**TO: ALL APPROVED MORTGAGEES**

**ATTENTION: Single Family Servicing Managers**

#### SUBJECT: Due Diligence in Acquiring Loans

The purpose of this Mortgagee Letter is to identify and recommend the
use of prudent industry practices related to due diligence in the
acquisition of whole loans or loan pools.

In recent months, national attention has been drawn to the devastating
impact of predatory lending on families who are victimized by a few
unscrupulous sellers, appraisers, real estate agents, mortgage
originators or investors. The Department believes that no responsible
FHA-approved mortgagee would knowingly purchase fraudulently originated
loans. Effective due diligence policies, uniformly applied by mortgagees
prior to purchase, would cripple the ability of fraudulent lenders to
pawn predatory loans off on others in the mortgage industry. If
predatory loans cannot be sold, they are unlikely to be made and all
borrowers, including FHA borrowers, will be protected.

The Department routinely solicits feedback from lenders regarding the
need for clarification of servicing requirements during various industry
forums such as servicing conferences. As a result of the national
attention on predatory lending, recent industry discussions focused on
predatory lending practices and due diligence in the purchase of FHA
insured loans. As a follow up to those discussions, several FHA-approved
lenders that regularly buy and sell loans provided examples of the
quality control procedures used by their firms to review both
underwriting and servicing aspects of loan purchase transactions.

Due to the importance of this matter, the Department is considering
amending its regulations to require pre-purchase quality control
reviews. Until such regulations are issued, the Department will
publicize through Mortgagee Letters prudent practices currently being
used by the industry.

As such, this letter is the first in a series of Mortgagee Letters on
prudent due diligence. Because of its focus on predatory lending, this
letter concentrates on due diligence reviews of how loans were
originated and underwritten. Future Mortgagee Letters will focus on
related matters including prudent due diligence of prior servicing
activity. The best practices described herein are provided as guidance
to HUD-approved lenders who may find it appropriate or necessary to
update their *Quality Control (QC) plan* to include procedures for
pre-purchase due diligence of acquired loans. While the Department
encourages lenders to review and revise QC plans in accordance with this
guidance, the performance of due diligence by asset purchasers is, at
present, voluntary.

**[BACKGROUND]{.underline}**

To obtain or maintain approval to participate in HUD mortgage programs,
mortgagees are required to "implement a written quality control plan,
acceptable to the Secretary, that assures compliance with the
regulations and other issuances of the Secretary regarding loan or
mortgage origination and servicing" (24 CFR 202.5 (h)). In addition,
this written plan must "provide for independent evaluation of the
significant information gathered for use in the mortgage credit
decisionmaking and loan servicing process for all loans originated or
serviced by the mortgagee" (see Chapter 6 (1) of the Mortgagee Approval
Handbook, 4060.1 REV-1). This requirement includes loans or loan pools
purchased by the mortgagee from unrelated originators.

There are also related requirements regarding the sale of the mortgage
in that the purchasing mortgagee succeeds to all rights and becomes
bound by all of the obligations of the seller under the contract for
mortgage insurance. This would include the originating lender and any
successive purchasing lender (see HUD Handbook 4330.1 Rev. 5, Chapter
6).

Prior to closing a portfolio or pool purchase from an independent
source, prudent servicers conduct a due diligence review of selected
loans within the portfolio. This procedure provides the acquiring
servicer the opportunity to measure the credit and collateral risks
inherent in the portfolio. Risk might arise from fraudulent
transactions, deficient underwriting, defective property condition,
inadequate servicing or other factors that may ultimately lead to
borrower default or indemnification of the Department.

Just as the written QC plan must identify a specific protocol for
on-going review of loans in the lender's portfolio, the plan should also
include a documented protocol for due diligence of loans to be acquired.
An effective due diligence plan should:

1.  Include specific procedures for reviewing the source of the loans;

2.  Describe portfolio risk analysis methods;

3.  Identify a sampling methodology (random, statistical and or risk
    targeted sampling);

4.  List evaluation criteria for the loan level review; and,

5.  Include outcomes if a loan, or a percentage of loans reviewed, is
    not in compliance with FHA requirements.

Following are examples of best practices for conducting due diligence.
These practices are used by many FHA lenders and servicers that
routinely purchase whole loans or loan portfolios.

**[PRE-PURCHASE DUE DILIGENCE]{.underline}**

All FHA mortgagees who purchase or anticipate purchasing loans are
encouraged to review and update their QC plan to include some or all of
the practices described herein.

*Review the Source of the Loans*

Integrity of source is a critical factor in assessing the risk inherent
in any transaction. A thorough review of the reputation, business
conduct and practice of the seller is an essential first step in any
pre-purchase due-diligence program. Seller review techniques commonly
used by FHA lenders are described below. Most of the lenders volunteered
that it is their practice to always conduct such reviews prior to a
specific purchase transaction and it is their practice to follow up the
initial review by conducting additional reviews at routine intervals for
a period of time.

1.  Utilize a comprehensive questionnaire to be completed by the
    originating lender or current seller prior to portfolio purchase
    that fully and completely describes the nature of the seller's
    business and how it is conducted and fully discloses the seller's
    current financial condition.

2.  Obtain and review a copy of the selling lender/servicer's QC plan
    and several annual reports.

3.  Use HUD's Neighborhood Watch website, which is accessible through
    the FHA Connection, to screen the originators from whom the seller
    regularly purchases loans. See ML 2002-15 for directions on
    accessing Neighborhood Watch.

4.  Establish key questions and responses that are likely to detect
    fraud or poor business practices and use these questions to conduct
    interviews with the seller's servicing and collection staff.

5.  Audit the seller's origination operations.

6.  Check the [Federal Register]{.underline} to see if the seller has
    been subject to Mortgagee Review Board actions. Also, use HUD's
    Neighborhood Watch System as a means of evaluating the originating
    lender's past performance and to see if HUD has taken any
    termination actions.

*Portfolio Risk Analysis*

Portfolio risk analysis looks at performance characteristics of all
loans in the transaction. In order to properly measure portfolio risk,
the acquiring mortgagee must establish benchmarks for performance
characteristics including interest rate, term, collateral type,
pre-payment runoff, loan-to-value, delinquency, foreclosure, early
payment default, etc. Buyers typically use computer assisted analysis to
review all loans in the sale transaction, determine the relative risk
and decide if the risk level of the transaction is acceptable before
proceeding with further due diligence.

*Sampling Methodology*

The surest way to know the quality of loans being purchased is to
completely

re-underwrite each origination file. While this is common for individual
loan purchases, it is not economically feasible in large transactions.
Pool purchasers typically rely on sampling.

Sampling allows the buyer to conduct a detailed loan level review of a
small number of loans in the portfolio and from this review draw
conclusions about the overall quality of originations. HUD's Mortgagee
Approval Handbook, 4060.1, Rev-1, Chapter 6-1(c), describes sampling
techniques relative to quality control reviews. These techniques,
including random and statistically valid sampling, may be helpful in
establishing a sampling protocol for due diligence reviews.

In addition to sampling, most loan purchasers also target certain loan
types or loan characteristics for detailed review. Targeted reviews are
conducted on some or all loans that present greater risk potential. FHA
lenders report that they commonly conduct targeted reviews using these
loan characteristics:

1.  Section 203(k) rehabilitation loans (review of initial documentation
    and current escrow status).

2.  Interest rates significantly exceeding the average portfolio rate.

3.  Fair Isaac (FICO) scores below acceptable benchmarks established by
    the purchaser.

4.  Loans to non-profit organizations.

5.  Loans made based on the credit qualifying of multiple mortgagors to
    meet minimum income requirements.

*Loan Level Review*

When conducting loan level due diligence of specific loans, the best
practices of many purchasing lenders also include reviewing the
following:

1.  Verification that each loan in the portfolio/pool is properly
    insured and that the mortgage insurance certificate has been issued.

2.  Verification that the property had not been sold at a significantly
    lower value within a short time prior to the subject transaction
    without documentation to support the increased value.

3.  Verification that the seller had been the owner of record for some
    reasonable period of time prior to the subject transaction.

4.  Re-calculation of the borrower's qualifying ratios and examination
    of the validity and sufficiency of the income.

5.  Review of the borrower's credit worthiness including:

-   FICO score

-   Credit report and adequacy of supplemental explanations

-   The in-file verification of employment (VOE), Gift Affidavits and
    other sources of downpayment.

6.  Determination that the points and fees charged to the buyer were
    reasonable based on market conditions at the time of origination and
    that the rate was fair and appropriate based on the borrower's
    credit and income.

7.  Evaluation of the appraisal to determine that all relevant HUD
    regulations and guidelines (including HUD Handbooks 4150.1 and
    4150.2), were met and followed during the underwriting process.

8.  Verification that proper borrower disclosures were provided, that
    all signatures appear to be genuine and that the file documentation
    provides no evidence of fraud or poor business practices.

*Outcomes*

A comprehensive due diligence plan includes planned reactions. It is
important that mortgage loan buyers establish risk thresholds and
projected outcomes prior to conducting the review so that they know when
to walk away from a transaction or an individual loan that presents an
unacceptable level of risk. Some common outcomes of pre-purchase due
diligence include:

1.  Exclusion of one or more individual loans or a cohort of similar
    loans from the transaction;

2.  Providing the seller the opportunity to correct defects;

3.  Adjusting pricing to account for the increased risk; or,

4.  Cancellation of the sale if the level of non-compliance is
    significant enough.

Essential to the success of any loan purchase policy is an enforceable
loan sale agreement. Typically loan sale agreements provide additional
protection for the purchaser by including recourse provisions in the
event of contractual default or noncompliance discovered after closing.
Recourse may include repurchase of selected loans, indemnity, or other
financial remedies for the benefit of the purchaser. HUD encourages use
of recourse provisions that require sellers to remedy any loan that is
subsequently discovered to have predatory characteristics.

If due diligence is to be an effective protection against predatory
lending, purchasers must complete their due diligence review prior to
closing the sale transaction **A rigorous pre-purchase review protects
the purchaser and puts sellers on notice that poor quality, predatory or
fraudulently originated loans cannot be pawned off on legitimate
mortgagees simply based on the strength of the FHA insurance
endorsement.**

If during any aspect of a loan sale transaction a mortgagee identifies
evidence of potential loan fraud or predatory practices, the Department
encourages the mortgagee to notify the seller in writing, listing the
loan or loans that appear suspect. If the mortgagee observes what
appears to be a fraudulent origination, the mortgagee must report this
to the Quality Assurance Division within the Homeownership Center where
the loan was originated.

If you have any questions concerning this Mortgagee Letter, please
contact the National Servicing Center in Oklahoma City, Oklahoma at 1
(888) 297-8685.

Sincerely,

John C. Weicher

Assistant Secretary for Housing-

Federal Housing Commissioner