Issue Date
July 28, 2009
Audit Report Number
2009-PH-1010
TO: David H. Stevens, Assistant Secretary for Housing – Federal Housing
Commissioner, H
FROM: John P. Buck, Regional Inspector General for Audit, Philadelphia Region, 3AGA
SUBJECT: J.P. Morgan Chase Bank, Newark, Delaware, Generally Complied with
HUD’s Origination and Quality Control Requirements for FHA-Insured Single-
Family Loans
HIGHLIGHTS
What We Audited and Why
We audited the Newark, Delaware, branch office (branch office) of J.P. Morgan
Chase bank (J.P. Morgan Chase), a supervised direct endorsement lender
approved to originate Federal Housing Administration (FHA) single-family
mortgage loans. We selected the branch office because its default rate was above
the state’s average default rate. Our objective was to determine whether J.P.
Morgan Chase complied with U.S. Department of Housing and Urban
Development (HUD) requirements in the origination and quality control review of
FHA-insured single-family loans.
What We Found
J.P. Morgan Chase generally complied with HUD requirements in the origination
and quality control review of FHA-insured single-family loans. However, a
review of eight sample loans valued at approximately $1.3 million showed that its
branch office did not underwrite one of the loans, originally valued at more than
$157,000, in accordance with HUD requirements. The branch office approved the
loan based on incorrect qualifying ratios.
In addition, J.P. Morgan Chase did not fully implement quality control procedures
as required for one improperly underwritten loan out of five loans it reviewed1 as
part of its quality control process. These deficiencies occurred because the branch
office did not exercise due care in the underwriting of the deficient loans and J.P.
Morgan Chase did not always implement quality control procedures as required.
As a result, the FHA insurance fund was exposed to an unnecessarily increased
risk.
What We Recommend
We recommend that HUD’s Assistant Secretary for Housing – Federal Housing
Commissioner require J.P. Morgan Chase to indemnify HUD $193,949 2 for one
loan it issued contrary to HUD’s loan origination requirements; reimburse
$26,352 for a loss from a claim incurred by HUD on another improperly
underwritten loan; and fully enforce its policies, procedures, and controls to
ensure that its staff consistently follows HUD requirements.
For each recommendation without a management decision, please respond and
provide status reports in accordance with HUD Handbook 2000.06, REV-3.
Please furnish us copies of any correspondence or directives issued because of the
audit.
Auditee’s Response
We provided a draft report to J.P. Morgan Chase on June 18, 2009. We discussed
the audit results with J.P. Morgan Chase during the audit and at an exit conference
on June 23, 2009. J.P. Morgan Chase provided written comments to our draft
report on July 7, 2009. J.P. Morgan Chase generally agreed with our results
pertaining to its loan origination activity but objected to our conclusions on its
quality control plan and implementation of quality control procedures. The
complete text of the response, along with our evaluation of that response, can be
found in appendix B of this report.
1
This loan was originally valued at more than $197,000.
2
This amount is the unpaid principal balance for the loan. The projected loss to HUD is $81,459 based on HUD’s
average insurance fund loss rate of 42 percent.
2
TABLE OF CONTENTS
Background and Objective 4
Results of Audit
Finding: J.P. Morgan Chase Generally Complied with HUD’s Origination and 5
Quality Control Requirements for FHA-Insured Single-Family Loans
Scope and Methodology 10
Internal Controls 12
Appendixes
A. Schedule of Questioned Costs and Funds to Be Put to Better Use 14
B. Auditee Comments and OIG’s Evaluation 15
C. Schedule of Case File Discrepancies 19
D. Narrative Case Presentations 20
3
BACKGROUND AND OBJECTIVE
The U.S. Department of Housing and Urban Development’s (HUD) strategic plan states that its
mission is to increase homeownership, support community development, and increase access to
affordable housing free from discrimination.
The National Housing Act, as amended, established the Federal Housing Administration (FHA),
an organizational unit within HUD. FHA provides insurance for lenders against loss on single-
family home mortgages and multifamily homes including manufactured homes and hospitals. It
is the largest insurer of mortgages in the world, insuring more than 34 million properties since its
inception in 1934. FHA mortgage insurance provides lenders with protection against losses as
the result of homeowners defaulting on their mortgage loans. The lenders bear less risk because
FHA will pay a claim to the lender in the event of a homeowner’s default. Loans must meet
certain requirements established by FHA to qualify for insurance. As of February 2009, FHA’s
market share of single-family insured mortgages was 68 percent.
HUD’s direct endorsement program authorizes approved lenders to underwrite loans without
HUD’s prior review and approval. HUD requires lenders to use its Neighborhood Watch system
to monitor and evaluate their performance, and has many sanctions available for taking actions
against lenders or others who abuse the direct endorsement program.
J.P. Morgan Chase is a direct endorsement lender for FHA loans. Its corporate office is located
in Iselin, New Jersey, and its quality control reviews are performed internally at its office
locations in Columbus, Ohio and Jacksonville, Florida. Its Newark, Delaware, branch office
(branch office) originated 36 FHA loans valued at approximately $5.8 million from July 2006
through June 2008 that defaulted within the first two years. We sampled and reviewed case files
for eight of the loans valued at approximately $1.3 million.
Our objective was to determine whether J.P. Morgan Chase complied with HUD requirements in
the origination and quality control review of FHA-insured single-family loans.
4
RESULTS OF AUDIT
Finding: J.P. Morgan Chase Generally Complied with HUD’s
Origination and Quality Control Requirements for FHA-Insured Single-
Family Loans
J.P. Morgan Chase generally complied with HUD requirements in the origination and quality
control review of FHA loans. However, its branch office did not originate one of eight loans
reviewed in accordance with HUD requirements. The branch office qualified the borrower based
on incorrect ratios. In addition, J.P. Morgan Chase did not refer to HUD significant underwriting
deficiencies related to one of five loans it reviewed as part of its quality control process. These
deficiencies occurred because the branch office did not exercise due care in underwriting the
deficient loans and J.P. Morgan Chase did not always implement quality control procedures as
required. As a result, the FHA insurance fund was exposed to an unnecessarily increased risk
and HUD incurred a loss from a claim paid in the amount of $26,352. J.P. Morgan Chase should
indemnify HUD $193,9493 for one loan, and reimburse HUD for the loss it incurred on the other
loan.
The Branch Office Incorrectly
Calculated Qualifying Ratios
According to HUD requirements,4 lenders are required to use ratios to determine
whether a borrower can reasonably be expected to meet the expenses involved in
homeownership and otherwise provide for the family. Lenders are required to
compute two ratios: the mortgage payment expense to effective income (front
ratio), which should not exceed 31 percent, and the total fixed payment to
effective income (back ratio), which should not exceed 43 percent. HUD5 also
requires lenders to include the monthly housing expense and all other additional
recurring charges extending 10 months or more in computing a borrower’s debt-
to-income ratios. Recurring charges include but are not limited to installment
accounts. Debts lasting less than 10 months must also be counted if the amount of
the debt affects the borrower’s ability to make the mortgage payment during the
months immediately after loan closing.
In one case (case number 071-1021875), the branch office qualified a borrower
based on incorrect ratios because it erroneously overstated the borrower’s
3
See footnote 2.
4
HUD Handbook 4155.1, REV-5, paragraph 2-12, and HUD Mortgagee Letter 2005-16
5
HUD Handbook 4155.1, REV-5, paragraph 2-11A
5
effective monthly income and did not consider two debts that were listed on the
borrower’s credit report. As a result, the loan was approved based on incorrect
debt-to-income ratios. If the branch office had used the correct income and debt
amounts, the borrower would not have qualified for the loan because the
mortgage payment expense-to-income ratio would have been 36.85 percent,
which exceeds the 31 percent allowed by HUD, and the total fixed payment-to-
income ratio would have been almost 64 percent compared with HUD’s 43
percent limit. HUD paid a claim that resulted in a loss of $26,3526 for this loan.
J.P. Morgan Chase Needs to
Update its Quality Control Plan
According to HUD requirements,7 approved lenders must have and maintain a
quality control plan for the origination and servicing of insured mortgages. The
quality control plan must be a prescribed function of the lender’s operations and
assure that the lender maintains compliance with HUD requirements and its own
policies and procedures. Further, HUD requirements8 indicate the specific
minimum elements that must be included in a lender’s quality control plan.
J.P. Morgan Chase’s quality control plan did not include all the elements required
by HUD. The quality control plan did not address key elements to determine
whether
Loan documents requiring signature (other than blanket verification
releases) were signed by the borrower or employee(s) of the lender only
after completion and that all corrections were initialed by the borrower or
employee(s) of the lender;
All required loan processing, underwriting, and legal documents were
included in loan files;
The seller acquired the property at the time of or soon before closing,
indicating a possible property “flip”;
The borrower transferred the property at the time of closing or soon after
closing, indicating the possible use of a “straw buyer” in the transaction;
and
All items requiring documentation had been properly evidenced and
retained in the file.
J.P. Morgan Chase stated that its quality control reviews addressed the elements
noted above and provided us examples of its checklists which included these
elements. However to ensure that these elements are consistently addressed and
6
HUD paid a claim for preforeclosure sale loss mitigation on July 15, 2007.
7
HUD Handbook 4060.1, REV-2, paragraph 7-1
8
HUD Handbook 4060.1, REV-2, paragraph 7-7
6
that HUD is fully protected from unacceptable risk and guarded against errors,
omissions, and fraud, J.P. Morgan Chase should update its quality control plan to
reflect the minimum elements required by HUD. One way it can accomplish this
would be to incorporate its comprehensive checklists directly into its quality
control plan.
J.P. Morgan Chase Did Not
Always Implement Its Quality
Control Plan as Required
HUD requirements9 state that quality control review findings must be reported to
lenders’ senior management within a month of completion of the initial report and
that management must take prompt action to deal appropriately with material
findings. The final report or an addendum must identify actions being taken with
regard to findings, the timetable for their completion, and planned follow-up
activities. HUD requirements10 also state that findings discovered during quality
control reviews should be reported to HUD within 60 days of the initial discovery.
J.P. Morgan Chase did not implement quality control procedures as required for
one (case number 071-1054663) of five loans reviewed to test the implementation
of its quality control plan. This loan is currently in delinquent status and was not
one of the eight sample loans reviewed. There were significant underwriting
deficiencies noted in relation to the loan including income and debt ratios in
excess of HUD requirements without compensating factors, a credit report
indicating late payments on 16 separate accounts over an 18-month period, and
year-to-date earnings that did not support the income used to qualify the
borrower. J.P. Morgan Chase reprimanded the responsible underwriter but did
not report the findings to HUD within 60 days of discovery. HUD paid a partial
claim of $8,05111 for this loan.
J.P. Morgan Chase’s quality assurance staff also reviewed the case in which we
determined that the qualifying ratios were incorrect but failed to identify the issue.
J.P. Morgan Chase Did Not
Always Exercise Due Care and
Follow Required Procedures
The loan origination deficiencies noted occurred because branch office staff did
not exercise due care in the underwriting of the loans. The quality control issues
9
HUD Handbook 4060.1, REV-2, paragraph 7-3I
10
HUD Handbook 4060.1, REV-2, paragraph 7-3J
11
HUD paid a partial claim for loss mitigation.
7
occurred because J.P. Morgan Chase did not always implement quality control
procedures as required. According to HUD requirements,12 one of the goals of
quality control is to ensure compliance with FHA’s and the lender’s own
origination or servicing requirements throughout its operations. Also, J.P. Morgan
Chase’s quality control plan for early payment defaults indicates that part of its
quality control review process includes a detailed review for accuracy and validity
of documentation for each loan, as well as a re-underwriting of the loan for credit
risk factors.
It is important for J.P. Morgan Chase to ensure that its staff exercises due care in
underwriting FHA loans. It must also update and implement its quality control
plan in accordance with HUD requirements so that it can accurately assess its
origination and servicing processes and take appropriate measures as needed to
prevent instances of noncompliance with HUD’s and its own requirements.
Conclusion
J.P. Morgan Chase generally complied with HUD requirements in its origination
and quality control review of FHA loans. However its branch office did not
comply with HUD requirements in originating one of eight loans reviewed. In
addition, J.P. Morgan Chase did not always implement quality control procedures
as required. These deficiencies occurred because the branch office did not always
exercise due care in underwriting and J.P. Morgan Chase did not always
implement quality control procedures as required. As a result, the FHA insurance
fund was exposed to an unnecessarily increased risk and HUD incurred a loss
from a claim paid in the amount of $26,352 on one loan. Therefore, J.P. Morgan
Chase should indemnify HUD $193,949 13 and reimburse HUD for the loss it
incurred (see appendixes C and D for more detail).
Recommendations
We recommend that the Assistant Secretary for Housing – Federal Housing
Commissioner require J.P. Morgan Chase to
1A. Indemnify HUD $193,949 for one loan which it issued contrary to HUD’s
loan origination requirements.
12
HUD Handbook 4060.1, REV-2, paragraph 7-2
13
See footnote 2.
8
1B. Reimburse HUD $26,352 for the loss incurred from a claim paid on one
loan which it issued contrary to HUD requirements.14
1C. Update its quality control plan to reflect the minimum elements required
by HUD.
1D. Enforce its policies, procedures, and controls to ensure that its staff
consistently follows HUD’s and its own requirements in the underwriting
and quality control review of FHA loans.
14
Case number 071-1021875
9
SCOPE AND METHODOLOGY
We reviewed lenders with high default rates and selected the Newark, Delaware, branch of J.P.
Morgan Chase because its percentage of defaults within two years was 5.9 percent, compared
with the Delaware state average of 4.6 percent.
We ran queries in HUD’s Neighborhood Watch system to identify the number of defaulted loans
within the first two years and the payments made against those loans for the branch office.
HUD’s Neighborhood Watch system is a web-based software application that displays loan
performance data for lenders and appraisers, by loan types and geographic areas using FHA-
insured single-family loan information. The loan information is displayed for a two-year
origination period and is updated on a monthly basis. The information on defaulted loans
includes current defaults, and defaults within the first and first two years of endorsement. HUD
requires lenders to use the Neighborhood Watch system to monitor and evaluate their
performance.
The branch office issued 36 FHA loans, valued at approximately $5.8 million, that defaulted
within the first two years. After eliminating loans that were refinanced and terminated and loans
with more than 12 payments before default, 24 defaulted loans remained. The 24 loans, valued
at more than $3.8 million defaulted after 12 payments or fewer. We sampled and reviewed case
files for 8 of the 24 loans valued at approximately $1.3 million. To determine whether the
branch office complied with HUD regulations, procedures, and instructions in the origination and
quality control review of FHA loans, we performed the following:
Reviewed applicable HUD handbooks and mortgagee letters,
Examined records and related documents for J.P. Morgan Chase,
Reviewed case files for eight sample loans,
Reviewed J.P. Morgan Chase’s quality control plan and its implementation of the plan,
and
Conducted interviews with officials and employees of J.P. Morgan Chase and employees
of HUD’s Quality Assurance Division.
We reviewed J.P. Morgan Chase’s implementation of its quality control plan by reviewing the
results of its quality control reviews of five early payment default (EPD) loans in its Quality
Assurance report dated December 4, 2008. One of the loans was included in the eight sample
cases we reviewed.
10
We relied in part on data maintained by HUD in the Neighborhood Watch system. Although we
did not perform a detailed assessment of the reliability of the data, we performed a minimal level
of testing and found the data adequately reliable for our purposes.
Our review covered the period July 2006 through June 2008.
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.
11
INTERNAL CONTROLS
Internal control is an integral component of an organization’s management that provides
reasonable assurance that the following objectives 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:
Loan origination process – Policies and procedures that management has in
place to reasonably ensure that the loan origination process complies with
HUD program requirements.
Quality control plan – Policies and procedures that management has in place
to reasonably ensure implementation of HUD’s quality control requirements.
We assessed the relevant controls identified above.
A significant weakness exists if management controls do not provide reasonable
assurance that the process for planning, organizing, directing, and controlling
program operations will meet the organization’s objectives.
Significant Weaknesses
Based on our review, we believe that the following items are significant weaknesses:
J.P. Morgan Chase did not always operate in accordance with HUD
requirements as they relate to loan issuance or origination.
12
J.P. Morgan Chase did not always implement quality control procedures in
accordance with HUD requirements.
13
APPENDIXES
Appendix A
SCHEDULE OF QUESTIONED COSTS
AND FUNDS TO BE PUT TO BETTER USE
Recommendation Ineligible Funds to be put
number costs1/ to better use 2/
1A $81,459
1B $26,352
1/ Ineligible costs are costs charged to a HUD-financed or HUD-insured program or activity
that the auditor believes are not allowable by law; contract; or federal, state, or local
policies or regulations.
2/ Recommendations that funds be put to better use are estimates of amounts that could be
used more efficiently if an Office of Inspector General (OIG) recommendation is
implemented. These amounts include reductions in outlays, deobligation of funds,
withdrawal of interest subsidy costs not incurred by implementing recommended
improvements, avoidance of unnecessary expenditures noted in preaward reviews, and
any other savings that are specifically identified. In this instance, implementation of our
recommendation to indemnify loans that were not originated in accordance with HUD
requirements will reduce the risk of loss to the FHA insurance fund. The above amount
reflects HUD statistics, which show that FHA, on average, loses 42 percent of the claim
paid for each property (see appendix C).
14
Appendix B
AUDITEE COMMENTS AND OIG’S EVALUATION
Ref to OIG Evaluation Auditee Comments
15
Comment 1
Comment 2
Comment 3
Comment 3
Comment 3
16
Comment 4
Comment 4
17
OIG Evaluation of Auditee Comments
Comment 1 Despite the fact that the subject underwriter is no longer employed with the
company, J.P. Morgan Chase still needs to enforce its policies, procedures, and
controls to ensure that its staff consistently follows HUD’s and its own
requirements.
Comment 2 According to HUD requirements, quality control review findings must be reported
to lenders’ senior management within a month of completion of the initial report
and management must take prompt action to deal appropriately with material
findings. The final report or an addendum must identify actions being taken with
regard to findings, the timetable for their completion, and planned follow-up
activities. Although J.P. Morgan Chase provided documentation indicating that it
reprimanded the underwriter of the deficient loan, it did not provide any evidence
to show the action(s) taken or being taken to address the findings pertaining to the
deficient loan, a timetable for the completion of the action(s), and any planned
follow-up activities.
Also, HUD requires mortgagees to immediately report serious violations and
report other findings within 60 days of the initial discovery. The loan in question
had significant underwriting deficiencies that warrant a request that HUD be
indemnified. However J.P. Morgan Chase did not report the deficiencies to HUD
as required. This is evidence of an instance in which required quality control
procedures were not fully implemented.
Comment 3 The overall conclusion of our report is that J.P. Morgan Chase generally complied
with HUD requirements in the origination and quality control review of FHA-
insured loans. However, we reviewed J.P. Morgan Chase’s quality control plan
for 19 specific elements required by HUD and five were missing. As discussed in
the report, J.P. Morgan Chase provided separate checklists which reflected the
required missing elements. In a discussion with a J.P. Morgan Chase manager
during the audit, the manager agreed that the missing elements should be
incorporated into the plan. We maintain that J.P. Morgan Chase should update its
quality control plan so that it reflects all the minimum elements required by HUD
to ensure that they are consistently addressed.
Comment 4 We reviewed the referenced documentation which J.P. Morgan Chase had
previously provided, and made revisions as appropriate to our initial draft report.
We have again reviewed the submitted documentation along with J.P. Morgan
Chase’s response and determined that no further changes to the report are
warranted.
18
Appendix C
SCHEDULE OF CASE FILE DISCREPANCIES
Quality
Unpaid High Income control
Case Mortgage principal 42% loss Claim qualifying not Poor plan not
number amount balance rate* paid** ratios supported credit followed
071-
1021875 $157,256 $155,319 $26,352 X
071-
1054663 $197,113 $193,949 $81,459 X X X X
Totals $354,369 $349,268 $81,459 $26,352
* This amount was calculated by taking 42 percent of the unpaid principal balance for the loans.
On average, HUD loses 42 percent of the claim amount paid.
** This amount represents a claim paid by HUD in June 2007 for the related property. A
preforeclosure sale was completed in May 2007 for the home in case number 071-1021875. The
home sale price of $150,000 was less than the unpaid principal balance.
Note: The issues related to the second case (071-1054663) were identified by J.P. Morgan Chase
during its quality control review of the loan. This loan was reviewed as part of our assessment of
J.P. Morgan Chase’s quality control process, and was not one of the eight sample loans
reviewed.
19
Appendix D
NARRATIVE CASE PRESENTATIONS
Case number: 071-1021875
Mortgage amount: $157,256
Date of loan closing: July 24, 2006
Status: Preforeclosure sale completed
Payments before first default reported: One
Unpaid principal balance: $155,319
Summary:
The branch office incorrectly calculated qualifying ratios, and, therefore, the borrower’s debt-to-
income ratios exceeded the allowed limits.
Pertinent Details:
HUD Handbook 4155.1, REV-5, paragraph 2-11A, requires lenders to include the monthly
housing expense and all other additional recurring charges extending 10 months or more in
computing a borrower’s debt-to-income ratios. Recurring charges include but are not limited to
installment accounts. Debts lasting less than 10 months must also be counted if the amount of
the debt affects the borrower’s ability to make the mortgage payment during the months
immediately after loan closing. Paragraph 2-12 states that ratios are used to determine whether
the borrower can reasonably be expected to meet the expenses involved in homeownership and
otherwise provide for the family. The lender must compute two ratios: mortgage payment
expense to effective income should not exceed 29 percent, and total fixed payment to effective
income should not exceed 41 percent. Mortgagee Letter 2005-16 increased the qualifying ratios
to 31 and 43 percent, respectively, for manually underwritten mortgages for which the direct
endorsement underwriter must make the credit decision.
The branch qualified a borrower based on incorrect ratios because it erroneously overstated the
borrower’s effective monthly income and did not consider two debts that were on the borrower’s
credit report. As a result, the loan was approved based on incorrect debt-to-income ratios. If the
lender had used the correct income and debt amounts, the borrower would not have qualified for
the loan because the mortgage payment expense-to-income ratio would have been 36.85 percent,
20
which exceeds the 31 percent allowed by HUD, and the total fixed payment-to-income ratio
would have been almost 64 percent compared with HUD’s 43 percent limit. A preforeclosure
sale was completed in May 2007 for the home in this case. The home was sold for $150,000.
HUD paid a claim for preforeclosure sale loss mitigation in July 2007.
21
Case number: 071-1054663
Mortgage amount: $197,113
Date of loan closing: October 31, 2007
Status: Delinquent
Payments before first default reported: Four
Unpaid principal balance: $193,949
Summary:
J.P. Morgan Chase did not report quality control findings to HUD as required. Quality control
findings for the subject loan included issues with qualifying ratios, supportability of income, and
the borrower’s creditworthiness.
Pertinent Details:
HUD Handbook 4060.1, REV-2, paragraph 7-3I, requires lenders to take prompt action to deal
appropriately with material quality control review findings. The final quality control review
report or an addendum must identify actions being taken with regard to findings, the timetable
for their completion, and planned follow-up activities. Paragraph 7-3J states that findings
discovered during quality control reviews should be reported to HUD within 60 days of the
initial discovery.
J.P. Morgan Chase did not implement quality control procedures as required for the subject loan.
Its quality control review of the loan revealed significant underwriting deficiencies including
income and debt ratios in excess of HUD’s allowed limits without compensating factors, year-to-
date earnings that did not support the income used to qualify the borrower, and a credit report
indicating late payments on 16 separate accounts within 18 months of closing. J.P. Morgan
Chase had identified these issues as of December 2008 but did not report them to HUD as
required. HUD paid a partial claim of $8,051 for loss mitigation on this loan.
22
J.P. Morgan Chase Bank, Newark, Delaware, Generally Complied with HUD's Origination and Quality Control Requirements for FHA-Insured Single-Family Loans
Published by the Department of Housing and Urban Development, Office of Inspector General on 2009-07-28.
Below is a raw (and likely hideous) rendition of the original report. (PDF)