Single-Family Housing: Stronger Oversight of FHA Lenders Could Reduce
HUD's Insurance Risk (Letter Report, 04/28/2000, GAO/RCED-00-112).

Pursuant to a congressional request, GAO provided information on the
Department of Housing and Urban Development's (HUD) oversight of lenders
participating in its Federal Housing Administration's (FHA) mortgage
insurance programs for single-family homes, focusing on: (1) how HUD
ensures that lenders granted direct endorsement authority by FHA are
qualified to receive such authority; (2) the extent to which HUD focuses
on high-risk lenders in monitoring the lenders participating in FHA's
mortgage insurance programs; and (3) the extent to which HUD holding
lenders are accountable for poor performance.

GAO noted that: (1) HUD's process for granting FHA-approved lenders
direct endorsement authority provides limited assurance that lenders
receiving this authority are qualified; (2) according to HUD's guidance,
FHA-approved lenders seeking direct endorsement authority must
demonstrate acceptable performance in underwriting at least 15 mortgage
loans, which undergo evaluations, known as preclosing reviews, by HUD's
homeownership centers; (3) however, the guidance does not define what
would constitute overall acceptable performance on the 15 loans; (4) in
the 6 months prior to GAO's 1999 visits, the centers granted direct
endorsement authority to a total of 36 lenders; (5) overall, 12 of the
36 lenders had received 4 or more poor ratings from the centers for
their last 15 preclosing reviews; (6) contrary to HUD's guidance, the
homeownership centers' monitoring of lenders does not adequately focus
on the lenders and loans that pose the greatest insurance risks to HUD;
(7) on-site evaluations of lenders' operations--known as lender
reviews--are one of HUD's primary tools for assessing the quality of
lenders' mortgage-lending practices; (8) HUD's guidance states that 85
percent of the lender reviews should be targeted at high-risk lenders;
(9) however, the homeownership centers have often not reviewed the
lenders that they consider to be the highest risk; (10) HUD has not
taken sufficient steps to hold lenders accountable for poor performance
and program violations; (11) 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
centers have made limited use of this ability; (12) on the basis of
GAO's analysis, if HUD had reviewed all of the lenders' fiscal year (FY)
1999 loans, the percentage of poor ratings could have been expected to
exceed 30 percent; (13) of these lenders, 131 made 10 or more
FHA-insured loans in FY 1999; (14) as of October 1, 1999, HUD's
homeownership centers had not suspended the direct endorsement authority
of any of the 131 lenders GAO identified; (15) in May 1999, HUD's
headquarters implemented its Credit Watch program to terminate the loan
origination authority of lenders with excessive defaults and insurance
claims on FHA-insured mortgages; (16) however, because the program's
regulations pertain only to the lenders that originated the troubled
loans, HUD does not always hold accountable lenders that underwrote and
approved the loans; and (17) according to HUD, the program's regulations
did not permit HUD to take enforcement actions against these lenders.

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

 REPORTNUM:  RCED-00-112
     TITLE:  Single-Family Housing: Stronger Oversight of FHA Lenders
	     Could Reduce HUD's Insurance Risk
      DATE:  04/28/2000
   SUBJECT:  Mortgage programs
	     Mortgage protection insurance
	     Risk management
	     Internal controls
	     Loan defaults
	     Noncompliance
	     Mortgage loans
	     Contract oversight
	     Lending institutions
IDENTIFIER:  HUD Credit Watch Program
	     Atlanta (GA)
	     Denver (CO)
	     Philadelphia (PA)
	     Santa Ana (CA)
	     District of Columbia
	     Puerto Rico
	     HUD Computerized Home Underwriting Management System
	     Mutual Mortgage Insurance Fund
	     HUD 2020 Management Reform Plan

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GAO/RCED-00-112

Appendix I: Comments From the Department of Housing
and Urban Development

36

Appendix II: Objectives, Scope, and Methodology

42

Appendix III: GAO Contacts and Staff Acknowledgments

44

Table 1: Results of the First Three Rounds of HUD's Credit
Watch Program 25

Table 2: Summary of the Mortgagee Review Board's Fiscal
Year 1999 Actions on 24 Cases as of November 1999 29

Figure 1: Number of Single-Family Mortgage Loans Insured
by FHA, Fiscal Years 1997-99 6

Figure 2: Steps in the Approval Process for FHA-Insured
Mortgage Loans 7

Figure 3: Locations and Geographical Jurisdictions of HUD's
Four Homeownership Centers 9

Figure 4: Frequency of Poor Ratings for Mortgage Credit
Analysis Given to 36 Approved Lenders in Their
Last 15 Preclosing Reviews 13

Figure 5: Number of Lender Reviews Performed, Fiscal
Years 1996-99 15

Figure 6: Percentage of Loans Receiving Technical Reviews by Homeownership
Center, Fiscal Year 1999 18

Figure 7: Percentage of Lenders, by Type, Whose Loan Origination Authority
Was Terminated Because of Excessive
Defaults and Insurance Claims on Loans Made For
the 24-Month Period Ending March 31, 1999 26

CHUMS Computerized Homes Underwriting Management System

FHA Federal Housing Administration

GAO General Accounting Office

HUD Department of Housing and Urban Development

Resources, Community, and
Economic Development Division

B-283389

April 28, 2000

The Honorable Rick A. Lazio
Chairman, Subcommittee on Housing
and Community Opportunity
Committee on Banking
and Financial Services
House of Representatives

The Honorable Susan M. Collins
Chairman, Permanent Subcommittee
on Investigations
Committee on Governmental Affairs
United States Senate

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. During fiscal year 1999 alone,
FHA insured 1.3 million mortgages valued at about $124 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. Recent cases of mortgage fraud
across the country have raised concerns about HUD's oversight of these
lenders. For example, in December 1999, HUD's Office of the Inspector
General and the Department of Justice announced criminal charges against 39
California mortgage lenders, real estate professionals, and other persons
accused of obtaining more than $110 million in fraudulent FHA-insured loans.

As you requested, this report provides information on HUD's oversight of
lenders participating in FHA's mortgage insurance programs for single-family
homes. While almost 10,000 lending institutions are approved to participate
in FHA's single-family mortgage insurance programs, only about 2,900 of
these 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. Specifically, this report addresses
the following questions: (1) How well does HUD ensure that lenders granted
direct endorsement authority by FHA are qualified to receive such authority?
(2) To what extent does HUD focus on high-risk lenders in monitoring the
lenders participating in FHA's mortgage insurance programs? (3) To what
extent is HUD holding lenders accountable for poor performance? To address
these questions, 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. Our review focused on the adequacy of HUD's
policies and procedures for overseeing lenders. We performed limited tests
and analyses to determine whether these policies and procedures were
properly utilized to limit HUD's insurance risk.

HUD's process for granting FHA-approved lenders direct endorsement
authority--the ability to underwrite loans and determine their eligibility
for FHA mortgage insurance without HUD's prior review--provides limited
assurance that lenders receiving this authority are qualified. According to
HUD's guidance, FHA-approved lenders seeking direct endorsement authority
must demonstrate "acceptable performance" in underwriting at least 15
mortgage loans, which undergo evaluations, known as preclosing reviews, by
HUD's homeownership centers. However, the guidance does not define what
would constitute overall acceptable performance on the 15 loans. In the
absence of such a clear definition, HUD's homeownership centers' recent
performance in approving lenders for direct endorsement authority was
uneven. In the 6 months prior to our 1999 visits, the centers granted direct
endorsement authority to a total of 36 lenders. While many of these lenders
had demonstrated proficiency in underwriting mortgages, many others made
multiple and serious underwriting errors. Overall, 12 of the 36 lenders had
received 4 or more "poor" ratings from the centers for their last 15
preclosing reviews.

Contrary to HUD's guidance, the homeownership centers' monitoring of lenders
does not adequately focus on the lenders and loans that pose the greatest
insurance risks to the Department. On-site evaluations of lenders'
operations--known as lender reviews--are one of HUD's primary tools for
assessing the quality of lenders' mortgage-lending practices. HUD's guidance
states that 85 percent of the lender reviews should be targeted at high-risk
lenders. However, the homeownership centers have often not reviewed the
lenders that they consider to be the highest risk. For example, although the
Philadelphia center conducted reviews of 228 lenders during fiscal year
1999, it reviewed only 39 of the 131 high-risk lenders (about 30 percent)
that it designated as high priority for review that year. HUD officials told
us that the lack of experienced staff and limited travel funds impeded their
ability to visit and review the riskiest lenders. Desk audits to evaluate
the underwriting quality of individual loans insured by FHA--known as
technical reviews--are another important tool for overseeing lenders.
Although the homeownership centers met the Department's goal to perform
technical reviews of no less than 10 percent of all loans insured in fiscal
year 1999, they generally did not target these reviews at high-risk lenders
and loans as recommended by HUD's guidance.

HUD has not taken sufficient steps to hold lenders accountable for poor
performance and program violations. 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 centers have
made limited use of this ability. In fiscal year 1999 the Philadelphia
center suspended the direct endorsement authority of eight lenders; however,
the other three centers did not take this action against any lenders.
Furthermore, HUD's technical review ratings for fiscal year 1999 showed
frequent noncompliance by lenders with FHA's requirements, indicating that
many other lenders may be candidates for this action. For example, we
identified 206 lenders that received "poor" ratings for their mortgage
credit decisions in more than 30 percent of the loans that HUD reviewed in
fiscal year 1999. Furthermore, on the basis of our analysis, if HUD had
reviewed all of the lenders' fiscal year 1999 loans, the percentage of poor
ratings could have been expected to exceed 30 percent. Of these lenders, 131
made 10 or more FHA-insured loans in fiscal year 1999. As of October 1,
1999, HUD's homeownership centers had not suspended the direct endorsement
authority of any of the 131 lenders we identified. In May 1999, HUD's
headquarters implemented its Credit Watch program to terminate the loan
origination authority of lenders with excessive defaults and insurance
claims on FHA-insured mortgages. However, because the program's regulations
pertain only to the lenders that originated the troubled loans, HUD does not
always hold accountable lenders that underwrote and approved the loans.
According to HUD, the program's regulations did not permit the Department to
take enforcement actions against these lenders.

This report makes recommendations designed to improve HUD's processes for
(1) approving lenders to underwrite FHA-insured mortgages, (2) targeting
lenders and loans for quality control reviews, and (3) taking enforcement
actions against poorly performing lenders.

Established by the National Housing Act, FHA insures lenders against losses
on mortgages for single-family homes. 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 1997 through 1999, the number of single-family mortgage loans that FHA
insured grew from approximately 800,000 to nearly 1.3 million--a 63-percent
increase. (See fig. 1.) For the 3 years combined, FHA insured over 3 million
mortgages with a total value of $292 billion.

Figure 1: Number of Single-Family Mortgage Loans Insured by FHA, Fiscal
Years 1997-99
Source: HUD.

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. 2.) 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 LLP indicated that,
as of September 30, 1999, the Fund exceeded the legislative target for
capital reserves.

Figure 2: Steps in the Approval Process for FHA-Insured Mortgage Loans

Lenders must obtain approval from HUD to participate in FHA's mortgage
programs. In addition to an application form and fee, lenders are required
to submit supporting documentation, including the resumes of senior
corporate officers; certified financial statements; and photographs and
floor plans of the lender's main office. HUD uses this information to
determine whether the applicants meet FHA's requirements for lending
experience; financial worth; and adequacy of facilities, among other things.
HUD also determines whether any of the lenders' principal officers are
ineligible to participate in FHA's programs because of outstanding federal
debts; because of recent bankruptcies or derogatory credit; or because they
have been suspended, debarred, or otherwise excluded from the Department's
programs and activities. Lenders must be annually recertified by HUD to
maintain their FHA-approved status.

As of December 1999, about 9,950 lending institutions were approved to
participate in FHA's mortgage insurance programs for single-family homes.
Most FHA-approved lenders are authorized to originate FHA-insured loans,
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.1 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. In 1996, as part
of an effort to streamline its lender approval process, HUD stopped
individually approving underwriters working for FHA lenders that were
granted direct endorsement authority. Prior to 1996, underwriters seeking
FHA's approval had to submit applications to HUD, and HUD reviewed and
verified their experience and qualifications. HUD now relies on lenders to
certify that their underwriters meet FHA's standards.

Some FHA-approved lenders with direct endorsement authority, known as
sponsoring lenders, enter agreements to underwrite and fund loans originated
by FHA lenders without direct endorsement authority, known as loan
correspondents. About 40 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. 3.) Under the 2020 plan, HUD's single-family housing staff
was cut by more than 50 percent. The homeownership centers are located in
Atlanta, Georgia; Denver, Colorado; Philadelphia, Pennsylvania; and Santa
Ana, California, and report directly to HUD's Deputy Assistant Secretary for
Single-Family Housing.

Figure 3: Locations and Geographical Jurisdictions of HUD's Four
Homeownership Centers

The centers are responsible for processing and approving mortgage insurance
as well as several critical aspects of HUD's lender approval, monitoring,
and enforcement activities. These responsibilities include (1) granting
direct endorsement authority to qualified FHA-approved lenders; (2) on-site
evaluations of lenders' operations, known as lender reviews, and monitoring
lenders' performance through reviews of individual loans, known as technical
reviews, and (3) taking and initiating 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 approves and annually recertifies
lenders wishing 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,2 can impose administrative sanctions against lenders,
including withdrawing the lenders' authority to make FHA-insured loans.

Lenders Are Qualified

HUD's process for granting FHA-approved lenders direct endorsement
authority--the ability to underwrite loans and determine their eligibility
for FHA mortgage insurance without HUD's prior review--provides only limited
assurance that lenders receiving this authority are qualified. HUD's
guidance does not adequately define the level of proficiency that lenders
must achieve in order to receive direct endorsement authority. As a result,
HUD's homeownership centers have applied the guidance differently and
granted direct endorsement authority to lenders that demonstrated various
levels of proficiency. Many lenders were approved by the centers despite
making multiple underwriting errors. Lenders such as these may pose a high
insurance risk to the Department once they begin underwriting and approving
FHA-insured loans without HUD's prior review.

Adequately Defined

HUD's homeownership centers are responsible for granting direct endorsement
authority--the ability to underwrite loans and determine their eligibility
for FHA mortgage insurance without HUD's prior review--to lenders
participating in FHA's programs. According to HUD's guidance, FHA-approved
lenders seeking direct endorsement authority must go through a probationary
period during which they are required to demonstrate acceptable performance
in underwriting at least 15 mortgage loans. At HUD's discretion, the
probationary period may extend beyond 15 loans. The mortgages are submitted
to and evaluated by HUD's homeownership centers against FHA's underwriting
requirements before the lenders close the loans. Known as preclosing
reviews, these evaluations rate various aspects of the lender's work,
including the analysis of the mortgage credit decision and the property
appraisal, as "good," "fair," or "poor."3 A "good" rating indicates no
underwriting deficiencies, a "fair" rating indicates the presence of
deficiencies that did not significantly affect HUD's insurance risk, and a
"poor" rating indicates that underwriting errors significantly increased
HUD's insurance risk. HUD's guidance provides specific criteria for the
centers to use in determining these ratings.

While HUD's guidance requires that lenders seeking direct endorsement
authority demonstrate acceptable performance on their preclosing reviews,
the guidance for what constitutes overall acceptable performance is unclear.
For example, the guidance does not state whether acceptable performance
requires that lenders receive all "good" scores or whether combinations of
"good" and "fair" scores are permitted. The guidance makes no mention of
whether a lender can receive any "poor" scores and still qualify for direct
endorsement authority. As a result of HUD's vague performance standards, the
four homeownership centers have interpreted what constitutes overall
acceptable performance on the preclosing reviews differently. Philadelphia
center officials said they generally approved only those lenders that had
submitted at least 15 cases and had received only "good" or "fair" ratings
in their last five preclosing reviews. The Denver and Atlanta centers
interpreted the guidance as meaning that lenders had to submit a total of 15
loans for which they received only "good" or "fair" ratings in their
preclosing reviews. Santa Ana center officials said they did not have strict
requirements regarding the number of loans that had to receive "good" or
"fair" ratings. While some officials at the centers believed that the
existing approval guidance gave them the flexibility they needed to make
approval decisions, others believed that more specific guidance was
necessary to ensure that the decisions were more consistent.

Reviews

HUD's four homeownership centers granted direct endorsement authority to a
total of 36 lenders during the 6 months prior to our 1999 visits to the
centers.4 Approximately 230 other lenders were in the process of seeking but
had not yet received direct endorsement authority at the time of our visits.
The 36 lenders submitted an average of 18 loans to the centers for
preclosing reviews.

We analyzed the 36 lenders' ratings in preclosing reviews to illustrate the
different types of performance that the centers considered as acceptable.
Specifically, we reviewed the ratings that each lender received for mortgage
credit analysis--the evaluation of the borrower's credit worthiness--on the
last 15 preclosing reviews before the lender received direct endorsement
authority. Our analysis showed significant variations in what HUD's
homeownership centers considered as acceptable performance, reflecting the
vagueness and inconsistent application of HUD's approval standards. Overall,
of the 36 lenders, 8 received no "poor" ratings during their last 15
preclosing reviews, while 3 received 6 "poor" ratings during their last 15
preclosing reviews. (See fig. 4.) The lenders' errors included their failure
to (1) verify the borrower's employment and income, (2) ensure that the
borrower had sufficient income to support the monthly mortgage payments, (3)
explain delinquent accounts and collections on the borrower's credit
reports, and (4) properly calculate the borrower's debts or liabilities.
Twelve of the 36 lenders received "poor" ratings in 4 or more of their last
15 preclosing reviews. In other words, these 12 lenders made serious errors
in underwriting over a quarter of the mortgages they submitted to HUD to
demonstrate their abilities to comply with HUD's requirements. While the
centers felt that the lenders they approved had shown the ability to
underwrite FHA-insured loans properly, we believe that lenders such as these
12 may pose a high insurance risk to the Department once they begin
underwriting and approving loans without HUD's prior review.

Figure 4: Frequency of Poor Ratings for Mortgage Credit Analysis Given to 36
Approved Lenders in Their Last 15 Preclosing Reviews

Note: Our analysis included all 36 lenders to whom the four homeownership
centers had granted direct endorsement authority in the 6 months prior to
our visits to the centers. We visited the Philadelphia center in August 1999
and the Denver, Santa Ana, and Atlanta centers in October 1999.

Source: GAO's analysis of data from HUD's homeownership centers.

Loans

HUD's guidance stresses the importance of using risk analysis to allocate a
larger share of monitoring resources to program activities that pose the
highest risks to the Department. However, HUD's homeownership centers have
not adequately focused their monitoring efforts on lenders and loans that
pose the greatest insurance risks. The centers use two monitoring tools to
ensure lenders' compliance with FHA's mortgage requirements: (1) on-site
evaluations of lenders' operations, known as lender reviews, and (2) desk
audits of the underwriting quality of individual loans already insured by
FHA, known as technical reviews. In recent years, HUD substantially
increased the number of lender reviews that it performs. However, contrary
to HUD's guidance, the centers have not always reviewed the lenders they
consider to be high risk. With respect to technical reviews, in fiscal year
1999, the centers met HUD's goals regarding the percentage of loans
undergoing these reviews but, contrary to HUD's guidance, selected most of
the loans at random instead of using a risk-based selection process. In
addition, while contractors perform most of the homeownership centers'
technical reviews, three of the four centers did not track the quality of
the contractors' work against performance standards in the contracts.

In recent years, HUD has placed greater emphasis on performing on-site
evaluations of lenders' operations. These 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 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. During fiscal years 1996 through 1999, HUD increased the
number of staff performing lender reviews from 23 to approximately 140. Over
this period, the number of lender reviews that HUD conducted also increased.
In fiscal year 1999, HUD's homeownership centers conducted 932 lender
reviews, exceeding the Department's goal of 900 reviews.5 (See fig. 5.)

Figure 5: Number of Lender Reviews Performed, Fiscal Years 1996-99

Source: GAO's analysis of data from HUD.

HUD's guidance states that lenders should be rated and prioritized for
review and that 85 percent of the reviews should be targeted at high-risk
lenders, while 15 percent should be selected randomly. Focusing on high-risk
lenders increases the likelihood that HUD will uncover improper lending
practices, which the Department can then take steps to curtail. However, we
found that the homeownership centers did not always review the lenders that
they considered to pose the highest risks. The Philadelphia center was the
only one that had developed and could provide us with a list of high-risk
lenders that it considered to be a high priority for review in fiscal year
1999.6 The list consisted of 131 lenders in the center's geographical
jurisdiction. However, despite conducting reviews of 228 lenders during
fiscal year 1999, the center reviewed just 39 of the 131 lenders on its
priority list. Had the Philadelphia center complied with HUD's guidance and
targeted 85 percent of its reviews at high-risk lenders, the center would
have been able to review all of the lenders on its priority list. We were
unable to determine the extent to which the other three centers reviewed the
lenders they considered to be the highest risk because they could not
provide us with similar priority lists of high-risk lenders for their fiscal
year 1999 reviews. However, officials at these centers told us that they
often targeted for review those lenders that did not pose a high insurance
risk to HUD. For instance, the director of the Santa Ana center's quality
assurance division estimated that half of the reviews that the center
performed in fiscal year 1999 were of lenders that had few or no early
defaults. Because early defaults are an indicator of poor lending practices
that may result in insurance losses, HUD considers them to be an important
factor in assessing lenders' risk.

Homeownership center officials cited inexperienced staff and limited or
uncertain travel funds as reasons why high-risk lenders were not always
reviewed. According to center officials, most of the centers' 140 staff who
conduct lender reviews assumed their current positions in fiscal years 1998
and 1999, largely from the pool of HUD field staff who remained unassigned
after HUD's 1998 reorganization. The officials said that many of these
individuals had no background in lender monitoring or mortgage credit
issues. To address this problem, the officials said that they provided both
classroom and on-the-job training to the new staff. However, center
officials also told us that they generally did not allow staff with less
than a year of experience to review high-risk lenders because their
inexperience might lead them to overlook serious deficiencies. Furthermore,
the centers' quality assurance directors told us that they typically had
little or no travel funding during the first 2 to 3 months of the fiscal
year. They said that during these periods, center staff are forced to
identify and review lenders within commuting distances of the staffs' homes
or offices--without primary regard to the lenders' risk--in order to avoid
incurring travel expenses.

Furthermore, although HUD's guidance states that lenders should be rated and
prioritized for review, the Department has not developed a systematic
process for doing so. HUD's guidance lists several risk factors that should
be considered in targeting lenders for reviews, including default rates, the
late payment of mortgage insurance premiums to HUD, and the volume of
business. But the guidance indicates neither how these factors should be
weighted nor how lenders should be prioritized. As a result, the centers
have not targeted lenders for reviews in a consistent manner. We found that
neither the Santa Ana nor the Atlanta centers had standardized ways to
assess lenders' risk and prioritize them for review. In contrast, the
Philadelphia and Denver centers had implemented more systematic but
different approaches. For example, the Philadelphia center established, as a
high priority for review, those lenders that, during the previous 5 years,
had made over 500 FHA-insured mortgages and had high percentages of loans
that defaulted within 24 months relative to the national and corresponding
state averages. By comparison, the Denver center focused on lenders that,
during the previous 3 years, had the largest number of loans that defaulted
within 13 months.

Technical reviews--desk audits that evaluate the underwriting quality of
individual loans already insured by FHA--are another tool that HUD uses to
monitor the performance of lenders. Technical reviews that reveal serious
deficiencies may result, among other things, in HUD's requiring the lenders
to compensate the Department for financial losses or HUD's suspending the
lenders' direct endorsement authority. While the homeownership centers met
the numerical goals for conducting technical reviews during fiscal year
1999, the reviews, contrary to HUD's guidance, did not focus on loans that
(1) exhibit high-risk characteristics or (2) were made by lenders with known
performance problems or newly approved lenders. As a result, underwriting
practices that significantly increase HUD's insurance risk may be going
undetected.

All four of HUD's homeownership centers met the Department's goal to perform
technical reviews on no less than 10 percent of the FHA-insured mortgage
loans made during fiscal year 1999. The four centers combined performed
151,575 technical reviews in fiscal year 1999, representing 11.7 percent of
the loans that FHA insured that year. (See fig. 6.)

Figure 6: Percentage of Loans Receiving Technical Reviews by Homeownership
Center, Fiscal Year 1999

Source: GAO's analysis of data from HUD.

The homeownership centers, however, have not effectively implemented HUD's
guidance, which recommends that high-risk loans should be selected for
technical reviews. The guidance cites as high-risk loans those mortgage
transactions involving multiunit dwellings; foreclosed HUD-owned properties;
and borrowers with unusually high expenses relative to their income, among
other factors. 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. Instead, the centers rely primarily on a random process for selecting
loans for technical reviews. According to center officials, HUD's
Computerized Homes Underwriting Management System (CHUMS)--a computer system
that assists and supports HUD staff in processing mortgage insurance for
single-family homes--is programmed to randomly select a certain percentage
of each lender's loans. However, CHUMS currently cannot automatically
identify and select for review those loans that exhibit high-risk
characteristics. Center officials told us that they sometimes manually
selected high-risk loans for review but that the large volume of loans they
processed for FHA insurance, coupled with staffing constraints, made it
impractical to do this on a routine basis. According to HUD officials, the
Department is developing a "mortgage scorecard" system, which, they believe,
will enable HUD to readily identify high-risk loans for technical reviews by
assigning risk scores to all FHA-insured mortgage loans on the basis of
various characteristics of the loans. The officials said that they hope to
fully implement this system by the end of fiscal year 2001.

CHUMS permits homeownership center staff to adjust the percentage of each
lender's loans that are selected for technical reviews. HUD's guidance
suggests that 5 to 10 percent of a lender's loans should be selected for
technical reviews but that this percentage should be increased up to 100
percent if problems are noted with the lender's performance (e.g., high
default rates, poor technical review ratings, or homebuyers' complaints).
However, the centers have infrequently used their ability to adjust the
percentage of lenders' loans selected for technical reviews to more closely
monitor lenders whose performance problems may increase HUD's insurance
risk. HUD's guidance states also that the centers should perform technical
reviews of 100 percent of the FHA-insured loans that are made by lenders
that are newly granted direct endorsement authority for 6 months or through
their first 50 loans. However, we found that the centers did not
consistently follow this guidance and lacked information systems to readily
identify and track the technical review ratings of new direct endorsement
lenders. For example, officials at the Philadelphia center told us they were
not aware of the guidance and selected only 10 percent of these lenders'
loans for technical reviews.

In contrast to HUD, both Fannie Mae and Freddie Mac--government-sponsored
enterprises that purchase home mortgages and issue mortgage-backed
securities--perform quality control reviews on samples of loans selected on
the basis of risk as well as samples of loans selected at random. Officials
with both organizations told us they had databases and statistical models to
generate these samples automatically. The officials said they used
risk-based samples to focus their monitoring resources at high-risk loans
and lenders that made such loans.7 They said they used random samples to
determine the prevalence of underwriting deficiencies throughout their
entire loan portfolios.

Limited

The large majority of HUD's technical reviews are performed by firms under
contract with the homeownership centers.8 Each contract contains 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 centers were not tracking the contractors' work
against these standards. As a result, these centers lack 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.

Each technical review contract states that each month, HUD staff will review
the accuracy and completeness of the contractor's work and provide the
contractors with performance feedback. The contracts for the Atlanta,
Philadelphia, and Santa Ana centers state that HUD may reject the reviews if
more than 10 percent of them contain significant errors or omissions (e.g.,
incorrect ratings given or significant issues not identified) and that an
error rate of over 10 percent may be considered failure to perform. The
corresponding percentages in the Denver center's contracts are 20 percent.

We found that the Atlanta, Denver, and Philadelphia homeownership centers
did not track the percentage of the contractors' work that contained
significant errors and omissions. Without this information, these centers
were not in a position to provide the contractors with adequate performance
feedback or, if necessary, to enforce the contracts' performance clauses.
The Santa Ana homeownership center's evaluations of one of its two technical
review contractors revealed an error rate of over 20 percent for the 5-month
period from April through August 1999--double the center's acceptable rate.
However, the center did not hold the contractor responsible for the high
error rates, as provided for by the contract. In October 1999, the center
began to intensively monitor both of its contractors in order to provide the
contractors with detailed feedback and to more aggressively enforce the
contracts' performance clauses. At the time of our review, all four centers
indicated that they were planning to adopt a database system developed by
the Denver center to, among other things, capture and track the results of
their evaluations of the technical review contractors' work.

Been Sufficient

To hold lenders accountable for program violations or poor performance, HUD
may (1) suspend their direct endorsement authority, (2) terminate their loan
origination authority through its Credit Watch program, or (3) take
enforcement action through its Mortgagee Review Board. However, the
homeownership centers have made only limited use of their ability to suspend
the direct endorsement authority. And while HUD's Credit Watch program is
designed to hold lenders accountable for excessive loan defaults and
insurance claims on FHA-insured mortgages, the program focuses on lenders
who originated the troubled loans and has not held accountable other FHA
lenders who underwrote and approved the loans. Furthermore, the Department's
authority to implement the program is also facing a legal challenge, leaving
the future of the program in doubt. Lastly, HUD's Mortgagee Review Board
often takes over a year to impose sanctions against lenders for program
violations.

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. The centers suspended a total of eight lenders
in fiscal year 1999, but our analysis of HUD's technical review ratings for
fiscal year 1999 showed frequent noncompliance by lenders with FHA's
requirements, indicating that many additional lenders may be candidates for
this action. By not suspending poorly performing lenders, HUD leaves itself
vulnerable to lending practices that increase the Department's insurance
risk.

HUD's guidance allows the homeownership centers to suspend the direct
endorsement authority of lenders that fail to comply with FHA's program
requirements but provides only general guidelines for determining which
lender's direct endorsement authority should be suspended. For example, the
guidance states that the centers should consider suspending lenders that
exhibit "patterns" of noncompliance, but it does not define what would
constitute a pattern. Lenders whose direct endorsement authority is
suspended must submit their mortgage case files to the centers, which
evaluate 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. Lenders that cannot
demonstrate satisfactory performance may have their direct endorsement
authority withdrawn by the centers.

Among the four homeownership centers, we found that the Philadelphia center
was the only one that had suspended the direct endorsement authority of any
lenders during fiscal year 1999. Specifically, the Philadelphia center took
this action against eight lenders in fiscal year 1999, citing underwriting
violations identified by technical reviews or lender reviews. While the
Santa Ana center did not suspend any lender's direct endorsement authority,
in October 1999, the center warned 27 lenders that it might do so if they
did not submit plans to eliminate and prevent the recurrence of underwriting
deficiencies revealed in technical reviews. The Denver and Atlanta centers
did not suspend any lender's direct endorsement authority. Officials at
these centers told us they had concerns about the additional workload
associated with suspending lenders and lacked the information systems
necessary to evaluate lenders' performance. The centers have taken steps to
address these problems, as follows:

ï¿½ In September 1999, the Atlanta center hired a contractor to evaluate the
underwriting decisions of lenders whose direct endorsement authority may be
suspended by the center in the future. Officials at the Atlanta center said
they lacked sufficient underwriting staff to do this function themselves.

ï¿½ Denver center officials said they were developing a database system to,
among other things, help all four centers better track and analyze the
results of technical reviews and identify poorly performing lenders for
enforcement actions. Although technical review ratings are entered into
CHUMS, this system is a limited monitoring tool because it does not capture
the reason for each rating--information that center officials believe is
necessary to justify enforcement actions against lenders.

We also found that the centers had not developed consistent criteria for
suspending lenders' direct endorsement authority. For example, the
Philadelphia center suspended several lenders because, according to center
officials, the lenders received "fair" or "poor" ratings for underwriting in
over half of their technical reviews in fiscal years 1998 and 1999 and had
above-average default rates on their FHA-insured mortgage loans. In
contrast, the Santa Ana center proposed suspending lenders solely because
the lenders' underwriters received six or more "poor" ratings in technical
reviews conducted during July through September 1999, regardless of the
number of reviews the lenders received during the period. Neither the
Atlanta nor the Denver center had developed criteria for suspending lenders'
direct endorsement authority.

Although HUD's homeownership centers suspended the direct endorsement
authority of relatively few lenders in fiscal year 1999, our analysis of
HUD's technical review ratings for fiscal year 1999 showed frequent
noncompliance by lenders with FHA's requirements, indicating that many
lenders may be candidates for this action. Specifically, our analysis showed
that in fiscal year 1999, about 5,000 lenders received technical review
ratings for mortgage credit analysis for the FHA-insured mortgages they
originated and underwrote.9 Nearly 20 percent of the loans subject to
technical reviews received "poor" ratings for mortgage credit analysis,
meaning that the lenders made mistakes in evaluating the borrowers' credit
worthiness that significantly increased HUD's insurance risk. We identified
206 lenders nationwide that, during fiscal year 1999, received "poor"
ratings for mortgage credit analysis on more than 30 percent of their
reviewed loans and whose percentage of "poor" ratings, on the basis of
statistical analysis, could have been expected to exceed 30 percent, had HUD
reviewed all of their fiscal year 1999 loans.10 Of these lenders, 131 made
10 or more FHA-insured loans in fiscal year 1999. HUD's guidance does not
define the extent of noncompliance with FHA's underwriting requirements that
would warrant the suspension of a lender's direct endorsement authority.
However, in our opinion, the extent of noncompliance demonstrated by these
131 lenders indicates that they may be candidates for this action. As of
October 1, 1999, HUD's homeownership centers had not suspended any of these
lenders' direct endorsement authority.

Responsibility for Excessive Default and Claim Rates Under HUD's Credit
Watch Program

HUD's Credit Watch program is an enforcement tool that the Department has
used to terminate the loan origination authority of lenders with excessive
default and claim rates on FHA-insured loans. However, because the program's
regulations pertain only to the lenders that originated the troubled loans,
HUD does not always hold accountable those lenders that underwrote and
approved the loans. For example, 18 of the 33 lenders whose loan origination
authority was terminated by HUD during the first round of Credit Watch used
other FHA lenders to underwrite all or virtually all of the troubled loans
that the 18 lenders originated. However, HUD did not hold the lenders that
underwrote these loans accountable. In addition, a legal challenge to HUD's
authority to implement the program leaves the program's future in doubt.

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. HUD planned to terminate the loan origination authority of any lender
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. Similarly, HUD planned to place on "Credit Watch" status the
lenders whose default and claim rates exceeded both the national average and
200 percent of the corresponding HUD field office average. While on Credit
Watch status, the lender can continue to originate FHA-insured loans, but
its performance receives greater scrutiny from HUD.

As of the end of January 2000, HUD had analyzed lenders' default and claim
rates for the three 24-month periods ending on March 31, 1999, June 30,
1999, and September 30, 1999. HUD limited its analyses to lenders that had a
minimum of 25 defaults or claims during these periods. This program has
resulted in the Department's actual or proposed termination of 50 lenders'
loan origination authority and the placement of 104 additional lenders on
Credit Watch status. (See table 1.)

Table 1: Results of the First Three Rounds of HUD's Credit Watch Program

 Credit WatchNumber of lenders whose FHA loan    Number of lenders that HUD
 round       origination authority was           placed on Credit Watch
             terminated by HUD                   status
 1           33                                  56
 2           5                                   25
 3           12a                                 23
 Total       50                                  104

aProposed as of February 1, 2000.

Source: HUD's Office of Lender Activities and Program Compliance.

The regulations governing HUD's Credit Watch program allow the Department to
hold accountable for excessive defaults or insurance claims the lenders that
originated the troubled loans. However, the regulations do not address HUD's
authority to also hold accountable those lenders that have underwritten the
loans. When originating mortgage loans, lenders 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. HUD officials
told us they recognized that the underwriting lenders contributed to
excessive defaults and insurance claims but that the Credit Watch program's
regulations did not permit them to take enforcement actions against these
lenders. The officials said they were considering regulatory changes to
address this problem.

The results of the first round of the Credit Watch program illustrate the
program's limitations as an enforcement tool. As shown in figure 7, of the
33 lenders that HUD terminated during the first round of the program, 17
were loan correspondents. Under HUD's regulations, loan correspondents sell
or transfer loans that they originate to other FHA lenders, known as
sponsoring lenders, for underwriting and approval. Sponsoring lenders
underwrote the nearly 6,200 loans that the 17 loan correspondents originated
and FHA insured during the 24-month period of analysis, but HUD did not
impose sanctions against the sponsoring lenders through the Credit Watch
program. The remaining 16 lenders had the authority to underwrite
FHA-insured loans. However, 1 of these 16 lenders relied largely on other
lenders to underwrite the loans it originated. Specifically, HUD's data
showed that other lenders underwrote 364 of the 365 loans that the lender
had originated and FHA insured during the 24-month period. The data showed
further that three lenders had underwritten 274 of these 364 loans and that
the lenders' default and claim rates for these loans were 6 to 13 times the
national average and 3 to 6 times the corresponding HUD field offices'
averages. Nevertheless, the three lenders were not subject to enforcement
actions under the Credit Watch program.

Figure 7: Percentage of Lenders, by Type, Whose Loan Origination Authority
Was Terminated Because of Excessive Defaults and Insurance Claims on Loans
Made For the 24-Month Period Ending March 31, 1999

Source: GAO's analysis of data from HUD.

In September 1999, one lender whose authority to originate FHA-insured
mortgage loans was terminated by HUD filed a lawsuit seeking to overturn
HUD's actions. Among other issues, the lender contended that HUD had
exceeded its statutory authority when it issued its Credit Watch regulations
and that the manner in which HUD terminated the lender's authority had
deprived the lender of due process. In October 1999, a federal district
court ruled that HUD's Credit Watch regulations were invalid and set aside
HUD's termination of the lender. The court stated that HUD's statutory
authority requires that after determining that a lender has excessive
defaults and claims, HUD must provide the lender the opportunity to provide
the Department with a plan and timetable for correcting the defaults. The
court stated that HUD had sidestepped its statutory mandate by enacting
regulations that allowed the Department to terminate a lender's authority to
originate loans whenever HUD deemed it appropriate because of the lender's
default and claim rates. The court also concluded that even if HUD had the
authority to issue such regulations, the regulations denied the lender its
right to due process.11 In December 1999, the same court ruled that its
October 1999 decision did not affect the other lenders whose FHA's loan
origination authority was terminated by HUD.

HUD has appealed this decision. An Assistant General Counsel in HUD's
Litigation Division told us that, in HUD's view, the National Housing Act
provides the Department with broad authority to issue regulations and
fashion programs for dealing with lenders with excessive default and claim
rates. According to this official, HUD also disagrees with the court's
contention that HUD's regulations denied the lender due process. He said
that the lenders whose authority HUD proposed to terminate were given 30
days written notice of HUD's intention and were provided the opportunity to
explain the reasons for the high default and claim rates. HUD officials told
us that if the Department loses its appeal of the court decision, it will
seek legislation that authorizes HUD to continue the Credit Watch program.

Time-Consuming

HUD's Mortgagee Review Board (Board) can impose administrative actions
against FHA lenders that commit program violations. However, the Board
frequently takes over a year to impose sanctions against lenders and faces
challenges to improving its timeliness. As a result, some of these lenders
continue making FHA-insured loans for a year or more before they are held
accountable for the violations.

In fiscal year 1999, 68 cases were referred to the Board for 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 and involve lenders that make mortgages for single-family homes.
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 FHA-approved
lenders, ranging from a letter of reprimand to withdrawal of a lender's FHA
approval.

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. For example, we reviewed
the Board's records for 24 of the 30 cases involving single-family housing
lenders that the Board acted on from October 1998 through April 1999.12 As
of November 1999, we found that in 18 of the 24 cases, the Board had either
reached settlement agreements with the lenders (5 cases) or was still
attempting to reach settlement agreements (13 cases). In the remaining six
cases, the Board had withdrawn the lenders' FHA approval. (See table 2.)

Our analysis of the 24 cases further showed that the Board's efforts to
review the cases and impose sanctions against lenders or to enter into
settlement agreements with them is frequently a time-consuming process. As
table 2 shows, for the 11 cases that the Board completed action on as of
November 1999, it took an average of 8.5 months from the notice of
violations to withdraw lenders' FHA approval and an average of 11.2 months
to reach settlement agreements. For one of the withdrawals and for two of
the settlement agreements, the Board took over a year to complete these
actions. For the 13 cases that the Board had not completed action on, an
average of 14.3 months had elapsed since the Board sent the lenders notices
of violation. The length of time required by the Board to complete its
actions in these 13 cases has allowed some of these lenders to continue
making FHA-insured loans for over a year without being held accountable for
their violations. For example, in April 1998, the Board sent a notice of
violation to one of these lenders because the lender committed several
violations, including using false information to originate loans. However,
the Board had not resolved the case as of November 1999--19 months
later--and during the 19-month period, the lender made over 300 FHA-insured
mortgage loans.

Table 2: Summary of the Mortgagee Review Board's Fiscal Year 1999 Actions on
24 Cases as of November 1999

                                            Average number of months
 Type of Board action           Number of   elapsed since the notices of
                                cases
                                            violation
 Board action completed
 Lender's FHA approval was
 withdrawn                      6           8.5
 Lender entered into a
 settlement agreement           5           11.2
 Board action ongoing

 Board and lender attempting to
 reach a settlement agreement
                                13          14.3
 Total                          24

Source: GAO's analysis of data from HUD.

HUD does not have guidelines for the time it should take for the Board to
take enforcement actions against lenders. However, the Board recognizes that
its review process and its efforts to impose sanctions against or enter into
settlement agreements with lenders that commit program violations can be
time-consuming. The Board has taken some steps to speed up the process. For
example, the Board's secretary told us that in December 1998, the Board
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, the Board recently hired another
person to help the Board's secretary review case referrals and prepare the
cases for the Board's action. In addition, to speed up the settlement
agreement process, the Board plans 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. If a lender's settlement offer was
acceptable to the Board, a settlement agreement could be prepared and signed
immediately. If a lender's offer was not acceptable, the Board could then
make its own proposal for settling the case.

FHA insures tens of billions of dollars in mortgages for single-family homes
each year. While FHA's Mutual Mortgage Insurance Fund is currently
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 important for HUD to
hold lenders accountable for the quality of these loans. However, HUD has
not taken adequate steps to maximize the effectiveness of its oversight
resources and minimize its insurance risk. Weaknesses in HUD's approval,
monitoring, and enforcement efforts point to the need for improvements in
HUD's oversight of FHA mortgage lenders.

HUD could significantly improve its process for approving lenders seeking
the authority to underwrite FHA-insured loans. Because the Department lacks
clear and specific standards for granting lenders direct endorsement
authority, its homeownership centers have implemented the existing standards
differently and approved lenders that demonstrated varying levels of
proficiency, including lenders that made multiple and serious underwriting
mistakes. Consequently, HUD has only limited assurance that the lenders it
is approving are qualified to underwrite loans and, therefore, may be
exposing the Department to unreasonable insurance risks. Addressing this
deficiency is especially important, given that since 1996, HUD has no longer
individually reviewed the qualifications of lenders' underwriting staff.

Contrary to HUD's guidance, the homeownership centers' monitoring of lenders
does not adequately focus on the lenders and loans that pose the greatest
insurance risks to the Department. Focusing on high-risk cases would
increase HUD's opportunities to uncover and curtail improper lending
practices. However, HUD's homeownership centers often have not conducted
lender reviews of the lenders considered to pose the highest risk, and HUD
lacks a systematic process for identifying and prioritizing such lenders for
review. Furthermore, HUD's centers have not consistently targeted for
technical reviews either high-risk loans or loans made by problem lenders
and newly approved lenders. In addition, HUD's oversight of contractors that
perform technical reviews does not provide adequate assurance that the
contractors are doing a good job. Because of these deficiencies, 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. Numerous lenders are not complying with
FHA's underwriting requirements, yet HUD's homeownership centers have
suspended the direct endorsement authority of relatively few lenders.
Furthermore, HUD's Credit Watch program is a strong enforcement tool but a
court decision has left the future of the program in doubt. In addition, we
believe that the program would be more effective if it held accountable all
the lenders involved in making problem loans rather than just those that
originated the loans. When poorly performing lenders are not held
responsible, they may continue to make loans that increase potential losses
to FHA's insurance fund.

To reduce the financial risks assumed by FHA and 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 do the
following:

ï¿½ Improve the process for granting lenders direct endorsement authority by
developing specific standards for overall acceptable performance in
preclosing reviews and ensuring that the homeownership centers comply with
these standards.

ï¿½ More effectively monitor lenders' performance by

ï¿½ developing procedures to identify and prioritize high-risk lenders for
lender reviews and ensuring that the homeownership centers consistently
apply these procedures;

ï¿½ developing procedures and enhancing FHA's management information systems
to identify and select, for technical reviews, loans and lenders within each
homeownership center's jurisdiction that pose a high insurance risk to the
Department;

ï¿½ complying with guidance to perform technical reviews of all the
FHA-insured loans that are made by lenders that are newly granted direct
endorsement authority; and

ï¿½ tracking the performance of contractors conducting technical reviews
against performance standards in the contracts and taking appropriate
actions against contractors whose performance is not acceptable.

ï¿½ Strengthen its enforcement efforts by clarifying and implementing
guidelines for identifying lenders whose direct endorsement authority should
be suspended.

In addition, we recommend that once the legal basis of the Credit Watch
program is resolved, the Secretary of HUD direct the Assistant Secretary for
Housing-Federal Housing Commissioner, to 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.

We provided HUD with a draft of this report for review and comment. HUD
stated that while it did not always agree with the report's characterization
of the Department's practices and procedures for overseeing FHA lenders, it
generally agreed with the report's recommendations.

In commenting on the draft report's discussion of technical reviews of
loans, HUD took issue with our statement that its selection of loans for
review was not based on risk. HUD stated that it performs technical reviews
of all Section 203(k) rehabilitation loans, mortgages made to nonprofit
agencies, and other categories of mortgages that historically have had
higher default rates. Our report recognizes that the homeownership centers
have, on a limited basis, targeted some high-risk loans for technical
reviews. At the same time, the centers' lack of information systems capable
of identifying high-risk loans makes it impractical for the centers to
select and review high-risk loans on a routine basis. Furthermore, the
categories of loans cited by HUD--Section 203(k) loans and mortgages made to
nonprofit agencies--account for a very small portion of FHA's loan
portfolio.

HUD also disagreed with our finding that it was not monitoring the
performance of technical review contractors. Our draft report did not
present such a finding. Rather, we observed that three of the four
homeownership centers did not track the percentage of the contractors' work
that contained significant errors and omissions and, therefore, were not in
a position to provide the contractors with adequate performance feedback or,
if necessary, to enforce the contracts' performance clauses.

HUD commented that our draft report's discussion of lender reviews did not
adequately recognize that its targeting guidance requires homeownership
center staff to consider several factors, in addition to lenders' default
and claim rates, in selecting lenders for review. Our report recognizes that
HUD's guidance requires that various risk factors, such as lenders' loan
volume and the late payment of mortgage insurance premiums to HUD, be
considered in targeting lenders for review. However, our concern is that the
guidance neither indicates how these factors should weighted nor how lenders
should be prioritized. As a result, the homeownership centers have not
targeted lenders for reviews in a consistent manner.

While agreeing with our recommendation to clarify and implement guidelines
for identifying lenders whose direct endorsement authority should be
suspended, HUD disagreed with the draft report's finding that the Department
had made limited use of its ability to suspend the direct endorsement
authority of lenders. HUD stated that while the homeownership centers had
not actually suspended the authority of many lenders, they had threatened
suspension in several dozen cases every year in an attempt to improve
lenders' performance. As our report notes, one center suspended 8 lenders in
fiscal year 1999 and another center threatened to suspend 27 lenders in
October 1999. At the other two centers, we found only one instance in which
the center threatened to suspend the authority of a lender. Taken together,
the actions of the four centers do not appear to support HUD's assertion
that the centers have routinely used the threat of suspension to improve
lenders' performance.

Finally, while HUD agreed with our recommendation to revise its Credit Watch
program to hold loan underwriters accountable for excessive default and
claim rates, HUD did not believe that it would be appropriate to stop taking
enforcement action against loan originators. We did not intend for HUD to
stop taking enforcement action against loan originators but rather that the
Credit Watch program hold both the lenders that originated the troubled
loans and the lenders that underwrote the loans accountable for excessive
default and claim rates because both share responsibility for the quality of
the loans.

The full text of HUD's letter is presented in appendix I.

We conducted our work at HUD's headquarters and its Atlanta, Denver,
Philadelphia, and Santa Ana homeownership centers. Our review focused on the
adequacy of HUD's policies and procedures for overseeing lenders. We
reviewed regulations, handbook guidance, and other documents related to
HUD's approval, monitoring, and enforcement activities for FHA lenders. We
interviewed officials from HUD's Office of Insured Single-Family Housing,
Enforcement Center, Mortgagee Review Board, and the four centers. We also
interviewed representatives from Fannie Mae, Freddie Mac, and a firm
contracted by HUD to perform technical reviews. In addition, we performed
limited tests and analyses to determine whether HUD's policies and
procedures were properly utilized to limit the Department's insurance risk.
We analyzed information on the performance of all 36 lenders granted direct
endorsement authority by the four homeownership centers in the 6 months
prior to our 1999 visits. We also reviewed documentation from the centers
pertaining to targeting of lenders for on-site monitoring and technical
reviews, the oversight of technical review contractors, and enforcement
actions against lenders. We analyzed data from HUD's Computerized Homes
Underwriting Management System to determine how frequently lenders received
"poor" ratings for mortgage credit analysis in technical reviews. We
determined the number and types of lenders sanctioned by HUD under its
Credit Watch program as of the end of January 2000. Finally, we reviewed the
Mortgagee Review Board's files for information on its enforcement
activities. We performed this review from June 1999 through April 2000 in
accordance with generally accepted government auditing standards. Appendix
II provides additional details on our scope and methodology.

As arranged with your office, unless you publicly release its contents
earlier, we plan no further distribution of this report until 30 days after
the date of this letter. At that time, we will send copies to the Honorable
Barney Frank, Ranking Minority Member, Subcommittee on Housing and Community
Opportunity, House Committee on Banking and Financial Services; the
Honorable James A. Leach, Chairman, and the Honorable John J. LaFalce,
Ranking Minority Member, House Committee on Banking and Financial Services;
the Honorable Carl Levin, Ranking Minority Member, Permanent Subcommittee on
Investigations, Senate Committee on Governmental Affairs; the Honorable Phil
Gram, Chairman, and the Honorable Paul S. Sarbanes, Ranking Minority Member,
Senate Committee on Banking, Housing, and Urban Affairs; and the Honorable
Fred Thompson, Chairman, and the Honorable Joseph Lieberman, Ranking
Minority Member, Senate Committee on Governmental Affairs. We will also send
copies of this report to the Honorable Andrew M. Cuomo, Secretary of HUD;
the Honorable William C. Apgar, HUD Assistant Secretary for Housing-Federal
Housing Commissioner; and the Honorable Jacob J. Lew, Director, Office of
Management and Budget. We will make copies available to others upon request.

Please call me on (202) 512-7631 if you or your staff have any questions
about this report. Major contributors to this report are listed in appendix
III.

Stanley J. Czerwinski
Associate Director, Housing and Community
Development Issues

Comments From the Department of Housing and Urban Development

Objectives, Scope, and Methodology

Our objectives were to answer the following questions: (1) How well does the
Department of Housing and Urban Development (HUD) ensure that lenders
granted direct endorsement authority by the Federal Housing Administration
(FHA) are qualified to receive such authority? (2) To what extent does HUD
focus on high-risk lenders in monitoring the lenders participating in FHA's
mortgage insurance programs? (3) To what extent is HUD holding these lenders
accountable for poor performance? Our review focused on the adequacy of
HUD's policies and procedures for overseeing lenders. We performed limited
tests and analyses to determine whether these policies and procedures were
properly utilized to limit HUD's insurance risk.

To determine how HUD ensures that lenders granted directed endorsement
authority are qualified to receive such 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 and
its four homeownership centers. We developed information on the number of
lenders granted direct endorsement authority by each of the four
homeownership centers during the 6 months prior to our visit to each of the
centers. We visited the Philadelphia center in August 1999 and the Denver,
Santa Ana, and Atlanta centers in October 1999. For each of the 36 lenders
approved during this time period, we reviewed documentation maintained by
the centers to determine (1) the ratings that the lender received on the
mortgages it submitted to the center to demonstrate its ability to comply
with FHA's requirements and (2) whether the centers followed FHA's
procedures in granting lenders direct endorsement program authority.

To determine the extent to which HUD is focusing its monitoring efforts on
high-risk lenders, we reviewed HUD's guidance and procedures for conducting
technical reviews (i.e., review of individual loans performed after approval
of mortgage insurance to assess the quality of lenders' underwriting
practices) and lender reviews (i.e., on-site reviews of lenders' operations
by HUD staff). We determined the extent to which each of the four
homeownership centers met HUD's fiscal year 1999 goals to (1) conduct
technical reviews of at least 10 percent of the single-family mortgage loans
insured by FHA during the fiscal year and (2) perform 225 lender reviews. We
reviewed HUD's use and oversight of contractors that perform technical
reviews and interviewed representatives from one contractor that was
performing reviews for three of the four homeownership centers. We
interviewed officials at each of the centers on a variety of issues dealing
with technical reviews and lender reviews. The issues discussed included the
(1) centers' criteria for targeting loans and lenders for review, (2)
procedures for monitoring the work of technical review contractors, and (3)
number and experience of the centers' staff who were performing lender
reviews. We also interviewed representatives from Fannie Mae and Freddie Mac
regarding their efforts to monitor the performance of lenders whose loans
they purchase.

To determine the extent to which HUD is holding lenders accountable for poor
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 poorly performing lenders. Using data from HUD's
Computerized Homes Underwriting Management System on the technical reviews
conducted during fiscal year 1999, we determined the percentage of reviews
that gave a "poor" rating for mortgage credit analysis. Using these same
data, we performed statistical analyses to identify, at the 95-percent level
of confidence, those lenders we would have expected to have received "poor"
ratings on more than 30 percent of their loans, had all of their fiscal year
1999 loans been subject to technical reviews. We determined the number and
types of lenders sanctioned by HUD under its Credit Watch program as of the
end of January 2000. We reviewed the Board's files for 24 of the 30 cases
involving single-family mortgage lenders that the Board acted on during
October 1998 through April 1999 and determined the nature and status of the
Board's actions as of November 1999.

Our reliability assessments of the specific data elements required for this
review indicated that the data were reliable enough for our analyses. To
assess reliability, we reviewed existing information about data quality and
controls supporting the data systems and discussed the data we analyzed with
agency officials to ensure that we interpreted them properly.

We performed this review from June 1999 through April 2000 in accordance
with generally accepted government auditing standards.

GAO Contacts and Staff Acknowledgments

Stanley J. Czerwinski (202) 512-7631

Paul J. Schmidt (312) 220-7681

In addition to those named above, Karen Bracey, Karin Lennon, John McGrail,
Stan Ritchick, Steve Westley, and Shana Whitehead made key contributions to
this report.

(385809)

Table 1: Results of the First Three Rounds of HUD's Credit
Watch Program 25

Table 2: Summary of the Mortgagee Review Board's Fiscal
Year 1999 Actions on 24 Cases as of November 1999 29

Figure 1: Number of Single-Family Mortgage Loans Insured
by FHA, Fiscal Years 1997-99 6

Figure 2: Steps in the Approval Process for FHA-Insured
Mortgage Loans 7

Figure 3: Locations and Geographical Jurisdictions of HUD's
Four Homeownership Centers 9

Figure 4: Frequency of Poor Ratings for Mortgage Credit
Analysis Given to 36 Approved Lenders in Their
Last 15 Preclosing Reviews 13

Figure 5: Number of Lender Reviews Performed, Fiscal
Years 1996-99 15

Figure 6: Percentage of Loans Receiving Technical Reviews by Homeownership
Center, Fiscal Year 1999 18

Figure 7: Percentage of Lenders, by Type, Whose Loan Origination Authority
Was Terminated Because of Excessive
Defaults and Insurance Claims on Loans Made For
the 24-Month Period Ending March 31, 1999 26
  

1. To 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.

2. The 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 the President of the Government
National Mortgage Association.

3. A preclosing review rates the quality of the loan-closing documents, the
property appraisal, the construction exhibits (for new or rehabilitated
homes), and the mortgage credit evaluation of the borrower.

4. We visited the Philadelphia center in August 1999 and the Atlanta,
Denver, and Santa Ana centers in October 1999.

5. HUD's fiscal year 1999 goals required each of the four homeownership
centers to conduct 225 lender reviews. All four centers exceeded this goal.

6. The Denver center's quality assurance division produces prioritized
targeting lists for each of the HUD field office locations within the
center's geographic jurisdiction. However, the division did not save copies
of the lists it used for targeting lenders in fiscal years 1998 or 1999.
Therefore, we were unable to determine the extent to which the
highest-priority lenders had been reviewed.

7. Some of the risk factors used by Fannie Mae and Freddie Mac to identify
high-risk loans may be applicable to FHA's loan portfolio, while other
factors may not. Fannie Mae and Freddie Mac consider the specific factors
they use to assess risk as confidential business information.

8. Virtually all of the Atlanta, Santa Ana, and Denver centers' technical
reviews are performed by contractors. In contrast, Philadelphia center
officials said that their own staff performed about one-third of the
center's reviews in fiscal year 1999. At the time of our review, the Santa
Ana and Denver centers each had two firms under contract, while the Atlanta
and Philadelphia centers each used a single contractor. The total annual
value of the centers' technical review contracts is about $2 million.

9. Lenders could have been counted more than once if they underwrote
FHA-insured mortgages in more than one HUD field office jurisdiction. The
lenders made a total of 111,699 mortgage loans that received technical
reviews from HUD.

10. Our statistical analyses identified, at the 95-percent level of
confidence, those lenders that we would have expected to receive "poor"
ratings on at least 30 percent of their loans, had all of their fiscal year
1999 loans been subject to technical reviews.

11. Capitol Mortgage Bankers, Inc. v. Cuomo, 77 F. Supp. 2d 690 (D. Md.
1999).

12. The records for the remaining six cases were being used by HUD staff and
were not available for our review (three cases) or our preliminary review
indicated that the cases did not involve single-family mortgage loans (three
cases). As of November 1999, the official minutes of the Board's meetings
during fiscal year 1999 were available only for the period covering October
1998 through April 1999.
*** End of document. ***