oversight

Reviews of Six FHA Lenders Demonstrated That HUD Needs To Strengthen Its Oversight of Prohibited Restrictive Covenants

Published by the Department of Housing and Urban Development, Office of Inspector General on 2013-09-23.

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




                                           September 23, 2013
                                                                                              MEMORANDUM NO:
                                                                                                   2013-LA-0803


Memorandum
TO:            Charles S. Coulter
               Deputy Assistant Secretary for Single Family Housing, HU




FROM:          Tanya E. Schulze
               Regional Inspector General for Audit, Los Angeles Region, 9DGA

SUBJECT:       Reviews of Six FHA Lenders Demonstrated That HUD Needs To Strengthen Its
               Oversight of Prohibited Restrictive Covenants


                                           INTRODUCTION

The U.S. Department of Housing and Urban Development (HUD), Office of Inspector General
(OIG), conducted a limited review of HUD’s oversight of loans underwritten by HUD-approved
Federal Housing Administration (FHA) lenders. We conducted the internal review as part of
OIG’s annual audit plan, prompted by four recent OIG external lender audits reporting that the
lenders allowed prohibited restrictive covenant agreements. Generally, the lenders stated they
were unaware that the documents violated HUD requirements for FHA insurance. The objective
of the internal review was to summarize the recently completed OIG external audits and
determine the extent to which HUD had identified and discouraged such agreements.

HUD Handbook 2000.06, REV-4, provides specific timeframes for management decisions on
recommended corrective actions. For each recommendation without a management decision,
please respond and provide status reports in accordance with the HUD Handbook. Please furnish
us copies of any correspondence or directives issued because of the review.

The Inspector General Act, Title 5 United States Code, section 8L, requires that OIG post its
publicly available reports on the OIG Web site. Accordingly, this report will be posted at
http://www.hudoig.gov.




                                               Office of Audit (Region 9)
                             611 West Sixth Street, Suite 1160, Los Angeles, CA 90017
                                      Phone (213) 894-8016, Fax (213) 894-8115
                          Visit the Office of Inspector General Web site at www.hudoig.gov.
                                  METHODOLOGY AND SCOPE

We reviewed seven OIG audit reports and memorandums, issued within the past 5 years, which
contained findings in which FHA lenders allowed prohibited restrictive covenants and in many
instances, liens corresponding to FHA-insured properties. Our internal review focused on the
four most recent audits, highlighted in blue below.

                              FHA                            OIG audit or
          Lender          identification      Location       memorandum               Issue date
                             number                            number
    CTX Mortgage
                             51358           Dallas, TX      2013-LA-1803           April 18, 2013
    Company, LLC
    Pulte Mortgage,
                             05369         Englewood, CO     2013-LA-1802           April 18, 2013
    LLC
    Standard Pacific
                             11775           Irvine, CA      2013-LA-1801          February 5, 2013
    Mortgage, Inc.
    Shea Mortgage, Inc.      78404         Aliso Viejo, CA   2012-LA-1801      September 26, 2012
    Universal American
                             21490         Las Vegas, NV     2011-LA-1017      September 21, 2011
    Mortgage Company
    DHI Mortgage                           Scottsdale, AZ    2010-LA-1009          March 19, 2010
                             05424
    DHI Mortgage                           Scottsdale, AZ    2009-LA-1018      September 10, 2009

We conducted the audit fieldwork from the OIG Phoenix, AZ, Office of Audit between May and
July 2013. To accomplish our objective, we

•         Reviewed prior OIG audit reports and memorandums with findings that included lenders’
          allowing prohibited restrictive covenants as noted above;

•         Reviewed relevant FHA requirements set forth in 24 CFR (Code of Federal Regulations)
          Parts 25, 28, 30, and 203; United States Code (U.S.C.), including 12 U.S.C. 1723i, 12
          U.S.C. 1735f-14, 31 U.S.C. 3729-3733, 31 U.S.C. 3801-3812, and 42 U.S.C. 3535(d);
          HUD Handbooks 4160.1, 4155.1, and 4155.2; and HUD Mortgagee Letters 2009-12 and
          2011-22 (including the attached Processing Guide);

•         Reviewed an OIG legal opinion pertaining to restrictive covenants;

•         Reviewed HUD management decisions discussing prohibited restrictive covenants;

•         Reviewed prior reviews conducted by the HUD Quality Assurance Division;

•         Discussed the prohibited restrictive covenants with HUD officials; and

•         Compiled and summarized the loan data from the seven audits with corresponding
          prohibited restrictive covenants.




                                                    2
We relied, in part, on and used HUD computer-processed data to select the claim and active
loans reviewed for prohibited restrictive covenants in the prior OIG audits. Additionally, we
used this data to update the loan status of the selected loans before issuance of the external
audits. Although we did not perform a detailed assessment of the reliability of data, we
performed a minimal level of testing and determined that the data were sufficiently reliable for
our purposes.

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 HUD.
We did not follow standards in these areas because our objective was to summarize prior OIG
audit results and determine HUD’s identification of similar problems and what it had done to
discourage such agreements. To meet our objective, it was not necessary to fully comply with
the standards, nor did our approach negatively affect our review results.

                                           BACKGROUND

FHA, created by Congress in 1934, is the largest mortgage insurer in the world aimed at helping
low- and moderate-income families become homeowners by lowering some of the costs of their
mortgage loans. It is also the only government agency that operates entirely from its self-
generated income from mortgage insurance paid by homeowners and costs the taxpayers
nothing. FHA mortgage insurance 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. At the same time, according to HUD requirements, the
lender has the responsibility at loan closing to ensure that any conditions of title to the property
are acceptable to FHA and that the mortgaged property will be free and clear of all liens other
than the mortgage. Lenders are responsible for complying with all applicable HUD regulations
and in turn are protected against default by FHA’s Mutual Mortgage Insurance Fund, which is
sustained by borrower premiums.

In the event of homeowner default, the FHA fund pays claims to participating lenders. To this
end, lenders have a responsibility to ensure that the FHA fund is protected by approving only
those loans that meet all eligibility requirements. The FHA fund capital reserve ratio has a
congressional mandate of 2 percent. However, based on the 2012 annual report to Congress on
the FHA fund, 1 its capital reserve ratio had fallen below zero to a negative 1.44 percent. A U.S.
Government Accountability Office report on the FHA fund stated, “If the [capital] reserve
account were to be depleted, FHA would need to draw on permanent and indefinite budget
authority to cover additional increases in estimated credit subsidy costs.” 2 As a consequence, the
FHA fund would no longer run on only self-generated income.

A prohibited restrictive covenant is a legal restriction on conveyance that prevents free
assumability of an FHA-insured property. 3 HUD has identified various types of prohibited
restrictive covenants involving housing finance agencies; affordable housing downpayment

1
  Annual Report to Congress, Fiscal Year 2012 Financial Status, FHA Mutual Mortgage Insurance Fund
2
  U.S. Government Accountability Office testimony, GAO-12-578T, Mortgage Financing, FHA and Ginnie Mae
Face Risk-Management Challenges, issued March 29, 2012
3
  See appendix B.




                                                    3
assistance agreements; and condominium covenants, conditions, and restrictions documents.
These prohibited restrictions have stipulated income, affordability, or length of stay restrictions.
Previous OIG audit reports and memorandums 4 reported that FHA lenders had allowed their
affiliated builders (sellers) to execute covenant agreements with the FHA borrower that
contained prohibited restrictions on conveyance.

We issued audit reports on Universal American Mortgage and DHI Mortgage based on general
underwriting reviews that also identified prohibited restrictive covenants during the course of
each audit. The Universal Mortgage audit reported that 15 loans contained prohibited restrictive
covenants, and the two DHI Mortgage audits reported a total of 213 loans in which a prohibited
restrictive covenant existed. Prompted by these reviews, we performed an auditability survey of
FHA lenders with affiliated builders to determine whether other instances existed in which a
lender allowed prohibited restrictive covenants between its builder and the FHA borrowers. This
survey led to the additional external lender audits, culminating in this internal review.

The objective of the internal review was to summarize recently completed OIG external audits in
which lenders allowed prohibited restrictive covenant agreements and determine the extent to
which HUD had identified and discouraged such agreements.

                                          RESULTS OF REVIEW

Our seven audit reviews of six different FHA lenders 5 demonstrated that HUD needs to
strengthen its oversight of prohibited restrictive covenants. HUD has regulations in place to
prevent prohibited restrictions on conveyance of FHA-insured properties; however, in the four
most recent OIG audits, we found an estimated 2,479 loans with prohibited restrictive covenants.
HUD should enhance its efforts to reiterate to the mortgage industry that prohibited restrictive
covenants are unacceptable and HUD regulations will be enforced with appropriate penalties.
HUD’s loan review process did not specifically include a review of restrictions on conveyance
and did not track review findings related to restrictive covenants. With the six lenders reviewed,
we identified more than $67 million in potential losses that would not have otherwise occurred,
putting the FHA fund at unnecessary risk.

SIX LENDERS ALLOWED PROHIBITED RESTRICTIVE COVENANTS

Reviews of the six FHA lenders demonstrated the prevalence and repeated use of prohibited
restrictive covenants in violation of HUD regulations at 24 CFR 203.41(b). 6 The four lenders
most recently targeted and reviewed specifically for this violation showed an estimated 2,479
loans with prohibited restrictive covenant agreements. 7 Of the 2,479 violating loans, 366 had
entered conveyance claim status, resulting in a loss to HUD. These violations generally occurred
because the lenders stated they were unaware that the restrictions violated HUD requirements.
4
  See Methodology and Scope section for a description of each completed audit.
5
  Four of the seven reviews were recently conducted as part of an OIG effort to target and identify lenders that
allowed the recording of prohibited restrictive covenants. Audit resolution on the four external audits is ongoing.
OIG and the Office of Housing have held discussions with the HUD Deputy Secretary to determine the appropriate
remedies for violations involving restrictive covenants.
6
  See appendix B.
7
  The properties identified were located in Arizona, California, Florida, Georgia, Nevada, South Carolina, and Utah.




                                                         4
The insurance of these loans placed the FHA fund at an unnecessary risk of an estimated loss of
more than $49 million.

                          Reported summary of loans with prohibited restrictive covenants 8
                                                                    Claims paid,
      OIG report or                                    Actual loss to             Potential loss
                           Total loans Claim loans                        loss                   Totals
      memorandum                                          HUD 9                10  to HUD 11
                                                                     unknown
                                           Recent OIG audits completed 12
    Shea Mortgage, Inc.        600           29      $ 1,467,611 $ 2,566,837 $ 5,092,201 $ 9,126,649
      Standard Pacific
                                90           28                 1,535,189     1,390,235       544,967        3,470,391
       Mortgage, Inc.
    Pulte Mortgage, LLC       1,106          181                9,909,292    11,865,597     1,359,876      23,134,765
       CTX Mortgage
                               683           128                5,285,281     7,975,892       892,032      14,153,205
      Company, LLC
         Subtotal             2,479         366      $ 18,197,373 $ 23,798,561 $             7,889,076 $ 49,885,010
                                           Prior OIG reviews completed
    Universal American
                                15            1         $        118,861 $           0     $1,188,588      $1,307,449
    Mortgage Company
      DHI Mortgage              8             0                        0             0    $789,984       789,984
      DHI Mortgage             205            2                  219,223             0   15,037,560   15,256,783
         Subtotal              228            3         $        338,084 $           0 $ 17,016,132 $ 17,354,216
          Totals              2,707          369        $ 18,535,457 $ 23,798,561 $ 24,905,208 $ 67,239,226

Shea Mortgage, Inc.

We reported that Shea Mortgage did not follow HUD requirements when it underwrote loans that
had executed and recorded agreements between Shea Homes and the FHA borrower, containing
prohibited restrictive covenants in connection with FHA-insured properties. The audit
memorandum reported on 600 loans (29 claim loans and 571 active loans12) that did not meet the
requirements for FHA insurance. Shea Mortgage’s failure to exercise due diligence allowed
prohibited restrictive covenants on the FHA-insured properties, which rendered them
uninsurable.

Additionally, we reported that these uninsurable loans placed the FHA fund at unnecessary risk
for potential losses because HUD would not otherwise see a loss on loans not insured by the
FHA fund. Of the 57 loans (29 claim loans and 28 sampled active loans) identified with
prohibited restrictive covenants, 11 resulted in an actual loss to HUD of more than $1.4 million.

8
  The loan information provided in the table reflects details reported in the specified OIG audit reports and
memorandums cited.
9
  The actual loss is the calculated amount of loss resulting from the sale of a HUD property. The loss is calculated
based on the sales price - [acquisition cost + capital income/expense (rent, repair costs, taxes, sales expenses, and
other expenses)].
10
   At the time of the given report, HUD had not posted an actual loss, but a claim had been paid.
11
   The potential loss was based on the unpaid mortgage balance for each loan multiplied by the applicable loss rate
at the time of the each report.
12
   The total number of loans with prohibited restrictive covenants for the four recently completed audits include
estimated amounts derived from statistical sample projections completed for each individual audit.




                                                            5
Another 18 of these loans had conveyance claims paid totaling more than $2.4 million. One loan
was a preforeclosure sale with a $135,699 claim paid by HUD. The remaining 27 loans found
with prohibited restrictive covenants had a total unpaid mortgage balance of more than $7.7
million with an estimated loss to HUD of more than $5 million.

Standard Pacific Mortgage, Inc.

We reported that Standard Pacific Mortgage did not follow HUD requirements regarding free
assumability and liens when it underwrote loans that had executed and recorded agreements
between Standard Pacific Homes and the FHA borrower, containing prohibited restrictive
covenants and liens in connection with FHA-insured properties. The audit memorandum
reported on 90 loans (28 claim loans and 62 active loans12) that did not meet the requirements for
FHA insurance, thereby rendering them ineligible for FHA insurance. Standard Pacific
Mortgage’s failure to exercise due diligence allowed prohibited restrictive covenants with liens
on the FHA-insured properties, which rendered them uninsurable.

Additionally, we reported that these uninsurable loans placed the FHA fund at unnecessary risk
for potential losses because HUD would not otherwise see a loss on loans not insured by the
FHA fund. Of the 33 loans (28 claim loans and 5 sampled active loans) identified with
prohibited restrictive covenants, 15 resulted in an actual loss to HUD of more than $1.53 million.
Another 13 of these loans had conveyance claims paid totaling more than $1.39 million. The
remaining five loans found with prohibited restrictive covenants had a total unpaid mortgage
balance of more than $878,000 with an estimated loss to HUD of more than $544,000.

Pulte Mortgage, LLC

We reported that Pulte Mortgage did not follow HUD requirements regarding free assumability
and liens when it underwrote loans that had executed and recorded agreements between sellers
and the FHA borrower, containing prohibited restrictive covenants and liens in connection with
FHA-insured properties. The audit memorandum reported on 1,106 loans (181 claim loans and
925 active loans12) that did not meet the requirements for FHA insurance, thereby rendering
them ineligible for FHA insurance. Pulte Mortgage’s failure to exercise due diligence allowed
prohibited restrictive covenants with the potential for liens on the FHA-insured properties, which
rendered the loans uninsurable.

Additionally, we reported that these uninsurable loans placed the FHA fund at unnecessary risk
for potential losses because HUD would not otherwise see a loss on loans not insured by the
FHA fund. Of the 192 loans (181 claim loans and 11 sampled active loans) identified in which a
prohibited restrictive covenant was found, 82 resulted in an actual loss to HUD of more than $9.9
million. Another 99 of these loans had conveyance claims paid totaling more than $11.8 million.
The remaining 11 loans found with prohibited restrictive covenants had a total unpaid mortgage
balance of more than $2.3 million with an estimated loss to HUD of more than $1.3 million.




                                                6
CTX Mortgage Company, LLC

We reported that CTX Mortgage did not follow HUD requirements regarding free assumability
and liens when it underwrote loans that had executed and recorded agreements between sellers
and the FHA borrower, containing prohibited restrictive covenants and potential liens in
connection with FHA-insured properties. The audit memorandum reported on 683 loans (128
claim loans and 555 active loans12) that did not meet the requirements for FHA insurance,
thereby rendering them ineligible for FHA insurance. CTX Mortgage’s failure to exercise due
diligence allowed prohibited restrictive covenants with the potential for liens on the FHA-insured
properties, which rendered the loans uninsurable.

Additionally, we reported that these uninsurable loans placed the FHA fund at unnecessary risk
for potential losses because HUD would not otherwise see a loss on loans not insured by the
FHA fund. Of the 136 loans (128 claim loans and 8 sampled active loans) identified in which a
prohibited restrictive covenant was found, 51 resulted in an actual loss to HUD of more than $5.2
million. Another 77 of these loans had conveyance claims paid totaling more than $7.9 million.
The remaining eight loans found with prohibited restrictive covenants had a total unpaid
mortgage balance of more than $1.5 million with an estimated loss to HUD of more than
$892,000.

PROHIBITED RESTRICTIVE COVENANTS WERE MATERIAL VIOLATIONS

The OIG reviews identified in this audit memorandum emphasize the materiality and
significance of the violations of HUD regulations and restrictions on conveyance. HUD
regulations 13 at 24 CFR 203.41(b) are clearly defined and state that to be eligible for insurance,
the property must not be subject to legal restrictions on conveyance. Further, HUD Handbook
4155.2, paragraph 6.A.1.h, stated that it is the lender’s responsibility at loan closing to ensure
that any conditions of title to the property are acceptable to FHA. Regardless of intent, a
deficiency becomes significant and material when it impacts the insurability of an FHA
mortgage loan and when responsibility was on the lender to ensure compliance with the specific
HUD regulations. In cases in which FHA properties have a prohibited restrictive covenant, we
determined the violations to be material violations that should have precluded the loans from
receiving FHA mortgage insurance.

Prior HUD Actions

Our findings and recommendations 14 for each review were made based on how HUD responded
and took action when it identified similar types of violations in its own reviews. In its prior
reviews of Shea Mortgage, 15 HUD identified unallowable restrictive covenants as a violation of
Federal regulations and FHA requirements, considering the violations a material, serious
deficiency, stating that loans with prohibited restrictive covenants were ineligible for FHA
insurance. Therefore, we followed a similar course in the recent four external OIG reviews and

13
   See appendix B.
14
   The HUD Office of Single Family Housing and OIG disagreed regarding recommendations concerning
indemnification. The HUD Deputy Secretary will determine the appropriate action.
15
   HUD postendorsement technical review results on FHA loans 048-6246440 and 048-5912514




                                                     7
included recommendations that HUD’s Associate General Counsel for Program Enforcement
pursue civil remedies, civil money penalties, or other administrative action against each lender, if
appropriate. We also recommended that HUD’s Deputy Assistant Secretary for Single Family
Housing require the lenders to (1) reimburse the FHA fund for the actual losses for claims paid,
(2) execute an indemnification agreement for claims paid for which the loss was not known, (3)
remove all active prohibited restrictions or execute indemnification agreements that prohibited
them from submitting claims on those loans identified, and (4) generally ensure that they follow
24 CFR 203.32 and 203.41.

Additionally, members of the United States Congress have illustrated their specific intent of
protecting the FHA fund by providing HUD with the appropriate tools and remedies. The
pending legislation, the FHA Emergency Fiscal Solvency Act of 2013, 16 states that if the HUD
Secretary determines that the lender knew or should have known of a serious or material
violation of the requirements established by the Secretary, such that the mortgage loan should
not have been approved and endorsed for insurance, and HUD pays an insurance claim with
respect to the mortgage, the Secretary may require the lender to indemnify HUD for the loss,
regardless of whether the violation caused the mortgage default. This legislation further
reinforces the OIG recommendations on the recent four external reviews discussed above by
providing the Secretary stronger tools to enforce indemnification.

FHA Fund Exposure

The FHA fund incurred actual and potential unnecessary losses of at least $67 million due to an
estimated 2,707 ineligible loans with prohibited restrictive covenants receiving FHA mortgage
insurance. The unnecessary risk stems from the fact that each of these loans should never have
received FHA mortgage insurance with the prohibited restrictions in place. Without regulatory
reinforcement, FHA is exposed to a higher risk of continued noncompliance and the potential for
incurring additional losses. Although we were unable to determine the prevalence of such
restrictions associated with FHA-insured loans, because HUD systems do not capture this data,
we know that it impacted part of the FHA insurance portfolio. According to HUD, in fiscal year
2012, FHA insured about 1.2 million single-family forward mortgage loans, totaling
approximately $213 billion. With such a large volume and dollar value of loans entering FHA’s
portfolio annually, it is important for HUD to do what it can to mitigate exposure to the FHA
fund to support the continued viability of the fund.

Consumer Protection

While HUD regulations are in place to first protect the FHA mortgage insurance fund, the issue
of prohibited restrictive covenants is especially significant as a secondary, but equally significant
component of the HUD regulations are to help protect the consumer (the FHA borrowers).
Specifically, HUD regulations at 24 CFR 203.41 protect FHA borrowers from prohibited
restrictions that carry the potential to impact decision making and impose unnecessary financial
burdens. An FHA borrower who is a party to prohibited restrictive covenants could feel pressure

16
  House Resolution 1145, sponsored by Congresswoman Maxine Waters and Congressman Michael E. Capuano on
March 13, 2013. It was reintroduced under the 113th Congress after the 112th Congress referred it to the Committee
on Banking, Housing, and Urban Affairs.




                                                        8
to defer an attempted conveyance or transfer of his or her property to the detriment of his or her
current financial limitations because of perceived payable damages for a breach of contract. In
some instances, a waiting period could be the difference between a borrower making good on his
or her mortgage and lapsing into foreclosure, which could harm the borrower and ultimately the
FHA fund.

HUD NEEDS TO STRENGHTEN ITS OVERSIGHT OF RESTRICTIVE COVENANTS

HUD generally recognized the importance of ensuring that prohibited restrictive covenants were
not allowed to be recorded with FHA properties. HUD officials realized that there was a need to
inform lenders and reemphasize HUD regulations concerning restrictive covenant agreements.
However, HUD needs to do more to strengthen its oversight of prohibited restrictive covenants
and its message to lenders that such restrictions will not be tolerated. According to HUD, these
prohibited agreements persist due to the builders, with associated lenders, wanting to protect
their economic self-interests in the housing developments they built.

Homeownership Center personnel informed us that HUD did not track violations pertaining to
prohibited restrictive covenants and had no way of pulling instances of violations without
reviewing the data on a loan-by-loan basis. Therefore, we were unable to determine the
nationwide extent of prohibited restrictive covenant agreements identified by HUD.
Additionally, HUD’s loan reviews did not include specific procedures to identify prohibited
restrictive covenants, instead it relies on the experience and knowledge of the individual
reviewers.

When a violation was found, HUD generally required 17 lenders to (1) remove the restrictions or
request indemnification or (2) reconvey the loan to the lender if the loan had already been
conveyed to HUD. However, an Office of Single Family Housing official stated that HUD needs
to determine the appropriate penalty, describe the penalty, and then communicate that this
behavior will not be tolerated. 18 An appropriate remedy, coupled with consistent use of the
appropriate penalties, would not only reinforce the materiality of the violations, but would send a
message to lenders that such violations will not be tolerated. HUD believed that the use of the
Mortgagee Review Board for civil money penalties against lenders would discourage lenders
from allowing prohibited restrictive covenants and enforce HUD’s requirements, in part, because
these actions against a lender are published in the Federal Register. Additionally, HUD
Homeownership Center officials suggested that

•    An issuance of a mortgagee letter, in plain English, reiterating what are acceptable
     restrictions and what are not would help in preventing and reducing the risk of these
     violations.

•    A webinar or other training could help reinforce the policy on restrictive covenants.

•    Harsher penalties would need to be assessed before lender behavior would change.

17
   OIG disagreed with the Office of Housing regarding the appropriate remedies for cases identified with prohibited
restrictive covenant agreements.
18
   OIG was in discussions with the HUD Deputy Secretary to determine appropriate penalties.




                                                         9
We identified some HUD requirements 19 that had been made available to lenders which
specified that HUD could and would take action against lenders for violating FHA requirements.
These included but are not limited to Mortgagee Letter 2009-12; Mortgagee Letter 2011-22
(including the attached Processing Guide); HUD Handbook 4155.2, paragraph 9.A.1.a; and HUD
Handbook 4155.2, paragraph 9.D.1.a, which state, in part, that noncompliance actions vary
significantly in their scope and effect. The more serious the scope and effect of the action, the
more serious is the sanction that would be applied.

Conclusion

Our reviews of six FHA lenders clearly demonstrate that HUD needs to strengthen its oversight
and efforts in identifying prohibited restrictive covenants in connection with FHA-insured
properties, prohibited under 24 CFR 203.41(b), which violate FHA requirements for insurability,
and take additional action to stop the behavior. We were unable to determine the nationwide
extent of the issue as HUD did not specifically look for prohibited restrictive covenants during
loan reviews and did not track such violations. However, as stated above, we identified six
lenders that allowed the prohibited restrictive covenants. Generally these lenders allowed the
agreements because they stated they were unaware that it violated HUD requirements. We agree
with HUD that these prohibited agreements persist due to builders, with associated lenders,
wanting to protect their economic self-interests in their single family housing developments. We
also attribute this condition to HUD’s lack of recent public regulatory reinforcement and
discouragement of these material violations that impact the insurability of the loans. While HUD
did recommend corrective actions as violations were identified, this was done only on a case-by-
case basis. As a result, FHA insured ineligible loans and incurred unnecessary losses due to
ineligible loans’ receiving FHA mortgage insurance. Without regulatory reinforcement, FHA
and consumers are exposed to a higher risk of additional losses from the continued
noncompliance.

                                      RECOMMENDATIONS

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

1A.        Reinforce HUD regulatory requirements concerning restrictive covenant agreements to
           the industry, including lenders and builders. Reinforcement should include efforts such
           as the issuance of a mortgagee letter, addition of a section to the frequently asked
           questions, and distribution through LISTSERV. Reinforcement should also include a
           message to lenders and builders that prohibited restrictive covenant agreements will not
           be tolerated.

1B.        Develop and implement specific review procedures to identify prohibited restrictive
           covenants during Homeownership Center loan reviews and provide education to
           Homeownership Center personnel to reiterate the importance of identifying the various
           types of prohibited restrictive covenant agreements.



19
     See appendix B.




                                                   10
1C.   Develop and implement specific procedures detailing penalties and corrective actions that
      can be applied consistently to each violating lender and builder. HUD should consider
      including the various prohibited restrictive covenants known to HUD beyond those
      identified in this memorandum.

1D.   Develop and implement procedures for tracking loans identified with prohibited
      restrictive covenants, including the type of restriction, which would allow HUD and OIG
      to (1) identify their frequency and emerging trends, (2) determine the impact to FHA, and
      (3) adequately review of the loans.




                                             11
Appendix A

        AUDITEE COMMENTS AND OIG’S EVALUATION


Ref to OIG Evaluation   Auditee Comments




Comment 1

Comment 2


Comment 3




                         12
Comment 4




Comment 5




Comment 6




Comment 7




            13
Comment 8



Comment 9

Comment 5




Comment 10




             14
15
                               OIG Evaluation of Auditee Comments

Comment 1       We disagree with the Office of Single Family Housing’s (Housing) statement that
                the audit memorandum was misleading by reporting on an extrapolation of actual
                cases. Our methodology and reporting of statistical sample projections is an
                appropriate use of a statistical sample. For each of the underlying audits, if an
                unallowable restrictive covenant was found on a statistically selected random
                sample items (active loan review) these loans were projectable to the universe of
                the loans. As stated in the New York Law Journal’s article The Use of Statistical
                Sampling as Evidence, by George Bundy Smith and Thomas J. Hall,

                         Statistical sampling is a scientific methodology by which one draws
                         conclusions about a large population of data by measuring and analyzing
                         a smaller, representative sample of the population. When the sample is
                         randomly selected and of sufficient size so as to achieve statistical
                         significance, statisticians may confidently make inferences about the
                         larger population by reviewing the sample. As such, statistical sampling
                         can provide an efficient way to estimate accurately larger populations of
                         data, and has been utilized across many spectrums outside of the
                         courtroom, including election polling, television ratings, unemployment
                         surveys and analyses of public health issues.

Comment 2       Housing presented an analysis of restrictive covenants and stated that only 339 of
                479 cases contained an actual restrictive covenant. As specified in the audit
                memorandum, the loan data included in the audit finding is a summary of the loan
                information provided in the individual audit memorandums and reports. As the
                audit objective stated, in part, was to summarize the previous audit reports and
                memorandums we did not update the loan information, instead we reported the
                information as it was published. We added a footnote to the table on page 5 of
                this audit memorandum for clarification.

Comment 3       We agree with Housing that 27 of the claims identified contained a mitigating
                document 20, rending the restrictive covenants not enforceable. However, it is
                important to note that restrictive covenants were still recorded with the applicable
                counties for each of the 27 loans.

Comment 4       Housing stated that the presence of restrictive covenants was not a factor in
                whether loans went to claim or in whether the Department suffered insurance
                claim losses. The audit memorandum and associated external audit reports were
                completed with an objective of determining the presence of prohibited restrictive
                covenants. We determined the presence of a prohibited restrictive covenant was a
                significant, material violation, regardless of whether it was the cause of the loan
                default. The significance and materiality stems from the fact that loans with a


20
  See audit memorandum 2013-LA-1801, Standard Pacific Mortgage, Inc., Irvine, CA, Allowed the Recording of
Prohibited Restrictive Covenants.




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            prohibited restrictive covenant should not have received FHA mortgage
            insurance.

Comment 5   Housing agreed with the audit memorandum’s findings, however, disagreed that
            indemnification is warranted for the violations explained in this audit
            memorandum and each of the completed external audit memoranda. At the time
            of this memorandum, audit resolution for each of the four recently completed
            audits was still ongoing. OIG and the Office of Single Family Housing were in
            discussions with the HUD Deputy Secretary to determine appropriate penalties for
            lenders allowing the recording of prohibited restrictive covenants. We
            respectfully disagree with the Office of Single Family Housing and believe that
            indemnification, in addition to a referral to the Mortgagee Review Board, is
            warranted for the reasons cited in this audit memorandum. We added a footnote
            to this audit memorandum for clarification.

Comment 6   We disagree with Housing and believe the restrictive covenants did expose HUD
            to financial loss. Regulations at 24 CFR 203.41(b) states that loans with
            prohibited restrictive covenants are not eligible for FHA mortgage insurance. In
            this regard, the loans citied in this audit memorandum should not have received
            FHA mortgage insurance and associated losses should not have been incurred by
            HUD.

            We would like to clarify that the primary four audit memorandums discussed in
            the audit finding include prohibited restrictive covenants with a restriction period
            that ranged from 6 to 24 months (examples are provided in each of the four audit
            memorandums).

Comment 7   As explained in the audit finding under the “Consumer Protection” section, the
            prohibited restrictive covenants impact the consumer (FHA borrower) and not just
            FHA. Additionally, Housing’s position regarding clear title in the event of a
            foreclosure is secondary to the primary basis of this audit memorandum that each
            loan with a prohibited restrictive covenant was not eligible for FHA mortgage
            insurance in the first place. See also comments 4 and 5.

Comment 8   We agree with Housing that the issue of prohibited restrictive covenants in
            association with lenders and associated builders is most likely localized,
            concentrated in areas with more new construction. However, we would like to
            clarify that because of the lack of data collected by HUD pertaining to prohibited
            restrictive covenants, the extent of the problem is unknown and we cannot state
            the severity of the issue and do not have data indicating which areas have higher
            concentrations of prohibited restrictive covenants.

            During our review, we became aware of other restrictive covenants that
            potentially make the issue more significant and extend beyond this idea of
            localization. Interviews with HUD Homeownership Center staff indicated
            restrictive covenants were present in other situations beyond new construction,




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              involving housing finance agencies, affordable housing downpayment assistance
              agreements, and condominium Covenants, Conditions, and Restrictions (CCRs)
              documents. These prohibited restrictions have stipulated income, affordability, or
              length of stay restrictions.

Comment 9     We agree with Housing that the issue persists, in part, due to the economic self-
              interests of the builders affiliated with the FHA mortgage lenders. However,
              more pertinent to this audit memorandum, we believe HUD can do more to
              reinforce its regulations regarding prohibited restrictive covenants. We have
              modified the audit memorandum language discussing the cause to incorporate
              HUD’s belief that this issue continues as a result of the economic self-interests of
              the builders’ affiliated with FHA mortgage lenders.

Comment 10 While we do not disagree with Housing’s position that they have a risk
           management framework in place coupled with trained staff, we do, however,
           disagree with Housing’s statement that it has adequate controls in place with
           regards to prohibited restrictive covenants. As stated in the audit memorandum,
           each of the lenders allowed numerous FHA-insured properties to have prohibited
           restrictive covenants over the course of multiple years. The recommendations in
           this audit memorandum focus on strengthening HUD’s (1) controls in this area
           and (2) ensuring enforcement is appropriate and consistent.




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Appendix B
                                         CRITERIA

The FHA insurance requirements set forth in 24 CFR 203.41(b) state that to be eligible for
insurance, the property must not be subject to legal restrictions on conveyance. Further, 24 CFR
203.41(a)(3) defines legal restrictions on conveyance as “any provision in any legal instrument,
law or regulation applicable to the mortgagor or the mortgaged property, including but not
limited to a lease, deed, sales contract, declaration of covenants, declaration of condominium,
option, right of first refusal, will, or trust agreement, that attempts to cause a conveyance
(including a lease) made by the mortgagor to:

(i)     Be void or voidable by a third party;
(ii)    Be the basis of contractual liability of the mortgagor for breach of an agreement not to
        convey, including rights of first refusal, pre-emptive rights or options related to
        mortgagor efforts to convey;
(iii)   Terminate or subject to termination all or a part of the interest held by the mortgagor in
        the mortgaged property if a conveyance is attempted;
(iv)    Be subject to the consent of a third party;
(v)     Be subject to limits on the amount of sales proceeds retainable by the seller; or
(vi)    Be grounds for acceleration of the insured mortgage or increase in the interest rate.”

Regulations at 24 CFR 203.32 state that a “mortgagor must establish that, after the mortgage
offered for insurance has been recorded, the mortgaged property will be free and clear of all liens
other than such mortgage, and that there will not be outstanding any other unpaid obligations
contracted in connection with the mortgage transaction or the purchase of the mortgaged
property, except obligations that are secured by property or collateral owned by the mortgagor
independently of the mortgaged property.”

HUD Handbook 4155.2, paragraph 6.A.1.h, stated that it is the lender’s responsibility at loan
closing to ensure that any conditions of title to the property are acceptable to FHA. In essence, it
is the duty of the lender to ensure that FHA loans approved for mortgage insurance are eligible
and acceptable according to FHA rules and regulations.

Mortgagee Letter 2009-12 warns lenders about appropriate lending practices by stating that
HUD must hold lenders accountable for their lending practices to protect the public trust and the
FHA fund.

Mortgagee Letter 2011-22 in the attached Processing Guide, for the condominium approval
process, paragraph 1.8.8, reiterates 24 CFR 203.41 requirements for free assumability.
Additionally, it states, “If the conveyance could cause any of these things to occur, the property
is considered to be subject to legal restrictions on conveyance and is usually ineligible for FHA
mortgage insurance.”




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HUD Handbook 4155.2, paragraph 9.A.1.a, states, in part, that the objective of the
Homeownership Center action is to reduce the risk of defaults and claims to FHA, improve
lender performance, and remove noncomplying lenders from the program.

HUD Handbook 4155.2, paragraph 9.D.1.a, states, in part, that noncompliance actions vary
significantly in their scope and effect. The more serious the scope and effect of the action, the
more serious is the sanction that would be applied.




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