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 programï¿½the 203(b) programï¿½because 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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