    Single-Family Housing: Progress Made, but Opportunities Exist to
    Improve HUD's Oversight of FHA Lenders (12-NOV-04, GAO-05-13).

    Every year, the Department of Housing and Urban Development
    (HUD), through its Federal Housing Administration (FHA), insures
    billions of dollars in home mortgage loans made by private
    lenders. Oversight of lenders has historically been a challenge
    for HUD. In January 2003, GAO reported that, due in part to poor
    lender oversight, HUD's single-family mortgage insurance programs
    remained a high-risk area. This report examines (1) how well HUD
    follows its guidance when granting lenders direct endorsement
    authority (the ability to underwrite loans and determine their
    eligibility for FHA mortgage insurance without HUD's prior
    review), (2) the extent to which HUD uses a risk-based approach
    when monitoring FHA lenders, and (3) the extent to which HUD
    holds accountable lenders that it identifies as not complying
    with its performance requirements.
    -------------------------Indexing Terms-------------------------
    REPORTNUM:   GAO-05-13
        ACCNO:   A13453
      TITLE:     Single-Family Housing: Progress Made, but Opportunities
    Exist to Improve HUD's Oversight of FHA Lenders
         DATE:   11/12/2004
      SUBJECT:   Accountability
    	     Eligibility determinations
    	     Monitoring
    	     Mortgage loans
    	     Mortgage protection insurance
    	     Noncompliance
    	     Performance measures
    	     Quality assurance
    	     Risk management
    	     Policies and procedures
    	     HUD Computerized Homes Underwriting
    	     Management System

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    GAO-05-13

                     United States Government Accountability Office

                         GAO Report to Congressional Addressees

    November 2004

    SINGLE-FAMILY HOUSING

    Progress Made, but Opportunities Exist to Improve HUD's Oversight of FHA Lenders

                                           a

    GAO-05-13

    [IMG]

    November 2004

    SINGLE-FAMILY HOUSING

    Progress Made, but Opportunities Exist to Improve HUD's Oversight of FHA Lenders

      What GAO Found

    HUD has not consistently followed its guidance for granting direct
    endorsement authority. The guidance requires that, to receive the
    authority, lenders must, within a 1-year period, submit for HUD's approval
    at least 15 mortgage loans that HUD assesses "good" or "fair" using its
    assessment criteria, including the last 5 consecutive loans. However, we
    found that HUD deviated from this guidance when granting authority to some
    of the 49 lenders that were approved between October 1, 2002, and April
    30, 2004. For example, HUD granted authority to 7 lenders who did not
    submit the minimum 15 loans rated "good" or "fair."

    HUD has been using a risk-based approach to monitoring lenders, employing,
    among other things, aggregate loan performance data to target lenders for
    review. However, certain factors limit the usefulness of its monitoring
    tools. First, the rating system HUD uses when performing technical
    reviews-desk audits to evaluate the underwriting quality of loans insured
    by FHA-does not currently reflect the different levels of risk that
    detected underwriting errors pose to the insurance fund. HUD is in the
    process of revising the system to improve its usefulness. Second, while
    GAO found that, in fiscal year 2003 and the first half of fiscal year
    2004, HUD generally reviewed those lenders that met its targeting
    criteria, its reports on lender reviews do not distinguish between those
    conducted on-site (at lenders' offices) and off-site ("desk" reviews).
    HUD's guidance allows desk reviews, but on-site reviews are preferred
    because, among other things, they allow for direct observation and the
    ability to easily review more loans. HUD's reports do not identify the
    number of off-site reviews, but a manual search of records showed that 70
    of the 910 lender reviews conducted in fiscal year 2003 were off-site
    reviews.

    HUD's efforts to hold poor performing lenders accountable have not been
    comprehensive. HUD has made limited use of its ability to suspend the
    direct endorsement authority of noncompliant lenders, suspending 7 (of
    about 2,900 lenders with direct endorsement authority) in fiscal year 2003
    and the first half of fiscal year 2004. Further, HUD's Mortgagee Review
    Board can take over a year to take action, during which time noncompliant
    lenders may continue to make FHA-insured loans.

                     United States Government Accountability Office

    Contents

      Letter

    Results in Brief
    Background
    Homeownership Centers Have Not Consistently Followed HUD's

    Guidance for Granting Direct Endorsement Authority HUD's Monitoring Is
    Risk-Based, but Certain Factors Limit the Usefulness of Its Monitoring
    Tools Efforts to Hold Lenders Accountable for Poor Performance Have

    Not Been Comprehensive Conclusions Recommendations for Executive Action
    Agency Comments and Our Evaluation

    1 3 5

    9

    13

    27 35 36 36

    Appendixes

    Appendix I: Objectives, Scope, and Methodology 40

    Appendix II:Comments from the Department of Housing and Urban Development
    43

    Appendix III:GAO Contacts and Staff Acknowledgments 52 GAO Contacts 52
    Staff Acknowledgments 52

    Figures	Figure 1: Figure 2:

    Figure 3:

    Figure 4:

    Figure 5:

    Figure 6:

    Figure 7:

    FHA Mortgage Application Process 6
    Geographical Jurisdictions of HUD's Four
    Homeownership Centers and Lender Branches in Each
    Jurisdiction 8
    Preclosing Review Loan Rating Categories and Scoring
    System 10
    Steps to Be Taken Each Quarter to Target Lenders for
    Lender Reviews 14
    Extent to Which Lenders Reviewed by Homeownership
    Centers Were Targeted Lenders, Fiscal Year 2003 and
    First Two Quarters of Fiscal Year 2004 15
    Extent to Which Lenders Targeted by Homeownership
    Centers Were Reviewed, Fiscal Year 2003 and First Two
    Quarters of Fiscal Year 2004 16
    Percentage of Loans Receiving Technical Reviews, Fiscal
    Year 2003 and First Two Quarters of Fiscal Year 2004 19

    Contents

    Figure 8:	Percentage of Technical Review Contractors' Work Reviewed by
    Homeownership Centers in Fiscal Year 2003 21

    Figure 9:	Technical Review Contractors' Fiscal Year 2003 Performance 22

    Figure 10: Percentage of "Poor" Ratings Assigned during Technical Reviews
    Performed in Fiscal Year 2003 and First Two Quarters of Fiscal Year 2004,
    by Category 23

    Figure 11: Deficiencies Most Commonly Cited during Technical Reviews
    Performed in Fiscal Year 2003 and First Two Quarters of Fiscal Year 2004
    25

    Figure 12: Results of the First 19 Rounds of HUD's Credit Watch Program 28
    Figure 13: Status of the Mortgagee Review Board's Actions on 32 Cases as
    of June 2004 33

    Abbreviations

    CHUMS Computerized Homes Underwriting Management System
    FHA Federal Housing Administration
    HECM Home Equity Conversion Mortgage
    HUD Department of Housing and Urban Development

    This is a work of the U.S. government and is not subject to copyright
    protection in the United States. It may be reproduced and distributed in
    its entirety without further permission from GAO. However, because this
    work may contain copyrighted images or other material, permission from the
    copyright holder may be necessary if you wish to reproduce this material
    separately.

    A

    United States Government Accountability Office Washington, D.C. 20548

    November 12, 2004

    The Honorable Paul S. Sarbanes

    Ranking Minority Member

    Committee on Banking, Housing, and Urban Affairs United States Senate

    The Honorable Michael G. Oxley Chairman The Honorable Barney Frank Ranking
    Minority Member Committee on Financial Services House of Representatives

    Every year, the Department of Housing and Urban Development (HUD), through
    its Federal Housing Administration (FHA), insures billions of dollars in
    home mortgage loans made by private lenders.1 During fiscal year 2003
    alone, FHA insured over 1.3 million mortgages valued at about $160
    billion. While FHA insures lenders against nearly all losses resulting
    from foreclosed loans, it relies on the lenders to underwrite the loans
    and determine their eligibility for FHA mortgage insurance.2 Oversight of
    FHA lenders has historically been a challenge for HUD. In April 2000, we
    reported on weaknesses in HUD's lender approval, monitoring, and
    enforcement efforts.3 We also reported in January 2003 that, due in part
    to poor lender oversight, HUD's single-family mortgage insurance programs
    remained a high-risk area for HUD.4 Furthermore, HUD's Office of Inspector
    General noted in its most recent semiannual report to Congress

    1FHA is a part of HUD, and the Assistant Secretary for Housing is also the
    Federal Housing Commissioner.

    2Underwriting refers to a risk analysis that uses information collected
    during the origination process to decide whether to approve a loan.

    3GAO, Single-Family Housing: Stronger Oversight of FHA Lenders Could
    Reduce HUD's Insurance Risk, GAO/RCED-00-112 (Washington, D.C.: Apr. 28,
    2000).

    4GAO, High-Risk Series: An Update, GAO-03-119 (Washington, D.C.: Jan. 1,
    2003).

    that FHA's single-family mortgage insurance programs continue to be a
    major management challenge for the department.5

    While over 10,000 lending institutions are approved to participate in
    FHA's single-family mortgage insurance programs, only about 2,900 of these
    institutions have direct endorsement authority, meaning that they can
    underwrite loans and determine their eligibility for FHA mortgage
    insurance without HUD's prior review. Lenders with this authority
    underwrite virtually all FHA-insured mortgages for single-family homes.
    This report examines (1) how well HUD follows its guidance when granting
    lenders direct endorsement authority, (2) the extent to which HUD uses a
    risk-based approach when monitoring the lenders participating in FHA's
    mortgage insurance programs, and (3) the extent to which HUD is holding
    lenders that it identifies as not complying with its requirements
    accountable for their performance. We conducted this review on the
    initiative of the Comptroller General.

    To address our objectives, we reviewed the activities of HUD's
    headquarters and its four homeownership centers in Atlanta, Georgia;
    Denver, Colorado; Philadelphia, Pennsylvania; and Santa Ana, California,
    which administer HUD's single-family housing activities in all 50 states,
    the District of Columbia, and Puerto Rico. At each homeownership center,
    we reviewed the documentation maintained on lenders to which HUD had
    recently granted direct endorsement authority. We also obtained and
    analyzed data on the lenders that HUD had targeted for reviews and on the
    loans HUD had selected for technical reviews in fiscal year 2003 and the
    first two quarters of fiscal year 2004. Finally, we reviewed case files
    acted on by the Mortgagee Review Board-an enforcement body chaired by
    HUD's Assistant Secretary for Housing-Federal Housing Commissioner. We
    assessed the reliability of the HUD data we used by discussing the data
    with knowledgeable agency officials, reviewing information about the
    systems, and performing electronic testing to detect obvious errors in
    completeness and reasonableness. We determined that the data were
    sufficiently reliable for the purposes of this report.

    5U.S. Department of Housing and Urban Development, Office of Inspector
    General, Semiannual Report to Congress, October 1, 2003 through March 31,
    2004 (Washington, D.C.).

    We performed our work from December 2003 to September 2004 in accordance
    with generally accepted government auditing standards. Appendix I provides
    additional details on our scope and methodology.

    Results in Brief	HUD's homeownership centers are not consistently
    following the department's guidance for granting direct endorsement
    authority. FHAapproved lenders must demonstrate "acceptable performance"
    in underwriting at least 15 mortgage loans before receiving direct
    endorsement authority. HUD's four homeownership centers perform
    evaluations, known as preclosing reviews, of these loans in order to
    assess lenders' performance. According to HUD's guidance, acceptable
    performance is defined as submitting a minimum of 15 loans that are rated
    "good" or "fair" within a 1-year probationary period, with the last 5
    consecutive cases rated "good" or "fair." We found, however, that the
    homeownership centers have not consistently followed this guidance, based
    on our analysis of the preclosing reviews performed for all 49 lenders
    that entered the probationary period on or after October 1, 2002, and were
    granted direct endorsement authority by April 30, 2004. For example, 7 of
    the 49 lenders were granted direct endorsement authority, although they
    did not submit the minimum 15 loans rated "good" or "fair."

    HUD uses a risk-based approach to monitoring lenders, employing aggregate
    loan performance data, complaints of irregularities or fraudulent
    practices, the results of technical reviews of individual loans, and/or
    other factors to target lenders for review. However, certain factors limit
    the usefulness of its monitoring tools.

    o 	HUD's technical reviews do not distinguish between different levels of
    risk. Technical reviews are desk audits to evaluate the underwriting
    quality of individual loans insured by FHA. In February 2004, HUD
    implemented an algorithm that allows it to select loans for technical
    reviews based on certain risk factors, such as loans made to first-time
    homebuyers and adjustable rate mortgages. However, the ratings that are
    assigned during technical reviews do not currently reflect the different
    levels of risk that underwriting errors pose to the insurance fund.
    According to our analysis of technical reviews conducted in fiscal year
    2003 and the first two quarters of fiscal year 2004, 70 percent of the
    loans rated on mortgage credit analysis received "poor" ratings, meaning
    that the lenders made mistakes in evaluating the borrowers'
    creditworthiness. Under the current rating system, there is no way to
    distinguish a "poor" that represents a deficiency posing a risk to the

    insurance fund from a "poor" that represents a compliance or documentation
    issue (such as an undated or unsigned form). The homeownership centers are
    in the process of revising the rating system to make it more risk-based.
    Despite their numbers-over 130,000 in fiscal year 2003 and the first two
    quarters of fiscal year 2004-technical reviews serve a limited purpose and
    do not help HUD identify loans that have a high probability of default or
    loans susceptible to fraud.

    o 	HUD's reports on lender reviews do not distinguish between on-site and
    desk reviews. One of HUD's primary tools for evaluating the quality of
    lenders' mortgage-lending practices is lender reviews, which are generally
    on-site evaluations of lenders' operations. Since May 2000, the
    homeownership centers have been selecting lenders for lender reviews based
    on their default and claim rates on FHA-insured mortgages. We found that,
    in fiscal year 2003 and the first half of fiscal year 2004, HUD generally
    reviewed those lenders that met its targeting criteria. However, HUD's
    reports on lender reviews do not identify the number of reviews that were
    performed as desk reviews (off-site reviews). Although HUD's guidance
    allows staff to complete desk reviews of lenders' operations, the guidance
    and homeownership center officials acknowledge that on-site reviews at the
    lender's main office or branch are the preferred method of monitoring
    lenders' operations. Because HUD's reports do not routinely track the
    number of desk reviews, HUD officials conducted a manual search of their
    records and determined that 70 of the 910 lender reviews conducted in
    fiscal year 2003 were offsite reviews.

    HUD's efforts to hold poorly performing lenders accountable for their
    performance have not been comprehensive. HUD has recently proposed changes
    to improve the effectiveness of its Credit Watch program-an enforcement
    tool used to terminate the loan origination authority of lenders with
    excessive default and claim rates on FHA-insured loans. Specifically, it
    has proposed holding the lenders that underwrote the loans, in addition to
    the lenders that originated the loans, accountable for excessive defaults
    or insurance claims. Although HUD's guidance allows the homeownership
    centers to suspend the direct endorsement authority of lenders that fail
    to comply with FHA's underwriting requirements, the homeownership centers
    have made limited use of this ability. In fiscal year 2003 and the first
    two quarters of fiscal year 2004, the Philadelphia homeownership center
    suspended the direct endorsement authority of seven lenders; however, the
    other three homeownership centers did not take this action against any
    lenders. Additionally, the Mortgagee Review

    Board's (Board) process for sanctioning lenders is time consuming. The
    Board, which can impose administrative sanctions against lenders, has
    taken over a year to complete its actions, during which time the lender
    can continue to make dozens of loans.

    This report contains recommendations designed to improve HUD's processes
    for approving and monitoring FHA mortgage lenders and sanctioning them for
    unacceptable performance. We provided HUD with a draft of this report for
    review and comment. HUD agreed with our recommendations but disagreed with
    some of our findings and stated that the report does not fully recognize
    the accomplishments resulting from changes it has made to lender
    oversight. We did not change our findings because HUD provided no new
    evidence, and we believe that the report appropriately recognizes the
    progress HUD has made.

    Background	Established by the National Housing Act, FHA insures lenders
    against losses on mortgages for single-family homes.6 Lenders usually
    require mortgage insurance when a homebuyer has a down payment of less
    than 20 percent of the value of the home. FHA mortgage insurance allows a
    homebuyer to make a modest down payment and obtain a mortgage for the
    balance of the purchase price. FHA plays a particularly large role in
    certain market segments, including low-income borrowers and first-time
    homebuyers. During fiscal years 2001 to 2003, the number of single-family
    mortgage loans that FHA insured annually averaged about 1.2 million. For
    the 3 years combined, FHA insured about 3.7 million mortgages with a total
    value of about $425 billion.

    A homebuyer seeking a FHA-insured mortgage must submit a mortgage
    application to a FHA-approved lender. Once the lender approves the loan,
    it sends the loan documents to HUD for approval of FHA mortgage insurance.
    (See fig. 1.) If the borrower defaults and the lender subsequently
    forecloses on the loan, the lender can file an insurance claim with HUD
    for the unpaid balance of the loan. FHA insures most of its mortgages for
    single-family housing under its Mutual Mortgage Insurance Fund (Fund). To
    cover lenders' losses, FHA collects insurance premiums that borrowers pay
    to lenders and deposits the premiums in the Fund. The Fund has
    historically been self-sufficient. An actuarial study by Deloitte & Touche

    6Single-family loans insured by FHA may be used to finance the purchase of
    new or existing one-to-four-family properties. 12 U.S.C. 1709(b).

    meaning that they can accept mortgage applications, obtain employment
    verifications and credit histories on applicants, order appraisals, and
    perform other tasks that precede the loan underwriting process.
    Approximately 2,900 of the FHA-approved lending institutions also have
    direct endorsement authority, meaning that they can underwrite loans and
    determine their eligibility for FHA mortgage insurance without HUD's prior
    review.8 Underwriting refers to a risk analysis that uses information
    collected during the origination process to decide whether to approve a
    loan. Virtually all FHA-insured mortgages for single-family homes are
    underwritten by lenders with direct endorsement authority.

    Some FHA-approved lenders with direct endorsement authority, known as
    sponsoring lenders, enter into agreements to underwrite and fund loans
    originated by other FHA lenders who do not have direct endorsement
    authority, known as loan correspondents. About 71 percent of FHA's
    approved lenders are loan correspondents, meaning that they originate
    FHA-insured mortgages and sell or transfer the loan paperwork to
    sponsoring lenders for underwriting and approval. According to HUD's
    regulations, sponsoring lenders are responsible for the loan origination
    activities of their loan correspondents.

    HUD's 2020 Management Reform Plan, which was announced in 1997,
    consolidated the single-family mortgage housing activities of HUD's 81
    field offices into four homeownership centers, each of which is
    responsible for a multistate area. (See fig. 2.) The homeownership centers
    are located in Atlanta, Georgia; Denver, Colorado; Philadelphia,
    Pennsylvania; and Santa Ana, California; and report directly to the Deputy
    Assistant Secretary for Single Family Housing in HUD's Washington, D.C.,
    headquarters.

    8To be eligible to receive direct endorsement authority and to underwrite
    FHA-insured loans, a lender, in addition to meeting other HUD
    requirements, must be one of the following: (1) a member of the Federal
    Reserve System or an institution whose accounts are insured by the Federal
    Deposit Insurance Corporation or the National Credit Union Administration;
    (2) a financial institution whose principal activity is lending or the
    investing of funds in real estate mortgages; or (3) a federal, state, or
    municipal government agency.

    Figure 2: Geographical Jurisdictions of HUD's Four Homeownership Centers
    and Lender Branches in Each Jurisdiction

    Source: GAO analysis of HUD data.

    The homeownership centers are responsible for processing and approving
    mortgage insurance, as well as implementing several critical aspects of
    HUD's lender approval, monitoring, and enforcement activities. These
    responsibilities include (1) evaluating, through a process known as
    preclosing reviews, loans submitted by FHA-approved lenders seeking direct
    endorsement authority and granting direct endorsement authority to
    qualified lenders; (2) evaluating lenders' operations, through a process
    known as lender reviews, and monitoring lenders' performance through
    reviews of individual loans, known as technical reviews; and (3) taking
    enforcement actions against lenders that have not complied with FHA's
    requirements. HUD's headquarters also has important approval, monitoring,
    and enforcement functions. For example, HUD's headquarters is responsible
    for annually recertifying lenders that wish to participate in FHA's
    mortgage programs. HUD's Credit Watch program, an initiative to identify
    and impose sanctions against lenders with unacceptably high rates of
    defaults and insurance claims on FHA-insured mortgages, is managed by
    HUD's Office of Lender Activities and Program Compliance. HUD's Mortgagee
    Review Board, an enforcement body chaired by HUD's Assistant Secretary for
    Housing-Federal Housing Commissioner, can impose

    administrative sanctions against lenders, including withdrawing the
    lenders' authority to make FHA-insured loans.9

    In April 2000, we reported on HUD's lender approval, monitoring, and
    enforcement efforts. Among other things, we noted that HUD's guidance for
    granting direct endorsement authority was not clear, which led the
    homeownership centers to interpret it differently. We also reported that
    HUD's monitoring did not focus on the lenders and loans that posed the
    greatest insurance risks to the department. In addition, we observed that
    the homeownership centers were making only limited use of their ability to
    suspend lenders' direct endorsement authority and that HUD's Credit Watch
    program pertained only to the lenders that originated troubled loans.

      Homeownership Centers Have Not Consistently Followed HUD's Guidance for
      Granting Direct Endorsement Authority

    HUD's homeownership centers, which are responsible for granting direct
    endorsement authority to lenders participating in FHA's programs, have not
    consistently followed HUD's guidance for granting this authority.
    According to departmental guidance, FHA-approved lenders seeking direct
    endorsement authority must go through a probationary period and are
    required to demonstrate "acceptable performance" in underwriting at least
    15 mortgage loans. During this probationary period, the lenders send to
    the homeownership centers mortgage loans that have not yet been "closed"-
    that is, the borrower has not yet taken on the loan obligation. The
    homeownership centers then evaluate the loans against FHA's underwriting
    requirements.10 During these evaluations, known as preclosing reviews, the
    homeownership centers rate the quality of the construction exhibits (for
    new or rehabilitated homes), the valuation of the mortgaged property, and
    the mortgage credit evaluation of the borrower as "good," "fair," or
    "poor."11 (See fig. 3.) According to HUD guidance, a "good" rating
    indicates no underwriting deficiencies, a "fair" rating indicates the
    presence of deficiencies that would not affect the insurance eligibility
    determination,

    9The other members of the Board are HUD's General Counsel, Chief Financial
    Officer, Assistant Secretary for Administration, Assistant Secretary for
    Fair Housing and Equal Opportunity, and Director of the Enforcement
    Center; and the President of the Government National Mortgage Association.

    10At the Atlanta, Denver, and Philadelphia homeownership centers, staff
    perform these evaluations. In contrast, a contractor performs these
    evaluations for the Santa Ana homeownership center.

    11During a preclosing review, the Denver homeownership center also
    sometimes evaluates the quality of the loan-closing documents.

    and a "poor" rating indicates underwriting errors that would significantly
    increase HUD's insurance risk. HUD's guidance provides specific criteria
    for the homeownership centers to use in determining these ratings.

    Figure 3: Preclosing Review Loan Rating Categories and Scoring System

    Good

    Fair

    Poor

                                      Source: GAO.

    Note: "N/A" means not applicable. The three loan examples are provided for
    illustration only. The overall rating is equal to the lowest rating
    assigned to an individual rated category. For example, if one category is
    rated "poor," the overall rating for that loan is a "poor."

    In our April 2000 report, we noted that HUD's guidance for granting direct
    endorsement authority was unclear because it did not define what would
    constitute overall acceptable performance. As a result, we found that the
    homeownership centers had implemented the existing guidance differently
    and had approved lenders that demonstrated varying levels of proficiency,
    including lenders that had made multiple and serious underwriting
    mistakes. In response to our report, HUD issued its current guidance for
    granting FHA-approved lenders direct endorsement authority in September
    2002. The guidance states that, in order to qualify for direct endorsement
    authority, a lender must submit a minimum of 15 mortgage loans that
    receive ratings of "good" or "fair" within a year, with the last 5
    consecutive loans rated "good" or "fair." These 15 mortgages may include
    loans for

    home purchase transactions (including 203(k) loans) and full
    creditqualifying refinances.12 Only 5 of the 15 required mortgages may be
    from a combination of automated underwriting, streamline refinances, and
    fully underwritten loans denied by other lenders.13 In addition, a lender
    cannot submit more than 30 mortgage loans for HUD's review during this
    probationary period. The guidance states that, if the lender has submitted
    30 loans and has not met the standards to be granted direct endorsement
    authority, the lender must be notified that it cannot submit mortgage
    loans for at least 6 months.

    Although HUD has issued specific guidance, the homeownership centers have
    not consistently followed it. To determine how well each homeownership
    center followed HUD's guidance, we analyzed preclosing review ratings
    given to the loans submitted by all 49 lenders that entered the
    probationary period on or after October 1, 2002, (after the guidance was
    implemented) and were granted direct endorsement authority by April 30,
    2004.14 (Approximately 290 other lenders were in the process of seeking,
    but had not yet received, direct endorsement authority as of April 30,
    2004.) The 49 lenders submitted an average of 24 loans to the
    homeownership centers for preclosing reviews.

    12Under the 203(k) Home Rehabilitation Mortgage Insurance program, a
    borrower can get one mortgage loan to finance both the acquisition and
    rehabilitation of the property. A refinance transaction involves repaying
    an existing real estate debt from the proceeds of a new mortgage that has
    the same borrower and the same property.

    13When automated underwriting is used, a computer-based tool simplifies
    the processing of loan applications by analyzing, among other things, how
    a borrower managed credit obligations in the past and whether the borrower
    has the ability to repay the mortgage loan. It then provides a
    recommendation to the lender to approve the loan or refer it for manual
    underwriting. A streamline refinance is a type of refinance transaction
    that requires less paperwork. For example, streamline refinances can be
    made without an appraisal, and HUD does not require a credit report.

    14One additional lender with direct endorsement authority applied for and
    was granted the authority to underwrite Home Equity Conversion Mortgages
    (HECM)-mortgages that can be used by senior homeowners to convert equity
    into income-during this time period. HUD's guidance states that, after
    receiving direct endorsement approval, lenders may apply for approval to
    underwrite specialized loans such as HECM and 203(k) loans by submitting a
    minimum of five consecutive cases of that type rated "good" or "fair."
    According to our analysis, the lender submitted a minimum of five
    consecutive HECM cases rated "good" or "fair."

    Our analysis showed that the homeownership centers granted some of the 49
    lenders direct endorsement authority in violation of HUD's criteria.
    Specifically, we found the following:

    o 	Seven of the lenders did not submit at least 15 mortgage loans that
    were rated "good" or "fair."

    o 	Two lenders were granted direct endorsement authority although the last
    5 consecutive loans they submitted were not rated "good" or "fair."15

    o 	One lender exceeded the allowed 1-year probationary period, and eight
    lenders submitted more than the 30 loans allowed before being granted
    direct endorsement authority. The number of mortgage loans submitted by
    these lenders ranged from 31 to 73.

    Our analysis of the loans submitted by the 49 lenders was based on
    information contained in a log maintained for each lender seeking direct
    endorsement authority. According to homeownership center officials, they
    use this log to determine if a lender has met HUD's standards. When
    commenting on the results of our analysis, HUD officials stated that some
    of the information in the logs we reviewed was incorrect. For example,
    they noted that some of the loans were incorrectly entered as automated
    underwriting cases. Because the information in the log is what the
    homeownership center officials use to determine if the standards have been
    met, we did not change our findings based on the new information provided
    by HUD. HUD officials also noted that they had sometimes used management
    discretion when applying the standards. For example, for one case in which
    we determined that the last five consecutive cases were not rated "good"
    or "fair," the homeownership center staff determined that, despite the one
    loan rated "poor" out of the last five, the lender had submitted a
    sufficient number of loans rated "good" or "fair" to be approved.

    15In three additional cases, the lender continued submitting loans after
    it had satisfied HUD's requirements of having a total of 15 loans rated
    "good" or "fair," with the last 5 of the 15 loans rated "good" or "fair."
    One of the extra loans submitted was rated "poor," which meant that the
    last five consecutive cases submitted by the lender were not rated "good"
    or "fair."

      HUD's Monitoring Is Risk-Based, but Certain Factors Limit the Usefulness of
      Its Monitoring Tools

    Although HUD has adopted a risk-based approach to monitoring lenders,
    certain factors limit the usefulness of the tools it employs. The
    homeownership centers rely on two primary monitoring tools to ensure
    lenders' compliance with FHA's mortgage requirements: (1) lender reviews,
    which are generally on-site evaluations of lenders' operations, performed
    by HUD staff and (2) technical reviews, which are desk audits of the
    underwriting quality of individual loans already insured by FHA, performed
    mainly by contractors. Since May 2000, the homeownership centers have
    generally been targeting for review those lenders they consider to be high
    risk, but HUD's reports do not distinguish between on-site and desk
    reviews. HUD has started selecting loans for technical reviews based on
    characteristics associated with risk and done a better job of tracking the
    performance of the contractors that perform most of HUD's technical
    reviews. However, its technical review rating system does not currently
    reflect the different levels of risk that underwriting errors pose to the
    insurance fund.

        Although HUD Is Following Its Guidance in Targeting High-Risk Lenders, Its
        Reports Do Not Identify Desk Reviews

    Most Lenders Reviewed Were Targeted Based on Risk

    Since May 2000, the homeownership centers have targeted lenders for review
    based on indicators of risk, and our analysis shows that they have
    generally reviewed the lenders that they have identified as high-risk
    lenders. Although on-site reviews are the preferred method of monitoring,
    HUD's reports do not identify the number of desk reviews performed.

    Lender reviews typically involve an in-depth analysis of a sample of loans
    and assessments of lenders' internal control systems for making loans. If
    a lender review finds serious deficiencies with specific loans or the
    lender's internal controls, HUD may take actions that reduce the
    department's insurance risk, such as requiring the lender to compensate
    HUD for financial losses that HUD has incurred or may incur on certain
    loans. Staff assigned to each homeownership center's quality assurance
    division are responsible for scheduling and performing these reviews. In
    fiscal year 2003, HUD's homeownership centers conducted 910 lender
    reviews, exceeding the department's goal of 900 reviews.

    In April 2000, we reported that, contrary to HUD's guidance, the
    homeownership centers were not always reviewing the lenders that they
    considered to pose the highest risks and concluded that HUD lacked a
    systematic process for identifying and prioritizing such lenders for
    review. In response, HUD issued a May 2000 memo calling for the
    homeownership

    centers to target lenders for lender reviews based on indicators of risk.
    Because early defaults and claims-loans reported as 90 days or more
    delinquent and loans terminated by claim within the first 24 months of
    origination-are an indicator of poor lending practices that may ultimately
    result in insurance losses, HUD considers them to be the primary risk
    factors in targeting lenders for review. Thus, each quarter the
    homeownership centers use data from HUD's Neighborhood Watch Early Warning
    System (Neighborhood Watch)-an information system that displays loan
    performance data by loan types and geographic areas-to identify the
    lenders that pose the highest risk to the insurance fund in terms of
    defaults and claims.16 In addition, the guidance lists other factors to be
    considered when targeting lenders, including the length of time since
    their last review, complaints or reports of irregularities or fraudulent
    activity in a lender's practices, and the results of HUD's technical
    reviews of individual lenders' loans. (See fig. 4.) According to HUD, the
    target reports developed each quarter to identify the lenders to be
    reviewed are "fluid;" for example, changes may result if there is a large
    number of complaints about a particular lender.

    Figure 4: Steps to Be Taken Each Quarter to Target Lenders for Lender
    Reviews

    Source: GAO analysis of HUD guidance.

    Note: Other factors that the homeownership centers are to consider during
    the targeting process include high-risk programs such as the 203(k)
    program and sudden increases in business volume.

    16The loan information in Neighborhood Watch is displayed for a 2-year
    origination period and is updated monthly.

    We found that HUD's homeownership centers are generally following this
    guidance when targeting lenders for reviews. All four homeownership
    centers provided us with lists of the lenders they targeted for review in
    fiscal year 2003 and the first two quarters of fiscal year 2004 and the
    lenders they reviewed during the same time period. Overall, our analysis
    of these lists showed that about 80 percent of the lenders reviewed by the
    four homeownership centers during these six quarters were lenders on their
    target lists. As shown in figure 5, the percentage of lenders reviewed by
    each homeownership center that were on their target lists ranged from 68
    percent in Denver to 89 percent in Atlanta.

    Figure 5: Extent to Which Lenders Reviewed by Homeownership Centers Were
    Targeted Lenders, Fiscal Year 2003 and First Two Quarters of Fiscal Year
    2004

    Lenders reviewed

    1,500

    1,200

    900

    600

    300

    0 Atlanta Denver Philadelphia Santa Total Ana

    Homeownership center

    Nontargeted lenders Targeted lenders Source: GAO analysis of data provided
    by HUD's four homeownership centers.

    Furthermore, about 69 percent of the lenders that were targeted by the
    homeownership centers had been reviewed by the end of the six quarters. As
    shown in figure 6, the percentage of lenders that were targeted and

    reviewed ranged from 57 percent for Santa Ana to 82 percent for
    Philadelphia. According to HUD, reviews not completed during the quarter
    are carried over to the subsequent quarter and nearly all are completed.

    Figure 6: Extent to Which Lenders Targeted by Homeownership Centers Were
    Reviewed, Fiscal Year 2003 and First Two Quarters of Fiscal Year 2004

    Atlanta Denver Philadelphia Santa Ana Total

                           Targeted lenders not yet reviewed

                               Targeted lenders reviewed

    Source: GAO analysis of data provided by HUD's four homeownership centers.

    HUD is seeking to improve its risk-based monitoring of lenders. According
    to HUD officials, the department has hired a contractor to help it analyze
    all collected FHA loan data to determine if more of it can be used to
    target lenders for review. According to the statement of work, the
    contractor is to design, among other things, a risk-based model using HUD
    data that will identify lenders that pose a risk to the FHA insurance
    fund.17 In developing this model, the contractor is to (1) analyze
    risk-based models used by Fannie Mae, Freddie Mac, and private mortgage
    insurers to determine how these entities evaluate the risk related to
    single-family loans; (2) analyze the data available in HUD's data systems
    that can be used to develop riskbased model(s); and (3) recommend
    additional data not already available

    17The risk-based model that is to be developed by the contractor must be
    adaptable and compatible with HUD's Neighborhood Watch System. The lender
    information that may be used in developing the model includes, among other
    things, the percentage of originations with late up-front mortgage
    insurance premiums, the percentage of signed indemnification agreements
    (which require the lender to compensate HUD for financial losses that HUD
    has incurred or may incur on certain loans), and high default and claim
    rates.

    in HUD's systems that should be used in the development of a risk-based
    model.18

    Reports Did Not Distinguish According to HUD's guidance on conducting
    lender reviews, a desk review

    Between On-Site and Desk may be acceptable for a focused review-a review
    of a specific operational

    Reviews	area, specific loan type, or specific issue-and necessary when
    travel funds are constrained. Even so, both HUD and homeownership center
    officials acknowledge that on-site reviews are the preferred method of
    monitoring lenders' operations. General HUD guidance on monitoring states
    that onsite monitoring reviews are essential for high-risk programs. In
    addition, its guidance on conducting lender reviews lists certain factors
    that should be considered, including determining if the lender's office
    facilities meet HUD's requirements. For example, when conducting an
    on-site review a reviewer should, among other things, observe whether the
    public can properly identify the lender. Homeownership center officials
    also note that on-site reviews are preferable because they can request
    additional loans to review on short notice and they sometimes get leads
    from employees who want to disclose problems. On-site reviews also give
    HUD an opportunity to provide technical assistance to the lenders.

    All four homeownership centers are performing some off-site lender reviews
    (i.e., desk reviews); however, their reports do not identify the number of
    desk reviews performed. At our request, homeownership center officials
    conducted a manual search of their records and determined that 70 of the
    910 lender reviews performed in fiscal year 2003 (about 8 percent) were
    desk reviews. Although all four homeownership centers performed at least
    some desk reviews, HUD's Office of Lender Activities and Program
    Compliance, the headquarters office that oversees lender reviews,
    described all of the reviews that the homeownership centers performed in
    fiscal year 2003 as on-site reviews in its annual report.

    18Both Fannie Mae and Freddie Mac are federally-chartered corporations
    that purchase residential mortgages and convert them into securities for
    sale to investors; by purchasing mortgages, they supply funds that lenders
    may loan to potential homebuyers.

        HUD Now Selects Loans for Technical Reviews Based on Risk and Better
        Oversees Contractors, but Its Reviews Serve a Limited Purpose

    Selection Is Generally Based on Loan Risk Characteristics

    In response to recommendations in our April 2000 report, HUD has started
    selecting loans for technical reviews based on loan risk characteristics
    and improved its oversight of the contractors that perform technical
    reviews. However, technical reviews serve a limited purpose because the
    system used to rate lender performance on individual loans does not
    identify the underwriting errors that pose the greatest risk, and the
    reviews do not help HUD identify (1) loans that have a high probability of
    default or claim or (2) loans susceptible to fraud.

    Technical reviews are desk audits that evaluate the underwriting quality
    of individual loans already insured by FHA. They are similar to preclosing
    reviews in that HUD evaluates the quality of the construction exhibits
    (for new or rehabilitated homes), the valuation of the mortgaged property,
    the mortgage credit evaluation of the borrower, and the loan-closing
    documents and assigns a "good," "fair," or "poor" rating in each
    applicable category. Reviews revealing serious deficiencies may result in,
    among other things, HUD's requiring the lenders to compensate the
    department for financial losses or HUD's suspending the lenders' direct
    endorsement authority. In total, the four homeownership centers performed
    133,446 technical reviews in fiscal year 2003 and the first two quarters
    of fiscal year 2004, representing 7 percent of the loans that FHA insured
    during that time period (see fig. 7).

    Figure 7: Percentage of Loans Receiving Technical Reviews, Fiscal Year
    2003 and First Two Quarters of Fiscal Year 2004

    Percentage

    8

    7

    6

    5

    4

    3

    2

    1

    0 Atlanta Denver Philadelphia Santa Total Ana

    Homeownership center

    Source: GAO analysis of HUD data.

    Prior to February 2004, HUD used the Computerized Homes Underwriting
    Management System (CHUMS)-a computer system that assists and supports HUD
    staff in processing mortgage insurance for single-family homes-to randomly
    select a certain percentage of each lender's loans for technical reviews.
    However, as we noted in our April 2000 report, HUD's guidance recommends
    that the loans selected for technical reviews should be those that pose a
    high risk of loss to the insurance fund. In February 2004, HUD implemented
    a CHUMS algorithm that provides a risk-based statistical process for
    selecting loans for review at time of approval. The algorithm selects
    loans for review based on certain characteristics-such as loans made to
    first-time homebuyers, loans with adjustable rate mortgages, and loans for
    multiple housing units. According to HUD officials, loans that exhibit
    these high-risk characteristics are, all other things being equal, more
    likely to be subject to default and/or contain underwriting errors than
    loans that do not.

    Homeownership center staff also have the ability to adjust, in CHUMS, the
    percentage of a lender's loans selected for technical reviews to more

    closely monitor certain lenders. For example, HUD's guidance states that
    the homeownership centers should perform technical reviews of 100 percent
    of at least the first 30 FHA-insured loans made by newly approved direct
    endorsement lenders. However, our analysis of loans made by the 49 lenders
    that entered the probationary period on or after October 1, 2002, and were
    granted direct endorsement authority by April 30, 2004, shows that the
    homeownership centers have not followed this guidance. As of June 2004,
    only 16 of these lenders had used their direct endorsement authority to
    make loans. Contrary to HUD guidance, the homeownership centers had
    reviewed only about 7 percent of these lenders' early loans. According to
    homeownership center officials, they do not always select the first 30
    loans to review because some of the lender's early loans may have been
    made by a new branch office of which they are unaware.19 Also, CHUMS does
    not automatically maintain the 100 percent designation used to flag a new
    lender's early loans for review. As part of an effort to control the
    volume of technical reviews, CHUMS revises some of the review percentages
    each quarter. As a result, the 100 percent designation for newly
    authorized lenders is sometimes changed to less than 100 percent, causing
    the homeownership centers to miss some of these lenders' loans.

    Tracking of Technical Review The large majority of HUD's technical reviews
    are performed by firms

    Contractors' Performance Has under contract with the homeownership
    centers, and HUD has done a

    Improved in Recent Years	better job of tracking these contractors'
    performance in recent years.20 In our April 2000 report, we noted that the
    technical review contracts in place at the time contained specific
    performance standards expressed as the maximum acceptable percentage of
    reviews that could contain significant errors or omissions. However, we
    found that three of the four homeownership centers were not tracking the
    contractors' work against these standards. As a result, these
    homeownership centers lacked the information necessary to evaluate the
    quality of the contractors' work or to determine whether actions should be
    taken against the contractors for poor performance.

    19Direct endorsement authority is granted to a lender's home office and
    applies to all of the lender's branch offices.

    20Virtually all of the Atlanta, Philadelphia, and Santa Ana homeownership
    centers' technical reviews are performed by contractors. In contrast,
    Denver homeownership center staff performed 44 percent of the
    homeownership center's reviews in fiscal year 2003. At the time of our
    study, the Santa Ana homeownership center had two firms under contract,
    while the Atlanta, Denver, and Philadelphia homeownership centers each
    used a single contractor.

    The four homeownership centers are currently evaluating the quality of
    their contractors' work. Each homeownership center's technical review
    contract states that the contractor must deliver 90 percent of the
    completed reviews without any errors. An error is defined as any instance
    in which HUD has to change a "poor" rating to a "good" or "fair" rating or
    when it has to change a "fair" or "good" rating to a "poor" rating. To
    determine if the contractor is meeting this standard, the contracts
    require HUD to randomly select and evaluate a minimum of 5 percent of the
    contractor's completed reviews. If the contractor's error rate exceeds 10
    percent for the review period, HUD's payment will be reduced by 1 percent
    for each error percentage point above 10 percent. As shown in figure 8,
    the homeownership centers reviewed at least 5 percent of their
    contractors' work in fiscal year 2003.

    Figure 8: Percentage of Technical Review Contractors' Work Reviewed by
    Homeownership Centers in Fiscal Year 2003

    Percentage

    14

    12

    10

    8

    6

    5% guidance

    benchmark 4

    2

    0 Atlanta Denver Philadelphia Santa Ana Homeownership center

    Source: GAO analysis of data provided by HUD's four homeownership centers.

    The homeownership centers have used the results of their quality assurance
    reviews to track their contractors' performance. For each month in fiscal
    year 2003, the four homeownership centers calculated their

    contractors' error rate (a total of 60 calculated error rates because
    Santa Ana uses two contractors). As a result, they were able to track
    whether their contractors exceeded the allowed error rate of 10 percent.
    As shown in figure 9, three of the four centers identified that their
    contractors had exceeded the allowed error rate.

    Figure 9: Technical Review Contractors' Fiscal Year 2003 Performance

    Months

    12

    10

    8

    6

    4

    2

    0 Atlanta Denver Philadelphia Santa Ana Santa Ana

                             (contractor 1) (contractor 2)

    Homeownership center

    Months contractor stayed under or equaled 10% error rate

    Months contractor exceeded 10% error rate

    Source: GAO analysis of data provided by HUD's four homeownership centers.

    Despite better tracking, the homeownership centers were not always able to
    hold their contractors accountable for unacceptable performance. Only the
    Santa Ana center could provide us with support that it assessed
    contractors a penalty when appropriate in fiscal year 2003. According to
    an Atlanta center official, they did not assess a disincentive to the
    contractor in fiscal year 2003 when its error rate exceeded 10 percent
    because they did not complete their quality assurance reviews within 30
    days. The official also stated that they had solved the timing problem as
    of October 2003 and that all reviews are currently completed within the
    30-day requirement in

    order to properly assess disincentives. Similarly, a Denver center
    official stated that the center did not assess any disincentives because
    system problems made it difficult to calculate the error rates correctly.
    The center has since corrected the problem, according to the same
    official. The Philadelphia center's contractor did not exceed the allowed
    error rate in fiscal year 2003.

    Technical Reviews Serve Limited Homeownership center staff have questioned
    the usefulness of technical

    Purpose 	reviews because the rating system does not identify the
    underwriting errors that pose the greatest risk to the insurance fund.
    According to homeownership center officials, the current rating system
    results in too many "poor" ratings being assigned. To determine the
    percentage of "poor" ratings assigned, we requested data from all four
    homeownership centers for fiscal year 2003 and the first two quarters of
    fiscal year 2004. As shown in figure 10, the percentage of "poor" ratings
    was over 50 percent for at least one category at three of the four
    homeownership centers. At each homeownership center, the highest
    percentage of "poor" ratings was in mortgage credit. Overall, 70 percent
    of the loans that were rated in the mortgage credit category received
    "poor" ratings.

    Source: GAO analysis of Underwriting Reports System data provided by HUD's
    four homeownership centers.

    Note: Not all loans are evaluated in all four categories. For example,
    only loans for new or rehabilitated homes receive an architecture and
    engineering rating.

    Although HUD guidance states that a "poor" rating indicates underwriting
    errors that significantly increased HUD's insurance risk, homeownership
    center officials said that the current system does not distinguish between
    a "poor" rating that represents a compliance or documentation issue and a
    "poor" rating that represents a risk to the insurance fund. Our analysis
    of the most common deficiencies cited during technical reviews performed
    in fiscal year 2003 and the first two quarters of fiscal year 2004 shows
    that the majority of them are compliance issues. As shown in figure 11,
    the most common deficiencies cited often involve problems with paperwork.
    According to homeownership center officials, only 3 of the 10 deficiencies
    that we identified as the most common represent a risk to the FHA
    insurance fund.

    Compliance issue Risk issue

    Source: GAO analysis of Underwriting Reports System data provided by HUD's
    four homeownership centers.

    Note: These were the most commonly cited deficiencies that must result in
    a "poor" rating. For some deficiencies, the reviewer has the discretion to
    decide, based on the severity of the deficiency, whether the rating should
    be "fair" or "poor."

    aThe Credit Alert Interactive Voice Response System is a federal
    government database of delinquent federal debtors maintained to prescreen
    direct loan applicants for creditworthiness. HUD maintains a list of
    parties who have been issued a limited denial of participation-an action
    that excludes a party from further participation in a HUD program area.
    The General Services Administration maintains a list of parties excluded
    from receiving (1) federal contracts or certain subcontracts and (2)
    certain types of federal financial and nonfinancial assistance and
    benefits.

    bThe "For Your Protection: Get a Home Inspection" form stresses the
    importance of obtaining a home inspection prior to purchase.

    cThe purpose of the homebuyer summary form is to provide timely
    information to the buyer for repairs to be completed or property
    conditions that have to be satisfied prior to FHA insurance endorsement.

    dThe HUD-1 form, also called the Settlement Statement, records the money
    flows that take place when the ownership of a home is transferred from a
    seller to a buyer.

    HUD's financial statement auditors have also questioned the usefulness of
    technical reviews. In the audit of FHA's financial statements for fiscal
    years 2002 and 2003, the independent auditors noted that technical
    reviews, as currently designed, assisted the homeownership centers in
    reporting documentation and processing errors back to the lenders but did
    not help them identify loans that have a high probability of default or
    claim as a result of poor lender underwriting practices.21 When the
    auditors analyzed data on the 2,000 lenders with the highest volume of
    originations, they found no strong correlation between the percentage of
    technical review "poor" ratings received by a lender and the lender's
    early default and claims rates. As a result, the auditors recommended that
    HUD consider redesigning the technical review process as an early warning
    control that better predicts loan performance so that it could be used not
    only as a lender monitoring tool but also as an effective tool to assist
    FHA in identifying lenders that originate loans that have a high
    probability of going to default or claim.

    HUD officials acknowledged that technical reviews were not designed to
    help HUD identify loans that have a high probability of default or claim
    or loans susceptible to fraud; instead, they were designed to evaluate the
    quality of the lender's underwriting. The department has taken several
    steps to make technical reviews more meaningful, according to HUD
    officials. First, HUD has converted the Underwriting Reports System-the
    system used to track the results of technical reviews-to a web-based
    system, which will allow it to perform more analysis of the technical
    review ratings. Second, HUD plans to revise the deficiency codes used to
    assign technical review ratings. Currently, there are over 250 codes for
    mortgage credit and valuation issues. The homeownership centers have
    proposed reducing that number substantially and replacing the "poor"
    rating with a "risk issues" rating-reserved for those deficiencies that
    affect the

    21To complete the FHA audit, HUD's Inspector General contracted with the
    independent certified public accounting firm of KPMG LLP. U.S. Department
    of Housing and Urban Development, Office of Inspector General, Audit of
    the Federal Housing Administration's Financial Statements for Fiscal Years
    2003 and 2002, 2004-FO-0001 (Washington, D.C.: Nov. 25, 2003).

    eligibility of the loan-and the "fair" rating with a "compliance issues"
    rating, given for those errors that do not affect eligibility.

      Efforts to Hold Lenders Accountable for Poor Performance Have Not Been
      Comprehensive

    To hold lenders accountable for poor performance, HUD may (1) terminate
    their loan origination authority through its Credit Watch program, (2)
    suspend their direct endorsement authority, or (3) take enforcement action
    through its Mortgagee Review Board. HUD has terminated the loan
    origination authority of 262 lender branch offices and has recently
    proposed changes to make its Credit Watch program more effective as a
    means of sanctioning lenders responsible for high rates of defaults and
    insurance claims. However, the homeownership centers have rarely used
    their ability to suspend direct endorsement authority. Further, HUD's
    Mortgagee Review Board sometimes takes a year or more to take action
    against lenders for program violations, during which time the lender can
    continue to make dozens of loans.

        HUD Has Proposed Credit Watch Changes to Improve Program's Effectiveness

    HUD has recently proposed changes to improve the effectiveness of its
    Credit Watch program. In May 1999, HUD announced that it would begin to
    use its Credit Watch program to sanction lenders with excessively high
    loan default and claim rates. Initially, HUD planned on a quarterly basis
    to (1) terminate the loan origination authority of any lender branch
    office whose default and claim rates on mortgages insured by FHA during
    the preceding 24 months exceeded both the national average and 300 percent
    of the average rate for the HUD field office serving the lender's
    geographic location (field office rate) and (2) place on Credit Watch
    status the branch offices whose default and claim rates exceeded 200
    percent of the average field office rate. While on Credit Watch status,
    the branch could continue to originate FHA-insured loans, but HUD would
    review the insured loans that the branch originated during a 6-month
    period from the date the Credit Watch status became effective for
    excessive default rates. In October 2001, HUD announced that it was
    eliminating the placement of lenders on Credit Watch status because
    advanced warning of excessive default and claim rates was no longer
    necessary since the department had provided lenders with access to their
    performance via Neighborhood Watch. Also, in September 2002, HUD stated
    that it would be gradually reducing the 300 percent termination threshold
    set for the HUD field office rate to the 200 percent allowed in HUD's
    regulations.

    As of July 2004, HUD had conducted 19 rounds under its Credit Watch
    initiative, with the last round being based on analysis of the 24-month
    period ending December 31, 2003.22 This program has resulted in the
    department's termination of 262 branch offices' loan origination
    authority.23 As shown in figure 12, the number of branch offices that were
    terminated as a result of each round has varied.

    Figure 12: Results of the First 19 Rounds of HUD's Credit Watch Program

    Number of branch offices terminated Type of lender terminated 50 45

    40

    35

    Loan 30 correspondents

    25

    20

    15

    10 Round

                                                               Lenders authorized
    5                                                            to underwrite
                                                                FHA-insured loans
    0
          1  2  3  4  5  6 7 8 9 10 11 12 13 14 15 16 17 18 19

    Source: GAO analysis of HUD data.

    Currently, the regulations governing HUD's Credit Watch program only allow
    the department to hold the lenders that originated the troubled loans
    accountable for excessive defaults or insurance claims. The regulations do
    not address HUD's authority to also hold accountable those lenders that
    have underwritten the loans. When originating mortgage loans, lenders

    22Every quarter, HUD conducts a round of Credit Watch by reviewing the
    rate of defaults and claims on loans insured by FHA within the preceding
    24-month period.

    23A terminated lender branch may request to have its authority to
    originate FHA loans reinstated no earlier than 6 months after the
    effective date of the termination.

    perform such functions as accepting mortgage applications and obtaining
    employment verifications and credit reports on the borrowers. When
    underwriting mortgage loans, lenders use this information to determine
    whether borrowers are able to make their mortgage payments and whether the
    loans should be approved. As shown in figure 12, 44 percent of the lenders
    terminated during the first 19 rounds of Credit Watch were loan
    correspondents-lenders that sell or transfer loans that they originate to
    other FHA lenders, known as sponsoring lenders, for underwriting and
    approval.

    In response to a recommendation in our April 2000 report, HUD has
    published a proposed rule making several amendments to the Credit Watch
    program, including holding underwriting lenders accountable for excessive
    default and claim rates.24 The proposed rule, issued in April 2003,
    includes several changes designed to strengthen HUD's capacity to
    safeguard the FHA mortgage insurance fund. Specifically, it proposes,
    among other things, applying the default and claim threshold to both
    originating and underwriting lenders and prohibiting a lender from opening
    a new branch office in the same lending area as an existing branch that
    has received a notice of proposed termination. The proposed rule was open
    for comments through June 2, 2003, and HUD submitted an interim rule to
    the Office of Management and Budget in July 2004.

        Homeownership Centers Rarely Used Their Ability to Suspend Lenders' Direct
        Endorsement Authority

    HUD's homeownership centers have made limited use of their ability to
    suspend the direct endorsement authority of lenders that fail to comply
    with FHA's program requirements. Lenders whose direct endorsement
    authority is suspended but who wish to continue underwriting mortgages
    insured by FHA must submit each proposed mortgage case file to a
    homeownership center, which evaluates the lenders' underwriting decisions
    before deciding whether to insure the loans. The lenders must follow this
    procedure until HUD's evaluations of the case files indicate that the
    lenders have demonstrated satisfactory performance in underwriting loans.

    HUD's guidance allows the homeownership centers to suspend direct
    endorsement authority but does not prescribe the circumstances under

    24In our April 2000 report, we recommended that HUD revise the Credit
    Watch program's regulations to cover lenders that underwrite FHA-insured
    loans with excessive default and claim rates, as well as those lenders
    that originate such loans.

    which the homeownership centers must do so. HUD's handbook on the direct
    endorsement program provides general guidelines. For example, the guidance
    states that the homeownership centers should consider suspending lenders
    that exhibit "patterns" of noncompliance, but it does not define what
    would constitute a pattern. After our April 2000 report recommended that
    HUD clarify and implement guidelines for identifying lenders whose direct
    endorsement authority should be suspended, the department issued
    supplemental guidance in a November 2000 memo. The memo describes certain
    conditions under which the homeownership centers may suspend direct
    endorsement authority.25

    Among the four homeownership centers, we found that the Philadelphia
    homeownership center was the only one that suspended the direct
    endorsement authority of any lenders during fiscal year 2003 and the first
    two quarters of fiscal year 2004. Specifically:

    o 	The Philadelphia homeownership center took this action against seven
    lenders during this time frame, citing underwriting violations identified
    during technical reviews and high default rates.26

    o 	Although the Denver homeownership center did not suspend any lender's
    direct endorsement authority during the same time period, it had warned
    seven lenders that it might do so if they did not address underwriting
    deficiencies revealed in technical reviews.

    o 	Rather than suspending a lender's direct endorsement authority, Atlanta
    homeownership center officials told us they will work with problem lenders
    to develop performance improvement plans. Such plans generally involve
    raising the percentage of a lender's loans that are selected for technical
    reviews, meeting with the lender to discuss its performance, and requiring
    the lender's staff to take training.

    25These conditions include when a lender has maintained a "poor"
    percentage in excess of 20 percent for more than 90 days after being
    placed on 100 percent review status or when a lender has a claim and
    default rate that exceeds both the national rate and 250 percent of the
    field office rate (the rate for the HUD field office serving the lender's
    geographic location).

    26The Philadelphia homeownership center first identifies lenders that (1)
    have a default rate that exceeds 150 percent of the field office rate and
    (2) have received technical review "poor" ratings over 20 percent (when
    more than 20 loans have been reviewed) and begins to review 100 percent of
    their loans. For lenders that do not improve after two quarters, the
    homeownership center suspends their direct endorsement authority.

    o 	Similarly, Santa Ana homeownership center officials said that they tend
    to increase the percentage of a lender's loans that are selected for
    technical reviews instead of suspending direct endorsement authority.

    HUD officials provided several reasons why they do not make more use of
    their ability to suspend direct endorsement authority. Officials at all
    four homeownership centers told us that suspending lenders would create an
    additional workload for them. Atlanta and Santa Ana officials also noted
    that suspending a lender's direct endorsement authority would threaten the
    lender's business. In addition, Denver officials observed that large
    lenders, when faced with suspension at one branch, would just send all
    their FHA loans to another branch. Finally, Santa Ana officials stated
    that, as long as the percentage of "poor" ratings assigned during
    technical reviews was so high, they did not want to rely on them as
    grounds for suspending direct endorsement authority. Headquarters
    officials noted that they want the homeownership centers to conduct lender
    reviews after problems are identified during technical reviews rather than
    immediately suspend lenders' direct endorsement authority.

    Although HUD's homeownership centers suspended the direct endorsement
    authority of relatively few lenders in fiscal year 2003 and the first two
    quarters of fiscal year 2004, our analysis of HUD's technical review
    ratings for the same time period showed frequent noncompliance by lenders
    with FHA's requirements. About 7,800 lender branch offices received
    technical review ratings for mortgage credit analysis for the FHAinsured
    mortgages they underwrote.27 Of these branch offices, we identified 1,203
    that had at least 10 loans reviewed and received a "poor" rating for
    mortgage credit analysis-meaning that the lenders made mistakes in
    evaluating the borrowers' creditworthiness-on 75 percent or more of their
    reviewed loans. Even though the current rating system does not identify
    the underwriting errors that pose the greatest risks, this level of
    noncompliance indicates that more lenders may be candidates for
    enforcement action.

    27Lenders could have been counted more than once if they underwrote
    FHA-insured mortgages in more than one homeownership center jurisdiction.

        Mortgagee Review Board's Process for Sanctioning Lenders Is Time-Consuming

    HUD's Mortgagee Review Board (Board) can impose administrative sanctions
    against FHA lenders that commit program violations, such as withdrawal of
    a lender's FHA approval. HUD does not have guidelines for the time it
    should take for the Board to take enforcement actions against lenders. We
    found the process can take over a year from the time the lender is
    notified of its violations to Board action.

    The majority of the cases referred to the Board are the result of lending
    violations revealed in lender reviews performed by HUD's homeownership
    centers. Once the Board reviews and accepts a referral, it sends the
    lender a notice of violation that provides the lender 30 days to respond
    in writing to the Board. After reviewing the lender's response, the Board
    decides what actions to take. The Board may impose a number of sanctions
    against FHAapproved lenders, ranging from a letter of reprimand-a letter
    informing the lender of the existence or occurrence of a violation of
    HUD's requirement and directing the lender to bring and maintain its
    activities into conformity with all HUD requirements-to withdrawal of a
    lender's FHA approval. During the period of withdrawal (generally 3 to 5
    years), HUD will not insure any mortgage originated by the withdrawn
    lender. Except for a letter of reprimand, the lender has a right to a
    hearing before the Board's sanction becomes final.

    The majority of the Board's actions result in settlement agreements, which
    require lenders to indemnify improperly originated loans; pay fines;
    and/or take actions to prevent future lending violations. In June 2004, we
    reviewed the Board's records for the 32 cases involving single-family
    housing lenders that the Board had acted on in the previous 12 months.28
    We found that in 22 of the 32 cases, the Board had either reached a
    settlement agreement with the lender (20 cases) or was still attempting to
    reach a settlement agreement (2 cases).29 In 8 of the cases, the Board had
    withdrawn the lenders' FHA approval. In the remaining 2 cases, the Board
    had either assessed a civil money penalty (1 case) or was still pursuing a
    civil money penalty (1 case).

    28The 32 cases were acted on in Board meetings held in June 2003, August
    2003, October 2003, December 2003, February 2004, and April 2004.

    29In one case that resulted in a settlement agreement, the Board also
    issued the lender a letter of reprimand.

    Our analysis of the 32 cases further showed that the Board's effort to
    review the cases and impose sanctions against lenders or to enter into
    settlement agreements with them is frequently a time-consuming process. As
    figure 13 shows, it took an average of 6.7 months from the notice of
    violation to withdraw lenders' FHA approval and an average of 11.1 months
    to reach settlement agreements. For the one case where the Board assessed
    a civil money penalty, it took 27.6 months from the notice of violation to
    complete the action. The process is even lengthier when considering the
    time elapsed between the referral and the final Board action. It took an
    average of 10.3 months from the referral to withdraw lenders' FHA approval
    and an average of 17.7 months to reach settlement agreements. It took 34.8
    months from the referral to assess one lender a civil money penalty.

    Source: GAO analysis of data provided by the Mortgagee Review Board.

    The length of time required by the Board to complete its actions allowed
    nine of the lenders to continue making FHA-insured loans for over a year
    without being held accountable for their violations. For example, in April
    2003, the Board sent a notice of violation to one of these lenders because
    the lender had committed several violations, including allowing non-FHA
    approved entities to originate loans, failing to properly verify borrower
    information, and charging excessive and/or unallowable fees. By the time

    the Board withdrew the lender's FHA approval in April 2004, the lender had
    made 584 additional FHA-insured mortgage loans.

    The length of time required for the Board to withdraw lenders' FHA
    approval has improved somewhat since our April 2000 report. We found then
    that, for the six cases completed during our time frame for that report,
    it took an average of 8.5 months from the notice of violation to withdraw
    lenders' FHA approval (as opposed to 6.7 months for the completed cases we
    reviewed in June 2004).30 The length of time required for settlement
    agreements is about the same. We reported in April 2000 that it took an
    average of 11.2 months to reach the five completed settlement agreements,
    which is similar to the 11.1 months for the completed cases we reviewed in
    June 2004. At that time, Board officials told us that they had taken some
    steps to speed up the process. For example, the Board's secretary told us
    that in December 1998 the Board had adopted a policy of meeting every 2
    months to consider case referrals. This official told us that prior to
    adopting this policy, the Board did not have an established meeting
    schedule and met only whenever a sufficient number of cases had
    accumulated for review. Also, to speed up the settlement agreement
    process, the Board planned in future violation letters to ask the lenders
    whether they would be willing to settle their cases and, if so, under what
    terms and conditions.

    HUD officials recognize that the Mortgagee Review Board process can be
    time-consuming and have taken some steps to speed it up. They noted that
    progress on certain cases can be slowed when HUD's Office of Inspector
    General requests that the Board place a hold on the processing of cases
    against lenders until the Inspector General has completed its
    investigations. During fiscal years 2003 and 2004, the Inspector General
    asked for a hold on 14 cases. In accordance with its plans, the Board has
    started asking lenders prior to Board meetings whether they would be
    willing to settle their cases. If a lender's settlement offer is
    acceptable to the Board, a settlement agreement can be prepared and signed
    immediately. If a lender's offer is not acceptable, the Board can then
    make its own proposal for settling the case. Also, the Board has hired new
    staff and plans to implement an internal quality control process by the
    end of calendar year 2004.

    30We reviewed 24 cases involving single-family housing lenders that the
    Board acted on from October 1998 through April 1999. As of November 1999,
    the Board had completed action on 11 of the cases, while action was still
    pending on 13 cases.

    Conclusions	FHA insures tens of billions of dollars in mortgages for
    single-family homes each year. While FHA's Mutual Mortgage Insurance Fund
    is financially healthy, poor lending practices could adversely affect the
    Fund's financial position. Because lenders underwrite virtually all
    FHA-insured mortgages without HUD's prior review, it is essential that HUD
    allow only qualified lenders to participate in its single-family programs,
    adequately monitor lenders and loans to assess the risks they pose, and
    hold lenders accountable for the quality of the loans they make.

    Contrary to HUD's guidance, the homeownership centers have granted direct
    endorsement authority to some lenders that did not demonstrate performance
    that is acceptable under HUD's criteria. Ensuring that the lenders that
    are being granted direct endorsement authority demonstrate acceptable
    performance would better assure HUD that these lenders are qualified to
    underwrite loans without HUD's prior review. By not following HUD's
    guidance, the homeownership centers may be exposing the department to
    unreasonable insurance risks.

    The homeownership centers generally use a risk-based approach to
    monitoring, which helps them to focus on the lenders and loans posing a
    high insurance risk to the department. However, HUD's oversight of lenders
    could be improved. First, while the homeownership centers are targeting
    high-risk lenders for examination, they do not always conduct these
    reviews on-site at the lenders' offices, even though HUD's guidance states
    that on-site reviews are the preferred method of monitoring. Tracking the
    lender review process to distinguish between desk and on-site reviews
    would help HUD ensure that the majority of high-risk lender reviews
    continue to be conducted on-site. Second, contrary to HUD's guidance, the
    homeownership centers have not consistently targeted for technical reviews
    loans made by newly approved lenders. This lack of consistency is due in
    part to weaknesses in the information system (CHUMS) HUD uses to select
    loans for technical reviews. Third, the ratings that are assigned during
    technical reviews do not currently reflect the different levels of risk
    that underwriting errors pose to the insurance fund. The homeownership
    centers have proposed revisions to the rating system, which, if
    implemented, may better ensure the usefulness of technical reviews in
    identifying the lenders that pose the greatest insurance risk to the
    department. Because of these conditions, HUD's lender reviews and
    technical reviews are not as effective as they could be in mitigating
    financial losses to the department.

    HUD has not taken sufficient steps to hold lenders accountable for poor
    performance and program violations. HUD's reviews show that numerous
    lenders did not comply with FHA's underwriting requirements, yet HUD's
    homeownership centers have suspended the direct endorsement authority of
    relatively few lenders. Even though the technical review rating system as
    currently implemented does not properly reflect the risk that different
    underwriting errors pose to the insurance fund, the extent of lender
    noncompliance revealed by the reviews indicates that more lenders may be
    candidates for enforcement action. By failing to suspend poorly performing
    lenders, HUD leaves itself vulnerable to lending practices that increase
    the department's insurance risk.

      Recommendations for Executive Action

    To improve HUD's oversight of FHA mortgage lenders, we recommend that the
    Secretary of HUD direct the Assistant Secretary for Housing-Federal
    Housing Commissioner to take the following five actions:

    o 	Ensure that the homeownership centers are following the guidance for
    granting direct endorsement authority.

    o  Track lender reviews to distinguish between desk and on-site reviews.

    o 	Enhance FHA's information system to ensure that the first 30 loans made
    by new direct endorsement lenders are reviewed as required.

    o 	Expeditiously complete efforts to revise the technical review rating
    system so that the ratings better reflect the risks that different
    underwriting errors pose to the FHA insurance fund.

    o 	Develop and implement guidance specifying the conditions under which a
    homeownership center must suspend a lender's direct endorsement authority.

    Agency Comments and 	We provided a draft of this report to HUD for its
    review and comment. In a letter from the Assistant Secretary for
    Housing-Federal Housing

    Our Evaluation	Commissioner (see app. II), HUD agreed with our five
    recommendations. Specifically, HUD:

    o 	agreed that it would update its guidance for granting direct
    endorsement authority and ensure that the homeownership centers
    consistently apply the requirements for granting direct endorsement
    authority;

    o 	stated that its lender tracking system had been modified to distinguish
    between desk and on-site reviews;

    o 	noted that it was aware of the limitations of its information system to
    accurately identify and count the first 30 loans made by new direct
    endorsement lenders, and was pursuing system enhancements to ensure that
    loans made by new direct endorsement lenders are reviewed as required;

    o 	stated that it was in the final phase of implementing a new technical
    review rating system, to be completed by January 2005; and

    o 	stated that it was currently developing consistent standards for
    returning lenders to preclosing status (i.e., suspending lenders' direct
    endorsement authority) and that implementation would occur by January
    2005.

    HUD also highlighted its program accomplishments, commenting that, while
    the report acknowledges that FHA has implemented policy and procedural
    changes since our last review, it does not fully recognize the substantial
    achievements and accomplishments that resulted from these changes. The
    department described improvements in lender monitoring, lender approval
    and recertification, and lender training, among other things. While we
    agree that HUD has made improvements, a number of the accomplishments
    cited were outside the scope of our review. Our draft report recognized a
    number of specific improvements that were relevant to our objectives. For
    example, we noted that HUD had revised its guidance for granting direct
    endorsement authority and started targeting lenders and loans for review
    based on risk.

    HUD also disagreed with some of our findings. First, HUD stated that our
    discussion of the percentages of lenders targeted and reviewed (figs. 5
    and

    6) did not acknowledge that target reports developed each quarter to
    identify the lenders to be reviewed are fluid and decisions regarding
    which lenders to review are subject to outside influences. For example,
    staff may be directed to complete other reviews based on information from
    sources other than Neighborhood Watch. HUD also noted that the reviews not
    completed during the quarter are carried over to the subsequent quarter

    and nearly all are completed. We included figures 5 and 6 in our draft
    report as empirical evidence supporting our statement that the
    homeownership centers generally were reviewing the lenders on their
    targeting list. Further, our draft report-in the text preceding figure
    4-acknowledged that the centers used other information to develop their
    targeting lists, specifically citing examples such as the existence of
    complaints about lenders. Nevertheless, we added to this text based on
    HUD's comments.

    Second, regarding the Mortgagee Review Board, HUD noted that the Board
    carries out a highly regulated administrative process that may lead to
    serious sanctions and penalties for lenders; therefore, the department is
    obligated to afford maximum due process to these lenders. HUD also stated
    that our conclusion that the length of time it takes for the Board to act
    on a case allows a lender to continue with inappropriate practices is
    misleading because (1) HUD staff communicate the findings of lender
    reviews to lenders during mandatory exit conferences and (2) the Board has
    the ability to suspend a lender or move a case quickly through the process
    when significant problems are found. We do not agree that the statement is
    misleading. Our report stated that the length of time required by the
    Board to complete its actions allowed nine lenders to continue making
    FHA-insured loans for over a year without being held accountable for their
    violations. While HUD may notify a lender of violations found during a
    lender review, such notification does not guarantee that the lender will
    choose to correct or improve its practices. Finally, although the Board
    has the ability to suspend lenders, it did not choose to suspend the nine
    lenders we highlighted in our report.

    HUD agreed with our statement that HUD's preferred method for monitoring
    is to conduct on-site reviews of lenders. It also noted that the
    difference between a desk review and an on-site review is minimal, but
    went on to say that its tracking system had been modified to distinguish
    between desk and on-site reviews. Finally, HUD stated that it anticipates
    publication of the Credit Watch regulation discussed in the report by the
    second quarter of fiscal year 2005.

    We are sending copies of this report to the Secretary of Housing and Urban
    Development and to other interested congressional committees. We also will
    make copies available to others upon request. In addition, the report will
    be available at no charge on the GAO Web site at http://www.gao.gov.

    If you or your staff have any questions regarding this report, please
    contact me at (202) 512-8678 or woodd@gao.gov or Paul Schmidt at (312)
    220-7681 or schmidtpj@gao.gov. Staff contacts and other key contributors
    are listed in appendix III.

    David G. Wood Director, Financial Markets and Community Investment

    Appendix I

                           Objectives, Scope, and Methodology

    Our objectives were to examine (1) how well the Department of Housing and
    Urban Development (HUD) follows its guidance when granting lenders direct
    endorsement authority, (2) the extent to which HUD uses a riskbased
    approach when monitoring the lenders participating in the Federal Housing
    Administration's (FHA) mortgage insurance programs, and (3) the extent to
    which HUD is holding lenders that it identifies as not complying with its
    requirements accountable for their performance.

    To determine how well HUD follows its guidance when granting lenders
    direct endorsement authority, we reviewed HUD's regulations, procedures,
    and other guidance relating to its process for approving lenders and
    granting lenders direct endorsement authority. Lenders with direct
    endorsement authority can underwrite and close FHA-insured mortgage loans
    without prior FHA review or approval. We interviewed officials from HUD's
    Office of Lender Activities and Program Compliance, Office of Single
    Family Program Development, and its four homeownership centers. We
    requested from each homeownership center the number of lenders that
    entered the probationary period on or after October 1, 2002, and were
    granted direct endorsement authority by April 30, 2004. We chose October
    1, 2002, as the start date because HUD revised its guidance for granting
    lenders direct endorsement authority in September 2002. We used April 30,
    2004, as our ending date because we visited the four homeownership centers
    in May and June 2004. For each of the 49 lenders that were approved during
    this time period, we reviewed documentation maintained by the centers and
    entered the ratings that the lender received on the mortgages it submitted
    to the center into a data collection instrument.1 All of the data
    collected was independently verified. We then analyzed the data to
    determine whether the centers followed FHA's procedures for granting
    lenders direct endorsement authority.

    To determine the extent to which HUD is using a risk-based approach when
    monitoring lenders, we reviewed HUD's guidance and procedures for
    conducting lender reviews (i.e., reviews of lenders' operations by HUD
    staff) and technical reviews (i.e., reviews of individual loans performed
    after approval of mortgage insurance to assess the quality of lenders'
    underwriting practices). We reviewed HUD's use and oversight of
    contractors that perform technical reviews. We interviewed officials at

    1One additional lender, which already had direct endorsement authority,
    was granted the authority to underwrite Home Equity Conversion Mortgages
    (HECM)-mortgages that can be used by senior homeowners to convert equity
    into income.

    Appendix I
    Objectives, Scope, and Methodology

    each of the centers on a variety of issues dealing with lender reviews and
    technical reviews. The issues discussed included the (1) centers' criteria
    for targeting loans and lenders for review, (2) number of off-site lender
    reviews, (3) the number and type of "poor" ratings assigned during
    technical reviews, and (4) procedures for monitoring the work of technical
    review contractors. We also interviewed Fannie Mae and Freddie Mac to
    discuss their efforts to monitor the lenders that participate in their
    programs.

    In addition to these steps, we obtained and analyzed lists of the lenders
    that the homeownership centers targeted for lender reviews in fiscal year
    2003 and the first two quarters of fiscal 2004 and the lenders they
    reviewed during the same time period. (We analyzed six quarters of data to
    ensure that the most recent data was considered.) We compared the lenders
    reviewed with those that were targeted to assess the extent to which HUD
    was performing lender reviews on lenders that it considered to pose a high
    risk to the insurance fund. We also analyzed the data to determine the
    percentage of targeted lenders that were reviewed.

    To determine the extent to which the homeownership centers were reviewing
    the first 30 loans made by new direct endorsement lenders, we analyzed
    data from HUD's Single Family Data Warehouse on the loans endorsed by the
    49 direct endorsement lenders that entered the probationary period on or
    after October 1, 2002, and were granted direct endorsement authority by
    April 30, 2004. Only 16 of the 49 lenders had endorsed loans as of June
    19, 2004.

    To determine the percentage of "poor" ratings each lender received during
    technical reviews, we analyzed data from HUD's Underwriting Reports System
    for fiscal year 2003 and the first two quarters of fiscal 2004. When we
    requested the data from each homeownership center, the Philadelphia and
    Santa Ana centers provided just the technical reviews where the review
    date was within our six-quarter time frame. In contrast, the Atlanta and
    Denver centers provided databases that included reviews outside our scope
    (including reviews where the review date was blank). To be consistent with
    the data that the other two centers provided, we limited our analysis of
    the data provided by Atlanta and Denver to just those technical reviews
    where the review date was within our six-quarter time frame. We used this
    data to determine the percentage of "poor" ratings assigned during
    technical reviews and the most common deficiencies cited during technical
    reviews.

    Appendix I
    Objectives, Scope, and Methodology

    To determine the extent to which HUD is holding lenders that it identifies
    as not complying with its requirements accountable for their performance,
    we reviewed HUD's regulations and policy guidance to determine the
    enforcement options available to HUD. We interviewed officials from HUD's
    Office of Lender Activities and Program Compliance, Enforcement Center,
    and Mortgagee Review Board. At each of the four homeownership centers, we
    discussed with cognizant officials each center's efforts to take
    enforcement actions against lenders that have violated program
    requirements. We determined the number and types of lenders sanctioned by
    HUD under its Credit Watch program as of the end of July 2004. In June
    2004, we reviewed the Board's files for the 32 cases involving
    single-family mortgage lenders that the Board had acted on in the previous
    12 months and determined the nature and status of the Board's actions. In
    addition, we analyzed data to determine the length of time it took the
    Board to take action against these lenders.

    To assess the reliability of the various HUD data we used, we discussed
    the data with knowledgeable agency officials, reviewed information about
    the systems, and performed electronic testing to detect obvious errors in
    completeness and reasonableness. We determined that these data were
    sufficiently reliable for the purposes of this report.

    We performed our work from December 2003 to September 2004 in accordance
    with generally accepted government auditing standards.

    Appendix II

    Comments from the Department of Housing and Urban Development

    Appendix II
    Comments from the Department of Housing
    and Urban Development

    Appendix II
    Comments from the Department of Housing
    and Urban Development

    Appendix II
    Comments from the Department of Housing
    and Urban Development

    Appendix II
    Comments from the Department of Housing
    and Urban Development

    Appendix II
    Comments from the Department of Housing
    and Urban Development

    Appendix II
    Comments from the Department of Housing
    and Urban Development

                                   Now on pp. 15-16.

    Now on p. 17.

    Appendix II
    Comments from the Department of Housing
    and Urban Development

                                   Now on pp. 33-34.

    Appendix II
    Comments from the Department of Housing
    and Urban Development

    Appendix III

                         GAO Contacts and Staff Acknowledgments

    GAO Contacts	David Wood (202) 512-8678 Paul Schmidt (312) 220-7681

    Staff 	In addition to those individuals named above, Eric Diamant, Mark
    Egger, Harold Fulk, Nadine Garrick, Curtis Groves, John McGrail, Marc
    Molino,

    Acknowledgments	Josephine Perez, David Pittman, Terry Richardson, Paige
    Smith, and Raymond Wessmiller made key contributions to this report.

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