005-16 (criterion 26)




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Case number: 291-3457668                      Insured amount: $53,744

Section of Housing Act: 203(b)                Status upon selection: Defaulted on 14th
                                                  payment

Date of loan closing: July 6, 2006            Current status: Active – current

Underwriter type: Manual

Missing Verification of Mortgage Payments
Peoples Bank did not obtain a verification of mortgage payments for a refinanced mortgage and
a home equity loan. The borrower’s credit report indicated that the borrower had two loans with
the prior lender; however, the credit report showed the first mortgage was paid off in 2001 and
the home equity loan was paid off in 2000. The credit report showed no outstanding mortgage
balance. The loan file included no documentation regarding the borrower’s payment history on
these prior mortgage loans or an explanation of why the credit report showed no outstanding
mortgage.

In addition, the payoff statements from the prior lender did not provide a payment history of the
loans to indicate whether the loans had a negative payment history (i.e., late payments,
significant defaults, etc.). Further, HUD does not allow refinanced mortgages to include late
interest, late fees, or escrow shortages. Without the payment history, Peoples Bank was unable
to adequately evaluate the borrower’s creditworthiness and to verify that the unallowable fees
were not included in the FHA mortgage.

HUD Requirements – Appendix C
HUD Handbook 4000.4, REV-1, CHG-2, paragraph 2-4C (criterion 2)
HUD Handbook 4155.1, REV-5, paragraph 1-11A(2) (criterion 16)
HUD Handbook 4155.1, REV-5, paragraph 2-3A (criterion 19)
HUD Handbook 4155.1, REV-5, section 3-1 (criterion 24)




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