Homeownership: Problems Persist With HUD's 203(k) Home Rehabilitation
Loan Program (Letter Report, 06/14/1999, GAO/RCED-99-124).
The 203 (k) Home Rehabilitation Mortgage Insurance Program was
established to help promote the rehabilitation and repair of housing
stock through a program that combines, in one insured mortgage, the
funds needed to purchase and rehabilitate a single-family home. The
loans are made by banks and other private lenders from their own funds
and are insured by the Department of Housing and Urban Development's
(HUD) Federal Housing Administration (FHA). Reports of waste, fraud, and
abuse in the 203 (k) program have raised serious concerns about HUD's
management. GAO was asked to determine the risk posed by the 203(k)
program to FHA's insurance fund relative to the 203 (b) program; (2)
HUD's efforts to correct program deficiencies identified by HUD's
Inspector General and others; and (3) weaknesses, if any, in HUD's
oversight of the 203 (k) program and the extent to which lenders are
complying with HUD's underwriting guidelines for making program loans.
GAO found that the 203(k) loan program is more risky than HUD's largest
single-family loan program�the 203(b) program�because it combines the
risk of a traditional mortgage with the risk of a construction loan.
--------------------------- Indexing Terms -----------------------------
REPORTNUM: RCED-99-124
TITLE: Homeownership: Problems Persist With HUD's 203(k) Home
Rehabilitation Loan Program
DATE: 06/14/1999
SUBJECT: Government guaranteed loans
Mortgage protection insurance
Internal controls
Comparative analysis
Property improvement loans
Mortgage loans
Risk management
Program abuses
Insurance claims
IDENTIFIER: HUD 203(k) Home Rehabilitation Mortgage Insurance Program
Mutual Mortgage Insurance Fund
General Insurance Fund
FHA 203(b) Insurance Program
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United States General Accounting Office GAO Report
to the Chairman, Subcommittee on Housing and Community
Opportunity, Committee on Banking and Financial Services, House of
Representatives June 1999 HOMEOWNERSHIP Problems Persist
With HUD's 203(k) Home Rehabilitation Loan Program GAO/RCED-99-124
GAO United States General Accounting Office Washington, D.C.
20548 Resources, Community, and Economic Development Division B-
280930 June 14, 1999 The Honorable Rick A. Lazio Chairman,
Subcommittee on Housing and Community Opportunity Committee on
Banking and Financial Services House of Representatives Dear Mr.
Chairman: The 203(k) Home Rehabilitation Mortgage Insurance
program was established to help promote the rehabilitation and
repair of the nation's housing stock through a program that
combines, in one insured mortgage, the funds needed to purchase
and rehabilitate a single-family home. These loans are made by
banks and other private lenders from their own funds and are
insured by the Department of Housing and Urban Development's (HUD)
Federal Housing Administration (FHA). If a borrower defaults and
the lender subsequently forecloses on the loan, the lender can
file an insurance claim with HUD for nearly all of its losses.
Over the past 4 years, reports of abuses within the 203(k) program
have raised serious concerns about HUD's management of it.
Collectively, these reports-by HUD's Inspector General and others-
indicate that the 203(k) program is highly vulnerable to waste,
fraud, and abuse. Because of your concerns with HUD's management
of the program, you asked us to determine (1) the risk the 203(k)
program poses to FHA's insurance fund1 relative to the 203(b)
program,2 (2) HUD's efforts to correct program deficiencies
identified by HUD's Inspector General and others, and (3)
weaknesses, if any, in HUD's oversight of the 203(k) program and
the extent to which lenders are complying with HUD's underwriting
guidelines for making program loans. We have also provided
information on the growth in the program, the performance of the
program's loans overall and by borrower type, and the customers
served by the program. (See app. I.) To address these issues, we
focused on the activities of HUD's headquarters and its four
Homeownership Centers located in Santa Ana, California; 1Loans
under the 203(k) Home Rehabilitation Mortgage Program are insured
by FHA's General Insurance Fund, which provides for a number of
specialized mortgage insurance programs. 2FHA provides most of its
single-family mortgage insurance through the 203(b) program, which
covers loans for purchasing a new or existing one-to four-family
home. Loans under the 203(b) program are insured by FHA's Mutual
Mortgage Insurance fund. In fiscal year 1998, loans worth over $90
billion were insured under the 203(b) program. Page 1
GAO/RCED-99-124 Problems With HUD's 203(k) Loans B-280930 Denver,
Colorado; Atlanta, Georgia; and Philadelphia, Pennsylvania. Each
of these centers is responsible for the general management of the
program in its region. We also reviewed reports and
recommendations by HUD's Inspector General, KPMG Peat Marwick, and
HUD management. We compared the 203(k) program with the 203(b)
mortgage insurance program because the 203(b) program is FHA's
largest single-family mortgage insurance program and HUD oversees
both programs in the same manner. Results in Brief The 203(k)
loan program is more risky than HUD's largest single-family loan
program-the 203(b) program-because it combines the risk of a
traditional mortgage with the risk of a construction loan. For
loans endorsed3 from fiscal years 1994 through 1996,4 the claim
rate5 for loans made under the 203(k) program is almost double
that of loans made under the 203(b) program. In addition, HUD
projects that while loans made under the 203(b) program in fiscal
year 1994 through fiscal year 1998 will make money for the Mutual
Mortgage Insurance Fund, it projects that 203(k) loans will cost
the General Insurance Fund-that is, claims and other costs will
exceed premiums and other income by over $25 million.6 This cost
represents approximately .7 percent of the total amount insured by
the program, as of the end of fiscal year 1998. HUD stated that it
finds this loss rate to be expected for a home rehabilitation
program. Figure 1 illustrates the expected losses from loans
endorsed in fiscal years 1994 through 1998.7 3After making a loan
to a borrower, a lender seeks FHA's approval to insure the loan.
When FHA formally approves mortgage insurance for the loan, it is
considered "endorsed." 4These are the most recent years with
sufficient data to establish claim rates. 5A claim rate is the
percentage of loans endorsed in a specific year that result in a
claim being filed against the insurance fund. 6This figure
represents the net present value of current and future projected
losses. 7Program losses are expressed in fiscal year 1999 dollars.
Page 2 GAO/RCED-99-124
Problems With HUD's 203(k) Loans B-280930 Figure 1: Projected
Losses to the General Insurance Fund for 203(k) $2
Projected Losses (in millions of dollars) Loans Made in Fiscal
Year 1994 Through Fiscal Year 1998, Dollars in Millions
0 -$2 -$4 -$6 -$8 -$10 -$12 1994 1995 1996 1997
1998 Fiscal Year of Endorsement Source: GAO's analysis of HUD's
data. Figure 1 shows that anticipated losses will increase from
approximately $2 million for loans endorsed in fiscal year 1995 to
over $11 million for loans endorsed in fiscal year 1997. Despite
the recognized risk associated with the 203(k) program and the
potential for mounting losses to the General Insurance Fund, HUD
has done little to address the problems identified by its
Inspector General and others. In the past 4 years, reports by
HUD's management, HUD's Inspector General, and others have
repeatedly cited problems and weaknesses in the management of this
program, indicating that it is highly vulnerable to waste, fraud,
and abuse. For example, HUD's Inspector General reported that the
program design encourages risky property deals and overstated
property appraisals and does not adequately safeguard HUD's
interests. Page 3 GAO/RCED-
99-124 Problems With HUD's 203(k) Loans B-280930 Furthermore, in
its review of a sample of loans made to investors and nonprofit
organizations, the Inspector General found that many of the homes
had not been properly rehabilitated. Although HUD's management
has, for the most part, agreed with the findings as reported, it
has done little to address the problems. The most recent study of
the program-completed in October 1998 by outside contractors-found
that the Department had done little to address the long term
viability of the program and recommended that HUD radically
redesign or eliminate it. HUD is not adequately overseeing key
aspects of the 203(k) program. With respect to lenders, HUD's
Homeownership Centers do not adequately ensure that lenders are
complying with the program's guidelines. At the four Homeownership
Centers, we found that 203(k) loans were not targeted for review
to ensure that the lenders are properly administering them. In one
center, HUD management made a conscious decision not to review
203(k) loans because it lacked trained staff. Furthermore, HUD
does not properly train and monitor 203(k) home inspectors and
consultants, who are responsible for designing and overseeing the
home rehabilitation process. We also found cases in which the
agency failed to address consultants' abuses or incompetence. For
example, we found incidences in which a consultant who was also an
inspector approved payments for work by contractors that was
either not completed or was completed improperly. Furthermore, HUD
still does not adequately ensure that nonprofit organizations
comply with HUD guidelines for participating in the program. This
report makes recommendations designed to improve HUD's management
and oversight of the 203(k) program. Background The 203(k) Home
Rehabilitation Mortgage Insurance program8 is HUD's primary
program for rehabilitating and repairing single-family homes. A
single loan insured under the 203(k) program can be used to both
purchase and rehabilitate a home. The 203(k) program, like other
FHA programs, insures mortgage loans to encourage lenders to make
loans available to borrowers who would not otherwise qualify for
conventional loans on affordable terms. Eligible borrowers may
include the owner/occupant, nonprofit organizations, and until
October 1996, 8The Rehabilitation Home Mortgage Insurance program
was authorized by section 203(k) of the National Housing Act, as
amended. Page 4 GAO/RCED-99-124
Problems With HUD's 203(k) Loans B-280930 investors.9 The General
Insurance Fund supports the 203(k) program as well as other
specialized housing programs.10 Unlike the Mutual Mortgage
Insurance Fund, which supports the 203(b) program, the General
Insurance Fund is not intended to be self-sustaining. When the
General Insurance Fund incurs losses, funds are appropriated by
the Congress. As of fiscal year 1998, HUD had about $3.6 billion
in insurance on 44,000 outstanding 203(k) loans. The 203(k)
program allows borrowers to finance both the purchase or
refinancing of a house and the cost of its rehabilitation through
a single mortgage or to finance the rehabilitation of their
existing home. When buying a house that is in need of repair or
modernization, homebuyers not using the 203(k) program often must
follow a complicated and costly process: They must obtain
financing to purchase the property, get additional financing to
rehabilitate it, and find a permanent mortgage after
rehabilitation is completed to pay off the interim loans. The
interim acquisition and improvement loans often have relatively
high interest rates and short repayment terms. However, the 203(k)
program helps both borrowers and lenders by insuring a single,
long-term, fixed- or adjustable-rate loan to cover the costs of
both the acquisition and the rehabilitation. A loan insured under
the 203(k) program also protects a lender by allowing it to have
the loan insured for the full value of the rehabilitated home
before the rehabilitation process begins. Compared with other FHA
mortgage loan programs, such as the 203(b) program, the structure
of the 203(k) program is far more complex. Like the 203(b)
program, the 203(k) program provides mortgage insurance to protect
lenders against the risk of default on loans to qualified buyers
and may be used to finance the purchase of single-family housing
as well as to refinance debt. The completion of a 203(k) loan,
however, involves multiple entities and estimates. At closing, a
lender must set aside the estimated funds to pay for the
rehabilitation in an escrow account. A HUD-approved consultant is
often needed to determine the extent of work that must be done to
rehabilitate a property and the estimated cost of that work. A
HUD-approved inspector is needed to monitor the progress of the
rehabilitation and to co-sign with the borrower any request of
escrow funds. HUD guidelines allow the consultant to also function
as the inspector. The procedures for the loan application and
rehabilitation process are discussed in appendix II. 9Because of
abuses by investors in the program, a moratorium on investor
participation was implemented in October 1996. 10The General
Insurance Fund provides for a large number of specialized mortgage
insurance programs, including insurance for loans for
condominiums, land development, and nonprofit hospitals. Page 5
GAO/RCED-99-124 Problems With HUD's 203(k) Loans B-280930 For
fiscal year 1994 through fiscal year 1998, HUD endorsed 62,757
loans for 203(k) insurance, with more than 80 percent of the
endorsements made in fiscal years 1996 through 1998. (See fig. 2.)
Although the 203(k) program was established in its present form in
1978, HUD began promoting and streamlining it in 1994 to make it
more acceptable to lenders and borrowers, and by 1995, program use
had noticeably increased. Since March 1994, HUD has made a number
of changes to the 203(k) program to make it more user-friendly for
lenders and borrowers. These changes were also made to streamline
and shorten the processing time for 203(k) loans. For example, in
an effort to streamline the process, HUD eliminated the
requirement for lenders to submit change orders to the HUD field
office for an extension of time to complete improvements. In 1995,
HUD made additional changes to the program that were recommended
by a working group that consisted of HUD offices, lenders,
nonprofit organizations, and government agencies. The changes
included (1) making the HUD offices responsible for ensuring that
consultants are properly trained and (2) allowing consultants to
serve as inspectors in order to reduce the processing time of a
203(k) loan. Figure 2: Number of 203(k) Loans Endorsed, Fiscal
Years 1990-98 20,000 Number of loans endorsed 18,000 16,000
14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 1990 1991
1992 1993 1994 1995 1996 1997 1998 Year
Source: GAO's analysis of HUD's data. Page 6
GAO/RCED-99-124 Problems With HUD's 203(k) Loans B-280930 The
management and oversight of the 203(k) program is distributed
among headquarters staff and the Department's four regional
Homeownership Centers in Philadelphia, Pennsylvania; Atlanta,
Georgia; Denver, Colorado; and Santa Ana, California. Each
regional Homeownership Center is responsible for the operation of
the 203(k) program in its territory. These responsibilities
include processing and underwriting; lender monitoring; marketing;
and customer assistance. In 1994, FHA's Office of Housing began
consolidating some of its mortgage insurance processes from its 81
field offices into the four Homeownership Centers in order to
provide faster processing. With the exception of a few field
offices that have not transferred to the Homeownership Centers,
the reorganization is complete. Program Design and The 203(k)
program's design, as well as its past performance, indicate that
Performance future claims from defaulted loans may
lead to losses to the General Insurance Fund. As a result of HUD's
streamlining of the program in 1994, Demonstrate a High the
value of insured 203(k) loans grew from just under $400 million in
Degree of Risk fiscal year 1994 to almost $3.6 billion in
fiscal year 1998, an increase of about 835 percent. Because of the
program's complex design and relatively high claim rate, this
increase in the dollar amount of loans insured has increased the
risk of loss to the federal government. After deducting premiums
paid and other income, HUD projects that net losses to the General
Insurance Fund will exceed $25 million from loans made during
fiscal years 1994 through 1998. These losses represent
approximately .7 percent of the total amount insured by the
program, as of the end of fiscal year 1998. HUD stated that this
loss rate is to be expected for a home rehabilitation program.
Program Design Poses The process for approving and disbursing
203(k) loans is far more Risk to the General complex than the
processes for other FHA-insured single-family lending Insurance
Fund programs. The complexity stems from the
rehabilitation component of the program, which (1) places far
greater emphasis on estimates, reports, and opinions; (2) has more
individual steps required in the underwriting and funding process;
(3) involves multiple participants; and (4) requires a greater
sophistication on the part of the borrower. Both internal and
outside reviews of the 203(k) program have found that the
program's design presents a high degree of risk to the Department
and the General Insurance Fund. In a February 1997 report on the
program,11 HUD's 11Audit Report: Section 203(k) Rehabilitation
Mortgage Insurance Program (HUD/OIG 97-AT-121-0001,Feb. 6, 1997).
Page 7 GAO/RCED-99-124 Problems
With HUD's 203(k) Loans B-280930 Inspector General concluded that
the program design does not adequately safeguard HUD's interests.
The report stated that the program design encourages risky
property deals, overstated property appraisals, and phony or
excessive fees. Furthermore, an internal HUD study of the 203(k)
program reported that because the loan program is designed to let
borrowers purchase and rehabilitate property, it poses multiple
inherent risks, including the failure to complete work in an
acceptable manner and to accurately estimate the cost of
rehabilitation. In an October 1998 draft study,12 HUD contractors
asserted that, by virtue of its complexity, the 203(k) program
poses a high risk of loss to the Department and that this risk has
been reflected in high default and claim rates. Past Performance
of The performance of loans made under the 203(k)
program is poorer than 203(k) Program Indicates that of
loans made under HUD's 203(b) program. For loans endorsed during
It Poses an Increasing Risk fiscal year 1994 through fiscal
year 1996-the most current years with of Loss
sufficient data to determine meaningful claim rates-the cumulative
claim rates through 1998 for 203(k) loans are almost double the
rates for 203(b) loans made in the same years. (See fig. 3.)
12KPMG/META's Front End Risk Assessment (FERA)-Section 203(k)
Rehabilitation Mortgage Insurance Program, Oct. 23, 1998. HUD
officials told us they consider this study to be a draft until
they issue a written response to it. Page 8
GAO/RCED-99-124 Problems With HUD's 203(k) Loans B-280930 Figure
3: Cumulative Claim Rates Through 1998 for the 203(k) and 203(b)
7.0 Percent Programs for Loans Endorsed in Fiscal Years 1994-96
6.0 5.0 4.0 3.0 2.0 1.0 0.0 1994 1995
1996 203(k) Cumulative Claim Rate 203(b) Cumulative Claim Rate
Note: Cumulative claim rates are total claims to date for a
specific year of loan endorsements, as of Sept. 30, 1998. Source:
GAO's analysis of HUD's data. Figure 3 shows that cumulative claim
rates for the 203(k) program are consistently higher than those
for the 203(b) program for the years shown. For example, as of
September 30, 1998, the cumulative claim rate for 203(k) loans
endorsed in fiscal year 1994 was 6.1 percent, while the claim rate
for 203(b) loans endorsed in the same year was 2.4 percent.
Furthermore, HUD projects that the 203(k) program will incur net
losses for loans endorsed in each of fiscal years 1995 through
1998, while the 203(b) program is projected to incur net gains for
the same period. For example, the projected net loss, as a percent
of endorsements, for 203(k) loans made in fiscal year 1997 is .75
percent of the total amount of endorsements Page 9
GAO/RCED-99-124 Problems With HUD's 203(k) Loans B-280930 in that
year. The projected net gain for 203(b) loans made in that year,
as a percent of endorsements, is 1.7 percent. According to HUD,
the projected net loss/gain for the General Insurance Fund for the
203(k) program is expected to go from a surplus of $810,000 for
loans endorsed in fiscal year 1994 to a deficit of $11.6 million
for loans endorsed in fiscal year 1997. This is in contrast to the
203(b) program, for which HUD projects each year's loans will add
economic value to the Mutual Mortgage Insurance Fund. Performance
Indicators The cumulative claim rates of loans made under the
203(k) program will Suggest Cumulative Claim most likely
increase. The recent growth in the 203(k) program, its Rates May
Increase historical pattern of claim rates, and an
increase in early default rates,13 Significantly
suggest that the percentage of loans resulting in claims for the
203(k) program will increase in the next few years. At least 75
percent of the loans endorsed under the 203(k) program since
fiscal year 1994 were made in the past 3 years. According to an
external review of historical and projected claim rate data for
HUD-insured loans,14 during the 1990s the percentage of 203(b)
loans resulting in claims is at its highest in the fourth and
fifth year after the loans were endorsed. If this pattern holds
for 203(k) loans, and it has so far, claim rates for loans
endorsed in fiscal year 1996 through fiscal year 1998 will
continue to increase over the next 4 years, resulting in
increasing claim outlays. The review also found that the claim
rate begins to decrease in the sixth year and beyond. For
instance, as of fiscal year 1995, only 5 of the approximately
3,700 loans made under the 203(k) program in fiscal year 1994 had
resulted in a claim against the General Insurance Fund, a
cumulative claim rate of .1 percent. By fiscal year 1998, 235
additional claims were filed against the fund from loans made in
fiscal year 1994, and the cumulative claim rate for these loans
grew to approximately 6.5 percent. While the 203(k) program was
growing by over 800 percent, the early default rate was
increasing. HUD tracks the early default rates of 203(k) loans by
lender to determine how well lenders are underwriting them. This
rate was about 2.3 percent for 203(k) loans made in fiscal year
1994, 13Early defaults are all loans that have defaulted within 1
year of loan closing. A mortgage loan is considered in default
when the borrower misses three consecutive monthly payments.
14Price Waterhouse, An Actuarial Review for Fiscal Year 1998 of
the Federal Housing Administration's Mutual Mortgage Insurance
Fund, Final Report, Mar. 1, 1999. Page 10
GAO/RCED-99-124 Problems With HUD's 203(k) Loans B-280930 5.5
percent for fiscal year 1995 loans, and 5.2 percent for fiscal
year 1996 and fiscal year 1997 loans. Figure 4: Early Default
Rates for 203(k) Program for Loans Endorsed in Fiscal 12
Percent of early defaults Years 1994 Through 1997 10 8 6 4 2 0
1994 1995 1996 1997 Fiscal year of
closing Within 1 Year Within 2 Years Volume Source: GAO's analysis
of HUD's data. According to HUD, an early default rate is a good
indication of a lender's underwriting quality and the likelihood
that a loan will result in a claim against the insurance fund. A
HUD official added that loans that default within 12 months after
they are endorsed frequently have serious underwriting problems
associated with them. Page 11
GAO/RCED-99-124 Problems With HUD's 203(k) Loans B-280930 HUD
Management Despite the risk of loss the 203(k)
program poses to the General Insurance Has Done Little to
Fund, HUD management has done little to address problems with the
program identified by both internal and external reviews over the
past 4 Address Recognized years. These reviews indicate
that the program is highly vulnerable to Problems in the
fraud, waste, and abuse and make a number of recommendations to
strengthen the program. Although HUD's management has agreed with
203(k) Program these reports and indicated a
willingness to implement most of the recommendations, it has
failed to do so in many cases. HUD Management Fails to
Reporting on the results of a 3-year review in February 1997,15
HUD's Adequately Address Inspector General stated that
the involvement of investors and nonprofit Problems Identified by
the organizations in the 203(k) program increased HUD's risk of
loss to the Inspector General General Insurance Fund
from defaults. Many of the homes covered by the loans the
Inspector General reviewed had not been properly rehabilitated.
The report concluded that the program design encourages risky
property deals and overstated property appraisals and does not
adequately safeguard HUD's interests. The Inspector General made
several recommendations for improving the program, such as
permanently barring investors from the program to curb their
abuses. The Inspector General added that anything less than a
permanent ban was unacceptable because of the substantial waste,
fraud, and abuse that the review had discovered. In addition, in
an August 1997 report, the Inspector General concluded that HUD
had no effective criteria for approving consultants16 and
consultant trainers and recommended that HUD develop uniform
criteria. In May 1998, the Inspector General commented positively
on owner-occupant participation in the program but expressed
concerns about lenders' performance. Auditors found problems with
the underwriting in 40 of the 50 loans they reviewed. For example,
several of the lenders were approving borrowers who did not meet
the eligibility criteria for 203(k) loans. The Inspector General
found that HUD needed to take steps to ensure more effective
lender performance in originating loans and administering the
rehabilitation process. Although it formally agreed to implement
most of the Inspector General's recommendations in these reports,
HUD has failed to do so. For example, 15Audit Report: Section
203(k) Rehabilitation Mortgage Insurance Program (HUD/OIG 97-AT-
121-0001, Feb. 6, 1997). 16Consultants are responsible for
preparing work write-ups and cost estimates and generally
overseeing the rehabilitation process to protect the interests of
the borrower. Page 12 GAO/RCED-
99-124 Problems With HUD's 203(k) Loans B-280930 the Inspector
General had recommended that HUD develop written criteria for
approving and training 203(k) program consultants. In response, in
an October 1997 memorandum, HUD stated that it would develop a
national certification examination for consultants. According to a
senior HUD official, HUD has no plans in the near future to
contract for, or otherwise develop, this examination. HUD
management has taken some steps in response to the Inspector
General's findings to minimize the program's exposure to fraud,
waste, and abuse. For instance, in October 1996, HUD placed a
moratorium on investor participation in the program. HUD has
issued several other policy directives clarifying for lenders the
Department's policy related to, among other things, lender
underwriting and the disbursal of funds. HUD has also eliminated
certain provisions, such as providing FHA insurance on 203(k)
second mortgages, which placed HUD at unacceptable risk. In
addition, in 1997, HUD developed a draft policy directive designed
to help curb fraud and abuse by program participants. The draft
directive proposes several changes to the program, including
limiting the number of properties that nonprofit organizations can
purchase under the program and imposing stricter requirements for
approving these organizations. Although the policy was to be
effective in October 1997, the directive was never issued because
the Acting Housing Commissioner was hesitant to make changes to
the program until a permanent Housing Commissioner was appointed.
The permanent Housing Commissioner was appointed in October 1998.
HUD Fails to Take Action In October 1998, the contractors
hired by HUD to study the 203(k) program on Problems Identified by
reported that the Department has done little to reduce the risks
associated Independent Studies with the program, and
hence, its long-term viability.17 Specifically, the draft report
identified six major risks associated with the 203(k) program: (1)
program complexity, (2) insufficient lender monitoring, (3)
inadequate guidance concerning consultants, (4) hesitant
management direction, (5) increased loss potential from nonprofit
organizations, and (6) low program volume. The contractors
reported that continued inaction on the part of HUD management
will likely contribute to a downward trend in the performance of
the program, putting it in jeopardy. The contractors recommended
that HUD either eliminate the program or radically redesign
17KPMG/META, Front End Risk Assessment (FERA)- Section 203(k)
Rehabilitation Mortgage Insurance Program, Oct. 23, 1998. HUD
officials told us they consider this study to be a draft until
they issue a written response to it. Page 13
GAO/RCED-99-124 Problems With HUD's 203(k) Loans B-280930 it. They
added that unless HUD can devote the resources to the program to
properly manage it, the program should be eliminated. Responding
to the contractors' study, HUD indicated that it would not take
immediate action to correct the problems identified. According to
the Acting Director of Single-Family Housing, the new FHA Housing
Commissioner, who took office in October 1998, has been devoting
most of his attention to addressing issues in programs that are
much larger in scope and volume than the 203(k) program. According
to this official, when resources are freed from addressing these
other programs, management would probably prepare a comprehensive
plan to improve the 203(k) program. HUD's Oversight of HUD
provides little direct oversight over the 203(k) program. We
identified the 203(k) Program Is three areas of particular
concern. HUD is not (1) targeting the 203(k) program for
oversight, (2) properly training and overseeing consultants
Inadequate and home inspectors, and (3) adequately
monitoring nonprofit organizations' participation in the program.
HUD Does Not Target the Although HUD recognizes the program's
unique risks and potential for 203(k) Program for abuse,
it has not targeted the 203(k) program to minimize those risks.
Oversight Instead, HUD oversees the 203(k)
program using the same approach it uses to oversee the less-risky
single-family insurance programs, such as HUD's 203(b) Home
Mortgage Insurance Program. For these programs, HUD's four
Homeownership Centers conduct post-endorsement technical reviews
and quality assurance reviews, which are HUD's primary means to
oversee lenders. HUD has not used post-endorsement technical or
quality assurance reviews effectively to minimize the unique risks
posed by the 203(k) program. Post-endorsement technical reviews
are desktop audits of a sample of loan cases that have already
been endorsed for insurance by FHA. These reviews are designed to
determine the quality of a lender's underwriting of an endorsed
loan. For example, the reviewer will ensure that all required loan
application documents were obtained or completed by the lender and
that these documents were properly signed. Quality assurance
reviews occur at a lender's place of business. Trained HUD staff
perform in-depth reviews of troubled loans and evaluate a lender's
internal control system for originating FHA-insured loans. Page 14
GAO/RCED-99-124 Problems With HUD's 203(k) Loans B-280930 We found
that 203(k) loans, although recognized as being high-risk, are not
targeted for these reviews. HUD officials told us that they plan
to start targeting 203(k) loans for review this year. We also
found that the detailed results of the post-endorsement reviews
are placed in the loan file; they are not given to the lender.
Twice a year, HUD sends the ratings from the post-endorsement
reviews to the lenders but does not specify why they were assigned
a given rating. As a result, HUD and the lenders cannot take
action on any problems identified in the review process in a
timely manner. HUD officials told us that while they do not target
203(k) loans for review, they do perform quality assurance reviews
on lenders that make these loans. Since January 1, 1996, HUD has
performed 52 quality assurance reviews on lenders that make 203(k)
loans. Seventeen of these reviews were on lenders that made over
100 203(k) loans during that period. However, HUD could not
provide information on how many 203(k) loans may have been
reviewed. HUD has emphasized increasing the number of 203(k) loans
endorsed by streamlining the program, but it has not committed the
resources needed to adequately oversee the program. Officials at
two Homeownership Centers told us that they do not have staff
qualified to do quality assurance reviews for 203(k) loans.
According to an official at a Homeownership Center responsible for
17 states, the Center did not have sufficient travel funds to
adequately oversee any of its single-family programs, including
the 203(k) program, during the first quarter of fiscal year 1999.
HUD Is Not Properly We found that HUD has no uniform
criteria for training, approving, and Training and Overseeing
evaluating the performance of consultants and inspectors who
participate Consultants and Home in the 203(k) program.
Consultants and inspectors can be used, Inspectors
interchangeably, to perform home inspections, identify health and
safety problems, and provide descriptions of the work to be
performed and cost estimates for the buyers. In addition to having
at least 3 years of specialized experience, consultants/inspectors
must receive training in the 203(k) program. However, at two of
the four centers we visited, HUD had not provided any training to
203(k) consultants/inspectors and had not taken any action to
evaluate the performance of approved consultant/inspectors. One of
the other centers provided minimal training, such as holding
training sessions via teleconference, but had not taken any action
to evaluate the performance of approved consultants. According to
Page 15 GAO/RCED-99-124 Problems With
HUD's 203(k) Loans B-280930 a HUD official, many consumer
complaints about the program result from the work of consultants
and inspectors. We also found cases in which the agency failed to
address consultants' abuses or incompetence. For example,
according to customer complaints we reviewed, a Chicago
consultant/ inspector allowed a contractor to receive thousands of
dollars for work the contractor either did not do or did not do
adequately. In a request for payment, the consultant/inspector
approved payments to the contractor for a ceiling installation
that was never completed. Figure 5 shows the incomplete ceiling.
Page 16 GAO/RCED-99-124 Problems With HUD's
203(k) Loans B-280930 Figure 5: Incomplete Ceiling and Light
Fixture Installation Source: GAO. The same inspector reported that
plumbing work had been completed. Figure 6 shows that this was not
the case. Page 17 GAO/RCED-99-124 Problems
With HUD's 203(k) Loans B-280930 Figure 6: Incomplete Plumbing
Work Source: GAO. Figures 7 through 9 show incomplete electrical
work in another Chicago home that was recorded as completed. Page
18 GAO/RCED-99-124 Problems With HUD's
203(k) Loans B-280930 Figure 7: Exposed Breaker Box and Wires
Connected to an Old Breaker Box Source: GAO. Page 19
GAO/RCED-99-124 Problems With HUD's 203(k) Loans B-280930 Figure
8: Hanging Electrical Wires in Closet Source: GAO. Page 20
GAO/RCED-99-124 Problems With HUD's 203(k) Loans B-280930 Figure
9: Electrical Wiring Strung Along Outside of Wall Instead of
Inside the Wall Source: GAO. Similarly, in a recent report, HUD's
Inspector General found that a Michigan HUD field office failed to
take action against a consultant who the office knew was either
incompetent or was abusing the program. This consultant was the
exclusive consultant/inspector for four of the largest 203(k)
lenders in the area. HUD Is Not Adequately
HUD has failed to properly monitor the participation of nonprofit
Monitoring Nonprofit organizations in the
203(k) program. HUD guidelines require that the Organizations'
Homeownership Centers recertify nonprofit organizations every 2
years. Participation in the At three of the
four centers we visited, we did not find evidence that the Program
centers had recertified any of the approved nonprofit
organizations for the program. Page 21
GAO/RCED-99-124 Problems With HUD's 203(k) Loans B-280930 While
they represent only about 5 percent of the 203(k) program's loan
volume, nonprofit organizations' participation is just as
problematic as investors' participation. Nonprofit organizations'
claim rate, on average, is more than double that of any other
borrower type in the 203(k) program, including investors. For
fiscal years 1994 through 1998, the claim rate for nonprofit
organizations was 6.3 percent, whereas the claim rate for
investors and owner/occupants was 2.7 percent and 1.2 percent,
respectively. In 1997, the Inspector General reported that
nonprofit organizations presented the same level of risk to the
program as investors and that their participation in the program
has failed to achieve HUD's objectives. Nonprofit organizations'
203(k) loans are so risky and problematic that one of the largest
lenders of funds for the program decided to no longer make or
purchase 203(k) loans. According to a senior official at this
lender, most of the nonprofit loans the bank acquired have
eventually gone into default. To illustrate how nonprofit
organizations can abuse the program, a HUD official told us that a
group of investors agreed to pay a nonprofit organization to
obtain mortgages under the 203(k) program on their behalf. The
nonprofit organization was to be paid for each mortgage it
obtained and for each property the investors rehabilitated and
sold. When the investors were unable to successfully rehabilitate
these properties, the organization defaulted on all of the
mortgages it had taken out and the properties went into
foreclosure. When we attempted to determine whether the nonprofit
organization met HUD's criteria for participation in the program,
we discovered that the local field office could not locate its
records on approved nonprofit organizations in its area.
Therefore, HUD officials were uncertain as to whether the
organization was even approved for the program. Conclusions The
203(k) program's design, coupled with its rapid growth and past
performance, pose a risk of loss to the government. Because of the
program's complexity, it is important that HUD aggressively
oversee the program. HUD, however, has been in a reactive mode
since the program began to grow rapidly. Because of reports issued
over the last 4 years by HUD's Inspector General and others, HUD
is fully aware of the weaknesses in the program but has done
little to correct them. The program's recent performance as well
as management's continued inaction suggest that the program will
continue to pose a risk of loss to HUD's $3.6 billion portfolio
Page 22 GAO/RCED-99-124 Problems With
HUD's 203(k) Loans B-280930 of 203(k) loans. Outside contractors
have recently suggested that HUD either eliminate the program
entirely or radically redesign it to mitigate future losses to the
General Insurance Fund. HUD has not used its primary oversight
methods-post-endorsement technical reviews and quality assurance
reviews-to target 203(k) lenders or loans. Although HUD has
identified the 203(k) program as one of its riskiest, it has
failed to devote sufficient resources to oversee the program. This
failure to target the 203(k) program has allowed those
participants who pose a risk to remain in the program.
Furthermore, HUD does not have a uniform training program for
consultants and inspectors. Most of the complaints that HUD
receives from 203(k) borrowers are the result of
consultants/inspectors' not adequately ensuring that the
rehabilitation work performed by contractors is adequate. The
borrower often depends on the consultant/inspector to ensure that
the work is properly completed and meets contractual requirements.
Incomplete or improper rehabilitation can leave the home
uninhabitable and can ultimately lead to foreclosure. Finally,
serious concerns have been raised by HUD's Inspector General
concerning the continued participation of nonprofit organizations,
particularly the problems associated with their loan underwriting
and loan administration. Waste, fraud, and abuse in the 203(k)
program by nonprofit organizations will most likely continue
unabated if HUD continues to fail to scrutinize their
qualifications and operations. Recommendations In order to
provide the necessary management and oversight of the 203(k)
program, we recommend that the Secretary of Housing and Urban
Development direct the Assistant Secretary for Housing-Federal
Housing Commissioner to take the following actions: Improve the
post-endorsement technical review to identify lenders'
underwriting violations before the program incurs losses as a
result of poor underwriting. Lenders should also be notified
immediately of underwriting violations and be required to rectify
the violation or risk losing HUD's insurance on the loan.
Recognizing the risk inherent in the program, target high-risk
203(k) lenders for routine Quality Assurance Reviews to minimize
the risks that these lenders pose to the General Insurance Fund.
Page 23 GAO/RCED-99-124 Problems With
HUD's 203(k) Loans B-280930 Establish strict criteria to ensure
that consultants/inspectors are well versed in residential
construction/rehabilitation and cost estimating to protect the
interests of the borrower. Establish strict criteria for
qualifying and recertifying nonprofit organizations for their
continued participation in the program to ensure they have the
resources and the expertise to rehabilitate properties. Agency
Comments We provided a draft of this report to the Department
of Housing and Urban Development for its review and comment. In
commenting on a draft of this report, the Department agreed that
lenders with poor underwriting practices should be targeted for
enforcement actions, but it did not agree with our approach of
improving the post endorsement review process to mitigate losses.
The Department believes that its new Credit Watch system will
identify lenders with unusually high loan default and claim rates.
The Credit Watch system is designed to terminate poor-performing
lenders or place them on probation, which results in heightened
scrutiny of their performance. We do not agree that the Credit
Watch system will improve the post endorsement technical review
process, which identifies underwriting violations early in the
life of the loans to mitigate potential losses before they occur.
Although the Credit Watch system may identify poor-performing
lenders, it does not address how the Department would better
communicate the results of the post endorsement technical review
to lenders to ensure that underwriting violations are corrected
expeditiously. Therefore, we made no change to this
recommendation. The Department also agrees that high-risk lenders
should be targeted for extra monitoring activities. However, it
did not comment on our recommendation of targeting 203(k) lenders
for routine quality assurance reviews. In response to this
recommendation, HUD stated that its new Credit Watch system will
result in a heightened level of review and monitoring for 203(k)
lenders. Accordingly, we did not change this recommendation. In
response to our recommendations to establish criteria for
consultants, home inspectors, and nonprofit organizations
participating in the 203(k) program, HUD agreed that the
consultants' role needs to be reassessed and will be considered as
part of the Department review of the 203(k) program. HUD will also
take into consideration our recommendation to improve qualifying
standards for nonprofit organizations. Page 24
GAO/RCED-99-124 Problems With HUD's 203(k) Loans B-280930 In
addition to its comments on our recommendations, HUD took
exception to our comparison of the 203(k) program with the Federal
Housing Administration's 203(b) loan insurance program, stating
that the 203(k) program is known to be inherently riskier. We
compared the two programs to highlight this inherent risk and to
demonstrate the need to devote resources to oversee the 203(k)
program. Furthermore, we recognize in the report that, while the
203(k) program is inherently risky because of the construction
component of the loan, HUD oversees both programs in essentially
the same way. In addition, HUD states that it includes 203(k)
lenders in its targeting of lenders for review. We do not disagree
that the Department has reviewed 203(k) lenders, but HUD could not
tell us the extent to which the lenders' 203(k) activity was
reviewed. HUD's comments and our detailed response are presented
in appendix IV. We conducted our review from May 1998 through May
1999 in accordance with generally accepted government auditing
standards. Our scope and methodology are discussed in detail in
appendix III. As agreed with your office, unless you publicly
announce its contents earlier, we plan no further distribution of
this report until 15 days from the date of this letter. At that
time, we will send copies of this report to Representative Barney
Frank, Ranking Minority Member, House Subcommittee on Housing and
Community Opportunity, Committee on Banking and Financial
Services. We will also send copies of this report to the Honorable
Andrew M. Cuomo, the Secretary of Housing and Urban Development;
and the Honorable Jacob J. Lew, Director, Office of Management and
Budget. We will make copies available to others on request. Page
25 GAO/RCED-99-124 Problems With HUD's
203(k) Loans B-280930 Please call me at (202) 512-7631 if you or
your staff have any questions about this report. Major
contributors to this report are listed in appendix V. Sincerely
yours, Stanley J. Czerwinski Associate Director, Housing and
Community Development Issues Page 26
GAO/RCED-99-124 Problems With HUD's 203(k) Loans Page 27
GAO/RCED-99-124 Problems With HUD's 203(k) Loans Contents Letter
1 Appendix I
30 203(k) Program Data, Fiscal Years 1994 Through 1998 Appendix II
33 203(k) Application and Rehabilitation Process Appendix III
34 Scope and Methodology Appendix V
36 Comments From the Department of Housing and Urban Development
Appendix VI
41 Major Contributors to This Report Table
Table I.1: Value and Number of Loans Endorsed in the 203(k)
31 Program, Fiscal Years 1994-98 Figures Figure
1: Projected Losses to the General Insurance Fund for 203
3 (k) Loans Made in Fiscal Year 1994 Through Fiscal Year 1998,
Dollars in millions Figure 2: Number of 203 (k) Loans Endorsed,
Fiscal Years 6 1990-98 Page 28
GAO/RCED-99-124 Problems With HUD's 203(k) Loans Contents Figure
3: Cumulative Claim Rates Through 1998 for the 203 (k)
9 and 203 (b) Programs for Loans Endorsed in Fiscal Years 1994-96
Figure 4: Early Default Rates for 203 (k) Program for Loans
11 Endorsed in Fiscal Years 1994 Through 1997 Figure 5: Incomplete
Ceiling and Light Fixture Installation 17 Figure
6: Incomplete Plumbing Work
18 Figure 7: Exposed Breaker Box and Wires Connected to an Old
19 Breaker Box Figure 8: Hanging Electrical Wires in Closet
20 Figure 9: Electrical Wiring Strung Along Outside of Wall
Instead 21 of Inside the Wall Figure I.1: Growth in
the Number of Loans Insured Under the 203 30 (k)
Program, Fiscal Years 1994-98 Figure I.2: Lenders' Share of 203
(k) Loans Endorsed in Fiscal 31 Years 1994-98
Figure I.3: Loans Endorsed in Underserved Areas by Borrower
32 Type, Fiscal Years 1994-98 Abbreviations FHA Federal
Housing Administration HUD Department of Housing and
Urban Development OIG Office of the Inspector General
Page 29 GAO/RCED-99-124 Problems With
HUD's 203(k) Loans Appendix I 203(k) Program Data, Fiscal Years
1994 Through 1998 This appendix presents information on the 203(k)
Home Rehabilitation Mortgage Insurance program for fiscal years
1994 through 1998. It provides data on the growth in the program,
the value and number of loans, types of lenders, and the customers
served by the program. 203(k) Program Has Over
the past 5 years, the number of active 203(k) loans has increased
Grown Substantially substantially, from 6,183
at the end of fiscal year 1994 to 43,794 at the end of fiscal year
1998, as figure I.1 shows. The data presented are for all loans
still active at the end of each fiscal year, ending September 30
of each year. Figure I.1: Growth in the Number of Loans Insured
Under the 203(k) 50,000 Number of loans outstanding
Program, Fiscal Years 1994-98 45,000 40,000 35,000 30,000
25,000 20,000 15,000 10,000 5,000 0 1994 1995 1996 1997
1998 Year Source: GAO's analysis of Federal Housing
Administration's (FHA) data. Table I.1 lists the dollar amount and
number of 203(k) loans insured at the end of each fiscal year.
Page 30 GAO/RCED-99-124
Problems With HUD's 203(k) Loans Appendix I 203(k) Program Data,
Fiscal Years 1994 Through 1998 Table I.1: Value and Number of
Loans Endorsed in the 203(k) Program, Fiscal Fiscal
Number of loans Years 1994-98 year
Value of loans endorsed outstanding 1994
$383,976,630 6,183 1995
652,188,055 9,819 1996
1,478,857,502 19,969 1997
2,471,945,434 31,743 1998
3,592,081,172 43,794 Source: GAO's analysis
of Department of Housing and Urban Development (HUD) data. A Few
Lenders Account for Since October 1993, 289 of the
2,340 lenders participating in the 203 Most of the Program's
program have accounted for 80 percent of 203(k) loans, and the top
10 Loans lenders have
accounted for 25 percent (15,682 loans). Half of the loans were
issued by only 51 lenders. More than half (1,370) of the
participating lenders had five or fewer loans. (See fig. I.2.)
Figure I.2: Lenders' Share of 203(k) Loans Endorsed in Fiscal
Years 1994-98 25% 10 lenders 50%
2,289 lenders 25% 41 lenders Source: GAO's
analysis of HUD's data. Page 31
GAO/RCED-99-124 Problems With HUD's 203(k) Loans Appendix I 203(k)
Program Data, Fiscal Years 1994 Through 1998 Most 203(k) Loans in
About 55 percent of all 203(k) loans insured between fiscal years
1994 and Underserved Areas Are 1998 were for
properties in underserved areas.1 By borrower type Made by Non-
Profit 75 percent of the loans to nonprofit
organizations went to underserved Organizations
areas, compared with 65 percent of investor loans and 51 percent
of owner-occupant loans. These ratios have remained relatively
constant over time, as shown in figure I.3. Figure I.3: Loans
Endorsed in Underserved Areas by Borrower Type, 90
percent of loans in underserved areas Fiscal Years 1994-98 80 70
60 50 40 30 20 10 0 1994 1995
1996 1997 1998 Fiscal year Investor
Owner/Occupant Nonprofit Source: GAO's analysis of data from HUD
1Underserved areas are those geographic areas that do not have
enough mortgage lenders to meet demand. These areas are usually
poor urban areas. Page 32
GAO/RCED-99-124 Problems With HUD's 203(k) Loans Appendix II
203(k) Application and Rehabilitation Process When a potential
borrower locates an eligible property, the borrower submits an
application to a lender and enters into a sales contract that is
contingent upon the approval of a 203(k) loan and the borrower's
acceptance of any additional required improvements as determined
by HUD or the lender. Either the borrower or a consultant
describes the work to be done and provides a cost estimate. The
rehabilitation must include at least $5,000 of eligible
improvements on the existing structure on the property. Eligible
improvements include any repair that may affect the health and
safety of the occupants. Minor or cosmetic repairs by themselves
cannot be included in the first $5,000 but may be added after the
$5,000 threshold is reached. Following the lender's acceptance of
the proposed work and cost estimate, a written appraisal of the
expected market value after rehabilitation work is completed. In
some cases, an as-is appraisal is also required. The lender
reviews the application and the appraisal to determine the maximum
insurable mortgage amount for the property. The value of the
maximum mortgage calculation is based on the lesser of (1) the as-
is value of property plus rehabilitation costs or (2) 110 percent
of the expected property market value after rehabilitation work is
completed. The as-is value of the property is usually based on the
borrower's purchase price or, for refinance cases, an as-is
appraisal. The rehabilitation cost can include up to six mortgage
payments to assist the borrower when the property is not occupied
during rehabilitation. The loan is then closed and the lender
submits copies of the mortgage documents to HUD for review. If the
documents are found acceptable, HUD issues a Mortgage Insurance
Certificate to the lender. The borrower then has up to 6 months to
complete the rehabilitation work. As the rehabilitation work
progresses, funds are released from the rehabilitation escrow
account after a HUD-approved inspector reviews the work. Any
unused funds in the rehabilitation escrow account are applied to
the mortgage. Page 33 GAO/RCED-99-124
Problems With HUD's 203(k) Loans Appendix III Scope and
Methodology To assess the risk the program poses to FHA's
insurance funds if deficiencies in the program are not corrected,
we reviewed several prior reports on the program and obtained data
on loan activity from HUD's Single-Family Data Warehouse, which is
a database on all 203(k) single family loans and others insured by
the FHA, for fiscal years 1994 through 1998. To determine the
performance of the program, we obtained data on defaults and
claims, types of borrowers, and lenders. To assess the costs of
the program, we obtained from HUD's Comptroller's Office data on
the total amount of claims paid for the period reviewed and net
losses incurred on those claims. To assess HUD's actions to
improve the program, we reviewed reports by HUD management, HUD's
Office of Inspector General, and a HUD contractor, which was hired
to study the program. We discussed the content of these reports
and HUD's plans to address the deficiencies cited in the reports
with HUD officials and the contractor. To determine how HUD
oversees the 203(k) program, we reviewed pertinent HUD regulations
and policy guidance. We also interviewed officials from HUD's
Office of Insured Single-Family Housing and each of the four
Homeownership Centers located in Santa Ana, California; Denver,
Colorado; Atlanta, Georgia; and Philadelphia, Pennsylvania. To
determine the nature and extent of HUD's primary oversight
methods, post-endorsement technical reviews and quality assurance
reviews, we interviewed cognizant HUD officials and obtained
relevant documentation, such as training and policy manuals. Our
reliability assessments of the specific data elements required for
this review indicate 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, * performed electronic testing of the data elements used,
* discussed data we analyzed with agency officials to ensure we
interpreted the data properly, and * compared a sample of selected
data elements to source documents submitted for endorsement.
During our review we found data indicating several cases in which
multiple owner-occupant loans were made to the same borrower. We
determined that many of the borrowers with multiple owner-occupant
Page 34 GAO/RCED-99-124 Problems With HUD's
203(k) Loans Appendix III Scope and Methodology loans were
actually investors and nonprofit organizations that were
incorrectly coded as owner-occupants in the database. We performed
our work from May 1998 through May 1999 in accordance with
generally accepted government auditing standards. Page 35
GAO/RCED-99-124 Problems With HUD's 203(k) Loans Appendix V
Comments From the Department of Housing and Urban Development See
comment 1. Page 36 GAO/RCED-99-124 Problems With HUD's 203(k)
Loans Appendix V Comments From the Department of Housing and Urban
Development See comment 2. See comment 3. See comment 4. See
comment 5. Page 37 GAO/RCED-99-124
Problems With HUD's 203(k) Loans Appendix V Comments From the
Department of Housing and Urban Development See comment 6. See
comment 7. Page 38 GAO/RCED-99-124
Problems With HUD's 203(k) Loans Appendix V Comments From the
Department of Housing and Urban Development The following are
GAO's comments on the Department of Housing and Urban
Development's letter dated May 17, 1999. 1. The report clearly
indicates that the 203(k) program is inherently more risky than
the 203(b) program. We compared the two programs to highlight the
inherent risk associated with the 203(k) program and to
demonstrate the need to devote resources to oversee the program.
Although the 203(k) program is riskier, FHA oversees the two
programs in essentially the same way. 2. We disagree that HUD's
current monitoring procedures are adequate to minimize the unique
risks posed by the 203(k) program. The report reflects information
provided by the Homeownership Centers that the 203(k) program is
not targeted for review. Since the 203(k) program is much more
risky than the 203(b) program, FHA should target lenders' 203(k)
activity for oversight. FHA officials were able to provide us with
the number of lenders the agency reviewed that had made one or
more 203(k) loans. However, they could not tell us the extent to
which these lenders' 203(k) activity was reviewed. Furthermore, at
the time of our review, none of the Homeownership Centers, which
are responsible for overseeing the 203(k) program, targeted
lenders for review on the basis of their overall 203(k) loan
performance. 3. Since we relied on net loss figures supplied by
FHA, we do not provide a detailed explanation of these figures in
the report. We do not draw any conclusions from the expected
increase in net losses other than that FHA expects the program to
incur increasing net losses from the time period covered by our
review. We point to other factors, such as an increase in the
early default rate, as an indication that the quality of loans
made under the program may be getting worse. We also state that
the net losses as a percentage of endorsements are in contrast to
the net gains as a percentage of endorsements expected for the
203(b) program over the same time period. We use this fact as a
further illustration that the 203(k) program is riskier than the
203(b) program and that FHA should oversee it differently. The
report does note that the program experienced substantial growth
during the period covered by our review. 4. We disagree. FHA did
not provide GAO evidence that its staff have been trained in
conducting 203(k) reviews. Our report reflects the additional
information provided by the Deputy Assistant Secretary for Single-
Family Housing regarding the targeting of 203(k) lenders for
review. In the report we include FHA's information showing that
the four Homeownership Page 39 GAO/RCED-
99-124 Problems With HUD's 203(k) Loans Appendix V Comments From
the Department of Housing and Urban Development Centers performed
52 quality assurance reviews on lenders that made 203(k) loans.
However, the information provided does not show how many 203(k)
loans have been reviewed. In addition, the information provided by
FHA did not show that every Homeownership Center has quality
assurance staff trained in the 203(k) program. Finally, during our
review, officials at two Homeownership Centers told us that they
did not have staff qualified to do quality assurance reviews. 5.
HUD clarified its statement that the 203(k) program default and
claim rates are acceptable. HUD noted that while the losses are to
be expected, it is reviewing the program to determine if some
program design changes are needed. We have incorporated these
clarifications where appropriate. In addition, while our report
states that the 203(k) program is complex because of the
rehabilitation component of the program, we did not state that the
program is unnecessarily bound by rules. 6. We do not agree that
the Credit Watch system will improve the post- endorsement
technical review process, which identifies underwriting violations
early in the life of the loans to mitigate potential losses before
they occur. HUD announced the Credit Watch program on May 12,
1999. This program is designed to identify high-risk lenders with
high default and claim rates. As we note in our report, a post-
endorsement technical review is intended to identify loan
underwriting violations or weaknesses before losses have occurred.
Credit Watch is not designed to improve the process for
identifying and notifying lenders of violations discovered in the
post-endorsement technical review. The intent of our
recommendation is to promptly resolve deficiencies noted in the
reviews in an attempt to prevent or mitigate losses before they
occur. We recognize that the Credit Watch program may be an
effective tool to identify problem lenders. 7. The Credit Watch
program is designed to identify lenders with high default and
claim rates. It does not, however, identify lenders based on
specific program loan activity. In most cases, the lenders'
portfolio of 203(k) loans is a small percentage of their overall
portfolio of FHA loans. Consequently, problems with a lender's
203(k) portfolio would not be noticed unless they were
encountering high default and claim rates with their non-203(k)
loans. The intent of our recommendation is to target high-risk
lenders on the basis of their experience with 203(k) loans, which
are inherently more risky than many other types of FHA-insured
loans. If the Credit Watch program is modified to identify high-
risk lenders by the various FHA programs, HUD may be able to
capture lenders' performance in the programs identified as high
risk. Page 40 GAO/RCED-99-124 Problems
With HUD's 203(k) Loans Appendix VI Major Contributors to This
Report Housing and Lenny R. Moore Community
LaSonya R. Roberts Paul J. Schmidt Development Issue Rick
B. Smith Area Office of the General John T. McGrail Counsel
(385744) Page 41 GAO/RCED-99-124
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