oversight

Prudential Huntoon Paige Associates, LTD, Did Not Underwrite and Process a $19.9 Million Loan in Accordance With HUD Requirements

Published by the Department of Housing and Urban Development, Office of Inspector General on 2015-06-30.

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

   Prudential Huntoon Paige Associates,
           LTD, Arlington, VA
         Multifamily Accelerated Processing Program,
              Amaranth at 544 (Lewisville, TX)




Office of Audit, Region 4       Audit Report Number: 2015-AT-1003
Atlanta, GA                                           June 30, 2015
To:            Kelly Haines, Director, Fort Worth Multifamily Hub, 6AHML
               Craig T. Clemmensen, Director, Departmental Enforcement Center, CACB


               //signed//
From:          Nikita N. Irons, Regional Inspector General for Audit, Atlanta Region, 4AGA
Subject:       Prudential Huntoon Paige Associates, LTD, Did Not Underwrite and Process a
               $19.9 Million Loan in Accordance With HUD Requirements


Attached is the U.S. Department of Housing and Urban Development (HUD), Office of Inspector
General’s (OIG) final results of our review of Prudential Huntoon Paige Associates’
underwriting of a 221(d)(4) project, Amaranth at 544.
HUD Handbook 2000.06, REV-4, sets 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 audit.
The Inspector General Act, Title 5 United States Code, section 8M, requires that OIG post its
publicly available reports on the OIG Web site. Accordingly, this report will be posted at
http://www.hudoig.gov.
If you have any questions or comments about this report, please do not hesitate to call me at
404-331-3369.
                   Audit Report Number: 2015-AT-1003
                   Date: June 30, 2015

                   Prudential Huntoon Paige Associates, LTD, Did Not Underwrite and Process
                   a $19.9 Million Loan in Accordance With HUD Requirements




Highlights

What We Audited and Why
We audited Prudential Huntoon Paige Associates, LTD’s underwriting of a $19.9 million
mortgage loan to develop Amaranth at 544, a senior multifamily project located in Lewisville,
TX. We initiated the review based on the early default, assignment, and significant amount of
the project. Our objective was to determine whether Prudential underwrote and processed the
loan for Amaranth according to the U.S. Department of Housing and Urban Development’s
(HUD) requirements.

What We Found
Prudential exposed the Federal Housing Administration (FHA) insurance fund to unnecessary
risk and a loss of more than $10 million because it did not underwrite and process the loan for
Amaranth in accordance with HUD’s guidelines and regulations. Specifically, Prudential did not
ensure that adequate cash reserves were provided at loan closing; the appraisal report was
supported; the market analysis included support to reflect the present economic conditions; and
the project revenue was not overstated. In addition, Prudential failed to obtain support for the
borrower’s financial capacity.

What We Recommend
We recommend that the Director of the Fort Worth Office of Multifamily Housing Programs
refer Prudential to the Mortgagee Review Board to take appropriate action for violations that
caused a more than $10 million loss to HUD’s FHA insurance fund, or other administrative
action as appropriate. Additionally, we recommend that the Departmental Enforcement Center
pursue administrative actions, as appropriate, against the responsible party for the material
underwriting deficiencies cited in the report.
Table of Contents
Background and Objective......................................................................................3

Results of Audit ........................................................................................................5
         Finding: Prudential Did Not Underwrite and Process a $19.9 Million Loan in
         Accordance With HUD Requirements ............................................................................ 5

Scope and Methodology .........................................................................................13

Internal Controls ....................................................................................................15

Appendixes ..............................................................................................................16
         A. Schedule of Questioned Costs .................................................................................. 16

         B. Auditee Comments and OIG’s Evaluation ............................................................. 17




                                                             2
Background and Objective
Prudential Huntoon Paige Associates, LTD, is one of the Nation’s leading originators of Federal
Housing Administration (FHA) multifamily and health care loans with regional offices located
throughout the United States. Prudential is a Multifamily Accelerated Processing (MAP)-
approved lender that underwrote and processed a section 221(d)(4) loan for the construction of
Amaranth at 544 in Lewisville, TX, which consists of 151 units.

Section 221(d)(4) of the National Housing Act authorizes loans to be insured by FHA for the
construction, substantial rehabilitation, and purchase or refinancing of multifamily projects. By
insuring mortgages, the U.S. Department of Housing and Urban Development (HUD)
encourages private lenders (mortgagees) to enter the housing market to provide financing, which
otherwise might not be available to owners. Under HUD’s MAP program, approved lenders
prepare, process, review, and submit loan applications for multifamily mortgage insurance. In
accordance with MAP guidelines, the sponsor works with the MAP-approved lender, which
submits required exhibits for the preapplication stage. After HUD reviews the exhibits, it either
invites the lender to apply for a firm commitment for mortgage insurance or declines the
application. For acceptable exhibits, the lender submits the firm commitment application,
including a full underwriting package, to HUD to determine whether the loan is an acceptable
risk. Considerations include market need, zoning, architectural merits, capabilities of the
borrowers, and so forth. If HUD determines that the project meets program requirements, it
issues a firm commitment to the lender for mortgage insurance.

In accordance with MAP guidelines and Federal regulations, Prudential is responsible for
reviewing all documents submitted to HUD for insurance. The application for Amaranth was
submitted in September 2006, with approval granted in March 2007. This project was initially
endorsed in July 2007 and finally endorsed in February 2010 for more than $19.9 million. The
first principal payment was due in June 2009; however, no principal payments were made on the
mortgage. As a result, the loan went into default and was assigned to HUD in August 2010. A
claim totaling more than $19.9 million was paid in April 2011, and after assignment to HUD, the
loan was included in an August 2011 note sale for $9.7 million, which resulted in a more than
$10 million ($19.9 million - $9.7 million) loss to HUD.

HUD’s Office of Multifamily Housing Programs is responsible for the overall management,
development, direction, and administration of HUD’s multifamily housing programs. The Office
of Multifamily Housing Development provides direction and oversight for FHA mortgage
insurance loan origination, including the implementation of the MAP program.

HUD’s Office of Multifamily Housing Programs required Prudential to obtain a project default
review of Amaranth from a third-party source. Its purpose was to determine what caused the
early default and whether the MAP lender complied with program requirements. Prudential
hired a third-party contractor, which reviewed the loan documents and submitted its report on
January 13, 2014. However, our audit was separate from this review.


                                                3
Our objective was to determine whether Prudential underwrote and processed the loan for
Amaranth according to HUD’s requirements.




                                               4
Results of Audit

Finding: Prudential Did Not Underwrite and Process a $19.9
Million Loan in Accordance With HUD Requirements
Prudential did not underwrite and process the FHA-insured mortgage loan for Amaranth in
accordance with HUD’s guidelines and regulations. We identified several underwriting
deficiencies, including (1) a lack of sufficient operating deficit reserves, (2) an unsupported and
misleading appraisal report (3) unsupported market need and lack of feasibility, (4) overstated
project revenue, and (5) a lack of documentation to support the borrower’s financial capacity.
This condition was caused by Prudential’s failure to conduct due diligence, practice prudent
underwriting, and conduct a sufficient review of related documents and third-party reports,
which HUD relied on. As a result, Prudential exposed the FHA insurance fund to unnecessary
risk and a loss of more than $10 million.

Insufficient Reserves Requirement
Prudential did not require the borrower to provide sufficient operating deficit reserves at closing
to ensure the ability to maintain the mortgage if operating income was insufficient. Specifically,
Prudential’s appraiser did not use current market conditions, as required, to estimate the
absorption rate used in the calculation of the initial operating deficit reserves 1 and, thus,
overstated the absorption rate and allowed the operating reserves to be understated. Specifically,
Prudential’s appraiser recommended an absorption rate of 9 units per month; however, the
immediate market had a current absorption rate of about 4.5 units per month, which was half of
the amount proposed.

In addition, Prudential’s appraiser included 13 properties to support the market absorption rate;
however, 9 of the properties included low-income tax credits, which were not comparable to
Amaranth, while 2 of the properties were located outside the market area in Fort Worth, TX,
more than 45 miles from Amaranth, and in Bedford, TX, more than 25 miles from Amaranth.
The absorption rate is significant in the calculation of the required operating deficit reserves. If a
higher absorption rate is used, it would represent a higher amount of units projected to lease
every month, which would provide higher projected revenues from leases. By overstating the
absorption rate, the monthly revenue would be overstated, thus understating the amount of the
operating deficit required by the borrower at closing. Prudential’s appraiser was responsible for
calculating the operating deficit, including the absorption rate, but understated this amount.
However, as the MAP-approved lender, Prudential was responsible for the third-party
contractors it hired as well as adequately conducting reviews of third-party reports. 2




1
    MAP Guide, Revised 2002, sections 7-14 A.3, 7-10B, and 7-14A
2
    MAP Guide, Revised 2002, sections 11-1, 7-2, 2-10A, and 15-1-A



                                                        5
By using an incorrect absorption rate, the appraiser calculated the operating deficit reserves at
closing as $482,507. We recalcualted the operating deficit reserves using an absorption rate of 5
units per month, which was supported by the comparable property located in Lewisville, TX,
with an absorption rate of 4.5 units per month. This property was included in the absorption
table of Prudential’s appraisal report. The recalculated amount totaled $958,636 (see table 1),
which was $476,129 more than the amount recommended by Prudential’s appraiser. In addition,
we determined that the deficit period should have been calculated over a period of more than 20
months instead of the 11 months as calculated by the appraiser. As stated in the MAP Guide, 3
the number of units to be absorbed divided by the monthly absorption rate will yield the total
number of months of the operating deficit period. Therefore, if fewer units are absorbed or
leased each month, the deficit period will be longer. Since we determined that the absorption
rate was only 5, it would take more than 20 months to achieve a break-even occupancy rate.

                    Table 1: Recalculation of initial operating deficit reserves
                                   Prudential’s         OIG               Difference
                                    appraiser       recalculated
                                      IOD*              IOD
                                        9                5                    4
             Absorption rate
                                    $482,507          $958,636            $476,129
             IOD reserves
           * IOD=initial operating deficit
Further, this loan included additional risks that Prudential should have mitigated by taking a
more conservative approach and requiring additional initial operating deficit reserves to maintain
the loan payments if the project revenue was insufficient. The additional risks involved with this
loan included unforeseen market changes and construction delays inherent in new construction,
longer lease-up periods due to the age restriction associated with senior facilities, and having a
borrower with no prior experience with HUD. Prudential was responsible for conducting due
diligence to ensure that the borrower had the capacity to maintain the project long term,
including sufficient initial operating deficit reserves. For Amaranth, management was unable to
lease the units at the proposed rents and had to provide concessions by reducing the rents to
increase the occupancy rates. In addition, the market conditions had decreased by the time the
units were available for leasing, which also hindered Amaranth’s ability to achieve higher
occupancy rates and project revenue.

Unsupported and Misleading Appraisal Report
Prudential did not ensure that the appraisal report used for underwriting and approving the loan
for Amaranth was supported and adequate. As a MAP-approved lender, Prudential was
responsible for hiring third-party contractors such as an appraiser; therefore, it was also
responsible for ensuring that the appraiser was prudent and the appraisal included supported and




3
    MAP Guide, Revised 2002, section 7.14, item 3



                                                    6
verifiable information. 4 Prudential signed certifications stating that all in-house, third-party
forms, reports, and reviews were reviewed by Prudential in accordance with HUD guidelines. In
addition, Prudential’s appraiser certified that the appraisal conformed with Uniform Standards of
Professional Appraisal Practice. Prudential’s appraiser valued the land for Amaranth at $1.6
million, which was unsupported due to vacant land sales not being comparable and unsupported
adjustments. More specifically, the inappropriate vacant land sales allowed the land value to be
overstated. Further, Prudential’s appraiser misled the reader and provided an inaccurate site
description.

        Unsupported Appraisal
        Prudential’s appraiser valued the land for Amaranth at $1.6 million, or $10,700 per unit,
        which we determined was unsupported. Prudential’s appraiser failed to make appropriate
        adjustments to the land sale comparables, included outliers 5 due to location and value,
        and included a property with incomparable zoning (see table 2). Land sales are used as
        the basis for determining land value of the subject site, however, the appraiser failed to
        provide appropriate comparables and adjustments to support the $1.6 million land value
        for Amaranth, as required 6.

        Table 2 illustrates the following determinations made by OIG:

             •   The appraiser selected an outlier which varied significantly from Amaranth due to
                 its location being inferior to Amaranth’s location (see sale 5),

             •   The appraiser failed to make appropriate adjustments to land sales due to its
                 location and visibility being superior to that of Amaranth (see sales 1 and 6), and

             •   The appraiser included a property that was an outlier due to value and was not
                 zoned for multifamily housing contrary to MAP requirements (see sale 3) (this
                 sale had the highest price per unit).




4
  MAP Guide, Revised 2002, sections 7-1A and 7-2; Uniform Standards of Professional Appraisal Practice, standard
rule 1-2, 2 and 3; and HUD Handbook 4465.1, paragraphs 2-1(a) and 1-8.
5
  An outlier is something that lies outside a reasonable range of numbers (values) and varies significantly from the
other data provided.
6
  MAP Guide, Revised 2002, section 7-4, and HUD Handbook 4465.1, section 2-1



                                                         7
        Table 2: Land sales used by Prudential’s appraiser and OIG’s determination
                                      Adjusted                  OIG determined
     Land                                            Size
                   Location           price per              appropriate comparable
      sale                                         (acres)
                                        unit                        (yes-no)
                                                                                No – superior location 7
     1          Lewisville, TX                    $5,944           11.708       (inappropriate adjustments)
                                                                                Yes – appraiser made
     2          North Richland Hills, TX          $6,229           7.394        adjustments for its superiority
                                                                                No – outlier due to value and
                                                                                not zoned for multifamily
     3          Irving, TX                        $13,318          6.700        housing
     4          Lewisville, TX-Amaranth           NA               7.317        NA – subject site
     5          Denton, TX                        $8,370           25.928       No – outlier due to location
                                                                                No – superior location
     6          Lewisville, TX                    $7,000           8.430        (inappropriate adjustments)

         Based on information available to Prudential’s appraiser at the time, we recalculated the
         land value by excluding inappropriate adjustments and land sales not comparable to the
         subject property and estimated the amount to be $1.3 million, $300,000 less than the
         appraised value. Our adjusted price per unit ranged from a low of $4,800 to a high of
         $8,600 instead of the $10,700 used by Prudential’s appraiser. In recalculating the land
         value, we concluded a value of the vacant site at $8,600 per unit, which was the upper
         end of the range.

         Misleading Site Information
         In addition, Prudential’s appraiser did not accurately describe the subject site (Amaranth)
         as required 8, which affected the calculation of the land value. Specifically, the appraiser
         failed to properly identify and report the relevant characteristics of the subject vacant site
         as of the date of the appraisal and stated that the site had road access and utilities, which
         it did not. The appraiser mislead the user of the report as it related to existing road
         access, infrastructure, and visibility and failed to adjust for these differences in the
         calculation of the land value. All land sales provided had utilities and road access and
         frontage, whereas Amaranth did not. The value of the vacant site was a “Hypothetical
         Condition,” which Prudential’s appraiser did not disclose or discuss as required. 9 This
         was a “Hypothetical Condition” because Prudential’s appraised value related to the future
         development of necessary roads, utilities, and other infrastructure for the site. The
         appraiser’s analysis failed to take into consideration the lack of infrastructure.




7
  Properties are rated as having a superior or excellent location if they have access and visibility and are located in
an area with ample shopping, grocery, and other facilities, such as medical.
8
  MAP Guide, Revised 2002, section 7-4, and Uniform Standards of Professional Appraisal Practice, standard rule
1-2
9
  Uniform Standards of Professional Appraisal Practice, standard rule 1-2(g), (h), and 2-2



                                                            8
Unsupported Market Need and Lack of Feasibility
Prudential did not underwrite the loan conservatively based on present market conditions.
Specifically, it did not ensure that the market analysis included verifiable information and did not
support a market need as proposed, which was required. 10 This noncompliance affected the
project’s feasibility. Specifically, the market study stated that Amaranth was superior to other
properties in the market and, thus, warranted higher rents. However, we reviewed the
comparable property data and identified that other properties offered the same or similar
amenities and in some instances, were located in superior areas as well. Some of the amenities
that were similar to those at Amaranth included but were not limited to washers and dryers in
units, carports, activity rooms, beauty salons, fitness centers, pools with hot tubs, and elevators.
Also, one of the comparable properties (which had the highest rental rates) was located outside
the market area by more than 45 miles and was not comparable to Amaranth. It appeared that
this comparable was included to support a higher average rent calculation. Prudential’s appraiser
also included ratings for the comparable properties to support whether they were superior to
Amaranth or inferior. Most of the properties were listed as superior to Amaranth but included
unsupported adjustments.

In addition, Prudential obtained a default report for Amaranth 11, which identified reasons for the
mortgage default. This report listed several issues with the market study. Specifically, it stated
that a review of supply and demand characteristics determined that Prudential’s appraiser’s
analysis of demand and supply was not reliable and that the appraisal’s growth rate projections
significantly exceeded historic trends and did not appear to have support from third-party
demographers. Inadequately assessing the market conditions for Amaranth negatively affected
the project’s long-term feasibility.

Overstated Project Revenue
Prudential overstated the project revenue that Amaranth could achieve, which affected the
project’s ability to meet its obligations. We reviewed HUD form-92264, HUD Multifamily
Appraisal Report, which was included in the loan application, and determined that the proposed
rents were not consistent with the current market and comparables included in Prudential’s
market study and appraisal. Based on our review of the market study, the average rent
calculation, as required, 12 supported lower rental rates for Amaranth at the time of development.
However, Prudential allowed the higher rents based on unsupported conclusions, thus overstating
project revenue the property could achieve. This overstatement placed the project at a
disadvantage in its ability to pay a higher mortgage amount and increased the risk of default.
Higher rents would support a higher mortgage amount; however, when the rents are overstated in
association with a higher mortgage, a default is very likely to occur. Prudential justified the high
rents by stating that the project was superior to the current market, which was unsupported.




10
   MAP Guide, Revised 2002, section 7-5, and HUD Handbook 4465.1, paragraphs 1-8(f) and 1-1(b)
11
   According to HUD’s requirements, Prudential obtained a mortgage default review conducted by a third party.
12
   MAP Guide, Revised 2002, section 7-6b



                                                        9
Further, the management company had to provide concessions to reduce the rental rates to lease
up Amaranth.

The market study included five comparable properties to support the rent projections for
Amaranth. We excluded comparable 5 from our analysis in the table below because it was not
comparable to Amaranth and was located more than 45 miles outside the market area (see table
3). This comparable had rental rates for a one-bedroom unit that ranged from $1,455 to $1,595,
and the rental rates ranged from $2,200 to $2,300 for a two-bedroom unit. Comparable 4 in
Lewisville, TX, was the most similar to Amaranth, offering similar amenities with lower rental
rates. Prudential’s appraiser acknowledged that comparables 1 and 3 had superior locations by
rating these properties as superior to Amaranth, which would require downward adjustments to
rent calculations. In addition, comparable 1 also had larger units with amenities similar to those
at Amaranth. Therefore, the average rent projections should have been even further reduced.

                              Table 3: Comparable properties’ rental rates
                                 Comparable 1                          Comparable 3
Unit
              Amaranth              (superior         Comparable 2        (superior      Comparable 4
size 13
                                     location)                            location)
           Sq. ft.    Rent      Sq. ft.     Rent      Sq. ft.   Rent   Sq. ft.   Rent    Sq. ft.   Rent
            721      $1,175      833       $1,280      650      $802    650     $1,200    690      $898
1 BR        754      $1,190      950       $1,375                       720     $1,380    690      $990
1 BA        793      $1,225
            738      $1,185
           1,042     $1,630     1,059      $1,790      952      $999    850    $1,520     990      $1,320
2 BR       1,044     $1,630     1,534      $2,110                      1,035   $1,875     990      $1,412
2 BA       1,061     $1,640
           1,090     $1,655


Further, Prudential’s market study included a chart with the developer’s proposed rents, which
were significantly lower than those proposed by Prudential’s appraiser and used for underwriting
(see table 4).




13
     BR stands for bedroom, and BA stands for bath.



                                                         10
                    Table 4: Developer’s and Prudential’s proposed rents
       Unit
                  Sq. ft.    Developer’s proposed rents       Prudential’s proposed rents
       size
                               Rent         Rent per sq.        Rent         Rent per sq.
                                                ft.                              ft.
                   721        $865            $1.20            $1,175          $1.63
       1 BR        754        $905            $1.20            $1,190          $1.58
       1 BA        793        $952            $1.20            $1,225          $1.54
                   738        $886            $1.20            $1,185          $1.61
                  1,042      $1,250           $1.20            $1,630          $1.56
       2 BR       1,044      $1,253           $1.20            $1,630          $1.56
       2 BA       1,061      $1,273           $1.20            $1,640          $1.55
                  1,090      $1,308           $1.20            $1,655          $1.52


Unsupported Financial Capacity
The borrower’s financial statements included $6.9 million in real property, which was included
in Amaranth’s net worth calculation of $7.9 million; however, Prudential did not conduct due
diligence and obtain additional support for the real property. Based on our review of the bank
statements, verification of deposits, and credit reports, there was no support or verification for
the $6.9 million in real property. Although the loan for Amaranth was fully funded, Prudential
should have obtained support and verification for the assets listed on the borrower’s financial
statements due to the additional risks noted above.

Conclusion
Prudential certified that the MAP application for the FHA-insured loan for Amaranth was
prepared and reviewed in accordance with HUD requirements; however, we identified material
underwriting deficiencies. Specifically, Amaranth was put at an unreasonable risk of default
because Prudential did not conduct a sufficient review of related documents and third-party
reports, which HUD relied on for insuring Amaranth’s mortgage loan. In addition, Prudential
did not obtain adequate support for the third-party reports and the borrower’s financial capacity
and did not adequately estimate a feasible amount of revenue that the project could sustain or the
cash reserves required from the borrower.

HUD placed confidence in Prudential’s integrity and competence, but Prudential failed to follow
and implement the MAP Guide and other relevant guidance during its underwriting and
submission to HUD. As a result, HUD approved a loan with significant financial and business
risks. The borrower immediately defaulted on the loan, resulting in a loss to HUD of more than
$10 million.




                                                 11
Recommendations
We recommend that the Director of HUD’s Fort Worth Office of Multifamily Housing Programs

      1A. Refer Prudential to the Mortgagee Review Board to take appropriate action for
          violations that caused $10,159,961 in unnecessary or unreasonable cost to HUD’s
          FHA insurance fund or other administrative action as appropriate.
We recommend that the Director of HUD’s Departmental Enforcement Center
      1B. Pursue administrative actions, as appropriate, against the responsible party for the
          material underwriting deficiencies cited in this report.




                                               12
Scope and Methodology
We conducted the audit from October 2014 through May 2015 at the HUD office in Fort Worth,
TX, Ballard Spahr 14 office in Washington, DC, and Atlanta HUD OIG regional office. The audit
covered the period March 2005 through April 2011 and was adjusted as necessary.

The review was conducted based on information contained in Prudential’s project files with no
reliance being placed on systems used and maintained by Prudential. The records obtained from
Prudential and reviewed for audit evidence were not computer generated or based; therefore, we
did not assess data reliability.

To accomplish our objective, we reviewed

     •   Organizational charts effective from March 11, 2005, to April 30, 2011;

     •   Applicable laws, regulations, and relevant HUD program requirements, including HUD’s
         MAP Guide;

     •   Prudential’s policies and procedures that govern the MAP program related to preparing,
         processing, and submitting the subject application;

     •   A list of current and past employees, including job function, date of hire, and date of
         termination, if applicable, who were directly or indirectly involved with the processing or
         approval of the loan;

     •   Prudential’s and HUD’s project files related to Amaranth, including but not limited to
         correspondence files, emails, third-party reports, processing and underwriting files,
         preapplication submissions, firm applications, servicing files, construction, and default
         activity; and

     •   General contractor, architect, City of Lewisville, Denton County, and engineer files
         related to Amaranth, including but not limited to construction plans, contracts,
         correspondence, land valuation, and draw requests.

We conducted interviews with management agents, the borrower, the architect, general
contractors, Prudential employees, and HUD employees.

We also conducted a site visit of Amaranth in January of 2015.



14
  Ballard Spahr was retained by Prudential and appointed as the point of contact for the audit. However, this did
not impair our audit or scope.



                                                          13
We determined the loss to the FHA fund to be more than $10 million (the amount of the claim
paid, $19,909,961, minus the amount of the note sale – $9,750,000 = $10,159,961).

We conducted the audit in accordance with generally accepted government auditing standards.
Those standards require that we plan and perform the audit to obtain sufficient, appropriate
evidence to provide a reasonable basis for our findings and conclusions based on our audit
objective(s). We believe that the evidence obtained provides a reasonable basis for our findings
and conclusions based on our audit objective.




                                                14
Internal Controls
Internal control is a process adopted by those charged with governance and management,
designed to provide reasonable assurance about the achievement of the organization’s mission,
goals, and objectives with regard to

•   Effectiveness and efficiency of operations,
•   Reliability of financial reporting, and
•   Compliance with applicable laws and regulations.
Internal controls comprise the plans, policies, methods, and procedures used to meet the
organization’s mission, goals, and objectives. Internal controls include the processes and
procedures for planning, organizing, directing, and controlling program operations as well as the
systems for measuring, reporting, and monitoring program performance.

Relevant Internal Controls
We determined that the following internal controls were relevant to our audit objective:

•   Policies, procedures, and other management controls implemented to ensure that Prudential
    underwrote and processed the mortgage loan for Amaranth in accordance with HUD’s MAP
    requirements.

We assessed the relevant controls identified above.
A deficiency in internal control exists when the design or operation of a control does not allow
management or employees, in the normal course of performing their assigned functions, the
reasonable opportunity to prevent, detect, or correct (1) impairments to effectiveness or
efficiency of operations, (2) misstatements in financial or performance information, or (3)
violations of laws and regulations on a timely basis.

We evaluated internal controls related to the audit objective in accordance with generally accepted
government auditing standards. Our evaluation of internal controls was not designed to provide
assurance regarding the effectiveness of the internal control structure as whole. Accordingly, we do
not express an opinion on the effectiveness of Prudential’s internal control.




                                                  15
Appendixes

Appendix A


                            Schedule of Questioned Costs
                        Recommendation     Unreasonable or
                            number          unnecessary 1/
                                1A                $10,159,961


1/   Unreasonable or unnecessary costs are those costs not generally recognized as ordinary,
     prudent, relevant, or necessary within established practices. Unreasonable costs exceed
     the costs that would be incurred by a prudent person in conducting a competitive
     business. We determined the unreasonable cost to be the loss to the FHA fund of $10,
     159,961. We determined the loss to the FHA fund to be more than $10 million (the
     amount of the claim paid, $19,909,961 minus the amount of the note sale – $9,750,000 =
     $10,159,961).




                                             16
Appendix B
             Auditee Comments and OIG’s Evaluation



Evaluation    Auditee Comments
Ref to OIG




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                         OIG Evaluation of Auditee Comments


Comment 1   Prudential’s comments state that OIG has ignored the requirements of the
            MAP Guide and is improperly substituting its own judgment as to how the
            Amaranth loan should have been underwritten. Prudential also stated that OIG
            failed to consider the MAP Guide in relation to its audit objective and believes
            that Prudential should have second-guessed the conclusions in both the appraisal
            and the market study. In addition, Prudential’s comments state that OIG alleged a
            responsibility of Prudential to confirm assets listed on the financial statements
            that were not required. Prudential’s comments included extensive criteria for
            HUD’s responsibilities in the underwriting process.
            However, OIG used the criteria in the MAP Guide to review what the lender did
            versus what the requirements state. Prudential has specific responsibilities, such
            as conducting a sufficient review of all loan documents submitted to HUD for
            review, which OIG determined did not occur. Although HUD approved the loan,
            Prudential was responsible for reviewing the documents to ensure compliance
            with the requirements and that the loan presented an acceptable risk, which it did
            not. Based on the MAP Guide, Revised 2002, paragraph 15-1(A), HUD places
            confidence in the Lender’s integrity and competence, thus relying on the
            documents provided by Prudential. The audit objective was to determine whether
            the loan was underwritten and processed in accordance with HUD guidelines,
            including but not limited to the MAP Guide. The report cites all related
            requirements to support the findings in the footnotes.
            OIG did not state that Prudential should have second-guessed the appraiser but,
            rather, that it was required to conduct a review of the appraisal and market study
            report to ensure compliance as required by the MAP Guide. OIG’s review
            identified that the appraisal and market study submitted to HUD did not comply
            with the requirements and did not include the information required. In addition to
            the criteria already cited in the report, the MAP Guide, Revised 2002, paragraph
            1-4(C)(5), states that for the firm commitment application, the lender performs a
            complete underwriting of the application, including an architectural review, a cost
            review, and a review of the appraisal. Further, Prudential certified that third-party
            reports, including the appraisal and market study, were reviewed to ensure
            compliance with requirements and that they were accurate and complete.
            Prudential should have conducted a review sufficient to certify that the third-party
            reports were in compliance. Paragraph 7-9(B) also lists the responsibilities of the
            lender.
            Regarding the assets on the financial statements, the audit report stated that
            Prudential “should” have obtained support for the assets to be prudent in its
            underwriting practices. Thus, OIG did not conclude that Prudential was required
            to obtain support but, rather, that it was required to practice due diligence and
            prudent underwriting practices (MAP Guide, paragraphs 11-1(C) and 15-3(A)(6)).



                                              42
Comment 2   Prudential’s comments state that HUD certified the accuracy and appropriateness
            of the judgments that OIG cites as evidence that Prudential did not properly
            underwrite the loan. However, Prudential has the responsibility to conduct a
            review before submitting the loan to HUD including certifying that the loan is in
            accordance with HUD guidelines and presents an acceptable risk to the
            Department, which it did not. See comment 1 above.
Comment 3   Prudential’s comments state that an independent reviewer concluded that
            Prudential complied with MAP Guide requirements while underwriting the loan
            for Amaranth. Prudential also stated that the independent reviewer included in its
            report that the unreliability of data in the appraisal and market study was not the
            fault of the third-party appraiser and it appeared that the appraiser may have been
            misinformed. Prudential’s comments state that the independent reviewer included
            the fact that neither the lender nor the appraiser could have predicted the global
            economic recession that occurred after the underwriting of the loan.
            However, OIG reviewed the independent reviewer’s report as part of the audit and
            noted the conclusions in the audit report as they related to the objective and
            findings. The independent reviewer stated that the report generally satisfied the
            requirements but that the supply and demand analysis was not reliable and growth
            rate projections exceeded historic trends and did not appear to have support from
            third-party demographers as stated in the audit report. These statistics were
            ultimately used by Prudential to justify a market need and feasibility for the
            project and later approval; therefore, they should have been reliable and
            supported.

            The independent reviewer further stated that the increased growth rate may have
            been due to the temporary relocation of displaced Hurricane Katrina victims and
            included various questions and discrepancies with Prudential’s appraisal report,
            including but not limited to turnover rates, supply projections, and conflicting
            conclusions. Despite the various discrepancies identified, the independent
            reviewer stated that it “appeared” that the appraiser could have been misinformed,
            which does not exclude the appraiser from providing a supported and accurate
            appraisal as well as practicing due diligence and using reliable information.
            Prudential’s appraiser also certified that the appraisal met HUD and Uniform
            Standards of Professional Appraisal Practice requirements. OIG’s review was
            conducted based on the information provided at the time of underwriting and did
            not suggest that Prudential should have been able to predict the economic
            recession that occurred after the underwriting of the loan. OIG concluded that the
            loan was not feasible at the time of underwriting based on the underwriting and
            not the change in the economy, which occurred after the initial endorsement.

Comment 4   Prudential’s comments state that OIG failed to consider factors,
            other than underwriting, that led to Amaranth’s default, including construction
            delays, borrower (principal) mismanagement and fraud, and the global recession.
            However, the objective of the audit was to determine whether Prudential


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underwrote and processed the loan according to requirements, which the audit
determined it did not. All loans, including new construction, involve risks,
including construction delays, that the lender is required to document in the
underwriting narrative and mitigate as required in MAP Guide, Revised 2002,
paragraph 11-1(B).

In addition, Prudential stated that OIG ignored the alleged borrower fraud and
mismanagement by the principals on behalf of the borrower, which was
mentioned in the third-party default report. However, OIG conducted extensive
audit work to try to substantiate the allegations included in the report, as discussed
below, but was not able to obtain support. Further, these issues occurred after the
underwriting conducted by Prudential, which was the focus of the audit. With
respect to the borrower mismanagement, OIG documented that the borrower had
no prior experience with HUD programs, which was a significant risk and known
at underwriting, and during an interview, the principal of the borrower stated that
the requirements were not made clear by Prudential or HUD until something went
wrong.

Specifically, the allegations of fraud stated that the principals of the borrower
occupied a unit free of rent, without prior approval from HUD or Prudential, and
upgraded the unit. During OIG’s site visit to Amaranth, it was able to verify that
no upgrades had been made to the occupied unit and that the principals brought in
personal appliances to use in the unit. In addition, OIG obtained an email from
Prudential, which stated that Prudential was aware that the principals would live
in the property and did not include rent for this unit. Once HUD informed the
principals that they were unable to reside in the property, they moved back to
their private residence and removed their personal appliances.

Another allegation of fraud and mismanagement was that the principals of the
borrower paid themselves management fees on top of salaries. However, during
the audit, OIG reviewed the monthly accounting reports during the time the
principals managed Amaranth and determined they did not collect a management
fee. OIG also interviewed one of the principals, who stated HUD told them they
could not collect management fees; therefore, they did not do so. The principal
stated that they completed maintenance work and collected salaries for this work.
OIG also obtained a letter from HUD that included several questioned costs and
required repayment from the principals.

The third-party report also alleged that the principals marketed Amaranth as
assisted living, which OIG was able to discuss with the subsequent management
agent. The management agent stated that the principals marketed Amaranth to
emphasize amenities similar to those of an assisted living facility, such as
including meal service, which were also provided at several comparable
properties for an additional fee. However, the management agent, as well as
monthly reports, confirmed that Amaranth had extremely low occupancy rates



                                  44
            and troubles leasing up. Prudential did not provide support to show that residents
            requiring medical assistance were moved in and the amount of alleged lost
            revenues. However, Amaranth was already suffering from lost revenues due to
            the inadequate occupancy.

Comment 5   Prudential’s comments state that during the exit conference, OIG stated that it
            had visited Amaranth and that no commercial-grade kitchen existed in the
            common area. However, during the exit conference, OIG confirmed that no
            upgrades to the “units” occurred. During the audit, OIG conducted a site visit and
            observed that Amaranth’s clubhouse included a small kitchen (about 600 square
            feet) to service the residents. However, no support was provided to show that
            HUD funding was used for the construction of the kitchen or to support fraud,
            which Prudential alleges.

Comment 6   Prudential’s comments state that the proposed OIG finding that Prudential did not
            underwrite and process a $19.9 million loan in accordance with HUD
            requirements is wrong. Prudential also stated that the first four of the five
            contentions that OIG uses to support its incorrect conclusion are based directly on
            the appraisal and market study that HUD reviewed and approved, which is HUD’s
            responsibility.

            However, Prudential, being a MAP-approved lender, failed to perform its roles
            and responsibility in the underwriting process before HUD’s approval of
            documents, which include conducting a review of third-party reports, such as the
            market study and appraisal. See comment 1 above. Prudential also provided a
            certification, which was relied on by HUD, that the loan documents, including the
            third-party appraisal and market study, were reviewed by Prudential and complied
            with HUD requirements.

Comment 7   Prudential’s comments state that the operating deficit reserves requirement was
            properly calculated under the MAP Guide, which the audit determined was not.
            Prudential also stated that OIG makes the contention because it disagrees with the
            absorption rate concluded by the third-party appraiser, which according to OIG,
            overstated the absorption rate and, therefore, understated operating reserves.

            However, as documented in the audit report, OIG reviewed the absorption rate
            table included in the market study and appraisal. Most of the properties included
            in the table were low-income tax credit properties, which were not comparable to
            Amaranth, as required by the MAP Guide, and would not support the absorption
            rate estimated by Prudential’s appraiser. Prudential certified that the third-party
            reports, including the market study, were reviewed and in compliance, including
            all required items, such as a “supported” absorption rate; however, OIG
            determined that this certification was not correct. In addition to the certification
            provided by Prudential, the MAP Guide, Revised 2002, paragraph 1-4(C)(5),
            requires Prudential to conduct a review of the underwriting, including reviewing



                                              45
            the appraisal and market study. Prudential’s response continues to emphasize
            HUD’s responsibility and approval; however, Prudential had the responsibility to
            fulfill its obligations under the MAP Guide as well.

            Further, Prudential stated that OIG has not and cannot demonstrate that the
            appraiser’s absorption analysis was wrong at the time the appraiser conducted the
            analysis. However, It is clearly stated in the finding of the report and restated in
            OIG’s evaluation of the auditee comments that OIG used only the information
            provided in the appraisal and market study, which was used during the time of the
            underwriting of Amaranth, to conduct its analysis and support its conclusions.
            Only the data that were available to Prudential and its appraiser at the time of
            underwriting were used to conduct the audit. OIG stated that an absorption rate of
            5 units per month was supported, not 4 as stated in Prudential’s comments, which
            was still higher than the 4.5 supported by the comparable property.
            Unfortunately, Prudential fails to recognize that a market rate complex is not
            comparable to a low-income tax credit complex. In addition, Prudential continues
            to justify using properties more than 45 miles away from Amaranth to support the
            projected absorption rate. Section 7-14 of the MAP Guide clearly states that the
            absorption rate must be supported by comparable properties within the market
            area.

Comment 8   Prudential’s comments state that the appraisal report complied with the MAP
            Guide requirements and that both HUD and the Lender Quality and Monitoring
            Division report concluded that the appraisal complied with MAP Guide
            requirements. However, as documented in the audit report, the appraisal did not
            comply. Prudential also stated that the appraisal was properly supported as
            required by the MAP Guide and that the site information was appropriate.
            However, as documented in the audit report, the appraisal did not comply with the
            requirements and was unsupported with inappropriate site information.

            Although the appraisal is a professional opinion, it must be supported and include
            verifiable information, which Prudential’s appraisal did not. The chart in the
            audit report is supported with factual information in the narrative of the report as
            well as cited requirements in the footnotes of the report. The land value
            concluded by OIG is supported with information that was available to
            Prudential’s appraiser at the time the appraisal was conducted. In addition, the
            hypothetical condition provided by Prudential’s appraiser did not, but should have
            recognized that Amaranth did not have road access and utilities, which would
            have impacted the conclusions included in the appraisal.

Comment 9   Prudential’s comments state that the market study demonstrated a market need
            and feasibility and that OIG invents requirements, which are not in the MAP
            Guide. OIG does not agree. The MAP Guide provides specific criteria for the
            market study in section 7-5. As documented in the audit report, the market study
            did not support a market need as proposed and included incomparable properties.



                                              46
              Although, some of the comparable properties were constructed in prior years,
              adjustments were not made to accommodate their superior location, which was
              also recognized by Prudential’s appraiser. In addition, Prudential’s appraisal
              stated that the primary market area for Amaranth included Carrolton, Farmers
              Branch, and Addison, which included properties comparable to Amaranth.
              Therefore, the property 45 miles south in Fort Worth was not included in the
              primary market area, as required by the MAP Guide, and appeared to be an outlier
              in comparison to the other properties. The MAP Guide, section 7-5, states that
              the market study must adequately describe the characteristics of the market area.
              In addition, HUD Handbook 4465.1, paragraph 1-8(F), states that data are used to
              determine quantitative demand in the community and qualitative demand for the
              project proposed in the neighborhood selected. The objective of this analysis is to
              provide information on market trends and predict the prospective absorption
              capacity of the market.

Comment 10 Prudential’s comments state that the project revenue was calculated as required by
           the MAP Guide and that OIG did not identify any section of the MAP Guide that
           would support its position. However, as documented in the audit report, the
           project revenue was not supported and, thus, was overstated. The criteria is
           referenced in the footnotes of the report, MAP Guide, paragraph 7-6(B), states
           that the indicated rent estimate will be from the central 60 percent of the rental
           range of the indicated rents (average). Just as the most appropriate rent
           comparable must receive more weight, the general health of the rental market
           must be recognized before relying upon one or two optimistic indicators.
           Prudential’s appraiser failed to take an average estimate from the primary market
           area as required and as a result, allowed the rental estimates to be overstated.

Comment 11 Prudential’s comments state that the MAP Guide does not require verification of
           real estate listed in personal financial statements. However, as stated above, the
           audit report stated that Prudential “should” have obtained support for the assets to
           be prudent in its underwriting practices. Thus, OIG is not concluding that
           Prudential was required to obtain support but, rather, that it was required to
           practice due diligence and prudent underwriting practices as defined in the MAP
           Guide, paragraphs 11-1(C) and 15-3(A)(6).




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