Internal Controls: VA Lacked Accountability Over Its Direct Loan and Loan
Sale Activities (Letter Report, 03/24/99, GAO/AIMD-99-24).

Pursuant to a legislative requirement, GAO provided information on: (1)
the level of Department of Veterans Affairs' (VA) accountability and
control over its Housing Credit Assistance (HCA) program direct loan and
loan sale activities: and (2) actions needed to improve VA's internal
control environment and financial and budgetary reporting for these
activities.

GAO noted that: (1) VA did not have appropriate management and
operational controls in place to maintain accountability over its direct
loan and loan sale activities; (2) VA provided little oversight of
contractors that were managing billions of dollars of assets on its
behalf and did not ensure that revenues and expenses were accurate or
that cash receipts were deposited promptly in Treasury accounts; (3)
when VA outsourced the servicing of its direct loan portfolio to a
contractor in fiscal year 1997, it did not adequately plan or manage the
transfer; (4) it concurrently shut down its automated district loan
system and surrendered almost all hard copy loan records to the
contractor without retaining basic information needed to confirm or
reconcile the number and value of loans serviced by the contractor; (5)
as a result, VA was unable to appropriately manage its loan portfolio;
(6) further, the data transferred to the contract servicer, which up to
that point had been maintained by more than 40 VA regional offices, were
incomplete and inconsistent; (7) this immediately created loan servicing
problems; (8) there were delays in allocating payments to borrowers'
accounts and in paying property taxes on behalf of borrowers as well as
property taxes on VA-owned houses; (9) VA lacked assurance that receipts
from loans were properly collected and allocated to borrowers' accounts,
and did not determine the propriety of property tax expenses associated
with VA-owned property and, accordingly, could not be confident that
appropriate amounts were transmitted to the government; (10) in
addition, VA lacked a basis for properly reconciling the financial
activity reported by the contractor to the data recorded in VA's general
ledger; (11) GAO found that VA's failure to timely monitor the
contractors that service the loans, representing roughly $9 billion
since 1992, allowed servicing inefficiencies and improper actions by two
servicers to cause financial losses to VA; (12) GAO found that VA's
financing and accounting for the guarantees associated with the loan
sales in effect masked both the existence of the estimated liability for
defaulted loans as well as the sources of funds being used to finance
those liabilities; and (13) until 1997, VA had not reported or disclosed
the loan sales in its financial statements or budget reports or
requested funding to cover the cost of these guarantees.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  AIMD-99-24
     TITLE:  Internal Controls: VA Lacked Accountability Over Its Direct 
             Loan and Loan Sale Activities
      DATE:  03/24/99
   SUBJECT:  Loan accounting systems
             Accounting standards
             Internal controls
             Government guaranteed loans
             Financial statement audits
             Direct loans
             Accountability
             Contract oversight
             Financial management
             Federal property management
IDENTIFIER:  VA Housing Credit Assistance Program
             VA Loan Servicing Automated Management System
             VA Portfolio Loan System
             
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Cover
================================================================ COVER


Report to the Subcommittee on Benefits, Committee on Veterans'
Affairs, House of Representatives

March 1999

INTERNAL CONTROLS - VA LACKED
ACCOUNTABILITY OVER ITS DIRECT
LOAN AND LOAN SALE ACTIVITIES

GAO/AIMD-99-24

VA Direct Loan and Loan Sale Activities

(919300)


Abbreviations
=============================================================== ABBREV

  CDSI - Computer Data Systems, Incorporated
  CDSI/SMG - Computer Data Systems, Incorporated/Seasons Mortgage
     Group
  COTR - Contracting Officer's Technical Representative
  FMFIA - Federal Managers' Financial Integrity Act
  GAO - General Accounting Office
  OIG - Office of Inspector General
  OMB - Office of Management and Budget
  HCA - Housing Credit Assistance Program
  LGY - Loan guaranty activity
  LSAMS - Loan Servicing Automated Management System
  PLOU - Portfolio Loan Oversight Unit
  PLS - Portfolio Loan System
  PMS - Property Management System
  SFFAS - Statement of Federal Financial Accounting Standards
  SMG - Seasons Mortgage Group
  USC - United States Code
  VA - Department of Veterans Affairs
  VBA - Veterans Benefits Administration

Letter
=============================================================== LETTER


B-280807

March 24, 1999

The Honorable Jack Quinn
Chairman
The Honorable Bob Filner
Ranking Minority Member
Subcommittee on Benefits
Committee on Veterans' Affairs
House of Representatives

As part of our responsibility to audit the consolidated financial
statements of the U.S.  Government for fiscal years 1997 and 1998, we
participated in the Department of Veterans Affairs (VA) Office of
Inspector General (OIG) audit of the VA's Housing Credit Assistance
(HCA) program.  In its report on VA's fiscal year 1997 financial
statements, the VA OIG described several deficiencies that
contributed to the VA receiving a qualified opinion on those
statements.  Among the areas of concern was the level of control and
accountability over HCA's direct loan and loan sale activities. 
Specifically, the OIG

  -- was unable to conclude that the $3 billion loans receivable
     account balance of the direct loan portfolio was fairly stated
     because of inadequate controls and incomplete records and

  -- identified a number of errors in recording loan sale
     transactions, including inaccurate and untimely recording of
     loan sales and improper accounting of loan guarantees. 

VA is working to address the internal control weaknesses identified
in the audit of its fiscal year 1997 financial statements, but many
of the internal control weaknesses that prompted the qualified
opinion have not yet been satisfactorily resolved. 

As you requested, this report describes weaknesses in the level of
VA's accountability and control over HCA's direct loan and loan sale
activities and recommends actions needed to improve VA's internal
control environment and financial and budgetary reporting for these
activities. 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :1

VA did not have appropriate management and operational controls in
place to maintain accountability over its direct loan and loan sale
activities.  VA provided little oversight of contractors that were
managing billions of dollars of assets on its behalf and did not
ensure that revenues and expenses were accurate or that cash receipts
were deposited promptly in Treasury accounts. 

When VA outsourced the servicing of its direct loan portfolio to a
contractor in fiscal year 1997, it did not adequately plan or manage
the transfer.  It concurrently shut down its automated direct loan
system and surrendered almost all hard copy loan records to the
contractor without retaining basic information needed to confirm or
reconcile the number and value of loans serviced by the contractor. 
As a result, VA was unable to appropriately manage its loan
portfolio, including knowing the composition and value of its loan
portfolio, reconciling cash flows, or properly monitoring the
contractor's work. 

Further, the data transferred to the contract servicer, which up to
that point had been maintained by more than 40 VA regional offices,
was incomplete and inconsistent.  This immediately created loan
servicing problems.  There were delays in allocating payments to
borrowers' accounts and in paying property taxes on behalf of
borrowers as well as property taxes on VA-owned houses.  Also, some
borrowers did not receive year-end statements showing interest paid
that would be needed for filing tax returns. 

VA lacked assurance that receipts from loans were properly collected
and allocated to borrowers' accounts, and did not determine the
propriety of property tax expenses associated with VA-owned property
and, accordingly, could not be confident that appropriate amounts
were transmitted to the government.  For example, VA reimbursed the
contractor for property tax expenses without verifying that such
expenses were appropriate and at the correct amount.  In addition, VA
lacked a basis for properly reconciling the financial activity
reported by the contractor to the data recorded in VA's general
ledger. 

VA's relationship with its contractor had cash management
implications.  VA had allowed the contractor to open an interest
bearing account and retain interest earned on government funds held
by the contractor.  VA also authorized the contractor to retain
receipts until payments could be allocated.  In addition, provisions
of the servicing agreement called for the contractor to transfer loan
payment collections to Treasury on a monthly rather than a daily
basis, substantially delaying submission of such collections to the
federal government.  Both the servicing agreement and VA's subsequent
authorizations to the contractor resulted in a violation of federal
law and the Treasury Financial Manual concerning timely deposits of
collections. 

Regarding VA's loan sale activity--in which VA packages some of its
direct loans into a trust and sells shares in the trust to investors
with a guarantee of full payment of principal and interest--we found
that VA's failure to timely monitor the contractors that service the
loans, representing roughly $9 billion since 1992, allowed servicing
inefficiencies and improper actions by two servicers to cause
financial losses to VA.  For example, delayed reporting of loan
liquidations by two servicers resulted in excessive payments to
investors.  Another servicer was charging unauthorized sales
management and referral fees to realtors who listed foreclosed
properties for sale.  VA officials estimated that these two problems
had cost VA more than $6 million. 

We found that VA's financing and accounting for the guarantees
associated with loan sales in effect masked both the existence of the
estimated liability for defaulted loans as well as the sources of
funds being used to finance those liabilities.  Until 1997, VA had
not reported or disclosed the loan sales in its financial statements
or budget reports or requested funding to cover the cost of these
guarantees.  For example, VA funded initial cash reserves maintained
by its trustee with loan sale proceeds and did not record this
transaction in its financial records.  VA also improperly directed
its trustee to use the unreported investment income from some of the
earlier trusts to replenish the reserves to finance the guarantee
costs associated with more recent trusts.  When that income became
insufficient to cover the growing guarantee costs, VA used
appropriated funds for such purposes, but lacked the information to
accurately tie those costs to the fiscal year when the loans were
sold (guarantees issued).  Thus, it could not properly reflect costs
consistent with the underlying principles of credit reform.\1

VA has started efforts to address these deficiencies.  For example,
it has developed an action plan and recently contracted with a
consulting firm to bring its financial and budgetary reporting into
compliance with credit reform. 


--------------------
\1 We use the term "credit reform" to encompass the (1) Federal
Credit Reform Act of 1990, which generally requires that agencies
calculate and record the net present value of loans and loan
guarantees in its credit programs and include the net cost to the
government in the budget, (2) Statement of Federal Financial
Accounting Standards No.  2, Accounting for Direct Loans and Loan
Guarantees, and (3) OMB Circulars A-11 and A-34, which provide
guidance to agencies for budget formulation and execution.  For
additional information on credit reform implementation, see
GAO/AIMD-99-31, Credit Reform:  Key Credit Agencies Had Difficulty
Making Reasonable Loan Program Cost Estimates, January 29, 1999. 


   BACKGROUND
------------------------------------------------------------ Letter :2

VA reported in its fiscal year 1997 Accountability Report that the
HCA program, managed by the Veterans Benefits Administration (VBA)
under the direction of the Under Secretary for Benefits, had over $69
billion in guarantees outstanding on mortgages with a face value of
$198 billion.  The primary objectives of the HCA program are to: 

  -- assist veterans, certain reservists, and active duty personnel
     in obtaining home mortgage loans from private lenders;

  -- assist veterans in avoiding foreclosures; and

  -- deliver loan guarantee benefits as efficiently as possible. 

The loan guaranty activity is the primary activity within the HCA
program.  VA partially guarantees the loans in lieu of veterans
making substantial down payments and meeting other conditions
generally applicable to conventional mortgage transactions.  VA
reports that it guarantees approximately 200,000 loans per year to
veterans, certain reservists, and active duty personnel. 

VA, through the HCA program, has responsibility for two secondary
activities described in detail in this report.  These activities,
intended to mitigate HCA program losses, are (1) a direct loan
activity with a portfolio valued at over a reported $3 billion as of
September 30, 1997, and (2) a loan sale activity where a reported $1
billion of loans from the direct loan portfolio are packaged into
trusts and sold to investors each year.  (See figure 1.) When a
financial institution notifies VA that a veteran's loan is in danger
of foreclosure, VA may provide assistance to the veteran by assuming
the loan and modifying the terms.  The veteran then has a direct loan
payable to VA rather than to the financial institution.  This loan
becomes part of VA's direct loan portfolio.  VA estimated that it
assumes 2,700 to 3,000 such loans per year. 

VA also has the option of allowing foreclosure and paying the claim
resulting from VA's guarantee.  In cases where VA pays the claim,
VA's involvement ends at this point.  However, in approximately 80
percent of such cases, VA purchases the mortgaged property, having
determined that it can recover part of its costs by reselling the
property.  At the end of fiscal year 1997, VA reported more than
16,000 such properties in foreclosure proceedings. 

When these properties are resold, VA uses the proceeds to reduce the
cost of the loan guaranty activity.  A VA property may be sold for
cash or offered with a 30-year, fixed rate mortgage.  These mortgages
are referred to as vendee loans.  VA reported that it sells
approximately 80 percent of its properties with vendee loans and
estimates that it will generate approximately 18,000 of such loans
per year.  Although veterans have preference in the bidding process
for these properties, vendee loan financing is available to all
qualified borrowers.  The assumed loans and vendee loans together
constitute the majority of VA's direct loan portfolio. 

   Figure 1:  Processes Supporting
   VA Guaranteed Loans in the
   Housing Credit Assistance
   Program

   (See figure in printed
   edition.)

Three times a year, VA selects marketable loans from its direct loan
portfolio.  The loans are packaged into a trust, and shares in the
trust are sold to private investors through private sector
underwriters with a guarantee of prompt payment of principal and
interest owed.  VA backs the guarantee with the full faith and credit
of the U.S.  Government.  With each sale, a new trust is created, and
each trust is to have a cash reserve based on the size of the
portfolio sold and the terms of the sales agreement.  VA reported
that since 1992 it has sold approximately $9 billion of loans in this
manner.  Before 1992, VA sold loans under a different financing
structure wherein VA retained a percentage of the ownership in the
trusts.  As a result of these pre-1992 loan sales, VA reports that it
holds an investment valued at $318 million. 

In response to a growing recognition of federal financial management
problems, the Congress enacted a series of laws designed to improve
financial management and the quality and use of cost data in
decision-making.  To address the deficiencies in recognizing the cost
of credit programs, the Federal Credit Reform Act of 1990 (Credit
Reform Act) was enacted as part of the Omnibus Budget Reconciliation
Act of 1990.  The Credit Reform Act was intended to ensure that the
full cost of credit programs would be reflected in the budget so that
the executive agencies and the Congress could consider these costs
when making budget decisions. 


   OBJECTIVES, SCOPE, AND
   METHODOLOGY
------------------------------------------------------------ Letter :3

Our objectives were to assess the level of control and accountability
over VA's HCA direct loan and loan sale activities.  To address our
objectives, we reviewed the VA OIG's audit documentation on the loans
receivable and liability for loan guarantee line items, and
interviewed VA officials from the HCA program, accounting, and budget
offices.  We discussed the processes for managing credit activities
and recording related financial information.  We compared VA's
accounting practices to federal accounting standards and industry
standards.  We interviewed staff at the nation's largest portfolio
manager of residential housing loans to obtain information on
management and monitoring processes. 

We analyzed VA's internal memoranda regarding planning for the
transfer of the direct loan portfolio to an outside servicer, and
interviewed VA staff at headquarters and regional offices as well as
contractor staff.  We assessed VA's monitoring of contractors' work
in the direct loan and loan sale activities and reviewed VA's
monitoring reports.  We also reviewed a 1996 report on internal
controls over loan sales, for which VA contracted with a consulting
firm. 

We briefed VA's management on the deficiencies in the HCA program
uncovered in the audit of the fiscal year 1997 financial statements,
for which the OIG issued a qualified opinion.  We also obtained and
reviewed information from VA about the current status of corrective
actions on the reported issues. 

We conducted our work from September 1997 through January 1999 in
accordance with generally accepted government auditing standards. 

We requested written comments on a draft of this report from the
Secretary or his designee.  The Secretary of Veterans Affairs
provided us with written comments, which are discussed in the "Agency
Comments" section and are reprinted in appendix I. 


   VA LACKED ACCOUNTABILITY AND
   CONTROL OVER ITS DIRECT LOAN
   PORTFOLIO
------------------------------------------------------------ Letter :4

VA did not effectively plan or carry out the transfer of its direct
loan portfolio to an outside contractor for servicing in fiscal year
1997.  Although outsourcing loan servicing is common, VBA officials
did not sufficiently consider the control implications of
transferring such a significant asset to an outside contractor. 

An effective internal control structure is as important, if not more
important, under outsourced loan servicing arrangements than when
loan servicing is performed in house.  While the authority for daily
operations has been shifted to a private sector entity, cognizant
agency officials remain responsible for the efficient, effective, and
economical management of the outsourced activity.  In this case, VA
was responsible for determining the adequacy of the servicer's
internal control environment, as well as establishing and maintaining
its own data or data sources for comparison purposes to allow it to
be confident that the activity is being managed in the best interest
of the federal government.  As of September 1998, about 15 months
after the transfer, VA was unable to fully account for the number,
value and status of direct loans in its inventory, and had been
receiving payments through the servicer for several hundred loans
that could not be matched to either servicer or VA loan account
records.  VA had not yet established adequate controls over cash
collected or disbursed on its behalf by the contractor and was unable
to properly reconcile the cash flows reported by the contractor to
those recorded in VA's general ledger.  In addition, there were
serious delays in depositing receipts to VA's account at Treasury. 

Furthermore, VA had transferred incomplete and inconsistent loan data
to the contractor.  This situation contributed to the contractor's
problems in servicing the loans and resulted in inconveniences to
some borrowers.  For example, there were delays in allocating
payments to some borrowers' accounts and in paying property taxes on
their behalf as well as paying property taxes on VA-owned houses. 


      INADEQUATE PLANNING FOR
      OUTSOURCING
---------------------------------------------------------- Letter :4.1

VA officials stated that in outsourcing the servicing of the direct
loans in June 1997, they saw an opportunity to replace outdated
systems\2 and concurrently to reduce staff.  Rather than managing the
loan portfolio out of more than 40 independent regional offices, the
direct loan portfolio would be serviced by a private-sector
contractor, in cooperation with VA's regional office in Indianapolis. 
The outsourcing was also seen as a way to better meet the cost data
requirements for federal credit programs, since the contractor's
systems offered the ability to code all loans and associated expenses
and revenues by the loan origination year, necessary information for
satisfying the Credit Reform Act.  Because the same data are required
for financial reporting, the outsourcing was also seen as a way of
enabling compliance with federal accounting standards. 

The outsourcing plan called for VA to transfer its direct loan
portfolio to a contractor that would provide computer facilities and
programs for servicing.  The contractor also received records related
to property still owned by VA and awaiting sale.  The winning bidder,
Computer Data Systems, Incorporated.  (CDSI) (hereafter referred to
as the contractor), had a commercial system, called the Loan
Servicing Automated Management System (LSAMS), to process, service
and account for mortgage loans.  CDSI subcontracted with Seasons
Mortgage Group (SMG) (hereafter referred to as the servicer) to
service the loan portfolio, a function consisting of collecting and
allocating mortgage payments from borrowers, pursuing delinquent
accounts, maintaining custody of escrow accounts, paying property
taxes and hazard insurance for borrowers, and transferring revenue to
Treasury for crediting to VA accounts.  In addition, the servicer was
to pay property taxes related to VA-owned property.  (See figure 2.)

   Figure 2:  Contractors Involved
   in VA's Direct Loan and Loan
   Sale Activities

   (See figure in printed
   edition.)

In preparation for the transfer, VA supplied CDSI with a list of the
data fields in VA's Portfolio Loan System (PLS), including those
containing borrower names and addresses, amounts for principal,
escrow and outstanding balance, and status of payments of property
taxes and hazard insurance.  CDSI then mapped\3 those fields onto the
fields in LSAMS in preparation for the initial transfer of loan
records.  VA created a tape of the information in PLS and sent the
tape to CDSI to be loaded onto LSAMS.  VA also created a tape of
information from its Property Management System (PMS) to provide CDSI
with information on VA-owned properties for which it would be paying
property taxes. 


--------------------
\2 Starting in fiscal year 1986, the inadequacy of VA's portfolio
loan system, implemented in 1964, was reported as a material weakness
in VA's Federal Managers' Financial Integrity Act (FMFIA) reports. 

\3 Mapping involves matching the fields (e.g., loan number) from one
database to the fields in another database. 


      VA DID NOT RETAIN RECORDS TO
      ACCOUNT FOR THE NUMBER AND
      STATUS OF LOANS
---------------------------------------------------------- Letter :4.2

As discussed later, even though the loan data originally submitted to
the contractor were not adequate for servicing purposes, VA was able
to reconcile contractor and agency records on the 24,000 loans with
an outstanding balance of $1.2 billion\4 that were initially
transferred.  However, its ability to reconcile and to provide
assurance regarding the accuracy of contractor data in LSAMS
deteriorated almost immediately.  Right after the data transfer, VA
shut PLS down, eliminating its most comprehensive source of automated
information on its direct loan portfolio.  Concurrently, VA
management instructed staff at the regional offices to send all
hard-copy loan files to the servicer, except the originals of
property deeds and deeds of trust that document the loans.  The
intent was to aid in SMG's loan servicing.  According to VA
officials, although the regional offices included an inventory of
loan information with the files they sent, regional staff were not
advised to retain a copy of the inventory, nor did they do so.  Three
months after the transfer, the regional offices we visited had
retained only a few files, aside from the original mortgage and title
documents, regarding the loans originated in their offices. 


--------------------
\4 The $1.2 billion represents only the outstanding balances on loans
transferred to CDSI.  For financial statement reporting, the $3
billion loans receivable account balance includes the outstanding
balance for loans, VA-owned property, and accrued interest. 


      DATA QUALITY PROBLEMS
---------------------------------------------------------- Letter :4.3

There were immediate problems with SMG's ability to service
borrowers' accounts because of inconsistencies in how name and
address information had been recorded by regional offices.  The data
transferred had not been critically reviewed to determine whether it
would meet the contractor's data requirements, nor had the data been
cleaned up prior to transfer to LSAMS.  As a result, what would
typically have been a straightforward procedure for developing a
mailing list to send loan coupons to borrowers led to serious
problems.  Loan coupons were sometimes misaddressed because of name
problems (e.g., "Mr.  Smith John" instead of "Mr.  John Smith") or
address problems (e.g., the mortgaged property addresses instead of
where borrowers actually lived).  In some cases, insufficient
information resulted in SMG not being able to contact borrowers at
all.  All of these factors contributed to delays in payments being
made, increasing VA's financial risk.  Meanwhile, borrowers were not
getting information they needed.  VA officials informed us that they
were not able to send IRS Form 1098, the 1997 Mortgage Interest
Statement tax form, to some borrowers by January 31, 1998. 

A major reason for the extent of the inaccurate and incomplete data
was the presumption that VA regional offices had consistently and
completely entered the data into PLS.  Although the regional offices
had administered the direct loan portfolio for more than 30 years, we
found that VA did not adequately involve them in planning for the
transfer or adequately advise them of procedures to be followed after
the transfer.  Prior to outsourcing, VA's regional offices entered
loan information in PLS according to their own preferences, because
VA had not established standardized procedures.  For example, some
regional offices used PLS for certain loan information while
maintaining other loan-related data elsewhere.  Among the data that
were not consistently entered in PLS were real estate tax data.  This
was because each regional office worked with a limited number of
taxing jurisdictions and some regional offices may have it found more
convenient to maintain the data elsewhere. 

SMG staff soon realized that in many cases they lacked basic
information about amounts and deadlines for taxes due on VA-financed
properties.  Within a few months of the transfer, SMG staff notified
VA that they could not ensure that property taxes would be paid on
time and in full on every property.  Although the contract clearly
stated that late payment penalties were the servicer's
responsibility, VA acknowledged that it had contributed to the delays
and VA agreed to pay all penalties for late taxes.  According to VA
officials, during fiscal year 1998, these penalties amounted to
$26,000 to $27,000 per month.  VA told us that, prior to outsourcing,
it had paid approximately $6,000 per month for penalties for late
taxes.  As of January 1999, VA and SMG were discussing available
options for reducing late-payment penalties. 

Concurrently, in the months immediately following the outsourcing, VA
was experiencing difficulties in accounting for the loans in the
direct loan portfolio.  As regional staff continued to foreclose on
VA-financed properties, take back foreclosed properties, resell
properties with new mortgages, and assume veterans' loans, there were
serious timeliness and accuracy problems in getting the necessary
information to CDSI/SMG.  As a result, LSAMS started presenting an
incomplete picture of the loans in VA's portfolio.  The major
breakdown was the delay in VA providing data to SMG on loans that VA
assumed when borrowers defaulted.  As of September 30, 1998, LSAMS
data showed that the assumed loans represented approximately 53
percent of the value of VA's direct loan portfolio.  VA data showed
that assumed loans often went unrecorded for extended periods because
it frequently took months and even years for VA staff to receive
final documents from financial institutions.  In addition,VA did not
thoroughly review the data for accuracy. 

The process under which VA assumes a guaranteed loan has proven to be
an extended task.  It includes purchasing the loan from the financial
institution that holds it and then typically modifying the loan
terms, such as interest rates or repayment periods.  Prior to the
outsourcing arrangement, VA regional staff serviced assumed loans,
collected the initial payments, and entered these loans in PLS. 

SMG would not accept assumed loans in its system unless and until the
loans were fully established.\5 After the transfer, assumed loans
were not being recorded in any automated system until they were fully
established.  Since regional offices maintained paper files for
assumptions in progress, there was no overall central reporting
mechanism to establish visibility, and therefore accountability, over
these loans. 

VA has developed procedures for loan assumptions that VA officials
believe will shorten the time it takes for it to assume VA defaulted
guaranteed loans.  These procedures include required settlement dates
for all assumed loans within 60 days after VA approves the loan
assumption request.  By refusing to pay supplemental claims after 60
days, VA believed that it would increase the incentive for lenders to
transfer all necessary documentation promptly. 

Over the period of our fieldwork, data on assumed loans was recorded
by VA's regional staff on a multipage form, which was reviewed by the
Portfolio Loan Oversight Unit (PLOU) staff in Indianapolis before
being entered into LSAMS.  We found that PLOU's review was not an
in-depth assessment, since PLOU staff maintained no loan files and
were, therefore, unable to check the accuracy of important items such
as payment amount, outstanding principal, amortization and escrow
amount.  PLOU staff informed us that they checked that all fields on
the sheets were filled in and that the correct fiscal year was
entered for the assumption.  If errors in this basic information were
found on the data sheets, PLOU staff returned the sheets to the
regional offices for correction.  As of September 1998, PLOU staff
told us that they were having an error rate of up to 40 percent for
these data sheets.  This error rate further delayed loans and their
associated cash payments from being recorded in LSAMS records and
VA's general ledger, and understated the loans receivable balance. 
As discussed in a later section of this report dealing with cash
management problems, such errors also resulted in delays in cash
receipts for the federal government. 

In July 1998, VA issued instructions to the regional offices to have
the multipage form reviewed by their respective finance departments,
since they have access to the vital information, before the form is
sent via electronic mail to PLOU.  As of December 1998, a PLOU
official told us that the error rate had dropped substantially but
was still about 5 to 6 percent. 

VA also experienced problems in transmitting to LSAMS reliable data
on properties previously owned by VA which had been recently sold
with VA direct financing, referred to as vendee loans.  Previously,
there had been an electronic link between VA's Property Management
System (PMS)\6 and PLS, so that as VA-owned properties were resold
with VA direct financing, that information would update PLS.  After
the shut-down of PLS, VA created a temporary arrangement whereby a
staff member would download vendee loan information monthly from PMS
and transmit it to LSAMS for entry.  Under this system problems such
as duplicate loan numbers, which delay servicing of the loans, were
not detected until the monthly transfer.  As of October 1998, VA was
developing an automated file transfer system with CDSI, which is
intended to give VA the means to transfer this information to LSAMS
automatically each month. 

All of these problems negatively affected allocation of payments to
the appropriate accounts.  During the period of our review, we found
that SMG was regularly receiving loan payments, which for the most
part referenced a loan number, but SMG could not match the payments
to the accounts of any borrowers in LSAMS or VA's records.  In some
cases, as many as 10 months of unallocated payments were involved. 
In September 1998, VA continued to receive payments for 289 loans
that could not be found in SMG's database.  VA officials told us that
no records of the loans involved could be found within LSAMS or in
paper files at regional offices.  At that time, unallocated payments
totaled over $541,000 for these 289 loans.  Our analysis of these 289
loans showed that VA had received at least two payments for 154 of
these loans.  VA was unable to explain the nature of these loans or
why they had not been recorded.  Lengthy delays in getting loan data
into LSAMS increased the risk that borrowers may not have been making
payments on some loans and that neither the servicer nor VA would be
aware of it. 

VA officials reported that as of December 4, 1998, they had reduced
the unallocated loan payments to approximately $160,000 and were
initiating a new procedure to further reduce this total.  The new
procedures require the servicer to (1) hold, without depositing, loan
payments that could not be allocated to a specific borrower's account
and (2) return the loan payments to the borrower in cases where two
or more payments were unallocated, or part of the loan number was
missing, unless either VA had instituted the paperwork for the loan
in process or the servicer had received e-mail instructions from one
of the regional offices regarding the borrower. 

This new procedure, however, does not address the underlying problem
of VA's incomplete direct loan portfolio and creates additional cash
management problems.  By not depositing these checks, the federal
government may not be receiving cash that it is owed.  Common
practice in the mortgage banking industry is to establish a suspense
account for unresolved items and to deposit the checks in the bank
until the appropriate research is completed and the items are
allocated to the proper accounts.  Creating suspense accounts
heightens the visibility over the extent of the problem and
establishes a control mechanism for resolving open items.  This
technique also would help ensure that loans originating in the
regional offices are recorded in VA's loan database. 


--------------------
\5 A loan is established when VA has a modification agreement with
the veteran and has received all necessary documents pertaining to
the loan. 

\6 PMS tracks program costs on property owned by VA as a result of
foreclosure. 


      INADEQUATE CONTROLS OVER
      ASSETS AND CASH IN THE
      DIRECT LOAN PORTFOLIO
---------------------------------------------------------- Letter :4.4

Many of the problems that followed outsourcing, including the
breakdown in the control environment for loan assets and cash, could
have been avoided or mitigated if VA had developed a loan origination
database.  For example, in the mortgage banking industry such a
database is commonly used to manage portfolios of direct loans and
loans sold with a guarantee that are serviced by other entities.  The
database generally contains all loan information needed to amortize a
loan, including origination date, original and current loan balance,
interest rate, payment date, and term of the loan.  Additional
information includes the borrower's name, property and borrower's
address, borrower's social security number and escrow balance on
every direct loan and loan guarantee.  Using a similar database as a
management control for its direct loan program, VA would be able to
forecast expected cash flows, and reconcile cash receipts,
disbursements, and loan activity with servicer records. 
Discrepancies between VA and servicer's data then could be
investigated and reconciled promptly. 

Furthermore, VA, in the absence of such a database, did not confirm
the validity and accuracy of collections and disbursements reported
by the contractor by alternative means, such as examining SMG's bank
statements, lockbox statements, or tax invoices.  Without some kind
of verification procedure, based on its own or third party
information, VA did not have an independent source of data against
which to test and validate the legitimacy of collection and expense
amounts reported by SMG.  As a result, VA had no way of knowing
whether SMG was collecting all payments that were due or whether VA
was reimbursing SMG for only valid expenses. 


      INSUFFICIENT DOCUMENTATION
      TO PERFORM RECONCILIATIONS
---------------------------------------------------------- Letter :4.5

In VA's reconciliation at the end of September 1998, reflecting
CDSI's entries through June 1998, VA could not reconcile differences
between contractor and VA records.  For example, there was a
difference of almost $4 million for loan principal outstanding. 
Since VA does not have either a complete list of loans, or
information on adjustments made by CDSI or the regional offices, VA
could not determine whether this difference was due to errors,
irregularities or merely timing differences. 


      CASH MANAGEMENT PROBLEMS
---------------------------------------------------------- Letter :4.6

Under the terms of the servicing agreement, SMG established an
interest-bearing bank account in its name for the deposit of all loan
payments made by VA's borrowers.  As payments were received, SMG
attempted to apply payments to the appropriate borrowers' accounts
and allocate payments to principal, interest, and escrow amounts. 
The contract called for SMG to remit by wire to VA on the third
business day of each month the total sum of funds collected,
including all principal and interest due, with respect to payments
received by SMG during the previous month.  In addition, VA allowed
SMG to defer remittance of any receipts that could not be allocated
to loan accounts.  VA also allowed SMG to keep all of the interest
accrued in this account which, essentially, resulted in additional
compensation to SMG.  The Contracting Officer's Technical
Representative (COTR)\7 told us that since the contract did not
specifically require SMG to remit to VA unallocated funds until they
were allocated or to remit interest earned on this account, these
practices were permissible. 

These unallocated funds included funds for which SMG could identify
the loan account, but, for a variety of reasons, SMG did not
allocate.  This pool of unallocated funds remained high throughout
the period of our fieldwork.  For example, in October 1997, 3 months
after SMG began servicing the direct loan portfolio, SMG reported
$3.2 million in unallocated funds.  When we questioned VA officials
about the reasons for this large amount, they attributed it to "the
float." They explained that loan payoffs, which required only a few
days to be allocated, represented the majority of the unallocated
funds, and that because new payoffs were constantly being added, the
balances of unallocated amounts in SMG's account remained relatively
stable. 

While our limited testing did confirm that the majority of these
unallocated funds were loan payoffs and the amount of unallocated
funds remained relatively high but stable, we also found that loan
payoffs did not always clear in a few days.  For example in September
1998, we requested from SMG schedules of unallocated funds on deposit
as of August 31, 1998, and February 28, 1998.  On the February
schedule, SMG reported over $2.5 million in unallocated funds of
which loan payoffs represented $1.6 million, or 64 percent of the
total.  We traced loan payoffs from the February schedule to the
payoffs on the unallocated schedule of August 1998.  We found that
approximately $618,000, or 37 percent of the loan payoff amounts on
the February 1998 schedule were still unallocated 6 months later. 

Allowing the contractor to deposit these federal collections in its
account and the delays in transferring funds to federal accounts
violates federal law.  An important statute governing federal fiscal
management is 31 U.S.C.  3302(b), known as the "miscellaneous
receipts" statute.  Section 3302(b) requires that government
officials and agents of the United States government receiving money
on behalf of the government from any source shall deposit the money
in the general fund of the Treasury as soon as practicable without
deduction for any charge or claim.  As a result of section 3302(b),
officials and agents of the government may retain and use funds they
receive, rather than depositing them in the general fund of the
Treasury, only if authorized by another law. 

Subsequent legislation, the Credit Reform Act requires that cash
flows to the government resulting from direct loan obligations or
loan guarantee commitments made prior to October 1, 1991, go to the
credit of the program's liquidating account at Treasury, which is a
budgetary account.  The act also requires that cash flows to the
government resulting from direct loan obligations or loan guarantee
commitments beginning October 1, 1991, go to the nonbudgetary
financing account at Treasury associated with the related credit
program.  In this regard, VA has not provided us and we have not
identified any statute that authorized VA to contractually or
otherwise permit SMG to retain the interest earned on these
government moneys as a form of compensation, instead of crediting the
interest to the appropriate VA account. 

Section 3302 also addresses the timing of deposits to the Treasury. 
Section 3302(c) requires that a person having custody of public money
deposit the money in the Treasury, or in a depository designated by
the Secretary of the Treasury, not later than the third day after the
custodian receives the money.  Subsection (c) also authorizes the
Secretary of the Treasury to prescribe a greater or lesser period for
deposit.  The Treasury Financial Manual states that depositors should
deposit funds in Federal Reserve Banks unless otherwise authorized,
and that deposits should be made daily.\8 VA did not request Treasury
to designate a depository before it authorized SMG to establish a
bank account and remit funds to VA only once a month.  Had SMG,
instead, deposited the funds it collected in a Federal Reserve Bank
for credit to the liquidating and financing account on a daily basis,
no interest would have accrued to SMG on the deposit of payments made
on VA loans.  To the extent SMG earned interest on the loan payments
it received, VA should have had SMG remit the amount of interest to
VA for credit to the appropriate liquidating and financing accounts. 
Because VA permitted SMG to retain interest on loan payments SMG was
not entitled to receive under law or contract, these amounts should
now be recovered. 

In comparison to VA's contractual arrangement with CDSI/SMG, we
looked at the practices of Fannie Mae, the nation's largest portfolio
manager, which regularly uses private-sector servicers for its direct
loans.  We found that as a means of maximizing its interest income
while controlling cash flow, Fannie Mae requires servicers to remit
cash receipts at a minimum on a daily basis, and more frequently if
collections exceed $2,500. 


--------------------
\7 A COTR is designated as VA's authorized representative for
technical monitoring and other functions of a technical nature not
involving a change to the scope, price, terms, or conditions of the
contract.  The COTR is responsible for certifying as to the
satisfactory delivery of service. 

\8 See I TFM Sections 4010, 4015. 


      NONCASH ADJUSTMENTS WERE
      MADE WITHOUT OVERSIGHT
---------------------------------------------------------- Letter :4.7

Noncash adjustments represent changes made to principal loan balances
without cash payments or disbursements being made.  After
transferring loans to SMG for servicing, the regional offices
continued to submit noncash adjustments to SMG to change the
outstanding loan balances of borrowers' accounts.  In ordinary
business practice of financial institutions, noncash adjustments are
unusual events that require an explanation by the person making the
adjustment and the approval of a supervisor.  Yet VA regional staff
were permitted to forward noncash adjustments regularly, causing
principal balances to go up and down, without proper approvals or
documentation.  For example, during October 1997, SMG recorded
approximately $250,000 in noncash adjustments requested by the
regional offices.  As a result, VA lacked assurance that changes were
legitimate and that funds were not being misdirected.  When we
advised VA management of these activities, it promptly instituted a
formal review process for all changes, which required documentation,
supervisory approval, and PLOU authorization. 


   VA LACKED ACCOUNTABILITY AND
   CONTROL OVER ITS LOAN SALE
   ACTIVITY
------------------------------------------------------------ Letter :5

Three times a year, VA selects marketable loans from its direct loan
portfolio, packages them, and sells them to investors through an
underwriter in order to recoup costs for the HCA program.  These
loans are sold with a guarantee of payment of principal and interest
and are backed by the full faith and credit of the United States. 
Since fiscal year 1992, the funding for this type of guarantee has
been subject to the Credit Reform Act and OMB's guidance but, until
recently, VA had not complied with the requirement to estimate the
future liability related to these loan sales and to include the
estimated cost of the liability in its annual budget request to the
Congress.  VA also had not been disclosing and properly accounting
for these sales and the associated liability created by the
guarantees in its financial statements as required by federal
accounting standards.  Furthermore, VA had not established an
effective control environment for monitoring the servicing on these
loans. 

Since the mid-1980's, VA has engaged the services of an investment
banking firm to sell securities backed by marketable loans in the
direct loan portfolio.\9 Each of the sales has a separate trust
agreement, which calls for a separate cash reserve associated with
each trust based on the size of the portfolio sold and the terms of
the sales agreement.  Initially, VA funded these cash reserves from a
portion of the proceeds VA received from the sale of loans as
stipulated in the sales agreement. 

Each trust has a loan servicer to collect monthly payments from the
borrowers and perform other traditional loan servicing functions,
including handling defaults, foreclosures, and routine payoffs.  VA
has hired the trust department of a major bank\10 to serve as the
trustee/custodian for all of these trusts.  (See figure 2.) The
trustee/custodian manages the trusts, maintains the custody of all
funds (including VA's cash reserves), pays the certificate holders,
reports to taxing authorities, and provides investors relevant data
needed for filing their annual tax returns. 

In practice, the servicer deposits receipts from the servicing
activities in a depository account managed by the trustee/custodian. 
The trustee/custodian subsequently transfers these funds to its
distribution account to pay investors.  When funds in the
distribution account are insufficient to pay investors, the
trustee/custodian transfers funds from VA's cash reserve account into
the distribution account. 

Because the loans are sold with guarantees to maximize the sales
yield, VA has a contingent liability to the certificate holders as
long as these loans remain outstanding.  To the extent that loans
default and aggregate cash flows are inadequate to pay investors and
trust expenses, the guarantee feature comes into play.  Because of
this guarantee, VA has a responsibility and vested interest in
monitoring the servicer and trustee/custodian activities to maximize
the cash flow from loan servicing operations and to minimize
expenses. 


--------------------
\9 Purchasers buy certificates representing a percentage of ownership
in the trust.  The certificates are collateralized collectively by
all of the loans in the portfolio and guaranteed by the U.S. 
government. 

\10 Banker's Trust of California is the trustee/custodian for all of
the trusts. 


      LITTLE OVERSIGHT OVER LOAN
      SERVICERS AND THE
      TRUSTEE/CUSTODIAN
---------------------------------------------------------- Letter :5.1

Although the sales contract requires VA to replenish cash reserves
when needed, in our opinion, an effective control environment
requires on-site monitoring of contractors to ensure that the
transactions reported are reasonable and appropriate.  OMB provides
guidance to credit agencies to evaluate and enforce servicers'
performance.  This guidance states that agencies should undertake
biennial on-site reviews of their contractors where possible, but
recommends annual on-site reviews for all lenders and servicers with
substantial loan volume.\11 The OMB guidance states that agencies are
to manage federal credit programs to ensure that federal assets are
protected and that losses are minimized in relation to the social
benefits provided by credit programs. 

VA did not comply with OMB guidance, and the trustee/custodian and
the four servicers used by VA operated with little oversight.  For
example, although VA had been selling loans in a trust structure
since the late 1980's, it did not begin monitoring its servicers
until 1994.  As of October 1998, it had only reviewed three of its
four servicers, and no servicer had been reviewed more than once. 
Further, VA had never reviewed the trustee/custodian. 

At one servicer, VA found procedural problems it characterized as not
resulting in any significant cost to the government.  However, the
other two servicers had servicing inefficiencies and had engaged in
unauthorized practices.  VA's reports on those servicers estimated
that the two most serious findings cited had cost VA more than $6
million over the period of the trusts they were servicing. 
Specifically,

  -- Servicers were not reporting cash receipts resulting from loan
     liquidations\12 in a timely manner to the trustee/custodian.  As
     a result, the trustee/custodian was not aware that principal and
     interest payments to investors were to be correspondingly
     reduced.  Another salient factor is that servicer fees are
     calculated as a percentage of outstanding loan principal being
     serviced.  Thus, any delays in reporting liquidations would
     result in both excessive payments to investors as well as
     servicer fees unless they were timely detected and appropriate
     adjustments made to both investor payments and servicer fees. 

  -- One servicer was charging certain sales management and referral
     fees to realtors who listed foreclosed properties for sale. 
     Such practices were not authorized under the servicing
     agreement.  In its monitoring report, VA stated that the
     realtors who paid the fee to the servicer had, in effect, agreed
     to sell the property for a lesser net commission than VA
     actually paid.  The servicer received the increment, which,
     according to VA's report, ranged from 1 percent to 1.3 percent,
     thus increasing VA costs and reducing net sale proceeds. 

In response to these monitoring efforts, VA officials told us that
they are negotiating recovery of estimated losses of federal revenues
with the servicers involved.  They also told us that while VA had not
realigned any of the existing servicing responsibilities, it was
channeling all new servicing work to the entity for whom monitoring
efforts had not revealed any significant problems. 


--------------------
\11 OMB Circular A-129 (as revised 1/11/93), Policies for Federal
Credit Programs and Non-Tax Receivables. 

\12 Loan liquidations are the proceeds of the sale of property from a
defaulted mortgage. 


      INADEQUATE MANAGEMENT
      INVOLVEMENT IN RELATIONSHIP
      WITH TRUSTEE/CUSTODIAN
---------------------------------------------------------- Letter :5.2

One trustee handles the custodial arrangements for all 31 of the
trusts originated from loan sales dating back to 1988, with reported
outstanding balances of approximately $7 billion as of September
1998.  Through the conclusion of our fieldwork, VA management had
taken little action to oversee the relationship with the
trustee/custodian, including management of the cash reserves and the
flow and sharing of critical financial and budgetary data associated
with trust operations.  In essence, the loan sale activity functioned
as a stand-alone project, removed from input and oversight by
management, accounting, or budget staff.  Financial data were not
adequately shared with staff who needed to review and record them in
VA's accounting and budget records. 

One individual at VA was in charge of all operational and
administrative phases of the loan sale activity, which included
preparing the loan sale documents, calculating the value of the loan
portfolio to be sold, authorizing payments to the trustee/custodian
for requested amounts when cash reserves fell below contractual
levels, and receiving financial reports the contractors generated. 
In our opinion, such a broad scope of authority without a strong
supervisory presence exposes VA to excessive risk that improprieties
could occur and not be detected, and that important activities could
be neglected.  Our 1983 Standards for Internal Controls in the
Federal Government, issued pursuant to the Federal Financial
Managers' Integrity Act of 1982 to be followed by federal agencies,
outlines key control objectives and explains specific techniques for
achieving those objectives.  Not achieving the goals for two of these
objectives, separation of duties and supervision, contributed to the
observed weaknesses in loan sale activities and reporting. 

This situation was a factor in VA not detecting or reversing a key
decision that authorized the trustee/custodian to report financial
data within the trusts on a consolidated basis.  The contract with
the trustee/custodian required that the reports to VA provide details
for each trust that would satisfy data requirements for both credit
program administration and financial reporting considerations.  A
report on the internal controls in the loan sale activity by a
consultant cited the trustee/custodian's consolidation of financial
reporting for the 12 trusts originated between 1992 and 1996 as a key
factor in VA not having the level of detail required to comply with
credit reform requirements.  Consolidated, rather than trust by
trust, reporting masked the performance of individual trusts and
eliminated critical data for reasonably estimating program costs
under the Credit Reform Act as well as for reliably reporting on
financial statements. 


      VA DID NOT PROPERLY ACCOUNT
      FOR LOAN SALES AND
      SUBSEQUENT FINANCIAL
      ACTIVITY
---------------------------------------------------------- Letter :5.3

In addition, VA did not have processes in place to ensure that
relevant reporting from servicers and the trustee/custodian was
channeled to appropriate VA offices.  Since all reporting from the
trustee/custodian came to one individual, there needed to be a
process for the individual to provide the reported information to
other VA officials who needed the information for accounting,
budgeting, and other purposes.  However, we determined that the
accounting staff did not have copies of any of the loan sales
agreements and that the information they had on the loan sale
activity was incomplete because it had either not been forwarded to
them or they had not requested it. 

This lack of data on loan sales and related transactions was a factor
in accounting and financial reporting errors.  Our review of the
accounting treatment of the loan sale transactions showed that the
entries were not in accordance with adopted federal accounting
standards and related guidance.  Specifically: 

  -- VA incorrectly calculated and classified gains and losses on
     loan sales,

  -- VA was not estimating and recording the liability for the
     guarantee on the loans sold at the time of sale, and

  -- the reserves held by the trustee/custodian were not recorded in
     VA's general ledger. 

This accounting treatment indicated a lack of familiarity with some
elements of proper accounting for credit transactions.  Not recording
the liability and reserves would suggest that VA had no further
responsibility for these loans or a continuing interest in the
appropriate servicing of the loans and maintenance of the cash
reserves, which is not the case. 

After we advised VA that its accounting and budgetary reporting did
not accurately reflect the loan sales or the contingent liability,
VA, in consultation with OMB, estimated a subsidy and recorded an
additional expense as an aggregate adjustment for future losses and
related liability for the loan sales not recorded between 1992 and
1997.  Because the adjustment was made to the financial statement
line item for the direct loan activity and was aggregated with other
adjustments related to direct loans, we were unable to determine what
portion of this $376 million adjustment was related to the loan sale
activity.\13

In September 1998, VA contracted with a private-sector firm to
develop a model for estimating the liability for the loan sales, and
to reconstruct all necessary historical information.  The firm agreed
to research and correct the missing or improperly recorded financial
information and produce auditable records supporting the information
recorded. 


--------------------
\13 The subsidy cost related to these trusts was recorded as part of
the direct loan program.  However, OMB Circular A-11 requires that
the related subsidy cost for loans sold with a guarantee be included
as part of the loan guarantee program.  For fiscal year 1999, VA
plans to include the subsidy cost for the loans sold in the
appropriate program. 


      REPLENISHMENT OF RESERVES
      NOT FINANCED PROPERLY
---------------------------------------------------------- Letter :5.4

Periodically, the trustee/custodian asked VA to replenish the cash
balances for the individual trusts to designated levels.  VA did not
follow the Credit Reform Act and related requirements when
identifying the sources of the funds to satisfy the underlying
federal guarantees.  As noted above, VA had been initially funding
the reserve for each trust from the proceeds of the loan sale
transaction.  It had not accounted for the source of the cash used to
fund the reserves or estimated and recognized the liability
associated with the federal guarantee.  Also, VA was not reporting
subsequent replenishment of the cash reserves or disclosing the
funding source. 

Under the Credit Reform Act, in order to fund the guarantees, VA
should have estimated its future liability for satisfying guarantees
on the loans sold and included it in annual budget requests to the
Congress.  In addition, VA should have notified both OMB and Treasury
to set up program and financing accounts for guarantees made
beginning October 1, 1991.  These accounts are used to record the
appropriation for the net cost to the government for the guarantee,
record the sale transactions, and track the subsequent activity for
the loans sold.  Annually, VA should have reestimated the liability
and included any reestimate in its budget and financial statements. 

Instead, VA had been financing those replenishments off the books. 
Specifically, VA did not record the interest income or the
replenishments of the reserve in its accounting records.  For several
precredit reform loan sales, VA reported that it had retained
investments valued at $318 million as of September 30, 1997.  We
found that VA had been improperly using the income from those
investments to finance replenishment of the reserves for trust
agreements initiated after 1991 (those subject to credit reform
requirements).  VA officials told us that since the income from all
of the trusts flowed to the same trustee/custodian, they had
instructed the trustee/custodian to use the investments to finance
replenishments for the post-1991 trusts.  The Credit Reform Act
clearly stipulates that income arising from pre-1992 credit
activities must be used only to offset expenses arising from those
same activities.  Such income is not to be used to offset expenses
for post-1991 activities, which is what VA routinely did. 

VA exclusively relied on income from the pre-1992 investments to
replenish the reserves of post-1991 trusts until fiscal year 1997,
when income from that source became insufficient.  At that juncture,
VA started using funds from the direct loan financing account to
replenish the trust reserves in fiscal years 1997 and 1998. 

For fiscal year 1997, VA transferred $14 million to the
trustee/custodian to augment cash reserves from the 1997 cohort\14 of
its direct loan financing account\15 because, as described above, it
had not set up the appropriate financing mechanism to finance those
losses.  In 1998, VA transferred another $40 million from the 1998
cohort in its direct loan financing account to replenish the
reserves. 

While VA had started to shift to post-credit-reform financing sources
for the post-1991 trusts replenishments, it did not have the
information that would enable charging the cost of replenishing the
related reserves to the proper fiscal years (cohorts).  Financing all
the losses incurred for any particular year from just one cohort is
contrary to the basic concept outlined in OMB's Circular A-11,
implementation guidance for the Credit Reform Act, which attempts to
accurately account for costs by the fiscal year in which the activity
was originated.  VA officials are currently in discussion with
Treasury officials on establishing the appropriate funding mechanism
for the guarantee on loans sold. 


--------------------
\14 As described in OMB Circular No.  A-34, a cohort applies to
post-1991 direct loans and loan guarantees committed by a program in
the same fiscal year even if disbursements occur in subsequent fiscal
years.  Accounting and other records must be maintained separately
for each cohort within the program's financing account.  Any payment
for losses from the financing account must be applied to the cohort
in which the original loan was disbursed. 

\15 Under the Federal Credit Reform Act of 1990, a financing account
is the nonbudgetary account or accounts associated with each credit
program account, which holds balances, receives the subsidy cost
payment from the credit program account, and includes all other cash
flows to and from the government resulting from post-1991 direct
loans or loan guarantees. 


   CONCLUSIONS
------------------------------------------------------------ Letter :6

The purpose of the loan sale and direct loan activities discussed in
this report is to provide opportunities for mitigating losses on
defaulted VA-guaranteed loans in the HCA program, where reported
guarantees outstanding total $69 billion.  VA has not been successful
in moving to outsourcing arrangements for these activities.  It has
not yet instituted adequate safeguards over either the assets or the
cash flows managed by private contractors.  Until it establishes an
adequate evaluation base and more stringent monitoring activities, it
will provide little assurance to others that the HCA programs are
being run prudently.  Instituting the kinds of controls employed by
major owners of housing loan portfolios is necessary and would help
in forming the basis for good program management and reliable data
for reporting financial and budgetary results. 


   RECOMMENDATIONS
------------------------------------------------------------ Letter :7

In order to effectively manage loan assets and the cash flows
associated with VA's direct loans, we recommend that the Secretary of
Veterans Affairs direct the Under Secretary for Benefits to: 

  -- Provide a basis for monitoring and controlling loan and property
     assets and any related cash flows managed by contractors by
     establishing a database for direct loans, through the
     development of a complete inventory of all loans originated. 
     The database should be similar to the information systems in
     place at major owners of housing loan portfolios.  Benchmarking
     with major owners of housing loan portfolios should offer
     perspective in the data requirements and capabilities offered by
     such systems for creating an adequate control environment for
     overseeing both in-house activities as well as outsourced
     functions. 

  -- Implement processes to allow immediate improvements in VA's
     capability to monitor contractor servicing of direct loans and
     disbursements related to VA-owned properties.  These
     improvements would include periodically obtaining tax bills for
     VA-owned properties from independent sources and comparing this
     information to that in its Property Management System to
     validate servicer requests for reimbursement of expenses. 

  -- Develop a centralized database to immediately record loans in
     the process of being assumed by VA in order to establish timely
     and thorough visibility over those assets and to facilitate
     transferring such information to the contract servicer
     expeditiously. 

  -- Reconcile all loan records in the contractor's database to VA's
     general ledger on a monthly basis, by the end of the following
     month. 

  -- Continue to develop standardized policies and procedures
     intended to ensure completeness, consistency, and accuracy of
     data obtained and recorded concerning individual loans and
     properties.  Implement quality assurance steps to ensure the
     accuracy of this data. 

  -- Adhere to federal legislation and guidance regarding cash
     management.  Servicers should be instructed to remit all
     proceeds to VA's Treasury accounts daily upon receipt.  Further,
     VA should recoup the total interest earned on SMG's account
     balances from the inception of VA's contract with CDSI/SMG. 

  -- Establish suspense accounts, and a control account in VA's
     general ledger, to record all collections that cannot be
     allocated to specific loan accounts. 

Regarding gaining operational and accounting control over loan sale
activities, the Secretary of Veterans Affairs should direct the Under
Secretary for Benefits to: 

  -- Complete the reconstruction of the historical data for the loan
     sales, the resulting trusts, and financing for the required
     reserve accounts for each trust. 

  -- Establish adequate separation of duties and supervision over VA
     staff involved in all loan sale operational and administrative
     activities. 

  -- Develop and implement procedures to ensure that relevant data
     from servicers and the trustee/custodian are provided promptly
     to VA offices responsible for managing or recording trust
     activities and transactions. 

  -- Record loan sale transactions and all subsequent activity
     associated with the trusts consistent with federal accounting
     standards and any related guidance.  This would include: 

making appropriate accounting adjustments to accurately reflect the
results of prior years' transactions and

recording all financial transactions relating to trust activities,
including those associated with the original sale, the establishment
of the reserves, drawdowns to satisfy the federal guarantee, subsidy
reestimates, and replenishments to satisfy trust agreement provisions
as well as revenue from trust investments and assets. 

Finally, we recommend that the Secretary of Veterans Affairs direct
the Under Secretary for Benefits to: 

  -- Establish and implement adequate monitoring activities of
     outsourced activities to include both direct loans and VA
     property servicing as well as activities associated with the
     loan sales.  These efforts should be designed to comply with OMB
     Circular A-129 and be stringent, given the risks inherent in the
     existing servicing environment. 

  -- Disclose cash flows related to loan sales and related guarantees
     in VA's budget records, calculate and report the cost of direct
     loans and loan guarantees, and budget for the subsidy and
     administrative cost of the loans and guarantees in accordance
     with the Credit Reform Act and OMB Circular A-11. 


   AGENCY COMMENTS AND OUR
   EVALUATION
------------------------------------------------------------ Letter :8

In commenting on a draft of this report, VA concurred with 11 of our
13 recommendations and agreed to implement them as part of its
current effort to correct direct loan and loan sale records.  Of the
remaining two recommendations, VA disagreed with one, and reserved
agreement pending a legal opinion on the other. 

VA characterized the financial management weaknesses presented in
this report as being relatively minor.  We disagree.  By any measure,
the problems we identified are material financial and management
control weaknesses.  The problems discussed in this report are so
pervasive that they resulted in qualified opinions by VA's Office of
the Inspector General on VA's financial statements for both fiscal
years 1997 and 1998.  The $3 billion in loans and VA-owned property
and $9 billion in potential liability on loan sales represent
guaranteed loans previously serviced by private lenders that went
into default and were acquired by VA.  VA now bears the primary
responsibility for insuring prudent management of these assets, in an
effort to recoup losses and to preclude additional losses on the
properties for which loans were originally guaranteed. 

VA stated that it had initiated a number of corrective actions.  In
our report, we recognize that VA is taking good first steps to
correct these problems, and our recommendations for improvements are
intended to assist the agency in attaining the level of
accountability and control envisioned in the growing body of
financial and program management legislation. 

VA did not concur with our recommendation that it test the validity
of contractor billings for property taxes paid on VA's behalf.  VA
stated that its Portfolio Loan Oversight Unit uses the Property
Management System to verify these payments.  We agree that verifying
VA ownership of property in order to determine whether VA had any
responsibility for taxes on individual properties is a good first
step.  However, the thrust of our recommendation is that VA verify
that amounts paid for property taxes were accurate.  As pointed out
in our report, VA could accomplish this by obtaining tax data through
readily available means.  The verification could be accomplished
efficiently by testing selected transactions that provided a
statistically valid sample.  Verifying the amounts in sample
transactions would provide adequate assurance that the billings from
the contractor were reasonable. 

Finally, VA pledged to modify its processes to adhere to cash
management principles established in federal legislation and other
guidance.  It did not take issue with our view that federal law does
not authorize VA to contractually or otherwise permit the contractor
to retain interest earned by depositing federal collections in the
contractor's account.  Regarding the matter of recouping of interest
earned by the contractor, VA neither concurred nor disagreed with our
recommendation, stating that its General Counsel is reviewing the
issue of recoupment. 

We are sending copies of this report to Senator Arlen Specter,
Senator Ted Stevens, Senator Robert C.  Byrd, Senator Fred Thompson,
Senator Joseph Lieberman, Senator John D.  Rockefeller IV,
Representative C.  W.  Bill Young, Representative Lane Evans, III,
Representative Bob Stump, Representative David Obey, Representative
Dan Burton, and Representative Henry A.  Waxman in their capacities
as Chairmen or Ranking Minority Members of Senate and House
Committees.  We are also sending copies to Togo D.  West, Jr.,
Secretary of Veterans Affairs, the Honorable Jacob J.  Lew, Director
of the Office of Management and Budget, and the Honorable Joseph
Thompson, Under Secretary for Benefits of the Department of Veterans
Affairs.  Copies will be made available to others upon request.  If
you have any questions or wish to discuss the issues in this report,
please contact me at (202) 512-4476.  Major contributors to this
report are listed in appendix II. 

Gloria L.  Jarmon
Director, Health, Education and Human Services,
 Accounting and Financial Management Issues




(See figure in printed edition.)Appendix I
COMMENTS FROM THE DEPARTMENT OF
VETERANS AFFAIRS
============================================================== Letter 



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)


The following are GAO's comments on the Department of Veterans
Affairs' letter dated February 24, 1999. 

GAO COMMENTS

1.  See "Agency Comments and Our Evaluation" section. 

2.  When VA uses the term "refunded" loans, it is describing a
transaction more commonly known as "assumed" loans.  We chose to use
the term most understandable to readers outside of VA. 

3.  Reconciliations are a basic control for financial management and
accountability.  The failure of VA to achieve timely and complete
reconciliations of its direct loan records with the contractor's
indicates a systemic problem with the flow of accounting information. 
The dollar amount involved is less significant than the fact that the
reconciliations cannot be performed successfully.  VA has the
responsibility to its borrowers to ensure that their loan balances
are accurate. 

4.  VA is responsible for ensuring the propriety and legality of
services it contracts for, and the practices to be employed. 


MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix II

ACCOUNTING AND INFORMATION
MANAGEMENT DIVISION, WASHINGTON,
D.C. 

Alana Stanfield, Assistant Director
Elizabeth Kreitzman, Audit Manager
Mel Mench, Senior Assistant Director
Maria Zacharias, Communications Analyst
Christina Quattrociocchi, Senior Auditor
Suzanne Lightman, Auditor

OFFICE OF GENERAL COUNSEL

Jeffrey A.  Jacobson, Assistant General Counsel


GLOSSARY
=========================================================== Appendix 0

Assumed loans - Loans which were originally guaranteed by VA and held
by private lenders.  After the lenders notified VA of intent to
foreclose, VA took over the loans from the lender and became the
creditor to the veterans involved.  VA may modify the terms of the
loan with the veteran during the assumption. 

Cash reserve fund - The fund created during a loan sale and financed
by VA.  VA retains ownership of cash in the fund.  The fund is used
to pay VA's guarantee of principal and interest as well as other
expenses. 

Cohort - As described in OMB Circular No.  A-34, a cohort includes
all loans obligated or loan guarantees committed by the program in
the same fiscal year, even if disbursements occur in subsequent
fiscal years.  Cohort accounting applies to post-1991 direct loans
and loan guarantees.  Accounting and other records must be maintained
separately for each fiscal year within the program's financing
account.  Any payment for losses from the financing account must be
applied to the fiscal year in which the original loan was disbursed. 

Computer Data Systems, Incorporated (CDSI) - The primary contractor
that services VA's direct loan portfolio.  It provides computer
facilities and the servicing programs. 

Credit reform - Refers to the collective requirements as set forth in
(1) the Federal Credit Reform Act of 1990, which generally requires
that agencies calculate and record the net present value for credit
programs and include the cost to the government in the budget, (2)
Statement of Federal Financial Accounting Standard No.  2, Accounting
for Direct Loans and Loan Guarantees, and (3) OMB Circulars A-11 and
A-34. 

Direct loan activity - Actions relating to the creation, recording,
and servicing of VA's direct loan portfolio.  The majority of direct
loans are classified as either assumed or vendee loans.  (See these
terms for further explanation.)

Established loan - An assumed loan for which VA has a modification
agreement with the veteran and has received all necessary documents
pertaining to the loan. 

Financing account - The nonbudget account or accounts associated with
a credit program account, which holds balances, receives the subsidy
cost payment from the credit program account, and includes all other
cash flows to and from the government resulting from post-1991 direct
loans or loan guarantees. 

Housing credit assistance program - A function of VA concerned with
housing credit activities.  Its objectives are to assist veterans,
certain reservists, and active duty personnel in obtaining mortgage
loans; assist in avoiding foreclosures; and deliver the loan
guarantee benefit as efficiently as possible. 

Loan guaranty activity - Actions related to providing a partial
guaranty of loans made by private lenders to veterans and service
members to purchase and retain homes, including claim payments, loan
assumptions, and property acquisition and management. 

Loan sale activity - Actions related to the sale by VA of loans from
its direct loan portfolio.  The loans are packaged into a trust and
sold with a guarantee of repayment of principal and interest. 

Loan Servicing Automated Management System (LSAMS) - Loan servicing
program provided by CDSI that processes and accounts for mortgage
loans for VA's direct loan portfolio. 

Pre-1992 loan sale investments - Investments VA holds from loan sales
prior to 1992 which continue to generate income. 

Outsourcing - The process of contracting for performance of a
function previously performed in-house, such as direct loan
servicing. 

Portfolio Loan Oversight Unit (PLOU) - A VA entity that oversees the
direct loan portfolio servicer's functions and reconciles the general
ledger accounts related to the direct loan portfolio. 

Qualified opinion - A opinion which states that, except for the
effects of the matter(s) to which the qualification relates, the
financial statements present fairly, in all material respects, the
financial position, results of operations, and cash flows of the
entity in conformity with generally accepted accounting principles. 

Seasons Mortgage Group - A subcontractor to CDSI that services VA's
direct loan portfolio. 

Servicer - A private sector entity that performs servicing functions
for VA's loan sale and direct loan activities.  For the direct loans,
the servicer collects and allocates mortgage payments from borrowers,
pursues delinquent borrowers, maintains custody of escrow accounts,
and pays taxes on VA-owned properties.  The servicers for the loan
sale activity are responsible for managing the loan portfolio of sold
loans, accounting for individual loans in the portfolio, collecting
mortgage payments, maintaining escrow accounts, foreclosing on
delinquent borrowers, maintaining and selling foreclosed property,
and reporting financial results of these activities to the
trustee/custodian. 

Subsidy cost - The government's estimated net costs, in present value
terms, of direct or guaranteed loans over the entire period the loans
are outstanding.  For direct or guaranteed loans disbursed during a
fiscal year, a subsidy expense is recognized.  The amount of the
subsidy expense equals the present value of estimated cash outflows
over the life of the loans minus the present value of estimated cash
inflows. 

Trust - A structure in which investors are issued certificates that
represent shares in the cash flows from loans sold by VA.  The trust
is administered by a trustee/custodian. 

Trustee/custodian - A financial institution VA contracts with in
connection with the loan sale activity.  The trustee/custodian
manages the trusts created by the sale and is responsible for
maintaining the custody of all funds (including VA's cash reserves),
paying certificate holders, and filing with taxing authorities.  The
trustee/custodian is also responsible for reporting to VA financial
activity within the trusts and other information as requested by VA. 

Vendee loan - A mortgage loan made by VA for the purchase of VA-owned
property. 


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