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**STATEMENT OF**

##  KENNETH M. DONOHUE

**INSPECTOR GENERAL**

## DEPARTMENT OF HOUSING AND URBAN

###  DEVELOPMENT

## HOUSE COMMITTEE ON THE BUDGET 

# "WASTE, FRAUD, AND ABUSE IN MANDATORY SPENDING PROGRAMS"

**THE UNITED STATES HOUSE OF REPRESENTATIVES**

**JULY 9, 2003**

Thank you for inviting me to submit a statement for the record on waste,
fraud, and abuse in mandatory spending programs within the Department of
Housing and Urban Development (HUD). For budgetary purposes, our
insurance programs meet the definition of mandatory programs.
Consequently, my remarks will only focus on our audit and investigative
efforts involving the Department's insurance and guarantee programs, The
Federal Housing Administration (FHA) and the Government National
Mortgage Association, known as Ginnie Mae. While these Government
Sponsored Enterprises are considered mandatory programs, the monetary
savings identified through our audits or investigations would generally
not be returned to the U.S. Treasury. For example, the FHA insurance
programs are self-sustaining. Income is generated through borrowers'
mortgage insurance premiums and the costs for foreclosure losses are
paid by the insurance fund. Mortgage insurance premiums are adjusted up
or down to cover program needs. If there are excess premium revenues,
the Assistant Secretary may authorize the payment of premium refunds.

Last month, we provided testimony for the House Committee on Financial
Services on areas of potential savings from our discretionary programs.
We identified several older programs with remaining obligated funds from
expired contracts (i.e., HUD's Section 8 Program which provides rental
assistance to low-income households). We recommended that these
obligations be recaptured and used to offset future budgetary needs. In
response to our findings, the Department has taken action to offset
fiscal year 2004 funding by \$1.7 billion.

**Program Background.** FHA was created as a U.S. Government Corporation
within HUD and administers active insurance programs designed to make
mortgage financing available to the home-buying public. FHA insures
private lenders against loss on mortgages that finance single-family
homes, multifamily projects, health care facilities' property
improvements and manufactured loans. Ginnie Mae, through its
Mortgage-Backed Securities Program, facilitates the financing of
residential mortgages by guaranteeing the timely payment of principal
and interest to investors. Ginnie Mae issuers pool FHA, VA and Farmers
Home mortgages into mortgage-backed securities. The Ginnie Mae guarantee
gives lenders access to the capital markets to originate new loans.

FHA insures more than a million loans each year. FHA's outstanding
insurance portfolio exceeds \$600 billion. Last year, Ginnie Mae reached
the \$2 trillion mark in mortgage-backed securities issued since 1970.
The outstanding portfolio of these securities now exceeds \$587 billion.
FHA and Ginnie Mae, from a financial standpoint, are both fiscally sound
organizations. FHA mortgage insurance premiums more than cover any
losses incurred through the foreclosure and note sales processes. The
FHA insurance fund is actuarially sound and it more than exceeds the 2%
capital ratio requirement set by the Congress. Ginnie Mae fees charged
to issuers currently earn Ginnie Mae between \$700 and \$800 million
annually.

**The Magnitude of the Problem.** You requested an estimate of the
magnitude of waste, fraud and abuse in these programs. As you can see
from the balance of my testimony, there are so many players in our
programs that making such an estimate would be extremely difficult. HUD
relies on thousands of approved FHA direct endorsement lenders for
underwriting. These lenders accept applications, verify borrower income/
assets / liabilities, and determine appraised property values. Any of
these many processes in the origination of an FHA loan can be
compromised. Much of our mortgage and lender targeting for OIG review is
based on the small percentage of loans that may be in default or
foreclosure at any time.

With more than a million FHA loans insured each year, the slightest
percentage of fraud can equate to high-risk loans valued at hundreds of
millions in dollars. HUD uses a detailed lender default monitoring
system to identify lenders with a high incidence of defaulted loans.
FHA's Quality Assurance Division and our office both use this default
information to identify lenders for review. An early loan default is
generally a good indicator of underwriting irregularities. However, not
all failed loans are fraudulent\--job loss, health issues, divorce,
etc., may be the reason for default. A significant part of our audit and
investigative resources are committed to FHA lender and Ginnie Mae
issuer reviews. Last year, we opened numerous investigations on
individuals potentially involved in FHA insurance fraud and our workload
continues to drastically increase.

**Single-Family Mortgage Fraud** continues to be an investigative
priority for the OIG. Our investigations of perpetrators of fraud
include: title companies, loan officers, mortgage companies and brokers,
real estate agents, closing attorneys and appraisers. These
perpetrators, through a variety of schemes, submit fraudulent loan
applications, appraisals, and other falsified loan documents and/or
utilize straw-buyers, and other conspirators, to effect the fraud.

Our Semiannual Report to the Congress for the period ending September
30, 2002 reflected investigative recoveries of \$59 million. During the
same period approximately 60% of our cases and 90% of our investigative
recoveries were attributable to Single-Family mortgage fraud cases.
During the first six months of this fiscal year, investigative
recoveries are approximately \$65 million, a figure that already exceeds
our recoveries for all of fiscal year 2002.

Recent statistical information gathered from our 10 investigation
regional offices shows that investigative efforts expended on these
Single-Family cases involve approximately 1400 subjects who have
originated more than \$1 billion in loans affecting nearly 36,000
FHA-insured properties. These investigations are worked in coordination
with 148 Assistant United States Attorneys.

A recent focus of our audit and investigative work has been on
Single-Family property flipping. In certain parts of the country,
especially in urban areas, investors have been purchasing distressed
properties and reselling them to an FHA-insured purchaser at an inflated
value. The purchase and resale was often done on the same day. In many
cases, there was collusion between sellers, lenders and appraisers to
inflate values. In our OIG reviews, we found a wide disparity between
the original purchase price and the resale price of the property. The
concentration of flipped properties in certain neighborhoods resulted in
one inflated property value being used as the comparable (i.e. setting
the value for another property). We have found, in particular, a
concentration of problems in Los Angeles, New York City, Ft. Lauderdale
and Baltimore. These involved hundreds of properties and millions of
dollars in losses to the FHA insurance fund. An example of one of our
flipping investigation involved Schmidbauer Realty, Inc. of Baltimore,
Maryland.

The OIG identified a series of real estate "flip" transactions through a
company owned by William Otto Schmidbauer. Schmidbauer bought and then
resold numerous Single-Family properties at prices well above their
market value. He used straw-buyers to complete the transactions and
would use pre-selected lenders, loan officers and appraisers to
facilitate the loans. The 58 real estate transactions identified to date
involved approximately more than \$5 million in fraudulent FHA loans.
Eleven straw purchasers and one loan officer have entered guilty pleas
in the District of Maryland.

Early this year, working with HUD program staff, a property-flipping
rule was put in place to stop immediate property sales or flips. By
establishing a ninety-day waiting period between FHA sales, investors
cannot quickly resell properties as they did in the past. We anticipate
this rule will deter a major part of fraudulent property flipping
schemes.

**Multifamily Equity Skimming** is another major focus of our audit and
investigative endeavors in FHA programs. Equity skimming is the illegal
use of rents, assets, proceeds, income or other funds derived from an
FHA-insured multifamily property for purposes other than to meet actual
or necessary expenses. When owners do not pay their mortgages, the
living conditions in the developments can deteriorate because the funds
intended to maintain the individual units and common areas are diverted
for unauthorized uses.

A recent example of equity skimming involved a housing development in
the Bronx, New York. The owner of the project was found guilty of equity
skimming and ordered to pay restitution to HUD in the amount of
\$894,000. The owner took cash from the project for fraudulent expenses
and stopped making mortgage payments. In another case, the project
manager of four projects in West Virginia was found guilty of submitting
false invoices for maintenance work not performed. As a result, the
physical condition of the projects deteriorated. This case involved more
than \$800,000 of false invoices. The project manager was sentenced to
two years in jail, three years probation and ordered to pay \$250,000 in
restitution.

HUD requires that insured projects receive a financial audit each year.
In the course of these reviews, the auditors identify the source and use
of funds at the project. These reports may provide information that
funds are being removed from projects in a non-surplus cash position and
thereby assist HUD-OIG investigators and auditors and the Department in
its efforts to uncover such activity.

**Ginnie Mae Issuers** are responsible for pooling eligible mortgages
into mortgage-backed securities and passing mortgage payments through to
investors each month. Another recent OIG investigation involved First
Beneficial Mortgage Corporation (FBMC) of North Carolina who was an
approved FHA direct endorsement lender as well as an approved Ginnie Mae
issuer. At the time the fraud was detected, this issuer had a Ginnie Mae
mortgage-backed security portfolio worth \$45 million. FMBC saw a window
of opportunity to originate fraudulent FHA mortgages and then pool them
into mortgage-backed securities. By using the investor proceeds from the
sale of securities, the issuer was able to continue a "pyramid" scheme
by appearing to pass through mortgage proceeds. Over 100 of the pooled
mortgages in 11 Ginnie Mae pools were, in fact, fraudulent. FMBC
systematically recruited straw-buyers to sign fraudulent and fictitious
mortgage notes for vacant parcels of land. FBMC would then submit these
false notes to their registered document custodian as backing for their
securities as required by Ginnie Mae.

FBMC was permitted to sell millions of dollars of Ginnie Mae securities
without verification through, or by, FHA that these mortgages were
appropriately insured. FBMC was continuing to issue pools using false
documents. FHA and Ginnie Mae communications could have detected the
fraud earlier. A simple verification by Ginnie Mae that the FHA pooled
loans were, in fact, insured would have raised a red flag. Ginnie Mae
has since started a process of verifying whether Ginnie Mae pooled
mortgages are FHA insured. This control should help detect improper
pools within a few weeks of their origination.

**Corrective Actions**. As we identify possible systemic weaknesses in
HUD's operations through our audits, we make recommendations that, in
our opinion, will best correct the problem. These recommendations will
assist in the correction of many internal control weaknesses by
establishing sound checks and balances through handbook or regulatory
changes. In addition to administrative recommendations, a legislative
remedy may, in our estimation, be required in some instances. Over the
years, we have submitted legislative proposals to the Congress in an
effort to reform wasteful or ineffective features in HUD programs,
increase accountability in the award of financial assistance, and
improve program enforcement.

Our last submission a number of years ago included close to 40
proposals. Several of these proposals involved FHA activities. For
example, we proposed the elimination of the Title 1 program under
Section 2 of the Housing Act. This program provides insured loans for
home improvements and for the purchase of mobile homes. We based our
proposal on the small number of individuals served, the inability of HUD
to effectively monitor this program and the availability of private
sector financing. Another proposal was to eliminate investor
participation in the Section 203(k) rehabilitation mortgage insurance
program. We based our proposal on our findings in a comprehensive review
of the 203(k) program where investors were using the program to obtain
unjust enrichment. The Assistant Secretary for Housing voluntarily
suspended the program for investors based on these findings. We have
also made several other proposals to increase penalties for activities
relating to mortgage fraud.

\* \* \* \* \* \*

In closing, our audits and investigations continue to uncover fraud and
abuse in HUD's programs. Abuses, such as those discussed above, have a
tremendous economic impact on the lives of the citizens these programs
are intended to serve. We are continuing to work jointly with
Departmental officials to correct the many problems I have discussed. I
recently hosted a forum in Philadelphia wherein senior managers from OIG
and HUD programs met to discuss waste, fraud and abuse. We characterized
this meeting as a "fraud symposium" where the OIG worked together with
program staff in collectively addressing prevention and detection of
losses in the programs. This collegial effort has been successful and
will continue into the future.

I've been the Inspector General at HUD for little more than a year. It
has been a very productive time. I have a well-trained and very
dedicated staff. Our goal is to ensure that the billions of taxpayers\'
dollars appropriated by the Congress for HUD programs are used
effectively to provide safe, decent, and sanitary housing for millions
of Americans. I've tasked my staff and I have challenged program
officials to work together to combat waste, fraud and abuse. The
structure of HUD programs and the diversity of programs make this a
formidable task. But by working in coordination together with program
staff and Congressional staff, I think we can take positive steps to
make HUD operate in an optimum manner.