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.
2
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.
11
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.
15
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)