oversight

Wells Fargo Home Mortgage, Newark, Delaware, Did Not Always Comply with HUD Requirements in the Origination of FHA-Insured Single-Family Loans

Published by the Department of Housing and Urban Development, Office of Inspector General on 2008-07-31.

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

                                                               Issue Date
                                                                  July 31, 2008
                                                               Audit Report Number
                                                                  2008-PH-1011




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



FROM:      John P. Buck, Regional Inspector General for Audit, Philadelphia Regional
             Office, 3AGA

SUBJECT:   Wells Fargo Home Mortgage, Newark, Delaware, Did Not Always Comply
            with HUD Requirements in the Origination of FHA-Insured Single-Family
            Loans


                                 HIGHLIGHTS

 What We Audited and Why

           We audited the Newark, Delaware, branch office (branch office) of Wells Fargo
           Home Mortgage (Wells Fargo), a supervised direct endorsement lender approved
           to originate Federal Housing Administration (FHA) single-family mortgage loans.
           The branch office is mainly responsible for underwriting loans for 22 Wells Fargo
           sales branch offices throughout Pennsylvania, excluding Pittsburgh, as well as
           two sales offices in Marlton, New Jersey. We selected the branch office because
           of its relatively high default rate, compared with the average default rate for the
           state of Pennsylvania. Our objective was to determine whether the branch office
           complied with U.S. Department of Housing and Urban Development (HUD)
           requirements in the origination and quality control review of FHA loans.

 What We Found

           Wells Fargo’s branch office did not always comply with HUD requirements in the
           origination of FHA-insured single-family loans. Four of eight loans we selected
                 for review 1 were not originated in accordance with HUD requirements. Wells
                 Fargo generally complied with HUD requirements in its quality control reviews of
                 FHA loans. The deficiencies we noted with the loan originations occurred
                 because Wells Fargo staff did not exercise due care in the underwriting of the
                 loans. As a result, the FHA insurance fund was exposed to an unnecessarily
                 increased risk.

    What We Recommend

                 We recommend that HUD’s Assistant Secretary for Housing – Federal Housing
                 Commissioner require Wells Fargo to indemnify more than $816,000 2 for four
                 loans, which it issued contrary to HUD’s loan origination requirements, and
                 enforce its policies, procedures and controls to ensure that its staff consistently
                 follows HUD’s 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 a draft report to Wells Fargo on June 9, 2008. We discussed the
                 report with Wells Fargo during the audit and at an exit conference on June 12,
                 2008. Following the exit conference, we provided an updated draft to Wells
                 Fargo on June 25, 2008. Wells Fargo provided written comments to our revised
                 draft report on June 30, 2008. In its response it stated it agreed with our findings
                 and provided a list of steps it has taken to address them. The complete text of
                 Wells Fargo’s response can be found in appendix B of this report.




1
  The eight loans were originally valued at more than $1.6 million.
2
  This amount is the unpaid principal balance. The projected loss to HUD is $318,596 based on HUD’s average
insurance fund loss rate of 39 percent.



                                                       2
                             TABLE OF CONTENTS


Background and Objectives                                                        4

Results of Audit
        Finding: The Branch Office Did Not Always Comply with HUD Requirements   5
        in the Origination of FHA-Insured Single-Family Loans

Scope and Methodology                                                            9

Internal Controls                                                                10

Appendixes
   A.   Schedule of Funds to Be Put to Better Use                                11
   B.   Auditee Comments                                                         12
   C.   Schedule of Case File Discrepancies                                      16
   D.   Narrative Case Presentations                                             17




                                              3
                     BACKGROUND AND OBJECTIVES


The U.S. Department of Housing and Urban Development’s (HUD) strategic plan states that its
mission is to increase homeownership, support community development, and increase access to
affordable housing free from discrimination.

The National Housing Act, as amended, established the Federal Housing Administration (FHA),
an organizational unit within HUD. FHA provides insurance for lenders against loss on single-
family home mortgages.

HUD’s direct endorsement program, authorizes approved lenders to underwrite loans without
HUD’s prior review and approval. HUD can place lenders on credit watch status or terminate
their approval if their rate of defaults and claims exceeds the normal rate for the area. Many
sanctions are available for taking actions against lenders or others who abuse the program.

Wells Fargo Home Mortgage (Wells Fargo) is a direct endorsement lender for FHA loans. Its
corporate office is located in Des Moines, Iowa.

The Newark, Delaware, branch office (branch office) issued 48 FHA loans valued at
approximately $6.6 million that defaulted within the first two years. We sampled and reviewed
case files for eight of the loans valued at approximately $1.6 million.

Our objective was to determine whether the branch office complied with HUD requirements in
the origination and quality control review of FHA loans.




                                                4
                                    RESULTS OF AUDIT


Finding: The Branch Office Did Not Always Comply with HUD
Requirements in the Origination of FHA-Insured Single-Family Loans
The branch office did not always comply with HUD requirements in the origination of FHA-
insured single-family loans. Four of eight loans selected for review were not originated in
accordance with HUD requirements. The branch office did not always verify borrowers’ rental
histories as required. It also approved a borrower with unacceptably high debt ratios and
improperly reimbursed a borrower for “sweat equity.” These deficiencies occurred because
Wells Fargo staff did not exercise due care in underwriting the loans, causing an unnecessarily
increased risk to the FHA insurance fund. Therefore, Wells Fargo should indemnify more than
$816,000 3 for the four defaulted loans.




    The Branch Office Did Not
    Verify Borrowers’ Rental
    Histories


                  According to HUD requirements, 4 lenders must obtain borrowers’ payment
                  histories of housing obligations through either credit reports, verification directly
                  from the landlords (with no identity of interest with the borrower), or canceled
                  checks covering the most recent 12-month period.

                  For two of our sample loans, the case files did not include rental histories or
                  verification of monthly rental payments, and the borrowers’ credit reports did not
                  include payment histories pertaining to housing obligations. Monthly rental
                  payment amounts were listed on the borrowers’ uniform residential loan
                  agreement, and one of the loans was a lease purchase. In the absence of the
                  information discussed, there was no evidence that the branch office determined
                  the borrowers’ payment history of housing obligations as required by HUD.




3
    See footnote 2.
4
    HUD Handbook 4155.1, REV-5, paragraph 2-3A.


                                                    5
    The Branch Office Improperly
    Reimbursed the Borrower for
    “Sweat Equity”


                HUD requirements 5 state that labor to be performed by the borrower on the
                property being rehabilitated may be used to create additional equity in the
                property (“sweat equity”), but that the borrower cannot receive any cash back for
                the labor performed. The borrower can only be reimbursed for the cost of any
                materials that the borrower may have purchased.

                One of the sample cases involved a Section 203K rehabilitation loan. The
                borrower performed the repair work on the property. He provided the branch
                office a quote/cost estimate prepared by a construction company that was also his
                employer. The quote reflected a total of $9,998 in rehabilitation costs and showed
                that the amount included the cost of materials and labor. The total drawn amount
                for the repairs was $9,998, indicating that the borrower was reimbursed the cost
                of his labor in violation of HUD requirements.

    The Branch Office Overstated
    the Borrowers’ Income and,
    Therefore, Relied on High
    Debt-to-Income Ratios



                According to HUD requirements, 6 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. HUD requirements 7 also state that
                ratios should be used to determine whether a borrower can reasonably be expected
                to meet the expenses involved in homeownership and otherwise provide for the
                family. Lenders are required to compute two ratios: the mortgage payment
                expense to effective income, which should not exceed 31 percent, and the total
                fixed payment to effective income, which should not exceed 43 percent.

                In one case, the branch office overstated the borrowers’ effective monthly income
                and, therefore, approved the loan based on incorrect debt-to-income ratios. The
                branch office included overtime income in the computation of the borrowers’
                effective income without developing an average of bonus or overtime income for
                the previous two years or documenting written justification for including the

5
  HUD Mortgagee Letter 94-11, paragraph 17.
6
  HUD Handbook 4155.1, REV-5, paragraph 2.7A.
7
  HUD Handbook 4155.1, REV-5, paragraph 2.12, and HUD Mortgagee Letter 2005-16.


                                                   6
                      overtime earnings. Without the overtime income, the borrowers would not have
                      qualified for the loan because their mortgage payment expense-to-effective
                      income ratio would have been 39.68 percent, which exceeds the 31 percent
                      allowed by HUD, and their total fixed payment-to-effective income ratio would
                      have been 54.69 percent, compared with HUD’s 43 percent limit.


    Wells Fargo Staff Did Not
    Exercise Due Care


                      The deficiencies noted occurred because branch office staff did not exercise due
                      care in the underwriting of the loans. We discussed the deficiencies with staff at
                      the branch office as well as staff in Wells Fargo’s Credit Risk Management
                      Division in Minneapolis, Minnesota. Wells Fargo could not provide justification
                      for the branch office’s noncompliance with HUD requirements. Also, although
                      Wells Fargo established a quality control plan and generally performed related
                      reviews in compliance with HUD requirements, for one of the cases in which we
                      determined the borrower’s rental history was not verified, Wells Fargo also
                      reviewed that particular loan as part of its quality control process but failed to
                      identify the issue we noted. The quality control review was performed by Wells
                      Fargo’s Credit Risk Quality Assurance staff in Minneapolis, Minnesota.

                      It is important for Wells Fargo to ensure that its staff exercises due care in
                      underwriting FHA loans and also in its quality control review process so that it
                      can correctly assess the performance of its underwriters and take appropriate
                      measures to prevent instances of noncompliance with HUD requirements.

    Conclusion

                      The branch office did not comply with HUD requirements in originating four of
                      eight loans reviewed. It did not always verify borrowers’ rental histories. It also
                      approved a borrower with unacceptably high debt ratios and improperly
                      reimbursed a borrower for “sweat equity.” These deficiencies occurred because
                      Wells Fargo staff did not exercise due care in underwriting the loans, causing an
                      unnecessarily increased risk to the FHA insurance fund. Therefore, Wells Fargo
                      should indemnify more than $816,000 8 for the four defaulted loans (see
                      appendixes C and D for more detail).

    Recommendations



8
    See footnote 2.


                                                       7
                      We recommend that HUD’s Assistant Secretary for Housing – Federal Housing
                      Commissioner require Wells Fargo to

                      1A.   Indemnify $816,912 9 for four loans which it issued contrary to HUD’s
                            loan origination requirements.

                      1B.   Enforce its policies, procedures and controls to ensure that its staff
                            consistently follows HUD requirements.




9
    See footnote 2.


                                                      8
                        SCOPE AND METHODOLOGY


We reviewed lenders with high default rates and selected the Jenkintown, Pennsylvania, branch
of Wells Fargo, HUD branch ID number 2299504147, because its percentage of defaults by two
years was 3.48 percent, compared with the Pennsylvania state average of 3.31 percent. We later
learned that the branch ID actually covers 22 Wells Fargo sales branch offices throughout
Pennsylvania (excluding Pittsburgh) as well as two sales offices in Marlton, New Jersey, and that
the underwriting for all these offices is performed at Wells Fargo’s Newark, Delaware, branch
office. As a result, we focused on and performed our review at that branch office.

We ran queries in HUD’s Neighborhood Watch system to identify the number of defaulted loans
within the first two years and the number of payments made against those loans for the branch
office. The branch office issued 48 FHA loans, valued at approximately $6.6 million, that
defaulted within the first two years. After eliminating loans that were processed outside the
branch office, 25 defaulted loans remained. The 25 loans, valued at more than $3.5 million,
defaulted with 12 payments or fewer. We sampled and reviewed case files for eight of the loans
valued at approximately $1.6 million. To determine whether the branch office complied with
HUD regulations, procedures, and instructions in the origination and quality control review of
FHA loans, we performed the following:

   •   Reviewed applicable HUD handbooks and mortgagee letters,

   •   Reviewed case files for the eight sample loans,

   •   Examined records and related documents of Wells Fargo and its branch office, and

   •   Conducted interviews with officials and employees of Wells Fargo and the branch office
       and employees of the HUD Quality Assurance Division.

In addition, we relied in part on data maintained by HUD in the Neighborhood Watch system.
Although we did not perform a detailed assessment of the reliability of the data, we performed a
minimal level of testing and found the data adequately reliable for our purposes.

Our review covered the period November 2005 through October 2007. When applicable, the
review period was expanded to include current data through February 2008.

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




                                                9
                             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:

                  •   Loan origination process – Policies and procedures that management has in
                      place to reasonably ensure that the loan origination process complies with
                      HUD program requirements.

                  •   Quality control plan – Policies and procedures that management has in place
                      to reasonably ensure implementation of HUD’s quality control 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 item is a significant weakness:

                  •   Wells Fargo did not operate in accordance with HUD requirements as they
                      relate to loan issuance or origination.




                                               10
                                  APPENDIXES


Appendix A

     SCHEDULE OF FUNDS TO BE PUT TO BETTER USE

                           Recommendation        Funds to be put
                                  number          to better use 1/

                                         1A            $318,596



1/   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. In this instance, implementation of our
     recommendation to indemnify loans that were not originated in accordance with HUD
     requirements will reduce the risk of loss to the FHA insurance fund. The above amount
     reflects HUD statistics, which show that FHA, on average, loses 39 percent of the claim
     paid for each property (see appendix C).




                                            11
Appendix B

             AUDITEE COMMENTS


                Auditee Comments




                       12
13
14
15
Appendix C

             SCHEDULE OF CASE FILE DISCREPANCIES



                                                                             Borrower
                               Unpaid       39%        No              High reimbursed
       Case       Mortgage    principal      loss    rental Overstated debt for “sweat
      number      amount       balance      rate*    history income ratios equity”
    441-7823233   $241,570    $240,466     $93,782      X
    441-7737514   $202,401    $198,456     $77,398              X       X
    441-7817005   $191,987    $190,571    $74,323       X
    441-7780695   $189,971    $187,419    $73,093                                X
       Totals     $825,929    $816,912    $318,596      2       1       1        1


* This amount was calculated by taking 39 percent of the unpaid principal balance for the loans.
On average, HUD loses 39 percent of the claim amount paid.




                                               16
Appendix D

                     NARRATIVE CASE PRESENTATIONS

Case number: 441-7823233

Mortgage amount: $241,570

Date of loan closing: June 26, 2006

Status: First legal action to commence foreclosure

Payments before first default reported: One

Unpaid principal balance: $240,466

Summary:

               The branch office did not verify the borrower’s rental history.

Pertinent Details:

               According to HUD Handbook 4155.1, REV-5, paragraph 2-3A, 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.

               The buyer/borrower leased the subject property from the seller for almost a year
               before buying it. No verification of the $1,200 monthly rental payment was
               noted, and no rental history was noted on the borrower’s credit reports.




                                                17
Case number: 441-7737514

Mortgage amount: $202,401

Date of loan closing: December 30, 2005

Status: Reinstated by borrower

Payments before first default reported: 12

Unpaid principal balance: $198,456

Summary:

               The branch office overstated the borrowers’ income and, therefore, relied on
               incorrect debt-to-income ratios.

Pertinent Details:

               The branch office overstated the borrower’s income.

               According to HUD Handbook 4155.1, REV-5, paragraph 2.7A, 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.

               The borrower’s combined monthly income was overstated by $607.98 per month.
               We calculated this amount by excluding the borrower’s overtime income, which
               had not been continuous for two years. There was no written explanation
               documented in the file to indicate why the borrower’s overtime income should be
               included in the calculation of his monthly income. Because the borrower’s
               income was overstated, the debt-to-income ratios as calculated by the branch
               office were incorrect (see below).

               The branch office used incorrect debt-to-income ratios.

               HUD Handbook 4155.1, REV-5, paragraph 2-12, states that ratios are used to
               determine whether the borrower can reasonably be expected to meet the expenses
               involved in homeownership and otherwise provide for the family. The lender
               must compute two ratios: mortgage payment expense to effective income should
               not exceed 29 percent, and total fixed payment to effective income should not
               exceed 41 percent. Mortgagee Letter 2005-16 increased the qualifying ratios to
               31 and 43 percent, respectively, for manually underwritten mortgages for which
               the direct endorsement underwriter must make the credit decision.



                                               18
We recalculated the debt-to-income ratios based on the borrower’s income
without the $607.98 overstatement. As recalculated, the mortgage payment-to-
income (front) ratio was 39.68 percent, and the total fixed payment-to-income
(back) ratio was 54.69 percent. Both recalculated ratios significantly exceed the
respective guidelines of 31 percent and 43 percent.




                                19
Case number: 441-7817005

Mortgage amount: $191,987

Date of loan closing: June 28, 2006

Status: Delinquent

Payments before first default reported: Five

Unpaid principal balance: $190,571

Summary:

               The branch office did not verify the borrower’s rental history.

Pertinent Details:

               According to HUD Handbook 4155.1, REV-5, paragraph 2-3A, the lender must
               obtain the borrower’s payment history of housing obligations through either a
               credit report, verification directly from the landlord (with no identity of interest
               with the borrower), or cancelled checks covering the most recent 12-month
               period.

               There was no rental history in the file, no verification of the $800 monthly rental
               payments, and no rental history noted on the credit reports.




                                                 20
Case number: 441-7780695

Mortgage amount: $189,971

Date of loan closing: June 14, 2006

Status: Modification started

Payments before first default reported: 12

Unpaid principal balance: $187,419

Summary:

               The branch office reimbursed the borrower for “sweat equity.”

Pertinent Details:

               According to HUD Mortgagee Letter 94-11, paragraph 17, labor to be performed
               by the borrower on the property being rehabilitated may be used to create
               additional equity in the property, but the borrower cannot receive any cash back
               for the labor performed. The borrower can only be reimbursed for the cost of any
               materials that the borrower may have purchased.

               This case involved a Section 203K rehabilitation loan. The borrower performed
               the repair work on his property. He provided the branch office a quote/cost
               estimate prepared by a construction company that also happened to be his
               employer. The quote/cost estimate reflected a total of $9,998 in rehabilitation
               costs and showed that the amount included the cost of materials and labor. The
               total drawn amount from the borrower’s escrow account for the repairs was
               $9,998, indicating that he was reimbursed the cost of his labor in violation of
               HUD requirements.




                                              21