oversight

Harry Mortgage Company, Oklahoma City, Oklahoma, Overstated the Financial Wherewithal of the Owner and General Contractor and Overestimated the Qualifications of the General Contractor When Underwriting the Cypress Ridge Apartments' $5.87 Million Loan und

Published by the Department of Housing and Urban Development, Office of Inspector General on 2009-06-26.

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

                                                                Issue Date
                                                                         June 26, 2009
                                                                Audit Report Number
                                                                         2009-FW-1010




TO:         Brenda L. Waters
            Acting Director, Kansas City Multifamily Hub, 7AHM

            Henry S. Czauski, Acting Director, Departmental Enforcement Center, CV


FROM:       Gerald R. Kirkland
            Regional Inspector General for Audit, Fort Worth Region, 6AGA

SUBJECT: Harry Mortgage Company, Oklahoma City, Oklahoma, Overstated the Financial
         Wherewithal of the Owner and General Contractor and Overestimated the
         Qualifications of the General Contractor When Underwriting the Cypress Ridge
         Apartments’ $5.87 Million Loan under the Multifamily Accelerated Processing
         Program


                                   HIGHLIGHTS

 What We Audited and Why

             In response to requests from the U. S. Department of Housing and Urban
             Development (HUD) and Senator James Inhofe, we audited the property owner’s
             application and the loan processing and underwriting of the HUD-insured
             mortgage loan to Greystone Apartments, Inc., for Cypress Ridge Apartments.
             Harry Mortgage Company, the lender, processed and recommended loan approval
             under the multifamily accelerated processing (MAP) program.

             The audit objective was to determine whether the lender satisfied HUD
             requirements for processing and underwriting the $5.87 million mortgage loan to
             rehabilitate Cypress Ridge Apartments.
What We Found


           The MAP lender’s underwriting analysis did not assess, as required, the financial
           wherewithal of the owner and general contractor, which are related entities, or the
           construction capabilities of the general contractor. As a result, the MAP lender
           did not identify risk and take necessary corrective action before recommending
           the loan for approval. Based on the lender’s recommendation, HUD approved the
           project and general contractor. The project failed, resulting in a $3.7 million loss
           on the mortgage loan insured by the Federal Housing Administration (FHA).

What We Recommend


           We recommend that the Acting Director of HUD’s Kansas City multifamily hub
           request that the Mortgagee Review Board take action against Harry Mortgage
           Company for negligence that resulted in a default and a resulting FHA insurance
           claim on Cypress Ridge Apartments. Further, we recommend that the Acting
           Director of HUD’s Enforcement Center take action against Harry Mortgage
           Company for negligence that resulted in a default and a resulting FHA insurance
           claim on Cypress Ridge Apartments.

           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


           On June 4, 2009, we provided a discussion draft report to the MAP lender. On
           June 11, 2009, we held an exit conference with HUD and the lender. On June 22,
           2009, we received the lender’s written comments on the draft. The lender did not
           agree with the finding.

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




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                             TABLE OF CONTENTS

Background and Objective                                                               4

Results of Audit                                                                       6
Finding:   The Lender Overstated the Financial Wherewithal of the Owner and General
           Contractor and Overestimated the Qualifications of the General Contractor


Scope and Methodology                                                                  10

Internal Controls                                                                      11

Appendixes
   A. Schedule of Questioned Costs                                                     12
   B. Auditee Comments and OIG’s Evaluation                                            13




                                              3
                      BACKGROUND AND OBJECTIVE

Section 221(d)(4) of the National Housing Act authorizes loans insured by the Federal Housing
Administration (FHA) for the substantial rehabilitation of rental housing. Under multifamily
accelerated processing (MAP) program guidelines, the sponsor works with a MAP-approved
lender, which submits required exhibits for the preapplication stage. After the U. S. Department
of Housing and Urban Development (HUD) reviews the exhibits, it either invites the lender to
apply for a firm commitment for mortgage insurance or declines to consider the application
further. For acceptable exhibits, the lender submits the firm commitment application, including a
full underwriting package, to HUD for review to determine whether the loan is an acceptable
risk. Considerations include market need, zoning, architectural merits, capabilities of the
borrower, etc. If HUD determines that the project meets program requirements, it issues a
commitment to the lender for mortgage insurance.

In May 2005, the Multifamily Program Center in Oklahoma City, Oklahoma (center), received a
Section 221(d)(4) mortgage loan application from Harry Mortgage Company, a MAP-approved
lender, for Greystone Apartments, Inc., the owner of Cypress Ridge Apartments. The center
issued an initial endorsement for a $5.87 million mortgage loan on December 14, 2005. For
comparable jobs, HUD reported that contractors usually complete substantial rehabilitation
within 12 months. In the appraisal, the contractor estimated that it would take nine months to
complete the rehabilitation.

One company managed the property and carried out the rehabilitation project. Williams
Commercial Property Management, Inc. (management company), was the management agent
that managed Cypress Ridge Apartments. Harry Mortgage Company recommended and HUD
approved the management company as the general contractor to carry out the property
rehabilitation. William L. Sharpe, a shareholder of Greystone Apartments, Inc., and the principal
contact person for ownership, owned the management company.

On October 1, 2007, 22 months after obtaining the loan, the owner defaulted on the loan. At the
time, the general contractor had finished only about 57 percent of the rehabilitation, which it did
not complete. The lender assigned the note to HUD, and HUD recorded the assignment on
November 28, 2007. It paid more than $4.2 million to Harry Mortgage Company for the
Greystone Apartments, Inc. (Cypress Ridge Apartments), insurance claim settlement and sold the
mortgage note for $484,376, a loss of more than $3.7 million.

HUD’s Lender Qualifications and Monitoring Division (division) in headquarters conducted a
project default review of Cypress Ridge Apartments during the week of October 29, 2007. Its
purpose was to determine what caused the default and whether the MAP lender and HUD had
complied with program requirements. The division’s June 24, 2008, report concluded that the
MAP lender primarily caused the default by not performing an adequate underwriting analysis.
The report stated that the lender overstated the economic feasibility and minimized the risk of the
loan, resulting in an under scoped rehabilitation plan, an incomplete rehabilitation, and poor



                                                4
construction.1 The division’s determination was that the misrepresentation by the lender’s
underwriter was the primary reason for the construction loan default and assignment of the loan.
Requests to perform this audit came from Senator James Inhofe and the HUD Kansas City
multifamily hub office. The center did not receive a copy of the division’s report until December
2008, when we were well into our audit. While the center did not take action against Harry
Mortgage Company because it elected to get out of the FHA multifamily business, the center did
flag the owner, its principals, and Williams Commercial Property Management, Inc. in HUD's
Active Partners Performance System for their poor performance in carrying out the Cypress
Ridge Apartments' project.

The audit objective was to determine whether the lender satisfied HUD requirements for
processing and underwriting the $5.87 million mortgage loan to rehabilitate Cypress Ridge
Apartments.

This is the first of two reports on the project. The second report will address funding used to
rehabilitate and operate the property.




1
    Our audit did not conclude that the general contractor carried out the project with a severely under scoped
    rehabilitation plan as the division concluded. We did not find a material number of unplanned work items
    excluded from the work scope or that the independent architect or engineer agreed with the division’s
    conclusion.

                                                         5
                                RESULTS OF AUDIT

Finding: The Lender Overstated the Financial Wherewithal of the
         Owner and General Contractor and Overestimated the
         Qualifications of the General Contractor
The lender did not thoroughly analyze the financial conditions of the owner and general
contractor as required by the MAP Guide. The lender also did not accurately assess the
qualifications of the general contractor. The lender’s underwriter did not practice the required
due diligence during its analyses. As a result, the lender reported to HUD unsupported
wherewithal for the owner and general contractor and construction capability that was not
evident. Relying on the lender’s recommendation, HUD insured the mortgage loan for a project
that the owner and its related general contractor could not complete, resulting in a loss to HUD
of more than $3.7 million.



 The Lender Did Not Obtain
 Sufficient Financial
 Information to Analyze the
 Financial Conditions of the
 Owner or the General
 Contractor


              The lender did not obtain sufficient financial information to determine whether
              the owner and general contractor had sufficient working capital to undertake the
              project. Working capital is the excess of current assets over current liabilities.
              The MAP Guide required the lender’s underwriter to make a working capital
              determination for the owner and the general contractor using their financial
              statements. The determinations affect the lender’s recommendation as to whether
              HUD should approve the loan. The lender’s underwriter should have reviewed
              the owner’s working capital to ensure that the owner had sufficient cash to
              maintain operations through the construction period. If the general contractor’s
              working capital was insufficient, the lender should have required it to establish a
              joint venture with a financially stronger general contractor or replaced the general
              contractor before recommending the loan to HUD for approval.

              For the owner, Greystone Apartments, Inc., the underwriter did not obtain a
              balance sheet or have other means to calculate working capital. Nevertheless, in
              the narrative accompanying the recommendation to approve the loan, the lender
              falsely reported to HUD that it had performed a careful review of the owner’s
              financial condition and had no negative findings to report.


                                                6
                 For the general contractor, Williams Commercial Property Management, Inc., the
                 underwriter calculated working capital based on (1) selected current asset and
                 liability balances from an unaudited balance sheet that did not identify current
                 liabilities and (2) cash confirmed by banks. The method was not consistent with
                 the MAP Guide, which requires the underwriter to use financial statements, not
                 bank confirmations.

                 The MAP Guide required2 the general contractor to have working capital that was
                 5 percent of the amount of the rehabilitation contract. Using the cash confirmed
                 by the banks, the lender wrongly concluded that the general contractor had
                 $147,549 in available working capital and reported to HUD that the general
                 contractor had working capital that was 7.1 percent of the contract amount. If the
                 lender had used the cash reported in the balance sheet in its calculation, as
                 required by the MAP Guide,3 it would have concluded that the general contractor
                 had a negative $19,541 in working capital.

                 The lender reported to HUD that, after careful review, the underwriter found no
                 negative finding to report regarding the general contractor’s financial condition.
                 This would not have been the case if the underwriter had required the general
                 contractor to provide a breakdown of current and long-term liabilities, used the
                 cash balance from the balance sheet, and identified the current portion of long-
                 term debt, as the MAP Guide required.4

                 In addition, the MAP Guide required the lender to obtain an income statement and
                 several supporting schedules. The general contractor only submitted the balance
                 sheet for the most recent three years. Without these additional documents, the
                 lender could not perform a complete financial analysis.

    The Lender Did Not Make a
    Valid Determination of the
    General Contractor’s
    Construction Capability


                 The lender’s evaluation of the general contractor’s construction capability did not
                 affirm the general contractor’s experience in terms of type and size of previous
                 projects. This condition occurred because the lender’s underwriter did not
                 exercise required due diligence when it analyzed the general contractor’s résumé
                 of experience.

                 According to requirements,5 “the underwriter serves as a member of the Lender’s
                 processing team, calling for specific requirements and terms in the preparation of

2
     MAP Guide, chapter 8, section 8.4.C.12.d
3
     MAP Guide, chapter 8, section 8.4.C.3
4
     MAP Guide, chapter 8, section 8.4.B.2.a
5
     MAP Guide, chapter 8, section 8.1.B.1

                                                  7
underwriting recommendations to HUD.” The underwriter should use trade
references, bank references, credit data, and construction experience résumés in
analyzing the construction capability of the general contractor, including financial
stability and ability to complete the project.

The underwriter did not record, as required, its use of trade references, bank
references, and credit data in analyzing the construction capability of the general
contractor. It was clear from the general contractor’s résumé that it did not have
experience in carrying out rehabilitation projects of this project’s size and
complexity. The previous work reported did not approach the size and scope of
the Cypress Ridge Apartments’ rehabilitation project. Its proposed work scope
totaled $1.9 million in repairs and included repairs to all 256 units. Whereas, the
résumé showed that the general contractor had completed routine management
agent jobs on five apartments with total units ranging in number from 104 to 200,
with only one job totaling more than 150 units, and repair costs ranging from
$285,000 to $785,000. This information did not demonstrate the level of
professional general contractor experience needed to carry out the rehabilitation
project, which the project outcome affirmed.

As mentioned above, the lender did not obtain income statements from the
general contractor. Had the lender requested and reviewed the September 15,
2005 income statement for the same period, it would have seen that the general
contractor had no recent construction activity.

From the start, the general contractor did not exhibit sound experience.
According to concurrent reviews, it did not follow a logical work plan, review the
work scope in detail, and obtain bids. It depended upon the lender and HUD to
monitor the construction activity.

As a result, throughout the rehabilitation, the general contractor’s efforts exhibited
the following deficiencies:

       Absence of a written, organized plan for completing work;
       Lack of an experienced contractor on site to supervise the work, resulting
       in poor construction;
       Poor workmanship that it had to redo;
       Occupancy of units before required inspections; and
       Change orders that did not follow requirements to provide a full detailed
       description of the work scope and/or materials, list the units that needed
       repairs, include materials specifications, provide detailed drawings with
       the engineers’ seal regarding structural review, or clearly explain the
       required permits.




                                  8
Conclusion


             The lender did not practice due diligence in underwriting the loan to Greystone
             Apartments, Inc. It did not thoroughly analyze the financial positions of the
             owner and general contractor and the qualifications of the general contractor as
             required by the MAP guidelines. Thus, it underwrote and recommended that
             HUD approve a loan with significant financial and business risk. As a result, the
             owner defaulted on the loan before final closing, causing HUD a loss of more
             than $3.7 million.

Recommendation



             We recommend that the Acting Director of HUD’s Kansas City multifamily hub

             1A. Refer Harry Mortgage Company to the Mortgagee Review Board for
                 appropriate action for violations that caused a more than $3.7 million loss to
                 HUD’s FHA insurance fund.

             We recommend that the Acting Director of HUD’s Enforcement Center

             1B. Take action against Harry Mortgage Company for negligence that resulted
                 in a default and a resulting FHA insurance claim on Cypress Ridge
                 Apartments.




                                              9
                        SCOPE AND METHODOLOGY

The audit covered Harry Mortgage Company’s loan processing and underwriting, which
occurred during calendar year 2005. To accomplish the objective, we interviewed the lender, the
architectural and cost reviewer, and the owner/general contractor. We reviewed background
information and criteria controlling underwriting and processing; documents in Greystone
Apartments, Inc.’s loan files located in Harry Mortgage Company’s office; unaudited financial
statements and other financial records of the property, the general contractor, and the key
principals of Greystone Apartments, Inc.; property inspection reports; and Cypress Ridge
Apartments’ rent rolls. We performed the audit from August 2008 to May 2009 at the office of
Williams Commercial Property Management, Inc., and the HUD Multifamily Oklahoma City
Center office.

We conducted the 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
objective. We believe that the evidence obtained provides a reasonable basis for our findings
and conclusions based on our audit objective.




                                              10
                              INTERNAL CONTROLS

Internal control is an integral component of an organization’s management that provides
reasonable assurance that the following controls are achieved:

       Program operations,
       Relevance and reliability of information,
       Compliance with applicable laws and regulations, and
       Safeguarding of assets and resources.

Internal controls relate to management’s plans, methods, and procedures used to meet its
mission, goals, and objectives. They include the processes and procedures for planning,
organizing, directing, and controlling program operations as well as the systems for measuring,
reporting, and monitoring program performance.



 Relevant Internal Controls


              We determined that internal controls were not relevant to our audit objectives
              because Harry Mortgage Company is no longer a going concern. As a result, we did
              not assess internal controls.

              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
              We did not assess internal controls; therefore, no significant weaknesses were
              identified.




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                                              APPENDIXES

Appendix A

                       SCHEDULE OF QUESTIONED COSTS

              Recommendation number                                   Unreasonable or unnecessary 1/



                           1A                                                     $3,759,333




1/   Unreasonable/unnecessary costs are those costs not generally recognized as ordinary, prudent, relevant, and/or
     necessary within established practices. Unreasonable costs exceed the costs that a prudent person would incur
     in conducting a competitive business.




                                                         12
Appendix B

        AUDITEE COMMENTS AND OIG’S EVALUATION


Ref to OIG Evaluation   Auditee Comments




Comment 1




Comment 2




                         13
Comment 3


Comment 4


Comment 5




            14
                         OIG Evaluation of Auditee Comments

Comment 1   According to the response, the lender’s underwriter carefully reviewed all the
            financial statements of the stockholders involved, which showed a gross net worth
            of $26 million. However, the lender did not dispute the conclusion in the report
            that its underwriter did not thoroughly analyze the financial conditions of the
            owner and general contractor as the MAP Guide required. With the two entities
            not having sufficient working capital, the lender should not have recommended
            the project to HUD for approval. Under the MAP program, HUD relies heavily
            on the MAP lender’s underwriting in making the decision to approve a project.

Comment 2   The lender stated that it knew the general contractor when he worked as a project
            manager for a person in Oklahoma City, Oklahoma, that had several apartment
            complexes. The general contractor reportedly had done several rehabilitation
            projects for this owner. As discussed in the finding, the general contractor had
            not performed rehabilitation projects with a similar scope or dollar value as
            Cypress Ridge. We did not conclude that knowing someone who worked as a
            project manager for an owner of several apartment complexes constituted
            reasonable assurance that one has the experience and capabilities to carry out a
            multimillion-dollar HUD project.

Comment 3   We disagree with the lender as discussed in the finding.

Comment 4   Under the MAP program, HUD relies heavily on the MAP lender’s underwriting
            in making the decision to approve a project. The program does not require HUD
            to duplicate the underwriting of the MAP lender. The intent of the MAP process
            is to reduce significantly the amount of HUD review time. Therefore, the
            expedited process did not allow HUD time to catch a misleading recommendation
            to approve a project in which the underwriter did not fulfill MAP requirements.

Comment 5   The lender concluded, based on its nearly 50-years of underwriting conventional
            and HUD projects, “. . . that the main reason that a project goes bad is based on
            the ownership and management of the project.” This statement affirms the
            importance of the lender’s underwriter to assess, as required, the financial
            wherewithal of the owner and general contractor and the construction capabilities
            of the general contractor.




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