oversight

Midwest Mortgage Capital Did Not Adequately Underwrite Seven Loans and Inadequately Performed Quality Control Reviews

Published by the Department of Housing and Urban Development, Office of Inspector General on 2009-07-08.

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

                                                                 Issue Date
                                                                      July 8, 2009
                                                                 Audit Report Number
                                                                       2009-KC-1007




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

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


SUBJECT: Midwest Mortgage Capital Did Not Adequately Underwrite Seven Loans and
         Inadequately Performed Quality Control Reviews


                                   HIGHLIGHTS

 What We Audited and Why

             We reviewed 29 Federal Housing Administration (FHA) loans underwritten by
             Midwest Mortgage Capital (Midwest) of St. Louis, Missouri. Our audit
             objectives were to determine whether Midwest followed U.S. Department of
             Housing and Urban Development (HUD) requirements for underwriting loans and
             performing its quality control function for single-family production.

             We audited Midwest due to its above-average default rate. During the two-year
             period ending December 2008, Midwest underwrote more than 860 FHA loans,
             and 63 of them defaulted.


 What We Found


             Midwest did not properly underwrite 7 of the 29 defaulted loans reviewed. These
             loans had material underwriting deficiencies that affected the insurability of the
             loans. In addition, Midwest’s quality control reviews were inadequate and did not
             meet HUD’s requirements.
What We Recommend


           We recommend that the Assistant Secretary for Housing – Federal Housing
           Commissioner require Midwest to indemnify HUD against future losses for seven
           loans with unpaid principal balances totaling more than $1 million.

           Further, we recommend that HUD verify that Midwest
              • Provides its underwriters with additional training on FHA requirements
                  and
              • Properly performs its quality control function.

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


Auditee’s Response


           We provided the draft report to Midwest on June 17, 2009, and requested a
           response by July 1, 2009. Midwest provided written comments on July 1, 2009,
           and agreed with the majority of our audit findings.

           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: Midwest Did Not Adequately Underwrite Seven FHA Loans               5
      Finding 2: Midwest’s Quality Control Reviews Were Not Adequate                 7

Scope and Methodology                                                                10

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. Schedule of Significant Underwriting Deficiencies                              21
   D. Case Narratives                                                                22
   E. Schedule of Loan Status for Loans with Significant Underwriting Deficiencies   29
   F. HUD Quality Control Criteria                                                   30




                                             3
                     BACKGROUND AND OBJECTIVES

Midwest Mortgage Capital (Midwest) is a nonsupervised direct endorsement lender based in St.
Louis, Missouri. Midwest received approval from the Federal Housing Administration (FHA) in
November of 2001 and currently operates two branch offices in Illinois.

FHA’s mortgage insurance programs help low- and moderate-income families become
homeowners by lowering some of the costs of their mortgage loans. FHA mortgage insurance
also encourages lenders to approve mortgages for otherwise creditworthy borrowers and projects
that might not be able to meet conventional underwriting requirements by protecting the lender
against default. The direct endorsement program simplifies the process for obtaining FHA
mortgage insurance by allowing lenders to underwrite and close the mortgage loan without prior
U.S. Department of Housing and Urban Development (HUD) review or approval. Lenders are
responsible for complying with all applicable HUD regulations and are required to evaluate the
borrower’s ability and willingness to repay the mortgage debt. Lenders are protected against
default by FHA's Mutual Mortgage Insurance Fund, which is sustained by borrower premiums.
FHA mortgages had a market share of 13 percent in February 2009.

From January 2007 through December 2008, HUD’s Neighborhood Watch system revealed that
Midwest approved 867 FHA loans. During this same period, 63 of the loans (7.27 percent) were
at least 90 days delinquent. The national average default rate was 5.23 percent.

Our audit objectives were to determine whether Midwest followed HUD requirements for
underwriting loans and performing its quality control function for single-family production.




                                                4
                                RESULTS OF AUDIT

Finding 1: Midwest Did Not Adequately Underwrite Seven FHA Loans
Midwest did not adequately underwrite 7 of 29 loans reviewed. This condition occurred because
the underwriter was not sufficiently aware of HUD underwriting requirements. As a result, the
lender placed the FHA insurance fund at an increased risk of loss on seven loans with original
mortgage amounts totaling more than $1.1 million.



 Underwriting Did Not Meet
 HUD Standards

              Midwest did not adequately underwrite 7 of 29 loans reviewed. The following table
              summarizes the material deficiencies identified.

                              Area of noncompliance       # of loans
                             Credit history/liabilities        5
                             Income                            1
                             Quality ratios and                1
                             compensating factors

              Appendix C contains a schedule of the material deficiencies identified in each of the
              seven loans. Appendix D contains detailed narratives for each of the loans.

              Credit History/Liabilities
              Midwest did not properly document the credit history and/or liabilities of borrowers
              for five loans. Specifically, the lender failed to obtain explanations for derogatory
              credit, verify the payment of outstanding judgments, adequately verify child support
              obligations, or follow up on credit report inquiries. In addition, the lender refinanced
              a loan when the prior month’s payment was outstanding.

              For example, in case # 292-4993498, Midwest failed to document the acceptance of
              a tax repayment plan by the Internal Revenue Service (IRS) or document the terms
              of the repayment plan. Additionally, Midwest failed to document the reason for the
              tax liability.

              Income
              Midwest did not properly evaluate the income used to compute qualifying ratios for
              one loan. In this case, the lender overstated the borrower’s overtime income. When
              recalculating the overtime income, the borrower’s total debt -to-income ratio grossly
              exceeds HUD’s limit of 43 percent. This ratio is the total of the mortgage payment
              and all recurring charges divided by the monthly income.


                                                 5
           Qualifying Ratios and Compensating Factors
           Midwest did not provide compensating factors for underwriting a loan when the
           borrower’s total debt-to-income ratio was 51.1 percent and the borrower did not
           have a large amount of assets in reserve or a high income level.


The Underwriter Was Not
Sufficiently Aware of HUD
Underwriting Requirements

           The underwriter did not fully understand HUD’s documentation requirements for
           loan approval. For example, the underwriter did not understand that he needed to
           verify the acceptance of the installment agreement by the IRS.

           Midwest indicated that it intended to provide its staff with more training. In
           addition, the underwriter developed a checklist to better document the loan file and
           remind him of key items to review before approving the loan.

Loans Placed the FHA
Insurance Fund at an Increased
Risk of Loss

           Midwest placed the FHA insurance fund at an increased risk of loss on seven
           loans with original mortgage amounts totaling more than $1.1 million and more
           than $478,000 in potential losses. One of these loans was in claim, four were in
           foreclosure, one was in default, and one was in forbearance.

Recommendations



           We recommend that the Assistant Secretary for Housing – Federal Housing
           Commissioner require Midwest to

           1A. Indemnify HUD for seven loans with unpaid principal balances totaling
               $1,140,282. The projected loss is $478,918 based on the FHA insurance
               fund average loss rate of 42 percent for fiscal year 2009. Appendix E lists
               the seven loans with material underwriting deficiencies.

           1B. Provide its underwriters with additional training, as approved by HUD, that
               address the deficiencies identified in this finding.




                                             6
Finding 2: Midwest’s Quality Control Reviews Were Not Adequate
Midwest’s quality control reviews were not adequate. This condition occurred because the
lender did not assign sufficient and knowledgeable staff to the quality control function. As a
result, Midwest was unable to ensure the accuracy, validity, and completeness of its loan
origination operations, resulting in an increased risk to the FHA insurance fund.



 The Quality Control Process
 Did Not Meet HUD Standards

               Midwest’s quality control reviews were inadequate and did not meet HUD
               requirements. Specifically, Midwest did not

                  •   Perform thorough quality control reviews.
                  •   Always review 10 percent of loans closed on a monthly basis.
                  •   Always properly reverify the borrowers’ employment status, income, and
                      assets or obtain new credit reports.
                  •   Document branch site reviews.
                  •   Semiannually check its employees against the limited denial of
                      participation/General Services Administration list.

               Quality Control Reviews Not Thorough
               HUD requires that each loan selected for a quality control review be reviewed for
               compliance with HUD underwriting requirements, sufficiency of documentation,
               and the soundness of underwriting judgments. Midwest’s quality control reviews
               were not thorough and did not provide sufficient detail regarding the documents
               examined and the result of the review. The reviewer’s notes on the quality control
               reports primarily concerned differences between the initial and final applications and
               did not analyze the merits of the transaction or draw a conclusion about the overall
               loan quality.

               10 Percent of Loans Closed on a Monthly Basis Not Reviewed
               HUD requires lenders to perform quality control reviews on 10 percent of the loans
               that close in any particular month. Midwest did not always perform quality control
               reviews on 10 percent of the loans that closed on a monthly basis. During 2007 and
               2008, Midwest closed 1,007 loans and, therefore, should have reviewed at least 101
               loans. Instead, it reviewed 88 loans. The following table shows the months in
               which Midwest performed fewer reviews than required.




                                                 7
                Closing month       # of loans closed      # of required      # reviewed
                                                              reviews
             February 2007                  19                    2               1
             March 2007                     16                    2               1
             April 2007                     28                    3               2
             May 2007                       32                    3               2
             June 2007                      32                    3               2
             July 2007                      25                    3               2
             September 2007                 35                    4               2
             October 2007                   36                    4               3
             December 2007                  50                    5               4
             January 2008                   61                    6               4
             March 2008                     55                    6               4
             May 2008                       55                    6               5
             June 2008                      38                    4               3
             November 2008                  41                    4               3

            Borrowers’ Employment Status, Income, and Assets Not Always Reverified and
            New Credit Reports Not Always Obtained
            HUD requires Midwest to reverify the employment status, income, assets, and credit
            report of the borrowers selected for quality control reviews. During the postclosing
            quality control process, Midwest did not always properly reverify the borrowers’
            employment status, income, and assets or obtain new credit reports. Frequently,
            Midwest would perform a telephone reverification of employment status but could
            not show whether it attempted a written reverification of the borrower’s income
            amount.

            Branch Reviews Not Documented
            HUD requires lenders to periodically review their branch offices for 10 required
            elements. Midwest’s president performed these reviews for its two branches but was
            unable to document that he had performed the reviews or that the reviews covered
            the required elements.

            Employee List Not Checked Semiannually
            HUD requires lenders to determine that employees involved in FHA transactions are
            checked against restricted participation lists at least semiannually. Midwest only
            performed this check on an annual basis. Midwest also checked some employees,
            such as loan officers, throughout the year, but it did not ensure that all employees
            received a second check against the list.

            See appendix F for HUD’s specific quality control requirements.

Midwest Did Not Assign
Adequate Quality Control Staff
            Midwest did not assign sufficient and knowledgeable staff to the quality control
            function.



                                             8
           Midwest did not have dedicated quality control staff as loan volumes increased.
           The vice president handled both the monthly and the early payment default
           quality control reviews until mid-2008. At that time, another staff member was
           assigned the task of conducting monthly quality control reviews on closed loans,
           while the vice president continued to review the early payment default loans.
           Both of these individuals had duties in addition to quality control. During this
           time, Midwest’s FHA loan volume increased from a monthly average of 29 loans
           in 2007 to 55 loans in 2008.

           Quality control reviews were performed by staff who were not fully aware of
           HUD’s quality control requirements. For example, staff were not aware that
           reverse mortgages should be counted when conducting monthly quality control
           reviews. In addition, contrary to HUD’s stated requirements, Midwest did not
           believe that it was necessary to document the branch office reviews. Staff had not
           received adequate training on FHA requirements.

           In response to our audit, Midwest hired a compliance officer with more than 10
           years of experience in various aspects of the mortgage industry including
           handling FHA loans. This individual will be dedicated exclusively to quality
           control.

Midwest Was Unable to Ensure
Proper Loan Originations

           As a result of the conditions described above, Midwest was unable to ensure the
           accuracy, validity, and completeness of its loan origination operations, resulting
           in an increased risk to the FHA insurance fund.

           In addition, HUD lacked assurance that Midwest consistently identified and
           corrected potential deficiencies in its loan origination process before submitting
           loans for FHA insurance.

Recommendation


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

           2A. Perform a review of Midwest's quality control function in six months to
               ensure it complies with HUD requirements (including that it has reviewed
               10 percent of the closed loans) and minimizes the risk to HUD's FHA
               insurance fund.




                                             9
                        SCOPE AND METHODOLOGY

To accomplish our objectives, we

   •   Reviewed HUD’s and Midwest’s policies and procedures,
   •   Interviewed Midwest’s staff,
   •   Reviewed HUD and Midwest loan files,
   •   Reviewed quality control reports, and
   •   Obtained reverifications as appropriate.

From January 2007 through December 2008, Midwest approved more than 860 FHA loans,
valued at more than $121 million. To select our underwriting review sample of 29 loans, we
selected all 32 loans that had defaulted within the first six payments as of December 31, 2008,
that were active and not streamline refinances. We excluded three loans that were reviewed by
HUD’s processing and underwriting division.

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 reviewing the 29 quality control reviews that Midwest performed on our sample loans, we
determined whether Midwest obtained new credit reports when required; properly reverified
employment, income, and funds needed to close; and addressed the required review elements in
its review files. We also obtained all 88 quality control reviews performed by Midwest on 10
percent of monthly loans closed during the audit period. We determined whether there was
documentation for each of these 88 loans. Two of the quality control reviews were included in
both samples.

We relied on computer-processed data contained in HUD’s Neighborhood Watch system and
provided by Midwest. 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 Midwest 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 2009
provided by HUD.

We performed audit work from January through May 2009 at Midwest’s office at 1227 Fern
Ridge Parkway, Suite 200, St. Louis, Missouri.




                                               10
We performed our review 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 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 the following internal controls were relevant to our audit
              objectives:

              •       Controls to ensure that FHA loans meet HUD underwriting requirements.
              •       Controls to ensure that the lender’s quality control program for single-family
                      production meets 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 that the following items are significant weaknesses:

              •       Midwest did not have adequate controls in place to ensure that FHA loans
                      met HUD underwriting requirements (see finding 1).
              •       Midwest did not have adequate controls in place to ensure that its quality
                      control program met HUD requirements (see finding 2).




                                                12
                                   APPENDIXES

Appendix A

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

                           Recommendation         Funds to be put
                                  number           to better use 1/
                                  1A                    $478,918



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. These amounts include reductions in outlays, deobligation of funds,
     withdrawal of interest, costs not incurred by implementing recommended improvements,
     avoidance of unnecessary expenditures noted in preaward reviews, and any other savings
     that are specifically identified.

     Implementation of our recommendations to require Midwest 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 42 percent of the unpaid principal balance based upon statistics
     provided by HUD. [$1,140,281 x .42 = $478,918]




                                             13
Appendix B

        AUDITEE COMMENTS AND OIG’S EVALUATION


Ref to OIG Evaluation   Auditee Comments




Comment 1




                         14
Ref to OIG Evaluation   Auditee Comments




Comment 2




                         15
Ref to OIG Evaluation   Auditee Comments




Comment 3




                         16
Ref to OIG Evaluation   Auditee Comments




Comment 4




                         17
Ref to OIG Evaluation   Auditee Comments




                         18
Ref to OIG Evaluation   Auditee Comments




                         19
                         OIG Evaluation of Auditee Comments

Comment 1   Midwest's written response along with its verbal response at the exit conference
            indicates agreement with the quality control finding and recommendations. The
            planned and already executed actions on the part of Midwest should resolve the
            issues that we identified.


Comment 2   The planned action by Midwest should help in identifying and reducing the
            occurrences of the violations.


Comment 3   Based on the phone call made by the OIG to the Missouri Department of Child
            Support Enforcement, the child support order was still in effect and the borrower
            was required to make payments. Midwest should have ensured that the borrower
            had no outstanding child support liability.


Comment 4   We disagree with Midwest's assertion that its overtime calculation was
            reasonable. As stated in our finding, the average over the previous two years
            (25.76 months) was $912. Even using a shorter one year period (13.76 months
            from January 2007 through February 22, 2008), the borrower only averaged
            $1,282, far less than the $1,760 computed by Midwest using its method. Midwest
            should have used a more conservative method to calculate the borrower’s
            overtime income.




                                            20
Appendix C

        SCHEDULE OF SIGNIFICANT UNDERWRITING
                    DEFICIENCIES

    #




                                                                 Credit history/liabilities



                                                                                              compensating factors
                                                                                              Qualifying ratios and
                                                                                                    Income
                                                    Original
                                      Underwriter
        Case number   Closing Date                  mortgage
                                         type
                                                     amount



    1   292-4993498   July 31, 2008    Manual        $285,468    x
    2   132-2034608   Mar. 21, 2008    Manual        $194,296                                 x
    3   292-4763517   June 21, 2007   Automated      $144,637                                               x
    4   132-1919870   Dec. 18, 2006    Manual        $142,980    x
    5   481-2681900   Feb. 12, 2008    Manual        $139,816    x
    6   292-5056597   Aug. 18, 2008   Automated      $135,045    x
    7   292-4800077   Jan. 24, 2008    Manual        $112,817    x
                        Total                       $1,155,059




                                      21
Appendix D

                                 CASE NARRATIVES

Case number: 292-4993498
Closing date: July 31, 2008
Underwriter type: Manual
Original mortgage amount: $285,468
Loan status as of April 30, 2009: Active (in foreclosure)
Unpaid balance: $283,415

Credit History/Liabilities
The borrower had a delinquent federal tax debt owed to the IRS for underreported income from
2006 and 2007. The borrower owed a total of $50,925. The file contained an IRS Form 433-D,
Installment Agreement, which stated that the borrower agreed to make payments of $560
monthly, starting August 1, 2008. The IRS stamped the form as received on July 23, 2008, but
there was no indication that it accepted the repayment plan as the form was not signed by an IRS
official. It is unclear how the repayment plan amount was calculated since the two previous tax
returns showed a tax-owed amount of $50,925, not $33,763 as stated on the Installment
Agreement. In addition, the borrower did not provide documentation to show that he had already
paid $17,162 ($50,925 - $33,763). The underwriter failed to explain the repayment plan terms
and failed to document the acceptance of the plan by the IRS. Midwest did not document the
reason why the borrower did not pay his federal taxes for 2006 and 2007. Additionally, the
borrower did not provide an explanation for the delinquent federal taxes.

Criteria
HUD Handbook 4155.1, REV-5, paragraph 2-3, states that major indications of derogatory credit
(including judgments, collections, and any other recent credit problems) require sufficient
written explanation from the borrower. The borrower’s explanation must make sense and be
consistent with other credit information in the file. It also states that when delinquent accounts
are revealed, the lender must document its analysis as to whether the late payments were based
on a disregard for financial obligations, an inability to manage debt, or factors beyond the control
of the borrower, including delayed mail delivery or disputes with creditors.

HUD Handbook 4155.1, REV-5, paragraph 2-5B, states that if a borrower is presently delinquent
on any federal debt, the borrower is not eligible until the delinquent account is brought current,
paid, or otherwise satisfied or a satisfactory repayment plan is made between the borrower and
the federal agency owed and is verified in writing.


Case number: 132-2034608
Closing date: March 21, 2008
Underwriter type: Manual
Original mortgage amount: $194,296
Loan status as of April 30, 2009: Active (in foreclosure)


                                                22
Unpaid balance: $192,099

Income/Employment
The underwriting worksheet, dated March 11, 2008, reported $3,602 base income and $1,760
overtime income. A verification of employment from the borrower’s employer, dated February
29, 2008, revealed overtime income of $5,867 for 2006, $12,234 for 2007, and $5,405 through
February 22, 2008. The verification of employment and a letter from the borrower’s employer
indicated that overtime was likely to continue and that unlimited overtime was available to the
borrower. The lender provided notes on its calculation of overtime income. The notes revealed
that the lender used the hourly overtime rate of $31.17 and a weekly average of 13 hours of
overtime to calculate $1,756 of monthly overtime income. Our calculation consisted of dividing
the total amount of overtime received by the 25.76 covered months. This calculation produces
average monthly overtime income of $912. This calculation is significantly less than the
overtime income used on the underwriting worksheet. The overtime income calculation used by
the underwriter was influenced heavily by the borrower’s overtime in the first 1.76 months of
2008, which was not necessarily indicative of a sustainable amount of overtime.

Criteria
HUD Handbook 4155.1, REV 5, paragraph 2-7A, states that overtime 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 the overtime income for the past two years,
and the employment verification must not state that such income is unlikely to continue. An
earnings trend also must be established and documented for overtime and bonus income.

Ratios and Compensating Factors
The recomputed income for the borrower would be $4,514 ($3,602 base + $912 overtime).
Using the recomputed income, the borrower’s mortgage payment-to-income ratio would be
36.25 percent, and the total debt-to-income ratio would be 58.78 percent, well above the
maximum ratios of 31 percent and 43 percent, respectively.

Criteria
HUD Mortgagee Letter 2005-16 states that the borrower’s qualifying ratios are currently limited
to 31 percent (payment-to-income ratio) and 43 percent (debt-to-income ratio). If either or both
ratios are exceeded on a manually underwritten loan, the lender must describe the compensating
factors used to justify loan approval.

HUD Handbook 4155.1, REV-5, paragraph 2-13, lists various compensating factors that may be
used in justifying approval of loans with excessive qualifying ratios. Underwriters must state the
compensating factors used to support loan approval in the “remarks” section of the underwriting
worksheet.



Case number: 292-4763517
Closing date: June 21, 2007
Underwriter type: Automated



                                               23
Original mortgage amount: $144,637
Loan status as of April 30, 2009: Claim (loss not yet determined)
Unpaid balance: $142,130

Ratios and Compensating Factors
Midwest failed to document adequate compensating factors when it underwrote this loan. The
loan was initially processed through the automated underwriting system. However, all liabilities
were not considered by the automated underwriting system. Midwest excluded three revolving
accounts from the automated underwriting report, which were listed on the April 9, 2007, credit
report. The three excluded accounts equal an additional $147 in monthly liabilities for the
borrower. At closing, the underwriter converted the loan from a cash-out refinance to a rate and
term refinance. He overrode the automated underwriting system, and the loan became a
manually underwritten loan. While the additional $147 in liabilities was included on the
underwriting worksheet, the underwriter failed to document compensating factors for
underwriting the loan as the borrower’s fixed expense-to-income ratio was 51.1 percent. The
borrower was under a temporary hardship forbearance on his student loans from August 17,
2007, to August 16, 2008, and did not have a large amount of assets in reserve or a high income
level.

Criteria

HUD Mortgagee Letter 2005-16 states that the borrower’s qualifying ratios are currently limited
to 31 percent (payment-to-income ratio) and 43 percent (debt-to-income ratio). If either or both
ratios are exceeded on a manually underwritten loan, the lender must describe the compensating
factors used to justify loan approval.

HUD Handbook 4155.1, REV-5, paragraph 2-13, lists various compensating factors that may be
used in justifying approval of loans with excessive qualifying ratios. Underwriters must state the
compensating factors used to support loan approval in the “remarks” section of the underwriting
worksheet.



Case number: 132-1919870
Closing date: December 18, 2006
Underwriter type: Manual
Original mortgage amount: $142,980
Loan status as of April 30, 2009: Active (in default)
Unpaid balance: $139,258

Credit History/Liabilities
The borrower and his spouse had an outstanding judgment in the amount of $2,661. There was
no documentation in the file to support the payment of this judgment before loan closing or an
agreement with the creditor to make regular and timely payments on the judgment, thus making
the mortgage ineligible for FHA insurance endorsement.




                                               24
The borrower had five collections listed, which occurred after the discharge of his Chapter 7
bankruptcy in November 2002. The borrower did not explain in writing all collections and
judgments. While the loan file contained multiple letters of explanation, the letters did not
specifically address the collections and judgments listed on the credit report.

Overall, the borrower had acquired several collections accounts since bankruptcy and had been
unable to pay his student loans due to his current financial situation. Therefore, the borrower had
not demonstrated a documented ability to responsibly manage his financial affairs.

Criteria
HUD Handbook 4155.1, REV-5, paragraph 2-3 C, requires that court-ordered judgments be paid
off before the mortgage loan is eligible for FHA insurance endorsement. FHA does not require
that collection accounts be paid off as a condition of mortgage approval. Collections and
judgments indicate a borrower’s regard for credit obligations and must be considered in the
analysis of creditworthiness with the lender, documenting its reasons for approving a mortgage
when the borrower has collection accounts or judgments. The borrower must explain in writing
all collections and judgments.

HUD Handbook 4155.1, REV-5, paragraph 2-3 E, states that a Chapter 7 bankruptcy
(liquidation) does not disqualify a borrower from obtaining an FHA-insured mortgage if at least
two years have elapsed since the date of the discharge of the bankruptcy. Additionally, the
borrower must have reestablished good credit or chosen not to incur new credit obligations. The
borrower also must have demonstrated a documented ability to responsibly manage his or her
financial affairs.

Other
The underwriter failed to consider the income, debts, and credit history of a purchasing spouse.
According to the application and underwriting worksheet, there was only one borrower on this
loan, and the spouse was supposed to be nonpurchasing. However, based on the loan file
documentation, both the borrower and his spouse were purchasing borrowers. In addition to
signing the mortgage note, the borrower’s spouse signed the purchase agreement, counteroffer,
amendment to the contract, and settlement statement as a coborrower. Further, she was listed on
the title insurance commitment and the warranty deed from the sellers. Based on these
documents, the underwriter should have considered the income, debts, and credit history of both
the borrower and his spouse when approving this loan.

Criteria
HUD Handbook 4155.1, REV-5, paragraph 2-2A, states, “Borrowers and Co-borrowers take title
to the property and are obligated on the mortgage note and must also sign the security
instrument. The co-borrower’s income, assets, liabilities, and credit history are considered in
determining creditworthiness.”

HUD Handbook 4155.1, REV-5, paragraph 2-2D, states, “If required by state law in order to
perfect a valid and enforceable first lien, the non-purchasing spouse may be required to sign
either the security instrument or documentation evidencing that he or she is relinquishing all
rights to the property. If the non-purchasing spouse executes the security instrument for such



                                                25
reasons, he or she is not considered a borrower for our purposes and need not sign the loan
application. In all other cases, the non-purchasing spouse is not to appear on the security
instrument or otherwise take title to the property at loan settlement.”



Case number: 481-2681900
Closing date: February 12, 2008
Underwriter type: Manual
Original mortgage amount: $139,816
Loan status as of April 30, 2009: Active (special forbearance)
Unpaid balance: $137,803

Credit History/Liabilities
The borrower had child support payments garnished from his weekly wages, which Midwest did
not consider when underwriting his loan. Child support payments were deducted in an amount
of $201 weekly or $869 monthly from his employment income. Midwest did not list child
support payments on the liability section of the borrower’s loan application, dated February 7,
2008. Adding the monthly child support liability to the amount of total installment debt listed on
the underwriting worksheet brings the total monthly debt payment to $1,436.

Further, the loan file did not contain borrower explanations for all inquiries shown on the credit
report in the last 90 days. There were eight unexplained inquiries from October 20, 2007,
through January 5, 2008. The borrower had an inquiry from a finance company on December
12, 2007, and then opened three accounts with the same company in December 2007, February
2008, and May 2008 for $720, $800, and $800, respectively. The borrower had also opened
accounts with the same finance company in November 2006 and September 2007 in the amount
of $640 and $720, respectively. This company was in the business of granting payday loans.
The borrower was borrowing larger sums of money over time, indicating that he was not able to
survive on his employment income, and Midwest should have discovered this fact. Additionally,
Midwest should have obtained an explanation for all of the eight inquiries on his credit report.

Criteria
HUD Handbook 4155.5, REV-5, paragraph 2-11A, states, “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 additional recurring charges extending ten months or
more, including payments on installment accounts, child support or separate maintenance
payments, revolving accounts and alimony, etc.”

HUD Handbook 4155.5, REV-5, paragraph 2-3B, states that borrowers must explain in writing
all inquiries shown on the credit report in the last 90 days.

Ratios and Compensating Factors
Midwest understated the borrower’s qualifying ratio. According to the underwriting worksheet,
the borrower’s qualifying ratios were 30.71 percent and 48.19 percent. Using the recomputed



                                               26
monthly liability of $1,436, the borrower’s mortgage payment-to-income ratio would remain the
same, but the total debt-to-income ratio would be 75 percent, well above the maximum ratio of
43 percent.

Criteria
HUD Mortgagee Letter 2005-16 states that the borrower’s qualifying ratios are currently limited
to 31 percent (payment-to-income ratio) and 43 percent (debt-to-income ratio). If either or both
ratios are exceeded on a manually underwritten loan, the lender must describe the compensating
factors used to justify loan approval.

HUD Handbook 4155.1, REV-5, paragraph 2-13, lists various compensating factors that may be
used in justifying approval of loans with excessive qualifying ratios. Underwriters must state the
compensating factors used to support loan approval in the “remarks” section of the underwriting
worksheet.



Case number: 292-5056597
Closing date: August 18, 2008
Underwriter type: Automated
Original mortgage amount: $135,045
Loan status as of April 30, 2009: Active (in foreclosure)
Unpaid balance: $134,205

Miscellaneous Refinance Issues
Midwest approved the borrower’s refinance loan when the prior month’s payment was
outstanding. The lender was required to document that the borrower made his July 2008
mortgage payment as the new mortgage closed in August 2008. According to the payoff
statement, the borrower made his June 2008 mortgage payment but did not make his July 2008
mortgage payment.

Criteria
HUD Handbook 4155.5, REV-5, paragraph 1-10E, states that lenders are not permitted to allow
borrowers to “skip” payments. The borrower is either to make the payment when it is due or
bring the monthly mortgage payment check to settlement. When the new mortgage amount is
calculated, FHA does not permit the inclusion of any mortgage payments “skipped” by the
homeowner in the new mortgage amount.



Case number: 292-4800077
Closing date: January 24, 2008
Underwriter type: Manual
Original mortgage amount: $112,817
Loan status as of April 30, 2009: Active (in foreclosure)
Unpaid balance: $111,372



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Credit History/Liabilities
The borrower had a child support order against him, which the underwriter failed to consider
when underwriting this loan. The borrower was required to make monthly payments of $290
based on his divorce decree signed in November 2005. The Missouri Department of Social
Services, Division of Child Support Enforcement, confirmed to us that the child support order
was still in effect and had not been satisfied. A review of Missouri court records also revealed
that the child support order had not been satisfied. The underwriter should not have omitted this
liability when underwriting this loan.

The borrower’s credit report, dated December 11, 2007, listed two inquiries within the past 90
days. The underwriter could not provide an explanation for these inquiries from the borrower.

Criteria
HUD Handbook 4155.5, REV-5, states, “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 additional recurring charges extending ten months or more,
including payments on installment accounts, child support or separate maintenance payments,
revolving accounts and alimony, etc.”

HUD Handbook 4155.5, REV-5, paragraph 2-3B, states that borrowers must explain in writing
all inquiries shown on the credit report in the last 90 days.

Ratios and Compensating Factors
The underwriter understated the borrower’s qualifying ratios and failed to present significant
compensating factors to justify approval of this loan. Using the recomputed liabilities, the
borrower’s total debt-to-income ratio would increase to 63.01 percent. While the underwriting
worksheet noted several potential compensating factors, these factors were inadequate.

Criteria
HUD Mortgagee Letter 2005-16 states that the borrower’s qualifying ratios are currently limited
to 31 percent (payment-to-income ratio) and 43 percent (debt-to-income ratio). If either or both
ratios are exceeded on a manually underwritten loan, the lender must describe the compensating
factors used to justify loan approval.

HUD Handbook 4155.1, REV-5, paragraph 2-13, lists various compensating factors that may be
used in justifying approval of loans with excessive qualifying ratios. Underwriters must state the
compensating factors used to support loan approval in the “remarks” section of the underwriting
worksheet.




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Appendix E

     SCHEDULE OF LOAN STATUS FOR LOANS WITH
      SIGNIFICANT UNDERWRITING DEFICIENCIES


                                                                 Payments
                                                                before first
                          Loan status as of         Unpaid
      Case number                                                  90-day
                           April 30, 2009           balance
                                                                   default
                                                                  reported
                                                   $ 283,415          0
     292-4993498 Active (in foreclosure)
                                                   $ 192,099         4
     132-2034608 Active (in foreclosure)
                                                   $ 142,130         1
     292-4763517 Claim (loss not yet determined)
                                                   $ 139,258         5
     132-1919870 Active (in default)
                                                   $ 137,803         5
     481-2681900 Active (special forbearance)
                                                   $ 134,205         0
     292-5056597 Active (in foreclosure)
                                                   $ 111,372         2
     292-4800077 Active (in foreclosure)

     Total                                         $1,140,282




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Appendix F

                        QUALITY CONTROL CRITERIA


HUD Handbook 4060.1, REV-2, paragraph 7-3G, states that a lender’s offices, including
traditional, nontraditional branch, and direct lending offices engaged in origination or servicing
of FHA-insured loans, must be reviewed to determine that they are in compliance with HUD’s
requirements. The review must include but not necessarily be limited to confirmation of the
following items:

    • The office is properly registered with FHA, and the address is current;
    • Operations are conducted in a professional, business-like environment;
    • If located in commercial space, the office is properly and clearly identified for any walk-in
           customers, has adequate office space and equipment, is in a location conducive to
           mortgage lending, and is separated from any other entity by walls or partitions
           (entrances and reception areas may be shared);
    • If located in noncommercial space, the office has adequate office space and equipment; it
           displays a fair housing poster if the public is received; if it is open to receive the
           public, it is accessible to persons with disabilities, including those with mobility
           impairments; if it is not open to the public but used occasionally to meet with members
           of the public, it provides alternate means of accommodation to serve persons with
           disabilities;
    • The servicing office provides toll-free lines or accepts collect calls from borrowers;
    • The office is sufficiently staffed with trained personnel;
    • Office personnel have access to relevant statutes, regulations, and HUD issuances and
           handbooks, either in hard copy or electronically;
    • Procedures are revised to reflect changes in HUD requirements, and personnel are
           informed of the changes;
    • Personnel at the office are all employees of the lender or contract employees performing
           functions that FHA allows to be outsourced; and
    • The office does not employ or have a contract with anyone currently under debarment or
           suspension or a limited denial of participation.

HUD Handbook 4060.1, REV-2, paragraph 7-3I, states that review findings must be reported to
the lender’s senior management within one month of completion of the initial report.
Management must take prompt action to deal appropriately with any material findings. The final
report or an addendum must identify actions being taken, the timetable for their completion, and
any planned follow-up activities.

HUD Handbook 4060.1, REV-2, paragraph 7-3L, states that the lender must determine that no
one is employed for HUD origination, processing, underwriting, or servicing who is debarred,
suspended, subject to a limited denial of participation, or otherwise restricted from participation
in HUD/FHA programs. Lenders must periodically check employee lists, at least semiannually.



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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.

HUD Handbook 4060.1, REV-2, paragraph 7-6C, states that because it is not feasible to review
all loans originated during a period, the program must require that an appropriate-size sample is
selected and evaluated during each review. A lender that originates and/or underwrites 3,500 or
fewer FHA loans per year must review 10 percent of the FHA loans it originates.

HUD Handbook 4060.1, REV-2, paragraph 7-6E (1), states that a new credit report must be
obtained for each borrower whose loan is included in a quality control review, unless the loan
was a streamline refinance or was processed using an FHA-approved automated underwriting
system exempted from this requirement.

HUD Handbook 4060.1, REV-2, paragraph 7-6E (2), states that documents contained in the loan
file should be checked for sufficiency and subjected to written reverification. If the written
reverification is not returned to the lender, a documented attempt must be made to conduct a
telephone reverification. If the original information was obtained electronically or involved
alternative documents, a written reverification must still be attempted. Examples of items that
must be reverified include but are not limited to the borrower’s employment or other income,
deposits, gift letters, alternate credit sources, and other sources of funds.

HUD Handbook 4060.1, REV-2, paragraph 7-6F, states that each direct endorsement loan
selected for a quality control review must be reviewed for compliance with HUD underwriting
requirements, sufficiency of documentation, and the soundness of underwriting judgments.




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