oversight

1st Advantage Mortgage, LLC, Lombard, IL, Did Not Properly Underwrite a Selection of FHA Loans

Published by the Department of Housing and Urban Development, Office of Inspector General on 2010-07-15.

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

                                             U.S. Department of Housing and Urban Development
                                             Office of Inspector General for Audit, Region V
                                             Ralph H. Metcalfe Federal Building
                                             77 West Jackson Boulevard, Suite 2646
                                             Chicago, Illinois 60604-3507

                                             Phone (312) 353-7832 Fax (312) 353-8866
                                             Internet http://www.hud.gov/offices/oig/




                                                                                MEMORANDUM NO:
                                                                                     2010-CH-1806

July 15, 2010

MEMORANDUM FOR: Vicki Bott, Deputy Assistant Secretary for Single Family, HU
                Dane M. Narode, Associate General Counsel for Program
                  Enforcement, CACC


FROM: Heath Wolfe, Regional Inspector General for Audit, 5AGA

SUBJECT: 1st Advantage Mortgage, LLC, Lombard, IL, Did Not Properly Underwrite a
           Selection of FHA Loans

                                      INTRODUCTION

We reviewed 20 Federal Housing Administration (FHA) loans that 1st Advantage Mortgage,
LLC (1st Advantage), underwrote as an FHA direct endorsement lender. Our review objective
was to determine whether 1st Advantage underwrote the 20 loans in accordance with FHA
requirements. This review was conducted as part of our Operation Watchdog initiative to review
the underwriting of 15 direct endorsement lenders at the suggestion of the FHA Commissioner.
The Commissioner expressed concern regarding the increasing claim rates against the FHA
insurance fund for failed loans.

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

We provided our discussion draft memorandum report to 1st Advantage’s legal counsel during
the review. We asked 1st Advantage to provide written comments on our discussion draft
memorandum report by June 29, 2010. 1st Advantage’s legal counsel provided written
comments to the discussion draft report, dated June 28, 2010. The legal counsel generally
disagreed with our finding and recommendations, but agreed that mistakes were made and
claimed that 1st Advantage wanted to mitigate the damages to the FHA insurance fund for the
losses sustained. The complete text of the lender’s comments, along with our evaluation of that
response, can be found in appendix C of this report.
                                     METHODOLOGY AND SCOPE

1st Advantage is 1 of 15 direct endorsement lenders we selected from the U.S. Department of
Housing and Urban Development’s (HUD) publicly available Neighborhood Watch1 system
(system) for a review of underwriting quality. These direct endorsement lenders all had a
compare ratio2 in excess of 200 percent of the national average as listed in the system for loans
endorsed between November 1, 2007, and October 31, 2009. We selected loans that had gone
into claim status. We selected loans for 1st Advantage that defaulted within the first 30 months
and were (1) not streamline refinanced and (2) for manually underwritten loans, associated with
an underwriter (usually an individual) with a high number of claims.

                                               BACKGROUND

1st Advantage was a nonsupervised direct endorsement lender based in Lombard, IL. FHA
approved 1st Advantage as a direct endorser in September 1997 and terminated this approval in
February 2010 for failure to submit audited financial statements. 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 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 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.

The goal of Operation Watchdog is to determine why there is such a high rate of defaults and
claims. We selected up to 20 loans in claim status from the 15 lenders. The 15 lenders selected
for our review endorsed 183,278 loans valued at $31.3 billion during the period January 2005 to
December 2009. These same lenders also submitted 6,560 FHA insurance claims with an
estimated value of $794.3 million from November 2007 through December 2009. During this
period, 1st Advantage endorsed 2,648 loans valued at more than $381 million and submitted 68
claims worth more than $8 million.

Our objective was to determine whether the 20 selected loans were properly underwritten and if
not, whether the underwriting reflected systemic problems.

We performed our work from January through May 2010. We conducted our work in
accordance with generally accepted government auditing standards, except that we did not
consider the internal controls or information systems controls of 1st Advantage, consider the
results of previous audits, or communicate with 1st Advantage’s management in advance. We

1
  Neighborhood Watch is a system that aids HUD/FHA staff in monitoring lenders and its programs. This system
allows staff to oversee lender origination activities for FHA-insured loans and tracks mortgage defaults and claims.
2
  HUD defines “compare ratio” as a value that reveals the largest discrepancies between the direct endorser’s default
and claim percentage and the default and claim percentage to which it is being compared. FHA policy establishes a
compare ratio of more than 200 percent as a warning sign of a lender’s performance.


                                                         2
did not follow standards in these areas because our objective was to aid HUD in identifying FHA
single-family insurance program risks and patterns of underwriting problems or potential
wrongdoing in poor-performing lenders that led to a high rate of defaults and claims against the
FHA insurance fund. To meet our objective, it was not necessary to fully comply with the
standards, nor did our approach negatively affect our review results.

                                    RESULTS OF REVIEW

1st Advantage did not properly underwrite 8 of the 20 loans reviewed because its underwriters
did not follow FHA’s requirements. As a result, FHA’s insurance fund suffered actual losses of
$325,452 on the eight loans, as shown in the following table.

                                                Number of        Original    Actual
                 FHA loan                     payments before    mortgage    loss to
                  number      Closing date      first default     amount      HUD
                261-9102016     8/28/06               6         $83,341     $96,276
                361-3030073     6/28/06               22         89,203      27,035
                421-4233347     8/14/06               2          61,514      39,455
                421-4238265    10/13/06                9         46,631      28,600
                492-7646642      7/7/06               14        127,991      38,810
                492-7676492     7/28/06               17         83,686      48,008
                492-7844383     7/13/07               18         98,124      36,843
                495-7563145    11/20/06               11         49,508      10,425
                                    Totals                      $639,998    $325,452

The following table summarizes the material deficiencies that we identified in the eight loans.

                                                           Number of
                                 Area of noncompliance       loans
                               Income                          6
                               Assets                          3
                               Credit report                   2
                               Excessive ratios                1

Appendix A shows a schedule of material deficiencies in each of the eight loans. Appendix B
provides a detailed description of all loans with material underwriting deficiencies noted in this
report.

Income

1st Advantage did not properly calculate borrowers’ income or determine income stability for six
loans. HUD does not allow income to be used in calculating a borrower’s income ratios if it
cannot be verified, is not stable, or will not continue. 1st Advantage is required to analyze
whether income is reasonably expected to continue through at least the first 3 years of the
mortgage loan (see appendix B for detailed requirements).

For example, for loan number 421-4233347, 1st Advantage approved this loan although the
borrower had a history of full-time employment and income for only 77 days, from May 29,
2006, to the loan closing date. This was borrower’s first full-time employment, as the


                                                 3
borrower’s previous employments were all part time. According to documentation in the loan
file, the borrower’s average monthly earnings were $282 for 2004 and $325 for 2005. In
addition to approving the loan based on just 77 days of full-time employment, 1st Advantage
included overtime pay to calculate total monthly income of $1,755. HUD requires the overtime
to be earned for the past 2 years to be included as income. By not including the overtime
income, the borrower’s qualifying ratios would increase to 34.4 and 46.1 percent.

For loan number 421-4238265, the borrower did not have a history of stable employment and
income for a period of 24 months before loan closing. The borrower had employment history for
approximately 15 months, 3.5 months of full time and the remaining 11.5 months as part time.
The borrower started his full-time job with the current employer on June 28, 2006, about 3.5
months before loan closing. The borrower worked for two different employers from July 2005 to
April 2006. The borrower did not have an employment record before July 2005. According to
the Internal Revenue Service Forms W-2 in the loan file, the borrower’s total earnings for 2005
were $3,146 or approximately $262 per month. 1st Advantage approved this loan based on the
borrower’s current rate of pay of $7.50 per hour or $1,300 per month.

Assets

1st Advantage did not properly document the source of the borrowers’ funds to close for three
loans. HUD requires the lender to verify and document the borrower’s investment in the
property (see appendix B for detailed requirements).

For example, for loan number 261-9102016, 1st Advantage did not obtain an explanation for the
source of funds for the earnest money deposit of $2,520. It was 3 percent of the sales price and
appeared excessive based on borrower’s history of savings, as shown by the bank statements in
the loan file. To document the earnest money deposit amount, the borrower provided a copy of a
$2,520 bank check, dated July 18, 2006. The money for the bank check came from the
borrower’s bank account. The bank statement showed a deposit of $2,520 on July 18, 2006. The
deposit was withdrawn on the same day, and the bank check for the earnest money was obtained
on the same day. The source of these funds was not detailed in the loan file or the bank
statements. Therefore, there was a lack of documentation to ensure that the borrower did not
obtain the earnest money deposit funds via an undocumented loan, funds from an interested
party, or funds from another excludable source.

For loan number 421-4238265, 1st Advantage did not obtain an explanation for the source of
funds for the borrower’s earnest money. The loan file included a copy of a cancelled check for
$250 as an earnest money deposit. The check was not written from the borrower’s account but
from an account of the person with the same name as borrower’s landlord.

Credit Report

1st Advantage did not properly evaluate the borrowers’ credit history for two loans. HUD
requires the lender to consider collection accounts in analyzing a borrower’s creditworthiness.
The lender must explain all collections in writing (see appendix B for detailed requirements).




                                                4
For example, for loan number 421-4238265, 1st Advantage approved the loan when the borrower
had a limited credit history. The credit report showed only two accounts. Both of the accounts
showed zero balances. One showed a high balance of $3,000, and the other had a high balance
of zero. The credit report contained statements from the three major credit reporting agencies
indicating that no score was assigned because the subject did not have sufficient credit. Further,
the credit report indicated that the borrower paid $100 per week in rent; however, no
documentation was included in the loan file to support the rental payments. To establish credit
for the borrower, 1st Advantage should have obtained documentation for the rental payment
history.

For loan 492-7646642, 1st Advantage approved the loan despite the borrower having a poor
credit history, as the borrower’s credit history reflected continuous delinquent and unpaid
accounts. According to the credit report, the borrower had 9 collection accounts for revolving
credit, rental payments, and utility payments; 10 collection accounts for medical expenses; and 3
accounts that were charged off for automobile repossession or utility bills. Two of the nine
collection accounts were for rental payments for housing for two different apartment complexes.
In a letter found in the loan file, the borrower claimed that the derogatory credit was due to
immaturity and ignorance, as well as her divorce.

Excessive Ratios

1st Advantage improperly approved one loan when the borrower’s ratios exceeded FHA’s
requirement. Effective April 13, 2005, the mortgage payment-to-effective income and total fixed
payment-to-effective income ratios were increased from 29 and 41 percent to 31 and 43 percent,
respectively. If either or both ratios are exceeded on a manually underwritten mortgage, the
lender is required to describe the compensating factors used to justify the mortgage approval (see
appendix B for detailed requirements).

For loan number 492-7646642, the borrower’s mortgage payment-to-effective income ratio
exceeded HUD’s qualifying ratio of 31 percent. The ratio reported on the mortgage credit
analysis worksheet3 was 33 percent. 1st Advantage’s underwriter used a compensating factor and
recorded in the worksheet’s remarks section that the borrower received child support payments
of $597, which were not included in her income. However, there was no documentation in the
loan file to support this compensating factor.

Incorrect Underwriter’s Certifications Submitted to HUD

We reviewed the certifications for the eight loans with material underwriting deficiencies for
accuracy, seven manually underwritten loans and one automated underwritten loan. 1st
Advantage’s direct endorsement underwriters incorrectly certified that due diligence was used in
underwriting the seven manual loans and incorrectly certified to the integrity of the data used to
determine the quality of the loan in underwriting the automated loan. When underwriting a loan
manually, HUD requires a direct endorsement lender to certify that it used due diligence and
reviewed all associated documents during the underwriting of a loan, and when underwriting a


3
    The mortgage credit analysis worksheet is used to analyze and document mortgage approval.


                                                         5
loan using an automated system, HUD requires a direct endorsement lender to certify to the
integrity of the data used to determine the quality of the loan.

The Program Fraud Civil Remedies Act of 1986 (231 U.S.C. (United States Code) 3801)
provides Federal agencies, which are the victims of false, fictitious, and fraudulent claims and
statements, with an administrative remedy (1) to recompense such agencies for losses resulting
from such claims and statements; (2) to permit administrative proceedings to be brought against
persons who make, present, or submit such claims and statements; and (3) to deter the making,
presenting, and submitting of such claims and statements in the future.

                                             RECOMMENDATIONS

We recommend that HUD’s Associate General Counsel for Program Enforcement

1A.        Determine legal sufficiency and if legally sufficient, pursue remedies under the Program
           Fraud Civil Remedies Act against 1st Advantage and/or its principals for incorrectly
           certifying to the integrity of the data or that due diligence was exercised during the
           underwriting of eight loans that resulted in losses to HUD totaling $325,452, which could
           result in affirmative civil enforcement action of approximately $710,9044.

We recommend that HUD’s Deputy Assistant Secretary for Single Family

1B.        Take appropriate administrative action against 1st Advantage and/or its principals for the
           material underwriting deficiencies cited in this report once the affirmative civil
           enforcement action cited in recommendation 1A is completed.


                                           Schedule of Ineligible Cost 1/

                                        Recommendation
                                            number                     Amount
                                                1A                    $325,452


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. The amount shown represents the actual loss HUD incurred when
           it sold the affected properties.




4
    Double damages plus a $7,500 fine for each of the eight incorrect certifications.


                                                             6
Appendix A

SUMMARY OF MATERIAL UNDERWRITING DEFICIENCIES




                                                                                         Significant credit-related deficiencies or
                           Unsupported income or questionable




                                                                                                                                      Excessive debt-to-income ratio
                                  employment history




                                                                                                         no credit
              FHA loan                                          Unsupported assets
               number
             261-9102016                                                             X
             361-3030073                           X
             421-4233347                           X
             421-4238265                           X                                 X                             X
             492-7646642                           X                                                               X                                                   X
             492-7676492                           X
             492-7844383                           X
             495-7563145                                                             X




                                                                7
Appendix B

 LOANS WITH MATERIAL UNDERWRITING DEFICIENCIES


Loan number: 261-9102016

Mortgage amount: $83,341

Section of Housing Act: 203(b)

Loan purpose: Purchase

Date of loan closing: August 28, 2006

Status: Claim

Payments before first default reported: Six

Loss to HUD: $96,276

Summary:

We found a material underwriting deficiency relating to the borrower’s assets.

Assets:

1st Advantage did not obtain an explanation for the source of funds for the earnest money deposit
of $2,520. It was 3 percent of the sales price and appeared excessive based on the borrower’s
history of accumulating savings, as shown by the bank statements in the loan file. To document
the earnest money deposit amount, the borrower provided a copy of a $2,520 bank check, dated
July 18, 2006. The money for the bank check came from the borrower’s bank account. The
bank statement showed a deposit of $2,520 on July 18, 2006. The deposit was withdrawn on the
same day, and the bank check for the earnest money was also obtained on the same day.
However, documentation in the loan file did not identify the source of these funds from a review
of the loan file or the bank statements.

The borrower maintained a low balance in his bank account, usually below $1,000, and the bank
statements clearly identified direct deposits for payroll. The payroll deposits were on a biweekly
basis and were below $1,500. There was a payroll deposit of $1,232 on July 12, 2006, and the
account balance on July 17, 2006, was $41. As it was not a payroll deposit, 1st Advantage should
have verified the source of funds for the earnest money to ensure that the borrower did not obtain
an undocumented loan, funds from an interested party, or funds from another excludable source.




                                                8
HUD/FHA Requirements:

HUD Handbook 4155.1, REV-5, paragraph 2-10, states that if the amount of the earnest money
deposit exceeds 2 percent of the sales price or appears excessive based on the borrower’s history
of accumulating savings, the lender must verify with documentation the deposit amount and the
source of funds.




                                                9
Loan number: 361-3030073

Mortgage amount: $89,203

Section of Housing Act: 203(b)

Loan purpose: Purchase

Date of loan closing: June 28, 2006

Status: Claim

Payments before first default reported: 22

Loss to HUD: $27,035

Summary:

We found a material underwriting deficiency relating to the borrower’s income.

Income:

1st Advantage used questionable income to approve the loan. The borrower’s income increased
from an average of $2,028 per month for the previous employer to $3,500 per month just 23 days
before loan closing. The borrower worked for the previous employer for 10.67 months, from
July 5, 2005, to May 26, 2006.

1st Advantage’s underwriter used an income of $3,500 per month on the mortgage credit analysis
worksheet. The income amount was based on an employment verification letter, dated May 24,
2006, stating that the borrower would begin to work for a salary of $3,500 per month on June 5,
2006. This information was supported in the loan file by three paystubs for pay periods June 6 to
June 12, June 11 to June 17, and June 19 to June 26, 2006. The paystubs were questionable and
contained discrepancies which were not resolved. For example, the pay period dates on two of
the three paystubs overlapped. Further, the last paystub showed lower year-to-date earnings and
taxes withheld than the previous paystub.

Based on unreliability of income, 1st Advantage’s underwriter should have noticed the
discrepancies and not used the $3,500 per month as income. Using the borrower’s previous
income of $2,028 per month would have increased the mortgage payment-to-effective income
ratio to 36.8 percent and the total fixed payment-to-effective income ratio to 72.04 percent.

HUD/FHA Requirements:

HUD Handbook 4155.1, REV-5, Foreword, states that lenders are expected to exercise both
sound judgment and due diligence in the underwriting of loans to be insured by FHA.




                                               10
HUD Handbook 4155.1, REV-5, paragraph 2-12, and Mortgagee Letter 2005-16 state that for
manually underwritten mortgages for which the direct endorsement underwriter must make the
credit decision, the qualifying ratios were raised to 31 and 43 percent, respectively. This change
will allow a larger number of deserving families to purchase their first home while not increasing
the risk of default. As always, if either or both ratios are exceeded on a manually underwritten
mortgage, the lender must describe the compensating factors used to justify mortgage approval.

HUD Handbook 4155.1, REV-5, section 2, states that income may not be used in calculating the
borrower’s income ratios if it comes from a source that cannot be verified, is not stable, or will
not continue. Paragraph 2-6 states that HUD does not impose a minimum length of time a
borrower must have held a position of employment to be eligible. However, the lender must
verify the borrower’s employment for the most recent 2 full years. Paragraph 2-7 states that the
income of each borrower to be obligated for the mortgage debt must be analyzed to determine
whether it can reasonably be expected to continue through at least the first 3 years of the
mortgage loan.




                                                11
Loan number: 421-4233347

Mortgage amount: $61,514

Section of Housing Act: 203(b)

Loan purpose: Purchase

Date of loan closing: August 14, 2006

Status: Claim

Payments before first default reported: Two

Loss to HUD: $39,455

Summary:

We found a material underwriting deficiency relating to the borrower’s income.

Income:

1st Advantage approved this loan although the borrower did not have a history of full-time
employment and income for a period of 24 months before loan closing. The borrower had
worked for his current employer for only 77 days, from May 29, 2006, to the loan closing date.
It was borrower’s first full-time employment. From March 7 to May 25, 2006, the borrower
worked for a previous employer as a part-time employee. Before March 2006, the borrower had
worked for two different employers, also on a part-time basis. The borrower’s total earnings
according to the documentation available in the loan file for 2005 was $3,895, or an average of
$325 per month, and $3,380 for 2004, or an average of $282 per month.

In addition to approving the loan based on just 77 days of full-time employment history, 1st
Advantage included overtime pay to calculate the average monthly income of $1,755. HUD
requires the overtime to be earned for the past 2 years to be included in income. The borrower’s
rate of pay was $9.00 per hour or $1,560 per month. By not including the overtime income, the
qualifying ratios would increase to 34.4 and 46.1 percent, which exceed HUD’s allowable ratios.

HUD/FHA Requirements:

HUD Handbook 4155.1, REV-5, section 2, states that income may not be used in calculating the
borrower’s income ratios if it comes from a source that cannot be verified, is not stable, or will
not continue. Paragraph 2-6 states that HUD does not impose a minimum length of time a
borrower must have held a position of employment to be eligible. However, the lender must
verify the borrower’s employment for the most recent 2 full years. Paragraph 2-7 states that the
income of each borrower to be obligated for the mortgage debt must be analyzed to determine
whether it can reasonably be expected to continue through at least the first 3 years of the


                                                12
mortgage loan. The lender must develop an average of bonus or overtime income for the past 2
years.

HUD Handbook 4155.1, REV-5, paragraph 2-12, and Mortgagee Letter 2005-16 state that for
manually underwritten mortgages for which the direct endorsement underwriter must make the
credit decision, the qualifying ratios were raised to 31 and 43 percent, respectively. This change
will allow a larger number of deserving families to purchase their first home while not increasing
the risk of default. As always, if either or both ratios are exceeded on a manually underwritten
mortgage, the lender must describe the compensating factors used to justify mortgage approval.




                                               13
Loan number: 421-4238265

Mortgage amount: $46,631

Section of Housing Act: 203(b)

Loan purpose: Purchase

Date of loan closing: October 13, 2006

Status: Claim

Payments before first default reported: Nine

Loss to HUD: $28,600

Summary:

We found material underwriting deficiencies relating to the borrower’s income, unsupported
assets, and credit history.

Income:

1st Advantage should not have approved this loan because the borrower did not have a history of
stable employment and income for a period of 24 months before loan closing. The borrower had
employment history for approximately 15 months, 3.5 months of full time and the remaining
11.5 months as part time. The borrower started her full-time job with the current employer on
June 28, 2006, about 3.5 months before loan closing. The borrower worked for two different
employers from July 2005 to April 2006. The borrower did not have an employment record
before July 2005.

1st Advantage approved this loan based on the borrower’s current rate of pay of $7.50 per hour or
$1,300 per month. This pay had recently increased from $6.75 per hour or $1,170 per month for
the same employer. Documentation in the loan file showed that the borrower was about 18 years
old at the time of loan closing and had graduated from high school on May 26, 2006. According
to the W-2s in the loan file, the borrower’s total earnings for 2005 were $3,146 for an average of
$262 per month.

HUD/FHA Requirements:

HUD Handbook 4155.1, REV-5, section 2, states that income may not be used in calculating the
borrower’s income ratios if it comes from a source that cannot be verified, is not stable, or will
not continue. Paragraph 2-6 states that HUD does not impose a minimum length of time a
borrower must have held a position of employment to be eligible. However, the lender must
verify the borrower’s employment for the most recent 2 full years. Paragraph 2-7 states that the
income of each borrower to be obligated for the mortgage debt must be analyzed to determine



                                                14
whether it can reasonably be expected to continue through at least the first 3 years of the
mortgage loan. The lender must develop an average of bonus or overtime income for the past 2
years.

Assets:

1st Advantage did not obtain an explanation for the source of funds for the borrower’s earnest
money. The loan file included a copy of a cancelled check for $250 as the earnest money
deposit. The check was not written from borrower’s account but from an account of a person
with the same name as the borrower’s landlord. 1st Advantage’s underwriter should have noticed
this discrepancy and asked the borrower to provide an explanation.

HUD/FHA Requirements:

HUD Handbook 4155.1 REV-5, paragraph 2-10A, states that if the amount of the earnest money
deposit appears excessive based on the borrower’s history of accumulating savings, the lender
must verify with documentation the deposit amount and source of funds. Satisfactory
documentation includes a copy of the borrower’s canceled check. Evidence of source of funds
includes a verification of deposit or bank statement showing that at the time the deposit was
made, the average balance was sufficient to cover the amount of the earnest money deposit.

Credit:

The borrower had a limited credit history, and her credit report in the loan file showed only two
accounts. Both of the accounts showed zero balances. One showed a high balance of $3,000,
and the other had a high balance of zero. The credit report contained statements from the three
major credit reporting agencies indicating that no score was assigned because the subject did not
have sufficient credit.

The credit report indicated that the borrower paid $100 per week in rent. To establish credit for
the borrower, 1st Advantage should have obtained documentation to support the rental payment
history.

HUD/FHA Requirements:

HUD Handbook 4155.1, REV-5, paragraph 2-3, states that for those borrowers without an
established credit history or for those who do not use traditional credit, the lender must develop a
credit history from utility payment records, rental payments, automobile insurance payments, or
other means of direct access from the credit provider. The lender must document that the
providers of nontraditional credit do, in fact, exist and verify the credit information.




                                                15
Loan number: 492-7646642

Mortgage amount: $127,991

Section of Housing Act: 203(b)

Loan purpose: Construct Home

Date of loan closing: July 7, 2006

Status: Claim

Payments before first default reported: 14

Loss to HUD: $38,810

Summary:

We found material underwriting deficiencies relating to the borrower’s income, credit, and
excessive ratios.

Income:

1st Advantage approved the loan based on income which was earned for only 2.5 weeks before
loan closing. Further, the loan file did not contain employment history for 2 years, as required
by HUD. It only contained history for about 18 months, from February 2005 to July 2006.

The borrower started her employment with the current employer on June 19, 2006, and had
received payment for 2 weeks of $1,610. The paystub and a letter from the employer showed the
bimonthly salary of $1,771. 1st Advantage used this information to calculate the borrower’s
monthly income of $3,541. The stability of this income was questionable because the borrower
earned much less from her previous two employers.

Before the current employer, the borrower worked for two different employers from February
2005 to June 16, 2006. According to W-2s in the loan file, the borrower earned $15,516 in 2005.
From January 1 to May 26, 2006, the borrower earned $13,538. Based on the income data
available in the loan file for 2005 and 6 months of 2006, we calculated the borrower’s average
monthly income as $1,804 ($15,516 plus $13,538 plus $1,610 divided by 17 months). Using this
average for the previous 17 months would increase the mortgage payment-to-effective income
ratio from 33 to 65.4 percent ($1,180 mortgage payment divided by $1,804 monthly income).

In a letter in the loan file, the borrower explained that she had been employed with her current
employer for more than a year, was employed with her previous employer for 2.5 years, and
before that was employed with a different employer for 3 years. However, this employment
explanation was not consistent with the documentation in the loan file. The borrower was only
employed for 2.5 weeks with the current employer and approximately 7.5 months with the



                                                16
previous employer. 1st Advantage’s underwriter should have noticed this discrepancy and
resolved it.

HUD/FHA Requirements:

HUD Handbook 4155.1, REV-5, section 2, states that income may not be used in calculating the
borrower’s income ratios if it comes from a source that cannot be verified, is not stable, or will
not continue. Paragraph 2-6 states that HUD does not impose a minimum length of time a
borrower must have held a position of employment to be eligible. However, the lender must
verify the borrower’s employment for the most recent 2 full years.

HUD Handbook 4155.1, REV-5, paragraph 2-12, and Mortgagee Letter 2005-16 state that for
manually underwritten mortgages for which the direct endorsement underwriter must make the
credit decision, the qualifying ratios were raised to 31 and 43 percent, respectively. This change
will allow a larger number of deserving families to purchase their first home while not increasing
the risk of default. As always, if either or both ratios are exceeded on a manually underwritten
mortgage, the lender must describe the compensating factors used to justify mortgage approval.

Credit:

1st Advantage should not have approved this loan because the borrower had poor credit history.
The borrower’s credit history reflected continuous delinquent and unpaid accounts.

According to the credit report in the loan file, the borrower had 9 collection accounts for
revolving credit, rental payments, and utility payments; 10 collection accounts for medical
expenses; and 3 accounts that were charged off for automobile repossession or utility bills. Two
of the nine collection accounts were for rental payments for housing for two different apartment
complexes. In a letter in the loan file, the borrower claimed that the derogatory credit was due to
the borrower’s immaturity and ignorance, as well as her divorce. There was no documentation to
support the borrower’s explanations.

HUD/FHA Requirements:

HUD Handbook 4155.1, REV-5, paragraph 2-1, states that the purpose of underwriting is to
determine a borrower’s ability and willingness to repay the mortgage debt, thus limiting the
probability of default and collection difficulties, and to examine the property offered as security
for the loan to determine whether it is sufficient collateral.

HUD Handbook 4155.1, REV-5, paragraph 2-3, states that past credit performance serves as the
most useful guide in determining a borrower’s attitude toward credit obligations and predicting a
borrower’s future actions. If the credit history, despite adequate income to support obligations,
reflects continuous slow payments and delinquent accounts, strong compensating factors will be
necessary to approve the loan. The lender must document its analysis regarding whether the late
payments were based on disregard for financial obligations or otherwise. Further, paragraph 2-
3C states that collections and judgments must be considered in the analysis of creditworthiness,
with the lender documenting its reasons for approving a mortgage when the borrower has



                                                 17
collection accounts and judgments. The borrower must explain in writing all collections and
judgments.

Excessive Ratio:

The borrower’s mortgage payment-to-effective income ratio exceeded HUD’s qualifying ratio of
31 percent. The ratio reported on the mortgage credit analysis worksheet was 33 percent. 1st
Advantage’s underwriter used a compensating factor and recorded on the worksheet’s remarks
section that the borrower received child support payments of $597, which were not included in
her income. There was no documentation in the loan file to support this compensating factor.

HUD/FHA Requirements:

HUD Handbook 4155.1, REV-5, paragraph 2-12, and Mortgagee Letter 2005-16 state that for
manually underwritten mortgages for which the direct endorsement underwriter must make the
credit decision, the qualifying ratios were raised to 31 and 43 percent, respectively. This change
will allow a larger number of deserving families to purchase their first home while not increasing
the risk of default. As always, if either or both ratios are exceeded on a manually underwritten
mortgage, the lender must describe the compensating factors used to justify mortgage approval.




                                               18
Loan number: 492-7676492

Mortgage amount: $83,686

Section of Housing Act: 203(b)

Loan purpose: Purchase

Date of loan closing: July 28, 2006

Status: Claim

Payments before first default reported: 17

Loss to HUD: $48,008

Summary:

We found a material underwriting deficiency relating to the borrower’s income.

Income:

1st Advantage’s underwriter overstated the borrower’s gross monthly income by $279 by
overestimating the overtime income. Despite having an employment and wage history of more
than 2 years (27.35 months) with the same employer, the underwriter calculated the borrower’s
average overtime income of $942 per month by using only 17.83 months (12 months of 2005
plus 5.83 months of 2006). For calculating the qualifying ratio of mortgage payment to effective
income, the underwriter used gross income of $2,578 per month ($1,636 base wages plus $942 in
overtime). The qualifying ratio was 31.17 percent on the mortgage credit analysis worksheet.

We calculated the borrower’s overtime income of $663 per month using the complete wage and
income data for the 27.35-month period, which was available in the loan file. As a result, we
calculated the borrower’s gross monthly income as $2,299 ($1,636 base wages plus $663 in
overtime pay). The most recent paystub in the loan file showed that the borrower’s year-to-date
earnings for the first 5.83 months of 2006 were $13,484, an average gross monthly income of
$2,305. This amount was close to our calculation of average gross income of $2,299 for the
27.35-month period.

Using the average gross monthly income of $2,299 increased the mortgage payment-to-effective
income ratio to 34.92 percent, above the allowable ratio of 31 percent.

HUD/FHA Requirements:

HUD Handbook 4155.1, REV-5, section 2, states that income may not be used in calculating the
borrower’s income ratios if it comes from a source that cannot be verified, is not stable, or will
not continue. Paragraph 2-6 states that HUD does not impose a minimum length of time a



                                                19
borrower must have held a position of employment to be eligible. However, the lender must
verify the borrower’s employment for the most recent 2 full years. Paragraph 2-7 states that the
income of each borrower to be obligated for the mortgage debt must be analyzed to determine
whether it can reasonably be expected to continue through at least the first 3 years of the
mortgage loan. The lender must develop an average of bonus or overtime income for the past 2
years.

HUD Handbook 4155.1, REV-5, paragraph 2-12, and Mortgagee Letter 2005-16 state that for
manually underwritten mortgages for which the direct endorsement underwriter must make the
credit decision, the qualifying ratios were raised to 31 and 43 percent, respectively. This change
will allow a larger number of deserving families to purchase their first home while not increasing
the risk of default. As always, if either or both ratios are exceeded on a manually underwritten
mortgage, the lender must describe the compensating factors used to justify mortgage approval.




                                               20
Loan number: 492-7844383

Mortgage amount: $98,124

Section of Housing Act: 203(b)

Loan purpose: Purchase

Date of loan closing: July 13, 2007

Status: Claim

Payments before first default reported: 18

Loss to HUD: $36,843

Summary:

We found a material underwriting deficiency relating to the borrower’s income.

Income:

1st Advantage used overtime income of $932 per month although the borrower had not earned
this income for 2 years. Instead, the borrower had earned this income for only 14 months. This
loan was processed through the automated underwriting system, using the FHA Total Scorecard.
1st Advantage did not meet one of the approval conditions required by the system. The condition
stipulates that the overtime income may be used if the borrower has received it for approximately
2 years.

The borrower started employment with his current employer on May 12, 2006, approximately 14
months before loan closing. The borrower had earned overtime income with this employer for
approximately 14 months. However, there was no documentation to support that the borrower
earned overtime before May 12, 2006. As the overtime income was for less than 2 years, 1st
Advantage should not have used this income. The loan file did not contain documentation from
1st Advantage justifying the reason for using the income for qualifying purposes. Excluding the
overtime income would increase the qualifying total fixed payment-to-effective income ratio to
54.6 percent.

HUD/FHA Requirements:

Approval condition number 22 in the automated underwriting system stated that overtime or
bonus income was used to underwrite the loan. Both may be used to qualify the borrower if the
borrower has received such income for approximately 2 years and there is reasonable prospect of
its continuing.




                                               21
HUD Handbook 4155.1, REV-5, section 2, states that income may not be used in calculating the
borrower’s income ratios if it comes from a source that cannot be verified, is not stable, or will
not continue. Paragraph 2-6 states that HUD does not impose a minimum length of time a
borrower must have held a position of employment to be eligible. However, the lender must
verify the borrower’s employment for the most recent 2 full years. Paragraph 2-7 states that the
income of each borrower to be obligated for the mortgage debt must be analyzed to determine
whether it can reasonably be expected to continue through at least the first 3 years of the
mortgage loan. The lender must develop an average of bonus or overtime income for the past 2
years.




                                                22
Loan number: 495-7563145

Mortgage amount: $49,508

Section of Housing Act: 203(b)

Loan purpose: Purchase

Date of loan closing: November 20, 2006

Status: Claim

Payments before first default reported: 11

Loss to HUD: $10,425

Summary:

We found a material underwriting deficiency relating to the borrower’s assets.

Assets:

1st Advantage did not ensure that the borrower made the required minimum investment in the
purchased property. The borrower obtained $5,000 in downpayment assistance from the City of
Harlingen, TX’s downpayment assistance program. However, the program required the
borrower to make a minimum investment of $525. The documentation in the loan file showed
that the borrower did not make this investment.

The borrower initially paid $850, $500 as an earnest money deposit and $350 for the appraisal
fee. The borrower did not have a bank account, and 1st Advantage did not verify the source of
these funds. According to the HUD-1 settlement statement, the borrower received $712 at
closing, thus bringing the borrower’s investment down to $138 ($850 minus $712).

HUD/FHA Requirements:

HUD Handbook 4155.1, REV-5, paragraph 2-10, states that all funds for the borrower’s
investment in the property must be verified and documented.




                                               23
APPENDIX C

         LENDER COMMENTS AND OIG’s EVALUATION


Ref to OIG Evaluation    Lender Comments




Comment 1


Comment 2




                          24
Ref to OIG Evaluation   Lender Comments




                         25
Ref to OIG Evaluation   Lender Comments




Comment 3




                         26
Ref to OIG Evaluation   Lender Comments




                         27
Ref to OIG Evaluation   Lender Comments




Comment 4




                         28
Ref to OIG Evaluation               Lender Comments




Comment 5




                        OIG’s Evaluation of Lender Comments




                                      29
                          OIG’s Evaluation of Lender Comments

Comment 1   1st Advantage agreed that some mistakes were made in the underwriting and/or
            documentation of the eight loans identified in the memorandum report. 1st
            Advantage also expressed its willingness to work with HUD to mitigate the losses
            to the extent that it is able.

Comment 2   1st Advantage believed that at the time the loans were originated, FHA
            encouraged lenders to be flexible in their underwriting to permit individuals who
            historically had not qualified for mortgage loans to become homeowners. 1st
            Advantage also believed that many of FHA’s underwriting standards were
            subjective, which permitted flexibility. However, FHA requires lenders to meet
            specific underwriting requirements and establish a borrower’s ability and
            willingness to repay the mortgage debt. According to FHA guidelines, lenders are
            expected to exercise both sound judgment and due diligence in the underwriting
            of loans.

Comment 3   1st Advantage contended that FHA loan numbers 361-3030073, 492-7676492,
            and 492-7844383 did not default until the borrower made between 17 and 22
            payments. Therefore, it suggested that it was not underwriting errors that led to
            the borrower’s default. These loans contained material underwriting deficiencies.
            For example, as stated in our review, for FHA loan number 361-3030073, the
            underwriter used questionable income to approve the loan. The borrower’s
            income increased from an average of $2,028 per month for the previous employer
            to $3,500 per month just 23 days before loan closing. The pay stubs were also
            questionable and contained discrepancies which were not resolved. Due diligence
            was not performed by 1st Advantage as evidenced by the material underwriting
            deficiencies identified in these loans.

Comment 4   1st Advantage believes that our recommendation for remedies under the Program
            Fraud Civil Remedies Act is not appropriate because certain elements to prove
            false claims were not satisfied. We did not change our recommendation, as this
            recommendation is appropriate based on the issues citied in the memorandum.
            Violations of FHA rules are subject to civil and administrative action.

Comment 5   1st Advantage believes that our recommendation to HUD’s Deputy Assistant
            Secretary for Single Family is not appropriate because 1st Advantage intends to
            work with HUD to mitigate its losses resulting from the subject loans. We did not
            change our recommendation, as HUD’s Deputy Assistant Secretary will
            determine the appropriate action.




                                           30