Issue Date
March 26, 2010
Audit Report Number
2010-NY-1009
TO: Vicki Bott, Deputy Assistant Secretary for Single Family Housing, HU
FROM: Edgar Moore, Regional Inspector General for Audit, New York/New Jersey
Region, 2AGA
SUBJECT: Somerset Investors Corporation, Melville, NY, Did Not Always Comply With
HUD/FHA Loan Underwriting Requirements
HIGHLIGHTS
What We Audited and Why
We audited Somerset Investors Corporation (Somerset), dba Somerset Mortgage
Bankers, a Federal Housing Administration (FHA)-approved direct endorsement
lender located in Melville, NY. We selected Somerset because its 10.09 percent
default and claim ratio reported in HUD’s Neighborhood Watch system for
insured single-family loans for the period January 1, 2007, to December 31, 2008,
was more than double the New York State average ratio of 3.77 percent for the
same period.
The audit objectives were to determine whether Somerset (1) originated FHA-
insured refinanced loans in accordance with the requirements of the U.S.
Department of Housing and Urban Development (HUD)/FHA and (2) conducted
quality control reviews that complied with HUD/FHA requirements.
What We Found
Somerset did not always originate refinanced loans in accordance with HUD/FHA
requirements. Specifically, 8 of 11 loans reviewed exhibited underwriting
deficiencies significant enough to warrant indemnification, such as inadequate
evaluation of previous mortgage payment history, excessive qualifying ratios
without significant compensating factors to justify loan approval, and improper
calculation of income. The remaining three loans disclosed other underwriting
deficiencies that were not significant enough to request indemnification. In
addition, six loans subject to Somerset’s quality control review evidenced
underwriting deficiencies that warrant indemnification. Consequently, 14
mortgage loans with an outstanding principal balance of over $4.6 million were
approved, which presented an unnecessary risk to the FHA insurance fund.
Somerset’s written quality control plan complied with HUD/FHA requirements;
however, the quality control reviews conducted did not comply with HUD’s and
its own quality control requirements regarding sample size and reporting.
Specifically, the completed quality control reviews did not include home equity
conversion mortgages; did not always identify corrective actions, a timetable for
completion, or planned follow-up activities; and did not report serious violations
to HUD. Consequently, assurance was lessened that Somerset’s quality control
process would identify and address underwriting problems in a timely manner and
thus protect Somerset and FHA from unacceptable risk.
What We Recommend
We recommend that the Deputy Assistant Secretary for Single Family Housing
require Somerset to (1) indemnify HUD for potential estimated losses of nearly
$2.8 million for 14 loans with significant underwriting deficiencies, (2) strengthen
controls over its underwriting procedures to provide assurance that HUD/FHA
requirements are met, and (3) implement procedures to ensure that quality control
reviews comply with HUD/FHA 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 discussed the results of the audit with the auditee during the audit and
provided them a draft report on January 11, 2010, which was discussed at an exit
conference on February 18, 2010. We requested written comments by February
25, 2010, which were received on that date. The auditee agreed with the request
for indemnification for 9 of the 14 loans and has taken, or plans to take, action to
address the other recommendations.
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: Refinanced Loans Were Not Always Underwritten in Accordance 5
With HUD/FHA Requirements
Finding 2: Quality Control Reviews Did Not Comply With All 12
HUD/FHA Requirements
Scope and Methodology 15
Internal Controls 16
Appendixes
A. Schedule of Questioned Costs and Funds To Be Put to Better Use 17
B. Auditee Comments and OIG’s Evaluation 18
C. Summary of Significant and Other Underwriting Deficiencies 27
D. Case Narratives 28
3
BACKGROUND AND OBJECTIVES
Somerset Investors Corporation (Somerset), d/b/a Somerset Mortgage Bankers, is a U.S.
Department of Housing and Urban Development (HUD)-approved Title II nonsupervised lender1
located at 290 Broadhollow Road, Suite 310E, Melville, NY. Somerset was designated a direct
endorsement lender on December 9, 1992, which allows it to underwrite Federal Housing
Administration (FHA)-insured single-family mortgages without prior review by FHA. Somerset
is also a mortgage banker/lender licensed in 22 States and the District of Columbia.
Somerset originates primarily conventional conforming and HUD loans and sells them to
investors, servicing released, and also brokers conventional loans that are closed by other
investors. It serves the New York metropolitan area, with the predominant portion of its
business conducted on Long Island.
HUD’s Neighborhood Watch2 system reported that Somerset had a 10.09 percent default and
claim ratio for insured single-family loans with beginning amortization dates between January 1,
2007, and December 31, 2008. This rate was more than double the New York State average of
3.77 percent for the same period. As of March 31, 2009, Neighborhood Watch reported that 42
of the 404 loans originated by Somerset with beginning amortization dates between April 1,
2007, and March 31, 2009, were in default. This represents a 10.40 percent ratio, compared to
the New York State average of 4.43 percent for the same period. Of the 404 loans, 385 were still
active, and 19 had been terminated.
In recognition of its high default rate, in November 2008, before the start of our audit, Somerset
hired a risk management consultant to develop procedures to more effectively address this rate
and the risk inherent in the underwriting process. The consultant created a risk matrix to apply to
all FHA loans, which determines the level of review needed before a loan will be approved.
The audit objectives were to determine whether Somerset (1) originated FHA-insured refinanced
loans in accordance with HUD/FHA requirements and (2) conducted quality control reviews that
complied with HUD/FHA requirements.
1
A nonsupervised lender is a HUD/FHA-approved lending institution that has as its principal activity the lending or
investment of funds in real estate mortgages and may be approved to originate, sell, purchase, hold, and/or service
HUD/FHA-insured mortgages, depending upon its wishes and qualifications.
2
Neighborhood Watch is a Web-based comprehensive data processing, automated query, reporting, and analysis
system designed to highlight exceptions to lending practices to high-risk mortgages so that potential problems are
readily identifiable.
4
RESULTS OF AUDIT
Finding 1: Refinanced Loans Were Not Always Underwritten in
Accordance With HUD/FHA Requirements
Somerset did not always underwrite refinanced loans in accordance with HUD/FHA
requirements. Specifically, 8 of 11 loans reviewed exhibited underwriting deficiencies
significant enough to warrant indemnification, such as inadequate evaluation of previous
mortgage payment history, excessive qualifying ratios without significant compensating factors
to justify loan approval, and improper calculation of income. The remaining three loans
reviewed disclosed other underwriting deficiencies that were not significant enough to request
indemnification. In addition, six loans subject to Somerset’s quality control review evidenced
underwriting deficiencies that warrant indemnification. These deficiencies occurred because
Somerset lacked adequate controls to address the considerable risk in underwriting refinanced
mortgage loans. Consequently, 14 mortgage loans with an outstanding principle balance of over
$4.6 million were approved, which presented an unnecessary risk to the FHA insurance fund.
Loans with Significant
Underwriting Deficiencies
Somerset did not always underwrite refinanced mortgage loans in accordance
with HUD/FHA requirements. As shown in the table below and in appendix C, 8
of 113 refinanced mortgage loans reviewed exhibited significant underwriting
deficiencies warranting indemnification of $1,737,298 (see appendix D for a
detailed description of deficiencies identified for each case). As a result, HUD is
at risk of loss on these eight loans and has already incurred and paid a $1,000 loan
modification claim on one of the eight loans.
Type of significant deficiency Number of loans4
Inaccurate evaluation of borrower’s
8 of 11 loans
previous mortgage payment history
Excessive ratios without acceptable
6 of 11 loans
compensating factors
Improper calculation of income 3 of 11 loans
3The 11 loans consisted of nine cash-outs and two no-cash-out refinanced loans.
4
The deficiencies noted are not independent of one another, as one loan may have contained more than one
deficiency.
5
Inaccurate Evaluation of
Mortgage Payment Histories
Somerset officials did not adequately evaluate the borrowers’ previous mortgage
payment history in eight cases reviewed because they did not obtain satisfactory
explanations for late mortgage payments, consider late mortgage payments in
evaluating borrower credit history, and ensure that borrowers were current with
mortgage payments before the new FHA loan closing. Chapter 2-3A of HUD
Handbook 4155.1, REV-5 provides that a borrower’s housing obligation payment
history holds significant importance in evaluating credit and the lender must
determine the borrower’s payment history of housing obligations through either
the credit report, verification of mortgage directly from the mortgage servicer, or
canceled checks covering the most recent 12-month period. Chapter 1-10E of this
handbook also prohibits inclusion in the new mortgage amount any mortgage
payments that were “skipped.” Therefore, borrowers must be current on their
mortgage payments or bring the monthly mortgage payment check to the loan
closing for settlement.
Loans with Excessive Ratios
and Inadequate Compensating
Factors
HUD Handbook 4155.1, REV-5, Chapter 2-13, provides that compensating
factors may be used to justify approval of mortgage loans with ratios exceeding
HUD’s front and back ratio5 benchmark guidelines. However, if such factors are
used to support loan approval, the underwriter must explain the compensating
factors in the “remarks” section of the mortgage credit analysis worksheet6 and
provide supporting documentation. Somerset officials approved six loans with
ratios that exceeded the applicable HUD benchmarks of 31 percent and 43 percent
without documenting acceptable compensating factors to justify approval. For
example, Somerset presented stable employment as a compensating factor for
case number 374-4632311; however, stable employment is not a valid
compensating factor because it is a requirement for loan approval. The qualifying
ratios used by the lender are shown in the chart below.
Mortgage payment- to- Fixed payment-to- income
# Case number
income ratio (front ratio) ratio (back ratio)
1 374-4676210 55.10% 66.83%
2 374-4756404 59.80% 66.14%
3 374-4632311 52.83% 52.83%
4 374-4668220 41.88% 53.55%
5 374-4623723 47.28% 47.28%
6 374-4727545 57.85% 58.19%
5
The front ratio is the mortgage payment-to-income ratio, and the back ratio is the fixed payment-to-income ratio;
HUD’s benchmarks are 31 percent and 43 percent, as set forth in Mortgagee Letter 2005-16.
6
The mortgage credit analysis worksheet is used to analyze and document mortgage approval.
6
Improper Calculation of
Income
Somerset officials did not properly calculate borrower income for three loans.
Chapter 2 of HUD Handbook 4155.1, REV-5, provides that the lender must verify
the borrower’s employment for the most recent 2 full years. Further, overtime
income may be used if the borrower had such income for the past 2 years and it is
likely to continue; however, the overtime income must be averaged for the past 2
years, and the employment verification must not state that such income is unlikely
to continue. In addition, any unemployment income must be documented for 2
years. In one case (FHA number 374-4676210), the borrower’s 2006 income was
used for loan qualification instead of the borrower’s current 2007 year-to-date
wages. In another case (FHA number 374-4632311), overtime income was used
for qualification without verifying that the borrower had received this overtime
income for the past 2 years or verifying that it was likely to continue. In a third
case (FHA number 374-4668220), the coborrower’s weekly contract rate was
used for loan qualification instead of the year-to-date wages earned as shown on
the coborrower’s pay stub. As a result, borrower income was overstated, and the
reported qualifying ratios were lower than they should have been for these three
loans.
Appendix C and D provide specific details on loans reviewed. Somerset agreed to
indemnification on seven of the eight loans for which we recommend
indemnification.
Other Underwriting
Deficiencies
For the remaining three loans reviewed, other underwriting deficiencies were
found; however, they were not significant enough to request indemnification. The
deficiencies are noted in the table below.
Type of deficiency Number of loans
Incorrect calculation of income but
2 of 3 loans
qualifying ratios were not excessive
Borrower demonstrated an inability
1 of 3 loans
to manage debt
Analysis of Loans Reviewed by
Quality Control
Analysis of 16 loans that received a quality control review by either staff from
Somerset and/or its quality control contractor disclosed that six loans had serious
7
underwriting deficiencies warranting indemnification of $1,062,534. The
significant deficiencies identified by Somerset’s quality control and/or confirmed
in our review are summarized below.
Unpaid Quality
Case Loan principal Indemnification control Description of significant deficiencies
#
number type balance as amount7 reported disclosed by audit analysis
of 10-31-09 deficiency
Underwriting
Cash Out
1 374-4708496 $314,391 $188,635 guidelines not Back ratio was incorrectly calculated.
Refinance
followed
Underwriting
Cash Out guidelines not Faxed employment documents were not
2 374-4819542 $355,971 $213,583
Refinance followed; authenticated.
serious error
Loan was approved with ratios exceeding
Quality HUD’s benchmarks of 31 percent and 43
control review percent (set forth in Mortgagee letter
Cash Out
3 374-4631720 $277,711 $166,627 ratios exceeded 2005-16) without documenting
Refinance
HUD's acceptable compensating factors required
benchmarks by Chapter 2-13 of HUD Handbook
4155.1, REV-5.
Income was improperly calculated and
this loan was approved with ratios
Quality
exceeding HUD’s benchmarks of 31
control review
Cash Out percent and 43 percent (set forth in
4 374-4647821 $346,101 $207,661 ratios exceeded
Refinance Mortgagee letter 2005-16) without
HUD's
documenting acceptable compensating
benchmarks
factors required by HUD Handbook
4155.1, REV-5.
Borrower's credit history was not
Serious
properly analyzed as required by Chapter
finding - other
2 of HUD Handbook 4155.1, REV-5
5 371-3668055 Purchase $209,677 $125,806 property
because additional property owned by the
owned by
borrower was not considered in the
borrower
underwriting of this loan.
Co-borrower income was improperly
calculated, the borrowers’ previous
mortgage payment history was
inadequately evaluated, and this loan was
Cash Out approved with ratios exceeding HUD’s
6 374-4738032 $267,039 $160,223 Serious Error
Refinance benchmarks of 31 percent and 43 percent
(set forth in Mortgagee letter 2005-16)
without documenting acceptable
compensating factors as required by
HUD Handbook 4155.1, REV-5.
Total Indemnification
$1,770,890 $1,062,534
Amount
During the audit, Somerset officials had agreed to indemnify HUD for the first
five loans but did not agree that indemnification was warranted for the sixth loan.
7
Indemnification amount was calculated by multiplying the unpaid principal balance by 60 percent, which is the
fiscal year 2009 loss rate as supported by the Actuarial Review of the FHA Mutual Mortgage Fund. The potential
loss on the six loans in which we seek indemnification is $1,062,534 ($1,770,890 x .60). Somerset agreed to
indemnification on two (374-4631720 and 374-4647821) of the six cases in the amount of $374,288.
8
For case number 374-4738032, officials maintained that the coborrower’s income
was correctly calculated, the previous mortgage history was properly evaluated,
and that adequate compensating factors were presented for exceeding HUD’s
benchmarks. This assertion is contrary to the findings of the quality control
review, which noted that the borrower had made six late mortgage payments
within 12 months before closing without adequate explanation and that its ratios
of 50.24 percent front and 50.55 percent back exceeded HUD’s benchmarks
without acceptable compensating factors. In addition, audit analysis found that
the coborrower’s income was incorrectly calculated, which resulted in ratios that
were lower than they should have been. These deficiencies were significant
enough to warrant indemnification.
At the exit conference, Somerset officials agreed to indemnify HUD for two (374-
4631720 and 374-4647821) of the six loans. In support of this position, Somerset
officials provided additional information and documentation at, and subsequent
to, the exit conference for the remaining four loans. For case number 374-
4708496, officials provided compensating factors of three months cash reserves
and borrower eligibility for increasing wages, as well as a reduction in child
support, resulting in a lower debt to income ratio. However, additional
information also disclosed that while $150 rental income was used to qualify, IRS
tax transcripts for 2006 and 2007 showed rental losses of $25,000. Including the
$25,000 rental loss caused the back ratio to greatly exceed HUD guidelines. For
case number 374-4819542, while a revised appraisal was provided to support data
integrity in the automated underwriting system, faxed employment documents
were not authenticated and in response to our inquiry it was determined that the
borrower did not file tax returns. For case number 371-3668055, Somerset
officials provided additional documentation showing that investment property
owned by the borrower was considered in the underwriting; however, no
documentation was provided to support that a third property associated with the
borrower was considered. For case number 374-4738032, the borrower’s income
was averaged over a 14 month period; the coborrower’s income was calculated as
$48,516 per year using the gross weekly pay from a verification of employment
dated March 2008 for employment that began in October 2007. Our review found
that the co-borrower's average income over the past two years, including
unemployment compensation, was only $27,363. Despite the additional
documentation provided for these cases, deficiencies significant enough to
warrant indemnification continue to exist.
Action Taken to Lessen
Underwriting Risk
In November 2008, before the start of our audit, Somerset officials recognized
that because the company had a high default rate, along with the risks inherent in
the underwriting process, action was needed. Therefore, they hired a risk
management consultant to develop procedures to address the high default rate.
The consultant created a risk matrix, using 15 different risk factors to be applied
9
to all FHA loans, which determines the extent to which a loan will be reviewed
before approval. Each loan is rated as low, moderate, or high risk. A loan rated
low risk requires one underwriter for approval, a loan rated moderate risk requires
the approval of two underwriters, and a loan rated high risk goes to a three-person
committee for review and approval. The committee is composed of the risk
management consultant, senior vice president, and a FHA senior underwriter.
We did not review any loans that were approved under Somerset’s current
underwriting procedures to assess the effectiveness of this risk matrix. However,
if implemented as designed, these new procedures should provide greater
assurance that the risk involved in underwriting and approving FHA loans has
been appropriately considered and that HUD/FHA requirements have been met.
Conclusion
Somerset officials underwrote 14 loans that did not comply with HUD/FHA
requirements. Eight of eleven loans reviewed, along with six loans reviewed by
Somerset’s quality control process and analyzed by the Office of Inspector
General (OIG), exhibited significant underwriting deficiencies that posed a
material risk to the FHA insurance fund, such as inadequate evaluation of
previous mortgage payment history, excessive qualifying ratios without
significant compensating factors, and improper calculation of income. Thus
indemnification is warranted for approximately $2.8 million ($1,737,298 per
Appendix D and $1,062,534 per page 8). Other deficiencies existed in the
remaining three loans reviewed that were not serious enough to warrant
indemnification. While underwriting is described as more of an art than a
science, inadequate controls to address the considerable risk in underwriting
refinanced mortgage loans caused these deficiencies to occur. Recognizing the
inherent risk in the underwriting process, Somerset officials developed new
procedures using a risk matrix, which should provide greater assurance that the
risk involved in underwriting and approving FHA loans will be adequately
assessed and thus ensure that risk to the FHA fund is lessened.
Recommendations
We recommend that the Deputy Assistant Secretary for Single Family Housing
require Somerset to
1A. Indemnify HUD for any losses incurred for the eight loans with significant
underwriting deficiencies. The projected loss is $1,737,298 based on the
loss rate of 60% as supported by the Actuarial Review of the FHA Mutual
Mortgage Fund for fiscal year 2009.
1B. Indemnify HUD for any losses incurred for the six loans subject to
Somerset’s quality control process that had significant deficiencies
10
confirmed by our analysis. The projected loss is $1,062,534 based on the
loss rate of 60% as supported by the Actuarial Review of the FHA Mutual
Mortgage Fund for fiscal year 2009.
1C. Strengthen controls over its underwriting procedures to provide assurance
that HUD/FHA requirements are always met in originating and
underwriting refinanced loans.
11
Finding 2: Quality Control Reviews Did Not Comply With All
HUD/FHA Requirements
Although Somerset’s written quality control plan complied with HUD/FHA requirements, the
quality control reviews conducted did not meet all HUD/FHA requirements. Specifically,
Somerset’s quality control reviews did not comply with HUD’s and its own quality control
requirements regarding sample size and reporting. The completed quality control reviews did
not include home equity conversion mortgages; did not always identify corrective actions, a
timetable for completion, or planned follow-up activities; and did not report serious violations to
HUD. These deficiencies occurred due to weaknesses in Somerset’s implementation of its
quality control plan. Consequently, Somerset’s quality control was not effective in identifying
problems, assuring swift and appropriate corrective action, and protecting Somerset and FHA
from unacceptable risk.
Written Quality Control Plan
Complied With HUD/FHA
Requirements
Somerset’s written quality control plan complied with HUD/FHA requirements.
Chapter 7 of HUD Handbook 4060.1, REV-2, provides that all FHA-approved
lenders must implement and continuously have in place a quality control plan for
the origination and/or servicing of insured mortgages as a condition of receiving
and maintaining FHA approval. This chapter also provides that quality control
must be a prescribed and routine function of each lender’s operations whether
performed by a lender’s staff or an outside source. Somerset’s routine quality
control reviews were conducted externally by a quality control contractor, and
Somerset used two different quality control contractors during our audit period.
Somerset’s quality control plan provided for the following:
Selections will be structured to comply with all requirements stated in HUD
Handbook 4060.1, chapter 7, section 7-6, and will include all FHA loan
programs.
A review of loans will be completed regularly, usually no later than 90 days
after the closing date.
A written variance report shall be prepared analyzing all discrepancies.
The variance report shall state all actions taken together with each discrepancy
reported.
Actions taken to correct deficiencies will be fully documented on the
management summary provided for each loan.
A report to the investor or government agency will be made for any violation
of law or regulation, false statements, material defect, or program abuses
within 30 days of discovery.
12
Quality Control Reviews Did
Not Comply with HUD/FHA’s
and Somerset’s Own
Requirements
Somerset’s quality control reviews conducted during the period April 2007
through March 2009 did not comply with all of HUD/FHA’s and its own
requirements. Specifically, the reviews conducted did not comply with provisions
for loan sample size, identification of corrective actions, and reporting of serious
violations to HUD.
Quality control review sample
size requirement was not met
A review of the routine quality control reviews completed for April 2007 through
February 2009 found that quality control reviews did not meet sample size
requirements because home equity conversion mortgages were not included in
loan selection in 14 of the 23 months. Chapter 7-6C of HUD Handbook 4060.1,
REV-2, provides that 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 and the
sample must include all FHA programs in which the lender participates, including
but not limited to 203(b), 203(k), 234(c), and home equity conversion mortgages.
The auditee’s risk management consultant agreed that Somerset’s quality control
reviews did not include home equity conversion mortgages and that its quality
control contractor did not select these loans for quality control review, although
they were in the population of loans that closed on a monthly basis.
Quality control reports
inadequately addressed
corrective actions
Chapter 7-3I of HUD Handbook 4060.1, REV-2, provides that review findings
must be reported to the lender’s senior management within 1 month of completion
of the initial report; management must take prompt action to deal appropriately
with any material findings; and the final report or an addendum must identify
actions being taken, the timetable for their completion, and any planned follow-up
activities. Review of the routine quality control reviews completed for April 2007
through February 2009 found that the results of quality control reviews were
provided to senior management in writing within the 1 month requirement.
However, the final quality control report did not always identify actions being
taken, a timetable for completion of the actions to be taken, and planned follow-
up activities, if any.
13
Loans with serious violations
were not reported to HUD
Somerset did not provide HUD with written notification of those loans that its
quality control reviews determined had serious violations. Chapter 7 of HUD
Handbook 4060.1, REV 2, provides that findings of fraud or other serious
violations must be immediately referred, in writing (along with any available
supporting documentation), to the Director of the Quality Assurance Division8 in
the HUD Homeownership Center having jurisdiction. Review of Somerset’s
routine and early payment default quality control reviews completed for our audit
period found that quality control reviews identified 24 loans9 with serious
violations, but Somerset officials only reported one of these loans to HUD.
Further review of these 24 loans confirmed that, while 11 of the loans had serious
violations that should have been reported to HUD, Somerset officials reported 1
of the 11 to HUD. For the remaining 10 loans with serious violations, 2 loans
were reviewed in our sample of 11 loans, and 8 loans were reviewed in our
sample of 16 loans, which is discussed in finding 1.
Conclusion
Although Somerset’s written quality control plan complied with HUD/FHA
requirements, the conducted quality control reviews did not comply with HUD’s
and its own quality control requirements regarding sample size and reporting.
The completed quality control reviews did not include home equity conversion
mortgages; did not always identify corrective actions, a timetable for completion,
and planned follow-up activities; and did not report serious violations to HUD.
Consequently, Somerset’s quality control process was not effective in identifying
problems, assuring swift and appropriate corrective action, and protecting
Somerset and FHA from unacceptable risk.
Recommendations
We recommend that the Deputy Assistant Secretary for Single Family Housing
require Somerset to
2A. Implement procedures to ensure that quality control reviews (1) meet
sample size requirements by including home equity conversion mortgages;
(2) identify actions being taken, a timetable for completion of the actions
to be taken, and planned follow-up activities, if any; and (3) report serious
violations to HUD.
8
The Quality Assurance Division monitors the performance of FHA approved lenders.
9
One loan, 374-4668220, was reviewed internally due to its default status and reviewed externally by Somerset’s
contractor due to its default status. Both reviews disclosed serious violations. This loan was also in our sample of
11 loans, and indemnification is being requested in this audit report.
14
SCOPE AND METHODOLOGY
To accomplish our objectives, we reviewed applicable HUD handbooks, mortgagee letters, and
reports from HUD’s Quality Assurance Division. We reviewed Somerset’s policies and procedures
for processing and underwriting loans and interviewed Somerset’s staff and consultant to obtain an
understanding of its quality control process and other internal control procedures.
We reviewed a nonstatistical sample of 11 defaulted refinanced loans originated by Somerset, which
was selected from a population of 42 defaulted loans with beginning amortization dates between
April 1, 2007, and March 31, 2009. The 42 defaulted loans were originated with mortgage
amounts totaling $13,798,106 and the sample of 11 FHA-insured loans were originated with
mortgage amounts totaling more than $4.1 million. These loans were selected because they were
currently in default, had a first default reported with six or fewer payments, and had a mortgage
amount greater than $300,000. Our detailed testing of these 11 loans included review and
analysis of (1) qualifying ratios and compensating factors; (2) borrowers’ income, assets, and
liabilities; and (3) borrowers’ previous mortgage payment and credit history. The results of our
detail testing only apply to these 11 loans and cannot be projected. Significant underwriting
deficiencies that warrant indemnification are deficiencies related to the collateral, credit history,
cash to close, and/or capacity to repay that present a material risk to FHA.
We reviewed Somerset’s quality control plan to ensure that it complied with HUD/FHA regulations.
Somerset’s routine quality control reviews were conducted by its contractors during our audit
period, and reviews of early payment defaulted loans were conducted by its own staff and its
contractor. We reviewed routine quality control reviews completed for the months of April 2007
through March 2009 to determine whether Somerset complied with the sample size, loan
selection, timeliness, and reporting requirements set forth in Chapter 7 of HUD Handbook
4060.1, REV-2. We reviewed a representative sample of quality control reviews for 11 loans
completed by Somerset’s contractors for the months of December 2007, April 2008, and January
2009 to determine whether the reviews complied with the requirements set forth in Chapter 7-6
E, F, and G and 7-7 of HUD Handbook 4060.1, REV-2. We reviewed routine quality control
reviews completed on 62 loans and reviews completed on 53 defaulted loans by Somerset’s
contractor and/or its own staff to determine whether the reviews identified serious violations.
We selected a nonrepresentative sample of 16 loans for which the quality control reviews
disclosed serious violations, underwriting deficiencies, and/or ratios exceeding HUD’s
benchmarks to determine whether any of these loans had significant deficiencies warranting
indemnification.
We performed our audit field work from July through October 2009. 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 objectives. We believe that the
evidence obtained provides a reasonable basis for our findings and conclusions based on our
audit objectives.
15
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:
Management’s controls to ensure that FHA-insured loans are underwritten in
accordance with HUD requirements.
Management’s policies and procedures to ensure that a quality control plan
is established and implemented in accordance with 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:
Somerset did not ensure that refinanced loans were underwritten in
accordance with HUD/FHA requirements (see finding 1).
Somerset did not ensure that its quality control reviews met all HUD/FHA
requirements (see finding 2).
16
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 $1,737,298
1B $1,062,534
Totals $ 2,799,832
1/ Recommendations that funds be put to better use are estimates of amounts that could be
used more efficiently if an 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. In this
instance, if HUD implements our recommendations to indemnify loans that were not
originated in accordance with HUD/FHA requirements, it will reduce FHA’s risk of loss
to the insurance fund. The amount above is based on the loss rate of 60% as supported
by the Actuarial Review of the FHA Mutual Mortgage Fund for fiscal year 2009.
17
Appendix B
AUDITEE COMMENTS AND OIG’S EVALUATION
Ref to OIG Evaluation Auditee Comments
Comment 1
18
Appendix B
AUDITEE COMMENTS AND OIG’S EVALUATION
Ref to OIG Evaluation Auditee Comments
19
Appendix B
AUDITEE COMMENTS AND OIG’S EVALUATION
Ref to OIG Evaluation Auditee Comments
20
Appendix B
AUDITEE COMMENTS AND OIG’S EVALUATION
Ref to OIG Evaluation Auditee Comments
Comment 2
21
Appendix B
AUDITEE COMMENTS AND OIG’S EVALUATION
Ref to OIG Evaluation Auditee Comments
Comment 3
Comment 4
Comment 5
22
Appendix B
AUDITEE COMMENTS AND OIG’S EVALUATION
Ref to OIG Evaluation Auditee Comments
Comment 5
Comment 6
23
Appendix B
AUDITEE COMMENTS AND OIG’S EVALUATION
Ref to OIG Evaluation Auditee Comments
Comment 7
Comment 8
24
OIG Evaluation of Auditee Comments
Comment 1 As recognized in the report, the auditee had acknowledged a need for significant
changes in its underwriting procedures and quality control and had implemented
corrective action prior to our audit.
Comment 2 The auditee agreed to indemnify HUD for nine of the 14 loans recommended for
indemnification.
Comment 3 While the loan file did not properly document compensating factors as required
by HUD Handbook 4155.1, REV-5, the auditee has subsequently identified the
existence of acceptable compensating factors; therefore we have removed
reference to the compensating factor deficiency. However, the auditee’s
explanation that repairs and remodeling, which created the rental loss, were
completed, and therefore not included in determining income calculations, is not a
valid reason for excluding the rental loss. Inclusion of this loss results in a back
ratio which significantly exceeds HUD's benchmarks, even after accounting for a
reduction in child support. Accordingly, we continue to recommend
indemnification of this loan.
Comment 4 The auditee does not agree that indemnification is warranted because the
underwriter relied upon a completed written verification of employment form, a
letter from the employer explaining the borrower’s year to date deduction
breakdown, and internet confirmations of the business address and phone number.
However, the employment documentation was faxed and the underwriter neither
verified the authenticity of the faxed documents as required by HUD Handbook
4155.1, REV-5, Chapter 3-1 nor requested IRS tax transcripts as required by
auditee procedures. Accordingly, indemnification of this loan is warranted.
Comment 5 While the auditee states that the questioned property not considered in the
underwriting was owned and occupied by the borrower’s wife, who was not a part
of or party to this transaction, a previous application in the file for a mortgage on
investment property reported the questioned property as jointly owned. Therefore,
ownership of the property should have been considered in the underwriting of this
loan. In addition, our search of Lexis Nexis disclosed that the borrower did
jointly own the property with his wife. Accordingly, we continue to recommend
indemnification of this loan.
Comment 6 While the auditee states that adequate compensating factors were presented and
income was properly calculated, adequate compensating factors to justify loan
approval were not documented and income was not properly calculated. A
compensating factor of a reduced mortgage obligation is not applicable because
documents in the file disclosed an escrow shortfall and late payments in the
borrower’s prior mortgage history. Further, while the borrower's income was
averaged, the co-borrower's income was not averaged. Rather, the co-borrower's
income was calculated at $48,516 while the co-borrower's averaged income
25
OIG Evaluation of Auditee Comments
would have been $27,363 over the past two years. This amount is based upon
reported unemployment compensation and a verification of current employment
which reported wages of $13,455 for 2007 and $12,474 for 2008 and no overtime.
Accordingly, we continue to recommend indemnification of this loan.
Comment 7 While the auditee presents cash reserves of $37,609 as a compensating factor, this
is not significant enough to justify approving a loan with a back ratio of 66.83
percent, incorrect calculation of qualifying income, and payment of the
borrower’s November and December 2007 mortgage payments 30 days past due.
Comment 8 The auditee agrees that reverse mortgages were not included in quality control
sampling because its contractor did not select them and states that it has modified
internal policies to ensure that any future findings of material deficiencies in its’
FHA underwriting and/or quality control results identified by either the Company
or by the quality control vendor will be promptly reported to HUD as required. If
implemented, these actions are responsive to our recommendations.
26
Appendix C
SUMMARY OF SIGNIFICANT AND
OTHER UNDERWRITING DEFICIENCIES
Excessive
Inaccurate
Ratios Without
Improper Evaluation
Documentation
Loan Unpaid Calculation of of Other
of Acceptable
Loan to Principal Indemnification Income Borrower's Origination Appendix
# Case number Compensating
type value Balance as Amount10 Resulting in Previous Deficiencies Reference
Factors To 11
ratio of 10-31-09 Excessive Mortgage
Justify
Ratios Payment
Mortgage
History
Approval
Cash Out
1 374-4676210 73.2 $408,167 $244,900 X X X D-1
Refinance
Cash Out
2 374-4756404 63.0 $467,630 $280,578 X X D-212
Refinance
Cash Out
3 374-4632311 83.9 $319,967 $191,980 X X X D-312
Refinance
Cash Out
4 374-4668220 75.6 $360,266 $216,160 X X X D-412
Refinance
Cash Out
5 374-4623723 91.5 $323,240 $193,944 X X D-512
Refinance
No Cash
6 374-4672543 Out 88.7 $339,553 $203,732 X X D-612
Refinance
Cash Out
7 374-4686723 71.5 $297,979 $178,787 X D-712
Refinance
No Cash
8 374-472754513 Out 95.0 $378,694 $227,216 X X D-812
Refinance
Cash Out
9 374-4676256 64.6 X
Refinance
Cash Out
10 374-4595651 74.3 X
Refinance
Cash Out
11 374-4752807 90.7 X
Refinance
TOTALS $ 2,895,496 $1,737,298 3 8 6
10
The fiscal year 2009 loss rate is 60 percent as supported by the Actuarial Review of the FHA Mutual Mortgage
Fund for fiscal year 2009. The potential loss on the eight loans in which we seek indemnification is $1,737,298
($2,895,496 x .60).
11
The other underwriting deficiencies include incorrect calculation of income and inadequate consideration of
borrower’s inability to manage debt.
12
Somerset agreed to indemnification for seven of the eight loans for which we seek indemnification.
13
HUD has already incurred and paid a loan modification claim of $1,000 for this case.
27
Appendix D
CASE NARRATIVES
Appendix D-1
Page 1 of 2
Case number: 374-4676210
Loan type: Cash-out refinance
Mortgage amount: $416,150
Closing date: 1/23/2008
Payments before first
default reported: Seven
Default status
as of 10/31/09: Delinquent
Unpaid principal balance: $408,167
Details of Underwriting Deficiencies:
A. Excessive Ratios Without Documentation of Acceptable Compensating Factors To
Justify Mortgage Approval
The auditee approved the mortgage with qualifying ratios (55.10 percent front and 66.83 percent
back) that significantly exceeded HUD’s benchmarks (31 percent front and 43 percent back as
set forth in Mortgagee letter 2005-16) without documenting acceptable compensating factors.
Chapter 2-13 of HUD Handbook 4155.1, REV-5, provides that compensating factors may be
used to justify approval of mortgage loans with ratios that exceed the benchmark guidelines, and
underwriters must record in the “remarks” section of the mortgage credit analysis worksheet any
compensating factor used and provide supporting documentation. The “remarks” section of the
mortgage credit analysis worksheet noted stable employment and “Reducing PITI14 by $550+ per
month.” However, HUD guidelines provide that stable employment is a requirement and not a
compensating factor to justify approving a mortgage with ratios above HUD’s benchmarks.
Additionally, while reducing the mortgage payment can be considered a compensating factor, we
do not regard the reduction as significant enough to justify exceeding HUD’s benchmarks to the
extent that this mortgage did, especially since the borrower’s previous mortgage payment history
showed late payments and this loan defaulted after seven payments.
B. Improper Calculation of Income
The lender improperly calculated borrower income because it did not use the borrower’s 2007
income to qualify for the mortgage loan. Specifically, the lender calculated borrower monthly
effective income as $4,537.75 using wages and unemployment compensation from the
borrower’s 2006 Internal Revenue Service (IRS) tax transcript. Chapter 2-6 of HUD
Handbook4155.1, REV-5, provides that the lender must verify the borrower’s employment for
14
PITI refers to mortgage principle, interest, taxes, and insurance.
28
Appendix D-1
Page 2 of 2
the most recent 2 full years, and Chapter 1 cautions that cash-out refinances for debt
consolidation represent considerable risk, especially if the borrowers have not had an attendant
increase in income, and such transactions must be carefully evaluated. Chapter 2-7L provides
that unemployment income must be documented for 2 years. The lender obtained the borrower’s
IRS tax transcripts for 2005 and 2006, a verification of employment from the borrower’s current
employer, and the borrower’s pay stubs for pay periods ending October 23, November 27, and
December 18, 2007, showing regular hours of 40, 32, and 29. The IRS tax transcripts for 2005
and 2006 showed wages of $29,796 and $52,428, respectively, and unemployment compensation
of $9,011 and $2,025, respectively. The verification of employment showed an hourly wage of
$31.25 and an average of 40 hours per week but did not show gross earnings for any years.
Since this was a cash-out refinance, the borrower’s wages varied, and the verification of
employment did not confirm the year-to-date wages for 2007, the lender should have averaged
the borrower’s wages over the 3-year period and verified and documented the unemployment
compensation for the 2-year period. Averaging the borrower’s wages for 2005, 2006, and 2007
and unemployment compensation for 2005 and 2006 results in borrower monthly effective
income of $4,323.69 compared to the lender’s $4,537.75. This calculation of borrower income
results in revised qualifying ratios of 57.17 percent and 69.36 percent compared to the lender’s
calculated ratios of 55.10 percent and 66.83 percent, which require the documentation of
significant compensating factors that the lender did not provide (see section A above).
C. Inadequate Evaluation of Borrower’s Previous Mortgage Payment History
The lender did not adequately evaluate the cause of late mortgage payments reported on the
borrower’s credit report. Chapter 2-3A of HUD Handbook 4155.1, REV-5, provides that the
borrower’s housing obligation payment history holds significant importance in evaluating credit
and the lender must determine the payment history through the credit report, verification directly
from the mortgage servicer, or canceled checks covering the most recent 12-month period.
While the borrower’s credit report obtained by the auditee reported two mortgage payments that
were 30 days past due during the 12 months from November 2006 to October 2007, the auditee
did not obtain a letter of explanation from the borrower for these late payments. Additionally,
copies of the borrower’s mortgage loan statement indicated that the borrower paid the November
1 and December 1, 2007, mortgage payments late. Nevertheless, there was no documentation in
the file to indicate that the underwriter considered any of these late mortgage payments in
evaluating the borrower’s past credit history. Consequently, the borrower’s payment history for
housing obligations was not adequately considered.
29
Appendix D-2
Page 1 of 2
Case number: 374-4756404
Loan type: Cash-out refinance
Mortgage amount: $476,542
Closing date: 5/12/2008
Payments before first
default reported: One
Default status
as of 10/31/09: First legal action to commence foreclosure
Unpaid principal balance: $467,630
Details of Underwriting Deficiencies: (Auditee has agreed to indemnification)
A. Excessive Ratios Without Documentation of Acceptable Compensating Factors To
Justify Mortgage Approval
The auditee approved the mortgage with qualifying ratios (59.80 percent front and 66.14 percent
back) that significantly exceeded HUD’s benchmarks (31 percent and 43 percent as set forth in
Mortgagee Letter 2005-16) without documenting acceptable compensating factors. Chapter 1 of
HUD Handbook 4155.1, REV-5, cautions that cash-out refinances for debt consolidation
represent considerable risk, especially if the borrowers have not had an attendant increase in
income, and such transactions must be carefully evaluated. Chapter 2-13 of the handbook
provides that compensating factors may be used to justify approval of mortgage loans with ratios
that exceed the benchmark guidelines; however, underwriters must record in the “remarks”
section of the mortgage credit analysis worksheet any compensating factor used and provide
supporting documentation. The underwriter listed on the mortgage credit analysis worksheet
“principal, interest, taxes, and insurance decreasing over $350+ monthly, job stability in
professional field, 20 year homeownership, loan to value below maximum financing, and
borrowers had a loss of business hardship.” However, some of these are not valid compensating
factors, and others are not acceptable for the risks inherent in this mortgage, which became
evident when the borrower defaulted after one payment. Job stability and loss of business
hardship are not valid compensating factors. While a decrease in principal, interest, taxes, and
insurance of more than $350+ monthly and 20-year homeownership are valid compensating
factors, we do not view them as acceptable because as noted below, the borrower had
unexplained late mortgage payments during the prior 12 months and a prior foreclosure. Further,
while loan to value below maximum financing is a valid compensating factor, we do not consider
it significant enough to offset the risk for this loan due to the back ratio exceeding HUD’s
benchmark for fixed payment-to-income ratio by more than 20 percentage points and the
inadequate consideration of the borrower’s housing obligation payment history.
B. Inadequate Evaluation of Borrower’s Previous Mortgage Payment History
The auditee did not adequately evaluate the borrower’s previous mortgage payment history
because late mortgage payments shown on the borrower’s credit report were not satisfactorily
30
Appendix D-2
Page 2 of 2
explained and the borrower’s May 2008 mortgage payment was included in the new FHA loan.
Chapter 2-3A of HUD Handbook 4155.1, REV-5, provides that the borrower’s housing
obligation payment history holds significant importance in evaluating credit and the lender must
determine the borrower’s payment history through the credit report, verification of mortgage
directly from the mortgage servicer, or canceled checks covering the most recent 12-month
period. The borrower’s credit report noted two mortgage payments made 30 days past due
(February and March 2008) and one mortgage payment that was 60 days past due (January 2008)
during the prior 12 months. There was a letter in the file from the mortgage company, dated
April 30, 2008, stating that the February 2008 payment was current and the credit bureaus had
been notified to make the change. There was also a letter in the file from the borrower stating
that the January 2008 mortgage payment was late due to “a mishap in funds available during the
month in which the check was returned” and that the borrower resent new funds to cover the
check. The letter further noted that the borrower did not know why the credit report showed the
January 2008 mortgage payment as 60 days late or why there were additional late payments.
There was no error letter in the file from the mortgage company regarding the March 2008
mortgage payment, and the lender did not follow up. In addition, foreclosure proceedings were
instituted against the borrower in 2006. Additionally, the May 5, 2008, mortgage payoff
statement showed that May 2008 was the next mortgage payment due date, as well as interest
charges for April 1-30, May 1-31, and June 1-2, 2008, which indicates that the borrower did not
make the mortgage payment for May 2008 and it was included in the new FHA loan amount.
Chapter 1 of HUD Handbook 4155.1, REV-5, provides that lenders are not permitted to allow
borrowers to “skip” payments and the borrower is either to make the payment when it is due or
bring the monthly mortgage payment check to settlement because FHA does not permit the
inclusion of any mortgage payments “skipped” by the homeowner in the new mortgage amount.
For example, a borrower whose mortgage payment is due June 1 and who expects to close the
refinance before the end of June is not permitted to roll the June mortgage payment into the new
FHA loan amount.
31
Appendix D-3
Page 1 of 2
Case number: 374-4632311
Loan type: Cash-out refinance
Mortgage amount: $327,800
Closing date: 8/27/2007
Payments before first
default reported: Two
Default status
as of 10/31/09: First legal action to commence foreclosure
Unpaid principal balance: $319,967
Details of Underwriting Deficiencies (Auditee has agreed to indemnification)
A. Excessive Ratios Without Documentation of Acceptable Compensating Factors To
Justify Mortgage Approval
The auditee approved the mortgage with qualifying ratios (52.83 percent front and back) that
exceeded HUD’s benchmarks of 31percent and 43 percent, respectively, without documenting
acceptable compensating factors to justify approval. Specifically, the mortgage credit analysis
worksheet showed 52.83 percent as the mortgage payment-to-income (front) and 52.83 percent
as the fixed payment-to-income (back) ratios, and the underwriter listed stable employment as a
compensating factor. Chapter 2-13 of HUD Handbook 4155.1, REV-5, provides that
compensating factors may be used to justify approval of mortgage loans with ratios that exceed
HUD benchmark guidelines; however, underwriters must note in the “remarks” section of the
mortgage credit analysis worksheet any compensating factor used and provide supporting
documentation. Stable employment is a requirement and not a compensating factor to justify
approving the mortgage with ratios above HUD’s benchmarks. The auditee agreed that this loan
contained significant underwriting deficiencies.
B. Improper Calculation of Income
The auditee improperly calculated borrower income because it did not verify that overtime
income used to calculate income had been received for the past 2 years or was likely to continue
as required. HUD Handbook 4155.1, REV-5, Chapter 2-7A, provides that overtime income may
be used to qualify if the borrower has received such income for the past 2 years and it is likely to
continue. In addition, the lender must develop an average of bonus or overtime income for the
past 2 years, and the employment verification must not state that such income is unlikely to
continue. The auditee calculated borrower monthly effective income of $4,891 by taking the
year-to-date wages from the borrower’s pay stub for period ending July 21, 2007, and averaging
it with the borrower’s 2006 IRS W-2 gross wages over 18.75 months. However, the pay stub
showed year-to-date overtime income of $3,407, which the auditee included in effective income
without verifying that the borrower had received it for the past 2 years or that it was likely to
continue. Further, there was no written verification of employment; the lender only obtained
32
Appendix D-3
Page 2 of 2
borrower pay stubs covering 3 weeks and not the required 30 days; and while a telephone
confirmation of borrower employment was made, overtime income was not verified. Since the
auditee did not verify that the borrower had received overtime income for the past 2 years or that
it was likely to continue, the overtime income should not have been included in the calculation of
borrower income. Therefore, based upon copies of the borrower’s 2005 and 2006 IRS tax return
transcripts in the file and the borrower’s most recent pay stub, the borrower’s verified monthly
effective income was $4,576, not the $4,891 used by the lender, which increased the ratios from
52.8 to 56.4 percent.
C. Inaccurate Evaluation of Borrower’s Previous Mortgage Payment History
The auditee did not accurately evaluate the borrower’s previous mortgage payment history
because it did not ensure that the borrower made all mortgage payments due before the new FHA
loan closing. Specifically, the borrower did not make the August 1 mortgage payment, and it
was rolled into the new FHA mortgage. Chapter 1 of HUD Handbook 4155.1, REV-5, prohibits
lenders from allowing borrowers to “skip” payments, and the borrower is either to make the
payment when it is due or bring the monthly mortgage payment check to settlement because
FHA does not permit the inclusion of any mortgage payments “skipped” by the homeowner in
the new mortgage amount. For example, a borrower, whose mortgage payment is due June 1 and
who expects to close the refinance before the end of June, is not permitted to roll the June
mortgage payment into the new FHA loan amount. The August 20, 2007, mortgage payoff
statement had a payoff amount of $290,997 with a projected payoff date of August 31, 2007, and
the HUD-1 settlement statement showed the mortgage payoff amount as $293,343, representing
a difference of $2,346. This difference represents the borrower’s August 1 mortgage payment of
$2,199 and per diem interest.
33
Appendix D-4
Page 1 of 2
Case number: 374-4668220
Loan type: Cash-out refinance
Mortgage amount: $368,200
Closing date: 11/28/2007
Payments before first
default reported: Two
Default status
as of 10/31/09: Special forbearance
Unpaid principal balance: $360,266
Details of Underwriting Deficiencies (Auditee has agreed to indemnification)
A. Excessive Ratios Without Documentation of Acceptable Compensating Factors To
Justify Mortgage Approval
The auditee approved the mortgage with qualifying ratios (41.88 percent front and 53.55 percent
back) that exceeded HUD’s benchmarks of 31 and 43 percent as set forth in Mortgagee Letter
2005-16, without documenting acceptable compensating factors to justify mortgage approval.
Chapter 2-13 of HUD Handbook 4155.1, REV-5, provides that compensating factors may be
used to justify approval of mortgage loans with ratios that exceed HUD benchmark guidelines;
however, underwriters must note in the “remarks” section of the mortgage credit analysis
worksheet any compensating factor used and provide supporting documentation. The
underwriter listed “9.125 to 6.875 and well under maximum financing” on the mortgage credit
analysis worksheet. A decrease in the mortgage interest rate from 9.125 to 6.875 could be a
compensating factor if the borrowers had successfully demonstrated the ability to pay housing
expenses equal to or greater than the proposed monthly housing expense for the new mortgage
over the past 12 to 24 months. However, the borrowers’ previous mortgage payment history
indicated a pattern of making late mortgage payments. Specifically, the borrowers’ credit report
disclosed six mortgage payments that were made 30 days past due and two payments that were
60 days past due within the prior 24 months, as well as a past-due amount of $2,676. The
auditee agreed that HUD’s benchmarks for front and back ratios were exceeded without valid
compensating factors.
B. Improper Calculation of Income
The auditee improperly calculated the coborrower’s income because it did not consider the year-
to-date wages earned on the coborrower’s most recent pay stub or address the decrease in the
coborrower’s income from 2005 to 2006. Chapter 2 of HUD Handbook 4155.1, REV-5,
provides that the anticipated amount of income and the likelihood of its continuance must be
established to determine a borrower’s capacity to repay mortgage debt, and income may not be
used in calculating the borrower’s income ratios if it comes from any source that cannot be
verified, is not stable, or will not continue. The lender calculated the
34
Appendix D-4
Page 2 of 2
coborrower’s monthly effective income as $1,416 using the coborrower’s weekly contract rate of
$708 from the October 26, 2007, pay stub, multiplying it by 24 pay periods, and dividing by 12
months, although the year-to-date wages shown on this pay stub were only $7,283. Since the
lender had copies of the coborrower’s 2005 and 2006 IRS W-2 forms and the coborrower’s most
recent pay stub, a more appropriate calculation of coborrower income would have been to
average the income over this period. An averaging of the coborrower’s 2005 and 2006 income
with the year-to-date wages from the October 26, 2007, pay stub results in coborrower monthly
effective income of $946 instead of $1,416. This calculation of coborrower income results in
revised qualifying ratios of 44.50 and 56.89 percent compared to the auditee’s calculated ratios
of 41.88 and 53.54 percent, which require the documentation of significant compensating factors
that the lender did not provide (see section A above).
C. Inadequate Evaluation of Borrowers’ Previous Mortgage Payment History
The auditee did not adequately evaluate the borrowers’ previous mortgage payment history
because it did not obtain a satisfactory explanation for late mortgage payments reported on the
borrowers’ credit report. Chapter 2-3A of HUD Handbook 4155.1, REV-5, provides that the
borrowers’ housing obligation payment history holds significant importance in evaluating credit
and the lender must determine the borrowers’ payment history through the credit report,
verification of mortgage directly from the mortgage servicer, or canceled checks covering the
most recent 12-month period. The borrowers’ credit report showed three mortgage payments
that were made 30 days past due and a past-due amount of $2,676 during the last 12 months.
The borrower explained that two of the mortgage payments were late due to a dispute with a
neighbor regarding the property line, for which the borrower incurred a survey cost and court
fees. However, there was no documentation in the file to support that the borrower incurred
these expenses. Additionally, the borrower and coborrower explained that the recent late
payment was an oversight because they thought they would be closing on the new loan and held
onto the payment.
35
Appendix D-5
Page 1 of 2
Case number: 374-4623723
Loan type: Cash-out refinance
Mortgage amount: $329,875
Closing date: 12/27/2007
Payments before first
default reported: Four
Default status
as of 10/31/09: First legal action to commence foreclosure
Unpaid principal balance: $ 323,240
Details of Underwriting Deficiencies (Auditee has agreed to indemnification)
A. Inaccurate Evaluation of Borrowers’ Previous Mortgage Payment History
The auditee did not accurately evaluate the borrowers’ previous mortgage payment history
because it did not ensure that the borrowers made no late mortgage payments during the previous
12 months. Mortgagee Letter 2005-43, issued October 31, 2005, states that FHA will insure a
cash-out refinance of up to 95 percent of the appraised value, as long as the borrower has made
all of his/her mortgage payments within the month due for the previous 12 months, no payment
was more than 30 days late, and the mortgage is current for the month due. Neighborhood
Watch reported that the borrowers were delinquent on the October 1, 2007, mortgage payment
for a prior FHA-insured mortgage. Therefore, the borrowers were not eligible for an FHA-
insured cash-out refinance mortgage loan. The auditee agreed that the borrowers made the
October 1, 2007, payment late and was not eligible for a cash-out refinance greater than 85
percent.
B. Excessive Ratios Without Documentation of Acceptable Compensating Factors To
Justify Mortgage Approval
The auditee approved the mortgage with qualifying ratios (47.28 percent front and back) that
exceeded HUD’s benchmarks of 31 and 43 percent set forth in Mortgagee Letter 2005-16,
without documenting acceptable compensating factors to justify approval. Chapter 2-13 of HUD
Handbook 4155.1, REV-5, provides that compensating factors may be used to justify approval of
mortgage loans with ratios that exceed HUD benchmark guidelines; however, underwriters must
note in the “remarks” section of the mortgage credit analysis worksheet any compensating factor
used and provide supporting documentation. The underwriter listed “excellent mortgage history,
going from adjusted to fixed rate, stable employment, and overall monthly savings after paying
off all debts is $900+.” While excellent mortgage history is a valid compensating factor, it is not
acceptable for this loan because the borrowers were delinquent on the October 1, 2007, mortgage
payment for a prior FHA loan. Similarly, while a decrease in interest rate is a valid
compensating factor, it is not acceptable in this loan because the borrowers did not successfully
demonstrate the ability to pay housing expenses equal to or greater than the proposed monthly
36
Appendix D-5
Page 2 of 2
housing expense for the new mortgage over the past 12-24 months, and the monthly mortgage
payment actually increased (from $2,504 to $2,611). Stable employment is a requirement and
not a compensating factor, and overall monthly savings after paying off all debts of $900+ is not
a compensating factor but is indicative of the borrowers’ poor credit history. Specifically, the
$900 savings is the result of paying tax liens and collections of $5,369 and debts of $7,642.
HUD Handbook 4155.1, REV-5, Chapter 2-3, states that if the credit history, despite adequate
income to support obligations, reflects continuous slow payments, judgments, and delinquent
accounts, strong compensating factors will be necessary to approve the loan. However, the
auditee did not document strong compensating factors. Specifically, while the borrowers’ letter
of explanation for collections and derogatory accounts noted that the borrower got sick in 2005
and had a number of medical bills, there was no documentation in the file showing that the bills
were not covered by health insurance and/or that the amounts paid by the borrower related to
medical costs. Therefore, the underwriter did not present and document compensating factors
that were significant enough to justify exceeding HUD’s benchmarks. Additionally, the quality
control review performed on this loan determined that the reason for default appeared to have
been poor credit history and disregard for credit obligations.
37
Appendix D-6
Page 1 of 2
Case number: 374-4672543
Loan type: No-cash-out refinance
Mortgage amount: $346,500
Closing date: 2/29/2008
Payments before first
default reported: Four
Default status
as of 10/31/09: First legal action to commence foreclosure
Unpaid principal balance: $339,553
Details of Underwriting Deficiencies (Auditee has agreed to indemnification)
A. Inadequate Evaluation of Borrowers’ Previous Mortgage Payment History
The auditee did not adequately evaluate the borrowers’ previous mortgage payment history
because late mortgage payments shown on the borrowers’ credit report were not satisfactorily
explained and the underwriter did not consider these late payments in evaluating the borrowers’
credit history. Chapter 2-3A of HUD Handbook 4155.1, REV-5, provides that the borrower’s
housing obligation payment history holds significant importance in evaluating credit and the
lender must determine the borrower’s payment history through the credit report, verification of
mortgage directly from the mortgage servicer, or canceled checks covering the most recent 12-
month period. The borrowers’ credit report, dated January 15, 2008, reported that the borrowers
had made two mortgage payments 30 days past due and one mortgage payment 60 days past due
during the past 12 months. Additionally, the credit report showed a mortgage delinquent date of
December 2007 and a past-due amount of $4,490. The borrowers’ letter of explanation, dated
January 15, 2008, explained that the late mortgage payments were due to their overextending
their consumer credit but that they were now up to date. This is not an acceptable explanation
because it does not demonstrate the borrowers’ ability to manage debt.
B. Incorrect Calculation of Income
The auditee incorrectly calculated the borrower’s monthly effective income because it calculated
the monthly effective income as $5,572 using wages from the 2007 IRS W-2 form without
considering the borrower’s 2008 current year-to-date earnings or averaging overtime income
over the past 2-year period. The borrower’s current year-to-date earnings should have been
averaged with the wages from the verification of employment to calculate the borrowers’ base
pay, and the borrower’s overtime earnings from the verification of employment for the past 2
years should have been averaged to calculate the borrowers’ other earnings. This calculation
results in borrower effective income of $5,356 as opposed to the $5,572 calculated.
Additionally, the lender included overtime income in its calculation of the coborrower’s monthly
effective income but did not verify that the coborrower’s overtime had been received for the past
2 years and that it was likely to continue. The lender calculated the coborrower’s monthly
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Appendix D-6
Page 2 of 2
effective income as $3,251; however, the documented coborrower monthly effective income was
$3,115. These revised calculations result in total monthly effective income of $8,471 and
qualifying ratios of 31.49 percent and 45.54 percent instead of the lender’s calculated income of
$8,824 and ratios of 30.23 percent and 43.71 percent. However, this miscalculation did not
cause the qualifying ratios to exceed HUD’s benchmarks.
C. Inadequate Evaluation of Borrowers’ Credit History
The auditee did not adequately evaluate the borrowers’ credit history because collection accounts
were not sufficiently explained. While the borrowers’ credit report showed four collections
accounts with monthly payments totaling $1,552 and a balance owed of $6,820, these amounts
were omitted from the fixed payment-to-income ratio without an explanation for their exclusion
by the auditee. The borrowers’ letters of explanation acknowledged that these debts were owed
and would have to be repaid. Including these debts in the fixed payment-to-income ratio
increases the ratio from 43.71 to 63.85 percent. The borrowers’ letters of explanation also stated
that the borrowers fought with the creditors and refused to pay balances owed. Chapter 2-3 of
HUD Handbook 4155.1, REV-5, provides that major indications of derogatory credit—including
judgments, collections, and any other recent credit problems—require sufficient written
explanation from the borrower and the borrower’s explanation must make sense and be
consistent with other credit information in the file. The borrowers’ explanation demonstrated a
disregard for financial obligations, and the lender should have considered this disregard in
analyzing the borrowers’ credit history. The borrowers’ credit report showed recurring monthly
debt payments totaling $1,189 with a total outstanding balance of $39,206, and none of this debt
was being paid off from the refinanced mortgage. The refinance paid off the previous mortgage,
homeowners insurance, and property taxes. Additionally, the quality control review of this loan
determined that the reason for default appeared to have been prior credit history.
39
Appendix D-7
Page 1 of 2
Case number: 374-4686723
Loan type: Cash-out refinance
Mortgage amount: $304,700
Closing date: 1/15/2008
Payments before first
default reported: Four
Default status
as of 10/31/09: First legal action to commence foreclosure
Unpaid principal balance: $ 297,979
Details of Underwriting Deficiencies (Auditee has agreed to indemnification)
A. Inadequate Evaluation of Borrower’s Previous Mortgage Payment History
The auditee did not adequately evaluate the borrower’s previous mortgage payment history
because late mortgage payments made by the borrower on a previous Section 203 (k) FHA loan
were not satisfactorily explained and the underwriter did not consider these late payments in
evaluating the borrower’s credit history. Chapter 2-3A of HUD Handbook 4155.1, REV-5,
provides that the borrower’s housing obligation payment history holds significant importance in
evaluating credit and the lender must determine the borrower’s payment history through the
credit report, verification of mortgage directly from the mortgage servicer, or canceled checks
covering the most recent 12-month period. The borrower’s credit report showed late payments
made on a prior FHA loan during the past 12 months; however, the credit report did not clearly
show in which months during the past 12 months the borrower made late mortgage payments.
The lender’s file contained a borrower letter of explanation for a late mortgage payment made in
April 2006; however, there was no letter of explanation for the various late mortgage payments
made in 2007 on the prior FHA loan. The credit report ordered through quality control showed
that the borrower paid January, February, and March 2007 mortgage payments 60 days past due
and the April 2007 mortgage payment 30 days past due. There was no documentation in the file
to indicate that the underwriter considered these late payments or obtained an explanation from
the borrower in evaluating the borrower’s credit history.
B. Inadequate Evaluation of Borrower’s Credit History
The lender did not adequately evaluate the borrower’s credit history because collections,
judgments, and derogatory accounts were not sufficiently explained. The borrower’s credit
report showed various collections, judgments, and derogatory accounts indicating a disregard for
credit obligations. The borrower’s explanation for the collections and judgments was that they
were from her ex-boyfriend and that while the accounts were mostly in her name, her ex-
boyfriend was responsible for payment and she did not find out they were delinquent until
Somerset checked her credit. Chapter 2-3 of HUD Handbook 4155.1, REV-5, states that while
minor derogatory information occurring 2 or more years in the past does not require explanation,
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Appendix D-7
Page 2 of 2
major indications of derogatory credit—including judgments, collections, and any other recent
credit problems—require sufficient written explanation from the borrower and the explanation
must make sense and be consistent with other credit information in the file. The borrower’s
explanation did not make sense because the borrower refinanced a prior 203(K) FHA loan
through Somerset with an interest-only conventional mortgage for $250,000, which closed on
April 30, 2007, and these collection accounts were listed to be paid off on that HUD-1 settlement
statement. Therefore, the borrower’s credit history demonstrates an inability to manage debt and
a disregard for financial obligations, which present a material risk to FHA and warrant
indemnification.
41
Appendix D-8
Page 1 of 2
Case number: 374-4727545
Loan type: No-cash-out refinance
Mortgage amount: $385,700
Closing date: 3/31/2008
Payments before first
default reported: Six
Default status
as of 10/31/09: Reinstated after loss mitigation intervention
Unpaid principal balance: $378,694
Details for Underwriting Deficiencies (Auditee has agreed to indemnification)
A. Excessive Ratios Without Documentation of Acceptable Compensating Factors To
Justify Mortgage Approval
The lender approved the mortgage with qualifying ratios (57.85 percent front and 58.19 percent
back) that significantly exceeded HUD’s benchmarks of 31 percent and 43 percent as set forth in
Mortgagee Letter 2005-16, without documenting acceptable compensating factors to justify
approval. Chapter 2-13 of HUD Handbook 4155.1, REV-5, states that compensating factors may
be used to justify approval of mortgage loans with ratios exceeding HUD benchmark guidelines;
however, underwriters must record the compensating factors used to support loan approval in the
“remarks” section of the mortgage credit analysis worksheet and any compensating factor used
to justify mortgage approval must be supported by documentation. The mortgage credit analysis
worksheet noted “Good Job Stability,” “Good Mortgage History,” and “Good Savings Pattern”
as compensating factors. Good job stability is a requirement and not a compensating factor.
While good mortgage history is a valid compensating factor, it is not applicable for this loan
because the borrower’s November 2007 mortgage payment was 30 days past due and the March
2008 payment was late with a charge of $54.43 added to the mortgage payoff amount. While
good savings pattern is a valid compensating factor, it is not acceptable for this loan because the
verification of deposit, dated March 26, 2008, noted a savings balance of $1 with an average
balance for the previous 2 months of $2.41 and a checking balance of $4,322 with an average
balance for the previous 2 months of $2,667. The lender obtained a copy of the borrower’s
401(k) plan statement, which reported a balance as of December 31, 2007, of $3,391. Thus, the
lender did not document a good savings pattern. Therefore, the underwriter did not present and
document compensating factors that were significant enough to justify exceeding HUD’s
benchmarks. The auditee agreed that HUD’s ratios were exceeded without valid compensating
factors.
B. Inaccurate Evaluation of Borrower’s Previous Mortgage Payment History
The lender did not accurately evaluate the borrower’s previous mortgage payment history
because the lender did not ensure that the borrower was current for the month due and made all
mortgage payments due before the new FHA loan closing. Chapter 2-3A of HUD Handbook
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Appendix D-8
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4155.1, REV-5, provides that the borrower’s housing obligation payment history holds
significant importance in evaluating credit and the lender must determine the borrower’s
payment history through the credit report, verification of mortgage directly from the mortgage
servicer, or canceled checks covering the most recent 12-month period. The borrower was not
current on the mortgage being refinanced. Specifically, the borrower did not make the March 1,
2008, payment, and a late charge of $54.43 was added to the mortgage payoff amount.
Mortgagee Letter 05-43, dated October 31, 2005, states that for “No Cash Out” (rate and term)
refinances and streamline refinances, the mortgage being refinanced must be current for the
month due. The borrower made his November 2007 mortgage payment 30 days past due and
explained that the mortgage company that was refinancing his loan told him not to make the
payment because a closing was set for the new loan. However, the closing did not take place on
time, and when the borrower made the payment, it was 30 days past due.
C. Incorrectly Calculated Fixed Payment-to-Income Ratio (Back Ratio)
The lender did not include a monthly installment debt of $364 for an auto lease. There was a
letter in the file from the loan officer stating that the auto lease was paid by the borrower’s
former fiancée, the lease ended in November, and the auto lease was for a car for which the
borrower consigned. The loan file contained copies of bank statements from the former fiancée
showing on-time payments. However, the credit report listed this account as a joint account and
not a cosigned account; therefore, it should have been included in the borrower’s monthly
installment debt. With this debt, the total monthly installment debt increases from $20 to $384,
the fixed payment increases from $3,402.36 to $3,766.36, and the borrower’s fixed payment-to-
income ratio increases from 58.19 percent to 64.42 percent, warranting significant compensating
factors to justify mortgage approval, which were not presented or documented (see section A
above).
43
Somerset Investors Corporation, Melville, NY, Did Not Always Comply With HUD/FHA Loan Underwriting Requirements
Published by the Department of Housing and Urban Development, Office of Inspector General on 2010-03-26.
Below is a raw (and likely hideous) rendition of the original report. (PDF)