Single-Family Housing: Stronger Oversight of FHA Lenders Could Reduce
HUD's Insurance Risk (Testimony, 06/29/2000, GAO/T-RCED-00-213).

Pursuant to a congressional request, GAO discussed the Department of
Housing and Urban Development's (HUD) oversight of Federal Housing
Administration (FHA) lenders.

GAO noted that: (1) GAO's work revealed a number of weaknesses in the
lender approval, monitoring, and enforcement efforts performed by HUD's
headquarters and its four homeownership centers; (2) HUD's process for
granting FHA-approved lenders direct endorsement authority--that is, the
ability to underwrite loans and determine their eligibility for FHA
mortgage insurance without HUD's prior review--provides only limited
assurance that lenders receiving this authority are qualified; (3) in
addition, while HUD's homeownership centers have monitored lenders'
compliance with FHA's lending requirements, these monitoring efforts
have not adequately focused on the lenders and loans that pose the
greatest insurance risks to the Department; and (4) although HUD has
taken enforcement actions against lenders with excessively high default
rates, it needs to take further steps to hold lenders accountable for
poor performance and program violations.

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

 REPORTNUM:  T-RCED-00-213
     TITLE:  Single-Family Housing: Stronger Oversight of FHA Lenders
	     Could Reduce HUD's Insurance Risk
      DATE:  06/29/2000
   SUBJECT:  Noncompliance
	     Mortgage programs
	     Lending institutions
	     Mortgage loans
	     Risk management
	     Mortgage protection insurance
	     Internal controls
	     Loan defaults
IDENTIFIER:  HUD Credit Watch Program

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GAO/T-RCED-00-213

SINGLE- FAMILY HOUSING

Stronger Oversight of FHA Lenders Could Reduce HUD's Insurance Risk
Statement of Stanley J. Czerwinski, Associate Director, Housing and
Community Development Issues, Resources, Community, and Economic Development
Division

United States General Accounting Office

GAO Testimony Before the Permanent Subcommittee on Investigations,

Committee on Governmental Affairs, U. S. Senate

For Release on Delivery Expected at 9: 30 a. m., EDT Thursday June 29, 2000

GAO/ T- RCED- 00- 213

1

Madame Chairman and Members of the Subcommittee: We are here to discuss our
report that you requested and are releasing today on the Department of
Housing and Urban Development's (HUD) oversight of lenders that make
mortgage loans insured by HUD's Federal Housing Administration (FHA). 1
During fiscal year 1999 alone, FHA insured 1.3 million mortgages valued at
about $124 billion. While FHA insures lenders against nearly all losses
resulting from foreclosed loans, it relies on the lenders to underwrite the
loans and determine their eligibility for FHA mortgage insurance.

Our review focused on the adequacy of HUD's policies and procedures for
overseeing lenders. We performed limited tests and analyses to determine
whether these policies and procedures were properly utilized to limit HUD's
insurance risk.

In summary, our work revealed a number of weaknesses in the lender approval,
monitoring, and enforcement efforts performed by HUD's headquarters and its
four homeownership centers. 2

ï¿½ HUD's process for granting FHA- approved lenders direct endorsement
authority--- that is, the ability to underwrite loans and determine their
eligibility for FHA mortgage insurance without HUD's prior review- provides
only limited assurance that lenders receiving this authority are qualified.

ï¿½ In addition, while HUD's homeownership centers have monitored lenders'
compliance with FHA's lending requirements, these monitoring efforts have
not adequately focused on the lenders and loans that pose the greatest
insurance risks to the Department.

1 Single- Family Housing: Stronger Oversight of FHA Lenders Could Reduce
HUD's Insurance Risk (GAO/ RCED- 00- 112, Apr. 28, 2000). 2 HUD's four
homeownership centers administer the single- family housing functions in the
50 states, the District of Columbia, and Puerto Rico. The centers are
located in Atlanta, Georgia; Denver, Colorado; Philadelphia, Pennsylvania,
and Santa Ana, California.

2

ï¿½ Finally, although HUD has taken enforcement actions against lenders with
excessively high default rates, it needs to take further steps to hold
lenders accountable for poor performance and program violations.

Our report makes recommendations designed to improve HUD's processes for
approving lenders to underwrite FHA- insured mortgages, for targeting
lenders and loans for quality control reviews, and for taking enforcement
actions against poorly performing lenders. In commenting on the report, HUD
stated that it generally agreed with the report's recommendations.

Background

A homebuyer seeking a FHA- insured mortgage must submit a mortgage
application to a FHAapproved lender. Once the lender approves the loan, it
sends the loan documents to HUD for approval of FHA mortgage insurance. If
the borrower defaults and the lender subsequently forecloses on the loan,
the lender can file an insurance claim with HUD for the unpaid balance of
the loan. As of December 1999, about 10,000 lending institutions were
approved to participate in FHA's mortgage insurance programs for single-
family homes.

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

Direct Endorsement Approval Process Provides Limited Assurance That Lenders
Are Qualified

HUD's process for granting FHA- approved lenders direct endorsement
authority-- the ability to underwrite loans and determine their eligibility
for FHA mortgage insurance without HUD's

3

prior review- provides only limited assurance that lenders receiving this
authority are qualified. HUD's guidance does not adequately define the level
of proficiency that lenders must achieve in order to be granted direct
endorsement authority. As a result, HUD's homeownership centers have applied
the guidance differently and have approved lenders that made multiple and
serious underwriting errors.

FHA- approved lenders seeking direct endorsement authority go through a
probationary period during which they are required to demonstrate acceptable
performance in underwriting at least 15 mortgage loans. The mortgages are
submitted to and evaluated by HUD's homeownership centers before the
mortgages are finalized. These evaluations rate as “good,”
“fair,” or “poor” various aspects of the lender's
work, including its analysis of the credit risk posed by the borrower and
the quality of the property appraisal. A “poor” rating indicates
that the lender made underwriting errors that significantly increased HUD's
insurance risk.

While HUD's guidance requires that lenders seeking direct endorsement
authority demonstrate overall acceptable performance on these evaluations,
the guidance is unclear on what constitutes “acceptable
performance.” As a result, HUD's homeownership centers have
interpreted the guidance differently. For example, the Denver center
interpreted the guidance to mean that lenders had to submit 15 mortgages for
which they received at least “good” or “fair”
ratings. In contrast, the Santa Ana center did not have a requirement for
the number of “good” and “fair” ratings that lenders
had to achieve.

HUD's four homeownership centers granted direct endorsement authority to a
total of 36 lenders during the 6 months prior to our 1999 visits to the
centers. We reviewed the ratings that each of these lenders received from
the centers for the lender's evaluation of the credit risk posed by the
borrower. Our analysis showed significant variations in what HUD's
homeownership centers considered as acceptable performance, reflecting the
vagueness and inconsistent application of HUD's approval standards. Overall,
of the 36 lenders, 8 received no “poor” ratings for the last 15
mortgages they submitted to the centers for review. However, 12 lenders
received “poor” ratings in over a quarter of their last 15
mortgages. The lenders' errors included their failure to (1) verify the
borrower's employment and income, (2) ensure that the borrower had
sufficient income to support the monthly mortgage payments, (3) explain
delinquent accounts and

4

collections on the borrower's credit reports, and (4) properly calculate the
borrower's debts or liabilities. We believe that lenders such as these 12
may pose a high insurance risk to the Department once they begin
underwriting and approving loans without HUD's prior reviews.

To improve HUD's process for granting lenders direct endorsement authority,
our report recommended that HUD develop specific performance standards for
lenders seeking this authority.

Monitoring Process Does Not Adequately Focus on Riskiest Lenders and Loans

HUD's homeownership centers use two monitoring tools to ensure lenders'
compliance with FHA's lending requirements: (1) on- site evaluations of
lenders' operations, known as lender reviews, and (2) desk audits of the
underwriting quality of loans already insured by FHA, known as technical
reviews. HUD's guidance stresses the importance of using risk analysis to
allocate a larger share of monitoring resources to program activities that
pose the highest risks to the Department. However, the homeownership centers
have not adequately focused their monitoring efforts on lenders and loans
that pose the highest insurance risks.

HUD Has Reviewed More Lenders in Recent Years but Often Not the Riskiest
Ones In recent years, HUD has placed greater emphasis on performing on- site
evaluations of lenders' operations. For example, the number of lender
reviews that HUD performed grew from 291 in fiscal year 1996 to 932 to in
fiscal year 1999. HUD's guidance states that 85 percent of the lender
reviews should be targeted at high- risk lenders. However, we found that the
homeownership centers often did not review the lenders that they considered
to pose the highest risks. For example, the Philadelphia center developed a
list of 131 high- risk lenders that it considered to be a high priority for
review in fiscal year 1999. Despite conducting reviews of 228 lenders during
fiscal year 1999, the center reviewed just 39-- or about 30 percent-- of the
131 lenders on its priority list. While the other homeownership centers did
not have similar priority lists, center officials told us that they
frequently selected for review those lenders that did not pose a high
insurance risk to HUD. For instance, a Santa Ana center official estimated
that half of the reviews the center performed in fiscal year 1999 were of
lenders that had few or no early defaults- that is, loans that defaulted
within 24 months. Because loans that default this quickly

5

are an indicator of poor lending practices that may result in insurance
losses, HUD considers them to be an important factor in assessing lenders'
risk.

Homeownership center officials cited inexperienced staff and limited or
uncertain travel funds as reasons why high- risk lenders were not always
reviewed. For instance, according to the four homeownership centers, most of
the centers' 140 staff who conduct lender reviews assumed their current
positions in fiscal years 1998 and 1999-- largely from the pool of HUD field
staff who remained unassigned after HUD's 1998 reorganization. Center
officials also told us that they generally did not allow staff with less
than a year of experience to review high- risk lenders because their
inexperience might lead them to overlook serious deficiencies.

Furthermore, although HUD's guidance states that lenders should be rated and
prioritized for review, the Department has not developed a systematic
process for doing so. HUD's guidance lists several risk factors that should
be considered in targeting lenders for reviews, including default rates, the
late payment of mortgage insurance premiums to HUD, and the volume of
business. But the guidance indicates neither how these factors should be
weighted nor how lenders should be prioritized. As a result, the centers
have not targeted lenders for reviews in a consistent manner. To more
effectively monitor lenders' performance, our report recommends that HUD
develop procedures to identify and prioritize high- risk lenders for lender
reviews and ensure that the homeownership centers consistently apply these
procedures.

Selection of Loans for Technical Reviews Was Not Based on Risk Technical
reviews-- desk audits that evaluate the underwriting quality of loans
already insured by FHA-- are another tool that HUD uses to monitor the
performance of lenders. If technical reviews reveal serious deficiencies,
HUD may suspend the lenders' authority to underwrite FHAinsured loans, among
other things.

All four of HUD's homeownership centers met the Department's goal to perform
technical reviews on no less than 10 percent of the FHA- insured mortgage
loans made during fiscal year 1999. However, the centers have not
effectively implemented HUD's guidance, which states that technical reviews
should be targeted at loans that exhibit high- risk characteristics, such as
loans to borrowers with unusually high expenses relative to their income.
Instead, HUD's

6

homeownership centers rely primarily on a random process for selecting loans
for technical reviews. The computer system that supports HUD staff in
processing mortgage insurance randomly selects a certain percentage of each
lender's loans for technical reviews. However, the system cannot
automatically identify and select for review those loans that exhibit high-
risk characteristics. HUD's four homeownership centers told us that they
sometimes manually selected high- risk loans for reviews but that the large
volume of loans that they processed for FHA insurance, coupled with staffing
constraints, made it impractical to do this on a routine basis. To address
this problem, our report recommends that HUD enhance its management
information systems to identify and select, for technical reviews, loans
that pose a high insurance risk to the Department.

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

To hold lenders accountable for program violations or poor performance, HUD
may, among other things, (1) suspend their direct endorsement authority and
(2) terminate their loan origination authority through its Credit Watch
program, which is designed to hold lenders accountable for excessive
defaults and insurance claims on FHA- insured mortgages. However, the
homeownership centers have made only limited use of their ability to suspend
lenders' direct endorsement authority. Furthermore, certain lenders have
escaped accountability under the Credit Watch program.

Homeownership Centers Made Limited Use of Their Ability to Suspend Lenders'
Direct Endorsement Authority

HUD's guidance allows the homeownership centers to suspend the direct
endorsement authority of lenders that fail to comply with FHA's program
requirements but provides only general guidelines for determining which
lenders should be subject to this action. Lenders whose direct endorsement
authority is suspended must submit their mortgage case files to the
homeownership centers, which evaluate the lenders' underwriting decisions
before deciding whether to insure the loans.

Among the four homeownership centers, we found that the Philadelphia center
was the only one that had suspended the direct endorsement authority of any
lenders during fiscal year 1999. Specifically, the Philadelphia center took
this action against eight lenders in fiscal year 1999, citing underwriting
violations identified by technical reviews or lender reviews. Although the

7

centers suspended relatively few lenders, our analysis of HUD's technical
review ratings for fiscal year 1999 showed frequent noncompliance with FHA's
underwriting requirements, indicating that many lenders may be candidates
for this action. Specifically, we identified 206 lenders nationwide that,
during fiscal year 1999, received “poor” ratings on more than 30
percent of their reviewed loans for their evaluation of the credit risk
posed by the borrower. 3 A “poor” rating means that the lender
made mistakes that significantly increased HUD's insurance risk. Of these
206 lenders, 131 made 10 or more FHA- insured loans in fiscal year 1999.
HUD's guidance does not specify the extent of noncompliance with FHA's
requirements that would warrant the suspension of a lender's direct
endorsement authority. However, in our opinion, the extent of noncompliance
demonstrated by these 131 lenders indicates that they may be candidates for
this action. As of October 1, 1999, HUD's homeownership centers had not
suspended any of these lenders.

To strengthen HUD's enforcement efforts against lenders, our report
recommends that HUD clarify and implement guidelines for identifying lenders
whose direct endorsement authority should be suspended.

Lenders Underwriting Loans Originated by Others Escape Responsibility for
Excessive Default and Claim Rates Under HUD's Credit Watch Program

In May 1999, HUD announced that it would begin to use its Credit Watch
program to sanction lenders with excessive defaults and insurance claims on
FHA- insured mortgages. HUD planned to terminate the loan origination
authority of any lender whose default and claim rates on mortgages insured
by FHA during the preceding 24 months exceeded both the national average and
300 percent of the average rate for the HUD field office serving the
lender's geographic location. Similarly, HUD planned to place on
“credit watch” status the lenders whose default and claim rates
exceeded both the national average and 200 percent of the corresponding HUD
field office average. While on “credit watch” status, the lender
can continue to originate FHAinsured loans, but its performance receives
greater scrutiny from HUD.

3 The 206 lenders were among the approximately 5,000 lenders that received
technical review ratings in fiscal year 1999 for mortgages they both
originated and underwrote.

8

As of April 2000, HUD had completed four rounds of its Credit Watch program.
This program has resulted in the Department's actual or proposed termination
of 64 lenders' loan origination authority and the placement of 140
additional lenders on “credit watch” status.

The regulations governing HUD's Credit Watch program allow the Department to
hold accountable for excessive defaults or insurance claims the lenders that
originated the troubled loans. However, the regulations do not address HUD's
authority to also hold accountable those lenders that underwrote the loans.
When originating mortgage loans, lenders perform such functions as accepting
mortgage applications and obtaining employment verifications and credit
reports on the borrowers. When underwriting mortgage loans, lenders use this
information to determine whether borrowers are able to make their mortgage
payments and whether the loans should be approved. HUD officials told us
they recognized that the underwriting lenders contributed to excessive
defaults and insurance claims but that the Credit Watch program's
regulations did not permit them to take enforcement actions against these
lenders. The officials said they were considering regulatory changes to
address this problem.

The results of the first round of the Credit Watch program illustrate the
program's limitations as an enforcement tool. Of the 33 lenders that HUD
terminated during the first round of the program, 17 relied on other lenders
to underwrite the nearly 6,200 loans that they originated and FHA insured
during the 24- month period of analysis. Nevertheless, the underwriting
lenders escaped sanctions under the Credit Watch program.

The Credit Watch program is also facing a legal challenge. In September
1999, one lender whose authority to originate FHA- insured mortgage loans
was terminated by HUD filed a lawsuit seeking to overturn HUD's actions.
Among other issues, the lender contended that HUD had exceeded its statutory
authority when it issued its Credit Watch regulations and that the manner in
which HUD terminated the lender's authority had deprived the lender of due
process. In October 1999, a federal district court ruled that HUD's Credit
Watch regulations were invalid and set aside HUD's termination of the
lender. The court stated that HUD's statutory authority requires that after
determining that a lender has excessive defaults and claims, HUD must
provide the lender with the opportunity to provide the Department with a
plan and timetable for correcting the defaults. The court stated that HUD
had sidestepped its statutory mandate by

9

enacting regulations that allowed the Department to terminate a lender's
authority to originate loans whenever HUD deemed it appropriate because of
the lender's default and claim rates. The court also concluded that even if
HUD had the authority to issue such regulations, the regulations denied the
lender its right to due process. HUD has appealed the court's decision. In
May 2000, another lender successfully sought a court injunction that
prevented HUD from terminating this lender's authority to originate FHA-
insured mortgages. Our report recommends that once the legal basis of the
Credit Watch program is resolved, HUD revise the program's regulations to
cover lenders that underwrite FHA- insured loans with excessive defaults and
claims rates as well as those lenders that originate such loans.

---- Madame Chairman, this concludes our testimony. We would be happy to
answer any questions that you or members of the Subcommittee may have.

Contact and Acknowledgement

For further information regarding this testimony, please contact Stanley J.
Czerwinski at (202) 512- 7631. Individuals making key contributions to this
testimony included Karen Bracey, Karin Lennon, Stan Ritchick, Paul Schmidt,
Steve Westley, and Shana Whitehead.

(385865)

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