oversight

Standard Pacific Mortgage, Inc., Irvine, CA, Allowed the Recording of Prohibited Restrictive Covenants

Published by the Department of Housing and Urban Development, Office of Inspector General on 2013-02-05.

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




                                                   February 5, 2013
                                                                                                   MEMORANDUM NO:
                                                                                                        2013-LA-1801


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

                   Dane Narode
                   Associate General Counsel for Program Enforcement, CACC



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

SUBJECT:           Standard Pacific Mortgage, Inc., Irvine, CA, Allowed the Recording 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 loans underwritten by Standard Pacific Mortgage, Inc. 1
We selected the lender based on the results of an auditability survey, which determined that
Standard Pacific Mortgage allowed prohibited restrictive covenants to be filed against Federal
Housing Administration (FHA)-insured properties. The objective of our review was to
determine the extent to which Standard Pacific Mortgage failed to prevent the recording of
prohibited restrictive covenants or potential liens in connection with FHA-insured loans closed
between January 1, 2008, and December 31, 2011.

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.



1
    FHA identification number 11775
                                                    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.
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.

                                   METHODOLOGY AND SCOPE

We reviewed 153 2 loans underwritten by Standard Pacific Mortgage with closing dates between
January 1, 2008, and December 31, 2011. We conducted the audit work from the HUD OIG
Phoenix, AZ, Office of Audit between June and November 2012. To accomplish our objective,
we

•       Reviewed prior HUD OIG audit reports with findings that included lenders allowing
        prohibited restrictive covenants; 3

•       Reviewed relevant FHA requirements set forth in 24 CFR (Code of Federal Regulations)
        Part 203 and HUD Handbooks 4000.2 and 4155.2;

•       Reviewed a HUD OIG legal opinion pertaining to restrictive covenants;

•       Reviewed a HUD management decision discussing prohibited restrictive covenants;

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

•       Discussed the prohibited restrictive covenants with Standard Pacific Mortgage officials;
        and

•       Obtained and reviewed FHA loan data downloaded from HUD’s Single Family Data
        Warehouse 4 and Neighborhood Watch systems. 5

We analyzed the Single Family Data Warehouse data as of May 31, 2012, and separated the data
into two categories: (1) loans that went into claim status and (2) loans that were still active. We
selected a 100 percent review of the claim loans, 84 loans total, and elected to review a highly
stratified attribute statistical sample of the 2,691 active loans. The stratified sample of the 69
loan samples was randomly selected and weighted by means of a computer program in SAS®
using a seed value of 7. To meet the audit objective, we also

•       Requested and received copies of the lender’s FHA lender files for the loans selected for
        review;


2
  84 claim loans and 69 statistically selected active loans
3
  Audit report numbers 2009-LA-1018, 2010-LA-1009, and 2011-LA-1017
4
  HUD’s Single Family Data Warehouse is a collection of database tables structured to provide HUD users easy and
efficient access to single-family housing case-level data on properties and associated loans, insurance, claims,
defaults, and demographics.
5
  Neighborhood Watch is a Web-based software application that displays loan performance data for lenders and
appraisers by loan types and geographic areas, using FHA-insured single-family loan information.




                                                       2
•       Interviewed some borrowers for loans where HUD paid a claim;

•       Conducted Internet research, identified and queried applicable county recorders’ offices,
        and searched Accurint 6 to obtain and review recorded documents related to the sampled
        FHA-insured mortgages; and

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

For the audit sample, the percentage and number of loans with unallowable restrictive covenants
were computed based on the weighted sampling results and extended to the population using the
“surveyfreq” procedure provided by SAS®. We used a nine-strata sample design to control for
potential bias that might arise from varying rates of price escalation and varying resale demand
based on population density. Of the selected samples, 5 had disallowed covenants, which
projects to 7.33 percent, or 197.3 loans. To account for the statistical margin of error, we
subtracted the standard error (80.55) times a t-score of 1.67. As a result, we can be 95 percent
confident that at least 62.8 of the 2,691 loans had similar problems with unallowable restrictive
covenants.

We relied in part on and used HUD computer-processed data to select the claim and active loans
reviewed for prohibited restrictive covenants. 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 was 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 Standard
Pacific Mortgage. We did not follow standards in these areas because our objective was to
identify the extent to which Standard Pacific Mortgage allowed prohibited restrictive covenants
and how that affected the FHA single-family insurance program risk. To meet our objective, it
was not necessary to fully comply with the standards, nor did our approach negatively affect our
review results.

                                               BACKGROUND

Standard Pacific Mortgage is a nonsupervised direct endorsement lender 7 headquartered in
Irvine, CA. It was approved to participate in HUD’s FHA mortgage insurance program in
December 2004. Its affiliate builder, Standard Pacific Homes, was the seller of the properties
discussed in this review memorandum.



6
  Accurint LE Plus accesses databases built from public records, commercial data sets, and data provided by various
government agencies.
7
  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 is not a supervised lender, a loan correspondent, a governmental
institution, a government-sponsored enterprise, or a public or State housing agency and has not applied for approval
for the limited purpose of being an investment lender.




                                                         3
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. However, according to HUD-FHA 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, 8 its capital reserve ratio had fallen below zero to a negative 1.44 percent. A
Government Accountability Office report on the FHA fund stated, “[i]f 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.” 9 Therefore, the FHA
fund would no longer run on only self-generated income.

We reviewed a legal opinion 10 from OIG’s Office of Legal Counsel regarding the seller’s
restriction on conveyance of FHA properties. Counsel opined that the recorded agreements
between the seller and borrowers would constitute a violation of HUD statutes, regulations, or
handbook requirements. In its opinion, the Office of Legal Counsel specifically stated that 24
CFR 203.41(b)(iv), pertaining to consent by a third party, appears to violate HUD’s regulations.
In this case, the seller is considered a third party.

Additionally, we obtained a HUD management decision on the recommendations of a prior OIG
audit 11 not related to Standard Pacific Mortgage. In the decision, HUD agreed that the execution
of prohibited restrictive covenants is a violation of Federal regulations and FHA requirements
and considered the violation a serious deficiency, stating that loans with prohibited restrictive
covenants are ineligible for FHA insurance.

                                          RESULTS OF REVIEW

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

8
  Annual Report to Congress, Fiscal Year 2012 Financial Status, FHA Mutual Mortgage Insurance Fund
9
  Government Accountability Office testimony, GAO-12-578T, Mortgage Financing, FHA and Ginnie Mae Face
Risk-Management Challenges, issued March 29, 2012
10
   The legal opinion was obtained during the review of a separate lender (2011-LA-1017) for a similar restriction
contained in the FHA purchase agreement.
11
   Audit report 2011-LA-1017




                                                         4
Pacific Homes and the FHA borrower, containing prohibited restrictive covenants and liens in
connection with FHA-insured properties. This noncompliance occurred because Standard
Pacific Mortgage did not exercise due diligence and was unaware that the restrictive covenants
recorded between Standard Pacific Homes and the borrowers violated HUD-FHA requirements.
As a result, we found 90 FHA-insured loans (28 claim loans and 62 active loans) with a
corresponding prohibited restrictive covenant and lien recorded with the applicable county
recording office, and Standard Pacific Mortgage placed the FHA fund at unnecessary risk for
potential losses.

Claim Loan Review Results

We identified and reviewed all 84 claim loans underwritten by Standard Pacific Mortgage, 12
limited to loans closed between January 1, 2008, and December 31, 2011. In our review of the
applicable county recorders’ documents, we identified unallowable restrictive covenants
corresponding to 28 of the 84 claim loans with properties in Arizona and Florida. Of the 28
loans, 15 resulted in actual losses 13 to HUD totaling $1.53 million (see appendix C, table 1), and
13 resulted in claims paid totaling $1.39 million, but the properties had not been sold by HUD
(see appendix C, table 2).

Active Loan Sample Results

Additionally, we completed a random attribute statistical sample and selected 69 of 2,691 active
loans within our audit period. In our review of the applicable county recorders’ documents of
the sampled active FHA loans, we identified an unallowable restrictive covenant corresponding
to 5 of the 69 sampled active loans with properties in Arizona and Florida. The five loans were
active with an unpaid principal balance of $878,000 (see appendix C, table 3).

Based on a highly stratified sample, designed to minimize error and accommodate varying rates
of price escalation and varying demand based on population density, 7.33 percent of the 69
weighted loan samples contained restrictive covenants, which are not allowed by HUD
rules. Therefore, we can be 95 percent confident that at least 62 of the 2,691 active loans in our
audit period had similar problems with unallowable restrictive covenants (see Scope and
Methodology).

Restriction on Conveyance

For each FHA loan, the lender certifies on the Direct Endorsement Approval for HUD/FHA-
Insured Mortgage, form HUD-92900-A, that the mortgage was eligible for HUD mortgage
insurance under the direct endorsement program (see lender certification excerpts below).




12
  Based on HUD’s Single Family Data Warehouse as of May 31, 2012
13
  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)].




                                                          5
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.”

Additionally, 24 CFR 203.32 states 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.” 14

Finally and of most significance, HUD Handbooks 4000.2, paragraph 5-1(B), and 4155.2,
paragraph 6.A.1.h, both state 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. The restrictive covenants identified placed a prohibited
restriction on the conveyance by a third party of the FHA properties, conflicting with the lender’s
certification that the loans met HUD-FHA insurance requirements set forth in 24 CFR 203.41
(a)(3).


14
     The CFR includes exceptions; however, the exceptions do not apply in this case.




                                                           6
HUD Handbook 4155.1, paragraph 4.B.2.b, states, “FHA security instruments require a borrower
to establish bona fide occupancy in a home as the borrower’s principal residence within 60 days
of signing the security instrument, with continued occupancy for at least one year.” However;
these security instruments would be between the lender and borrower, not a third party like the
seller. Extra emphasis must be placed on the fact that the conveyance of the property, during the
occupancy period, was at the consent of the seller, which violated HUD-FHA requirements at 24
CFR 203.41(a)(3)(iv). The following are excerpts from two versions of the recorded restrictive
covenants found between the seller, a third party to the FHA loans, and borrowers.




The above examples illustrate the language contained in the restrictive covenants identified;
specifically, that the property cannot be transferred from the buyer to another until the occupancy
period is over “without the prior written consent of [Standard Pacific Homes], which consent
may be given or withheld in [Standard Pacific Home’s] sole and absolute discretion,” which is
contrary to the HUD-FHA free assumability requirements set forth in 24 CFR 203.41(a)(3)(iv).

We also identified lien language, which stipulated monetary damages to the seller in the event of
a breach in the agreement (see excerpt below). A breach of the contract would include a
borrower selling, leasing, or otherwise transferring the property during the occupancy period. In
some instances, the restrictive covenant specifically stated that the buyer granted a lien to the
seller, Standard Pacific Homes, which is contrary to 24 CFR 203.32.




                                                7
The following are excerpts from three versions of the recorded restrictive covenants specifying
liquid damages for conveying the property within the specific restriction period.




Standard Pacific Mortgage officials stated that they were unaware that the restrictive covenants
recorded between Standard Pacific Homes and the borrowers violated HUD-FHA requirements.
In one discussion, Standard Pacific Mortgage officials informed us that they had reviewed the



                                                8
restrictions on occupancy and believed these were consistent with and not in conflict with HUD-
FHA requirements. Therefore, they allowed the use of Standard Pacific Homes’ restrictive
covenants on FHA properties. However, in some instances, the purchase contracts contained in
the lender’s FHA files contained language stating that the covenant did not apply to buyers that
purchased the property using FHA financing (see excerpt below). Based on this information, we
concluded that Standard Pacific Mortgage did not exercise due diligence, demonstrated by its
failure to ensure that language in the recorded property agreements was appropriate and followed
HUD rules and regulations. Standard Pacific Mortgage officials stated that the document was
commonly used with other mortgage financing instruments and was mistakenly executed and
recorded on the FHA loans.




Impact and Risk for Losses

We identified 90 loans (28 claim loans and 62 active loans) within our audit period that had
unallowable restrictive covenants on the FHA-insured properties. The third-party agreements,
which contained the prohibited restrictive covenants preventing free assumability of the property
and liens between the seller and borrowers, violated HUD-FHA requirements set forth in 24 CFR
203.41 (a)(3)(iv) and 203.32, respectively, thereby materially impacting the insurability of the
questioned loans, making the loans ineligible for FHA insurance. Additionally, the borrowers in
the restrictive covenant agreements were restricted in their ability to rent, lease, sell, or otherwise
convey the FHA properties. By allowing the restrictive conveyance agreements on FHA
properties that at minimum appeared to hinder free assumability, Standard Pacific Mortgage may
have forced borrowers with decreasing financial capability to remain in their property longer
than they would have otherwise.

As a result, Standard Pacific Mortgage’s failure to exercise due diligence placed the FHA fund at
unnecessary risk for potential losses by approving ineligible properties for FHA insurance and
restricting borrowers’ ability to rent, lease, sell, or otherwise convey the FHA properties and
stipulating unallowable liens for liquid damages for a breach of the agreement. Of most
significance, insuring properties that are not eligible for mortgage insurance increases the risk to
an FHA fund that is already facing dangerously low levels of funding. For the 90 loans
identified, HUD would not otherwise see a loss on the uninsurable FHA loans, as they would not




                                                  9
have been approved for FHA insurance and would not be the responsibility of the FHA fund.
For the 15 claim loans identified as ineligible for FHA insurance, HUD suffered a loss it should
not have otherwise suffered.

Conclusion

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. We identified 90 loans (28 claim loans and 62 active
loans) within our audit period 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. 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 (28 claim loans and 5 sampled active loans) loans reviewed with
prohibited restrictive covenants, 15 resulted in an actual loss to HUD of more than $1.53 million.
Another 13 of these loans had 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 (see appendix C).

                                   RECOMMENDATIONS

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

1A.    Determine legal sufficiency and if legally sufficient, pursue civil remedies (31 U.S.C.
       (United States Code) Sections 3801-3812, 3729, or both), civil money penalties (24 CFR
       30.35), or other administrative action against Standard Pacific Mortgage, its principals, or
       both for incorrectly certifying to the integrity of the data or that due diligence was
       exercised during the origination of FHA-insured mortgages.

We also recommend that HUD’s Deputy Assistant Secretary for Single Family Housing require
Standard Pacific Mortgage to pursue recommendations 1B through 1E after completion of
recommendation 1A:

1B.    Reimburse the FHA fund for the $1,535,189 in actual losses resulting from the amount of
       claims and associated expenses paid on 15 loans that contained prohibited restrictive
       covenants and liens (see appendix C, table 1).

1C.    Support the eligibility of $1,390,235 in claims paid or execute an indemnification
       agreement requiring any unsupported amounts to be repaid for claims paid on 13 loans
       for which HUD has paid claims but has not sold the properties (see appendix C, table 2).

1D.    Analyze all FHA loans originated, including the five active loans identified in this
       memorandum, or underwritten beginning January 1, 2008, and nullify all active
       restrictive covenants or execute indemnification agreements that prohibit it from




                                               10
        submitting claims on those loans identified. The five active loans with prohibited
        restrictive covenants had a total unpaid mortgage balance of $878,979, which carries a
        potential loss of $544,967 15 that could be put to better use (see appendix C, table 3).

1E.     Follow 24 CFR 203.32 and 203.41 by excluding restrictive language and prohibited liens
        for all new FHA-insured loan originations and ensure that policies and procedures reflect
        FHA requirements.
Appendix A

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


            Recommendation                                  Funds to be put
                           Ineligible 1/     Unsupported 2/
            number                                          to better use 3/
                        1B        $1,535,189
                        1C                       $1,390,235
                        1D                                         $544,967
                     Total        $1,535,189     $1,390,235        $544,967

1/      Ineligible costs are costs charged to a HUD-financed or HUD-insured program or activity
        that the auditor believes are not allowable by law; contract; or Federal, State, or local
        policies or regulations.

2/      Unsupported costs are those costs charged to a HUD-financed or HUD-insured program
        or activity when we cannot determine eligibility at the time of the audit. Unsupported
        costs require a decision by HUD program officials. This decision, in addition to
        obtaining supporting documentation, might involve a legal interpretation or clarification
        of departmental policies and procedures.

3/      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. If HUD
        implements our recommendations to indemnify loans not originated in accordance with
        HUD-FHA requirements, it will reduce FHA’s risk of loss to the fund. See appendix C
        for a breakdown, by FHA loan number, of the funds to be put to better use.



15
  The potential loss was estimated based on HUD’s 62 percent loss severity rate, multiplied by the unpaid mortgage
balance. The 62 percent loss rate was the average loss on FHA-insured foreclosed-upon properties based on HUD’s
Single Family Acquired Asset Management System’s “case management profit and loss by acquisition” as of
September 2012.




                                                       11
Appendix B
        AUDITEE COMMENTS AND OIG’S EVALUATION


Ref to OIG Evaluation   Auditee Comments




Comment 1

Comment 2


Comment 3
Comment 4




                         12
Comment 5


Comment 6

Comment 7


Comment 8




Comment 9




            13
Comment 9




Comment 10




             14
Comment 10




Comment 11




             15
Comment 3

Comment 4


Comment 5
Comment 12




Comment 13




             16
Comment 13




Comment 5
Comment 12




Comment 14




Comment 6




             17
Comment 5

Comment 6
Comment 8
Comment 14



Comment 15
Comment 7
Comment 8
Comment 14



Comment 7
Comment 15




             18
Comment 7
Comment 15




Comment 7
Comment 15


Comment 5



Comment 7
Comment 15




             19
Comment 7
Comment 8



Comment 7
Comment 8
Comment 13
Comment 14




Comment 8




             20
Comment 3
Comment 9
Comment 4

Comment 6

Comment 7
Comment 5

Comment 8

Comment 16




             21
22
23
24
25
26
27
28
29
30
31
                         OIG Evaluation of Auditee Comments


Comment 1   We disagree with Standard Pacific Mortgage’s request under footnote one. The
            two documents cited were used only to support that restrictive covenants have
            been reviewed by multiple parties and all have agreed they are unallowable and
            violate FHA rules and regulations. The legal opinion and management decision
            were obtained and reviewed after we conducted our own analysis and came to our
            own conclusion that HUD requirements were violated by the execution and
            recording of the restrictive covenants. Additionally, the documents were used to
            promote consistency between the recommendations contained within this audit
            memorandum and HUD actions taken against a lender in a similar situation.

Comment 2   We disagree with the assertion that the audit memorandum erroneously lumps
            together multiple Standard Pacific Homes contract documents that contain
            different terms. The scope of our audit included a review of each type of contract
            document. We categorized the contracts as containing unallowable restrictive
            covenants based on the documents violating HUD’s free assumability
            requirements set forth in 24 CFR 203.41(a)(3) and lien provisions under 24 CFR
            203.32. Additionally, we provided, in the body of the audit memorandum,
            excerpts of each set of verbiage violating these requirements. We determined it
            would be repetitive and unnecessary to include a copy of each of the 33
            questioned documents when an excerpt of each version would suffice.

Comment 3   Standard Pacific Mortgage takes exception, claiming the contract documents
            reviewed are not impermissible restrictive covenants. We disagree, as stated in
            the audit memorandum, the documents executed and recorded with the county
            recorders’ offices contained unallowable restrictive covenants – that at a
            minimum appear to – prevent free assumability of the FHA property and contain
            unallowable liens.

Comment 4   We disagree that the OIG did not consider whether Standard Pacific Mortgage
            knew or reasonably could have been expected to know that the documents
            containing the restrictive covenants were being recorded. As evidenced by the
            audit memorandum, included in the Scope and Methodology section of the audit
            memorandum, we reviewed the lender responsibilities as well as its relationship
            with the seller. The following is an excerpt from the audit memorandum.

                   Standard Pacific Mortgage officials stated that they were unaware that the
                   restrictive covenants recorded between Standard Pacific Homes and the
                   borrowers violated HUD-FHA requirements. In one discussion, Standard
                   Pacific Mortgage officials informed us that they had reviewed the
                   restrictions on occupancy and believed these were consistent with and not
                   in conflict with HUD-FHA requirements. Therefore, they allowed the use
                   of Standard Pacific Homes’ restrictive covenants on FHA properties.
                   However, in some instances, the purchase contracts contained in the




                                            32
                   lender’s FHA files contained language stating that the covenant did not
                   apply to buyers that purchased the property using FHA financing... Based
                   on this information, we concluded that Standard Pacific Mortgage did not
                   exercise due diligence, demonstrated by its failure to ensure that language
                   in the recorded property agreements was appropriate and followed HUD
                   rules and regulations.

Comment 5   We disagree with Standard Pacific Mortgage’s statement that indemnification is
            not its responsibility and would still be unwarranted even if HUD determined that
            unallowable restrictive covenants were recorded and it should have known about
            them. The FHA loans identified in this audit memorandum were determined to be
            ineligible for FHA insurance; therefore, any loss or claim tied to the loan presents
            an unnecessary loss to HUD’s FHA insurance fund. As with any underwriting
            review, deficiencies identified, such as overstated income and understated
            liabilities, do not have to be the reason an FHA loan went into default or claim for
            HUD to seek indemnification. Rather, the deficiencies are used as evidence that
            the FHA loan should not have been FHA-insured. In the same regard, the audit
            memorandum identifies a significant material deficiency that deemed the
            identified loans ineligible for FHA insurance; thereby warranting
            recommendations for indemnification of the loans identified.

            Based on our conclusions, it was our duty and obligation to HUD and other
            stakeholders to recommend HUD take necessary, appropriate action. In HUD’s
            prior actions, it also deemed the deficiency significant enough to warrant
            indemnification. We believe the recommendations contained in the audit
            memorandum are appropriate given the materiality of the OIG finding. As stated
            above, the recorded prohibited restrictive covenants impacted the insurability of
            the reviewed loans. Standard Pacific Mortgage had a duty to ensure loans it
            approved for FHA insurance were in accordance with all HUD rules and
            regulations.

            In addition, the FHA Reform Act of 2010 states, if the Secretary determines that a
            mortgage executed by a mortgagee approved by the Secretary under the direct
            endorsement program or insured by a mortgagee pursuant to the delegation of
            authority under section 256 was not originated or underwritten in accordance with
            the requirements established by the Secretary, and the Secretary pays an insurance
            claim with respect to the mortgage within a reasonable period specified by the
            Secretary, the Secretary may require the mortgagee to indemnify the Secretary for
            the loss.

Comment 6   We disagree that the seller’s efforts to ensure that homebuyers were not using
            FHA financing to obtain loans for investment properties was consistent with HUD
            policy. The FHA requirements do emphasize a one year occupancy period.
            However, we would like to emphasize that under 24 CFR 203.41(a)(3), for free
            assumability of the property, that there is a prohibition of a restriction where the
            conveyance of a property be subject to the consent of a third party, in this case the




                                             33
seller. An example of such language is contained within the audit memorandum
and additional excerpts from a recorded agreement are provided below to show
more language contained within some of the agreements.




                              34
                   * Names redacted for privacy reasons.

Comment 7   Standard Pacific Mortgage’s assertion that there is no evidence that any
            homebuyer was harmed is not relevant. The scope of our audit was to identify the
            presence of unallowable restrictive covenants and to determine if those
            restrictions violated HUD rules and regulations. To that end, we concluded that
            there were unallowable restrictive covenants, which are identified in this audit




                                           35
              memorandum, which violated Federal statute and were not eligible for FHA
              insurance. Therefore, any loss or claim tied to the loan presents an unnecessary
              loss to HUD’s FHA insurance fund. See also comment 5.

Comment 8     We acknowledge and appreciate Standard Pacific Mortgage’s steps taken to
              comply with applicable rules and regulations as a result of this review.
              Documentation evidencing corrective actions should be provided to HUD during
              audit resolution. HUD will review the adequacy and implementation of Standard
              Pacific Mortgage’s corrective actions during the audit resolution process to
              determine if they were sufficient.

Comment 9     Standard Pacific Mortgage stated that the unallowable restrictive covenants were
              not intended to be recorded with FHA financing, however, it affirmed that they
              were indeed recorded. Whether intended or not, the unallowable restrictive
              covenants were recorded with FHA financed mortgage loans, violating HUD’s
              rules and regulations as stated in the audit memorandum. As the lender, Standard
              Pacific Mortgage carries the burden to ensure all loans that receive FHA mortgage
              insurance are eligible and meet all HUD rules and regulations.

              For clarification, the audit memorandum finding is based on the executed and
              recorded documents at the applicable county recorders’ offices that are publicly
              available. The Non-FHA/VA Buyer Declaration and Rep & Warranty Version
              documents referred to by Standard Pacific Mortgage are not the same documents
              and do not contain the same language as the restrictive covenant documents
              recorded at the county recorders’ offices.

              Of most significance, the documents referred to by Standard Pacific Mortgage in
              attachment A, Non-FHA/VA Buyer Declaration, of its response contained one
              version of the purchase agreement (Schedule A to Purchase Contract or
              Declaration of Covenant Restricting Resale, Marketing or Rental of Property) that
              included the unallowable restrictive covenants, which were executed and recorded
              with the applicable county recorders’ offices. Standard Pacific Mortgage
              preceded this document in its response with an Addendum to Purchase Contract
              Occupancy/Investment Disclosure, which contained the language excluding
              FHA/VA financed properties. However, the Addendum to Purchase Contract
              Occupancy/Investment Disclosure was not an executed and recorded document
              with the county recorders’ offices. Therefore, there appeared to be no executed
              and recorded agreement with the county recorders’ offices that excludes the FHA
              financed properties from the agreed restrictive covenants.

Comment 10 We acknowledge Standard Pacific Mortgage’s claim that the Schedule A was not
           legally enforceable because it lacks consideration. Any records or information
           related to this claim should be provided to HUD during the audit resolution. To
           clarify, the existence of the publicly executed and recorded documents containing
           the restrictive covenants is in question and not the legality of said documents. See
           also comments 3 and 9.




                                              36
Comment 11 Standard Pacific Mortgage provides information stating that controls were in
           place to prevent the recording of prohibited restrictive covenants on FHA loans.
           However, the recording of such restrictions were still allowed to occur. Based on
           Standard Pacific Mortgage’s response, it appears that a breakdown in
           communication and internal control allowed the recording of prohibited restrictive
           covenants. Whether intentional or not, Standard Pacific Mortgage, as the lender,
           is responsible for ensuring the loan and its title instruments meet all HUD rules
           and regulations. As stated in the audit memorandum, HUD Handbooks 4000.2,
           paragraph 5-1(B), and 4155.2, paragraph 6.A.1.h, both state 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. See also comment 4.

Comment 12 We disagree with Standard Pacific Mortgage’s assertions that we may not
           extrapolate additional violations by referencing these loans. If an unallowable
           restrictive covenant was found on a statistically selected random sample items
           (active loan review) these loans are projectable to the universe of the loans (see
           Scope and Methodology section of the audit memorandum). 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.

              To clarify, the audit memorandum recommendations do not include a request for
              indemnification of any active loans projected to have similar unallowable
              restrictive covenants. Rather, recommendation 1D of the audit memorandum,
              limited the indemnification of active loans to the five sampled and reviewed loans
              where an unallowable restrictive covenant was found, but the recommendation
              also allows the lender to nullify active loans with active restrictive covenants
              instead of executing loan indemnifications.

Comment 13 Standard Pacific Mortgage included in its response Attachment B Rep &
           Warranty Version. We do not take exception to the language in these agreements
           that the borrower occupy or intend to occupy the FHA financed property;
           however, we take issue with the language contained within the agreements that




                                              37
              specify that if the property is conveyed within the occupancy period that a breach
              of contract would occur resulting in damages owed to the seller. As stated in the
              audit memorandum, the prevention of free assumability of the FHA property and
              liens are violations of HUD's requirements. The documents identified in the audit
              memorandum were obtained through public record inquiries are unallowable
              restrictive covenants. See also comment 9.

Comment 14 We acknowledge Standard Pacific Mortgage’s recognition that the two Tampa
           FHA loan numbers 093-6736524 and 093-6695022 had restrictive covenants.
           However, we disagree with Standard Pacific Mortgage that the unallowable
           restrictions do not warrant indemnification. Although the two loans in question
           have an expired restriction and no loan default, respectively, the presence of the
           restrictive covenant should have prevented them from reaching the point of
           receiving FHA mortgage insurance. Recommendation 1D of the audit
           memorandum first seeks to ensure that any active unallowable restrictive
           covenants on the five active loans be terminated. Indemnification on the five
           loans that are active is recommended only where the active unallowable
           restriction is not terminated. See also comment 5.

Comment 15 We disagree with Standard Pacific Mortgage’s statement that the audit
           memorandum implies borrowers were harmed. The audit memorandum states
           that the appearance of unallowable restrictive covenant may have impacted
           borrowers in their decision making or ability to convey their property. See also
           comment 7.

Comment 16 We acknowledge Standard Pacific Mortgage’s efforts to adhere to HUD’s rules
           and regulations and appreciate the consideration given to the audit findings.
           However, the finding and recommendations remain unchanged as the response
           and supporting documentation do not fully address the deficiencies cited. With
           regard to recommendation 1B and 1C, the FHA loans identified were determined
           to be ineligible for FHA mortgage insurance. With regard to recommendations
           1D and 1E, Standard Pacific Mortgage should provide documentation evidencing
           corrective actions taken to HUD during audit resolution. HUD will review the
           adequacy and implementation of Standard Pacific Mortgage’s corrective actions
           to determine adequacy. See also comments 5 and 8.




                                              38
Appendix C
                     SUMMARY OF FHA LOANS REVIEWED

                                       Table 1 - Actual loss to HUD
                                        Claim loan review results

                                 FHA loan               Recommendation 1B –
                                  number                 actual loss to HUD 16
                                023-2623614         $                      98,995
                                023-2694003                                80,954
                                023-2709846                               118,012
                                023-2737614                               108,438
                                023-2739962                               110,065
                                023-2745583                               101,603
                                023-2769226                                90,198
                                023-2809302                               129,163
                                023-2884798                                53,346
                                023-2890770                                98,206
                                023-2931245                               135,021
                                023-2931750                               111,243
                                023-2963543                               109,864
                                023-2991777                                82,323
                                023-3170701                               107,758
                                    Total           $                   1,535,189




16
     The actual loss to HUD was obtained from HUD’s Single Family Data Warehouse in November 2012.




                                                        39
                                   Table 2 - Claims paid, loss unknown
                                        Claim loan review results

                            FHA loan         Recommendation 1C – claims paid
                             number             but no actual loss known 17
                           023-2618236       $                         114,106
                           023-2618252                                 106,310
                           023-2618269                                 153,972
                           023-2624416                                  95,448
                           023-2685546                                 101,314
                           023-2719049                                 103,229
                           023-2736116                                 143,263
                           023-2741806                                 119,762
                           023-2751458                                  84,152
                           023-2768640                                 124,402
                           023-2858180                                  89,638
                           023-2890373                                 108,565
                           093-6736524                                  46,074
                               Total         $                            1,390,235




17
     The claims paid values were obtained from HUD’s Neighborhood Watch system in November 2012.




                                                      40
                                    Table 3 - Potential loss to HUD
                                      Active loan sample results

                FHA loan           Unpaid mortgage            Recommendation 1D –
                 number               balance 18           potential loss on active loans15
               023-2771367         $       246,428         $                       152,785
               093-6695022                 251,938                                 156,201
               093-6888630                 148,667                                   92,174
               093-7049064                 112,221                                   69,577
               093-7345094                 119,725                                   74,230
                   Total            $          878,979     $                         544,967




18
 The unpaid mortgage balance for each loan was obtained from HUD’s Single Family Data Warehouse in
November 2012.




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