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1

75–382 PS

" ! COMMITTEE PRINT 107th Congress

1st Session

S. PRT.

2001

107–44

PROPERTY ‘‘FLIPPING’’: HUD’S FAILURE TO

CURB MORTGAGE FRAUD

REPORT

PREPARED BY THE

MINORITY STAFF

OF THE

PERMANENT SUBCOMMITTEE ON

INVESTIGATIONS

OF THE

COMMITTEE ON GOVERNMENTAL AFFAIRS

UNITED STATES SENATE

SEPTEMBER 25, 2001

(II)

COMMITTEE ON GOVERNMENTAL AFFAIRS

JOSEPH I. LIEBERMAN, Connecticut, Chairman

CARL LEVIN, Michigan

DANIEL K. AKAKA, Hawaii

RICHARD J. DURBIN, Illinois

ROBERT G. TORRICELLI, New Jersey

MAX CLELAND, Georgia

THOMAS R. CARPER, Delaware

JEAN CARNAHAN, Missouri

MARK DAYTON, Minnesota

FRED THOMPSON, Tennessee

TED STEVENS, Alaska

SUSAN M. COLLINS, Maine

GEORGE V. VOINOVICH, Ohio

PETE V. DOMENICI, New Mexico

THAD COCHRAN, Mississippi

ROBERT F. BENNETT, Utah

JIM BUNNING, Kentucky

JOYCE A. RECHTSCHAFFEN, Staff Director and Counsel

HANNAH S. SISTARE, Minority Staff Director and Counsel

DARLA D. CASSELL, Chief Clerk

PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

CARL LEVIN, Michigan, Chairman

DANIEL K. AKAKA, Hawaii

RICHARD J. DURBIN, Illinois

ROBERT G. TORRICELLI, New Jersey

MAX CLELAND, Georgia

THOMAS R. CARPER, Delaware

JEAN CARNAHAN, Missouri

MARK DAYTON, Minnesota

SUSAN M. COLLINS, Maine

TED STEVENS, Alaska

GEORGE V. VOINOVICH, Ohio

PETE V. DOMENICI, New Mexico

THAD COCHRAN, Mississippi

ROBERT F. BENNETT, Utah

JIM BUNNING, Kentucky

LINDA J. GUSTITUS, Chief Counsel and Staff Director

CHRISTOPHER A. FORD, Minority Chief Counsel and Staff Director

CLAIRE M. BARNARD, Investigator to the Minority

MARY D. ROBERTSON, Chief Clerk

(III)

C O N T E N T S

Executive Summary ................................................................................................. 1

I. Introduction .......................................................................................................... 5

A. What is Flipping? ............................................................................................ 5

B. FHA’s Single Family Insured Program ......................................................... 6

C. Overview of PSI’s Investigation ..................................................................... 9

II. The ‘‘Players’’ in a Flipping Transaction .......................................................... 9

A. Lenders ............................................................................................................. 9

B. Appraisers ........................................................................................................ 11

C. Inspectors ......................................................................................................... 12

III. The Nationwide Scope of Flipping ................................................................... 13

A. New York City: The Story of Lisa Smith ...................................................... 13

(1) Victim of Mortgage Flipping .................................................................... 13

(2) Problems of HUD Oversight .................................................................... 16

B. Chicago: The Easy Life Realty Story ............................................................. 18

(1) Stekeena, Rollins ...................................................................................... 19

(2) Other Easy Life Realty Victims ............................................................... 24

C. South Florida: The Story of Sonia and Carlos Pratts .................................. 25

D. Norfolk ............................................................................................................. 28

E. Southern California ......................................................................................... 30

IV. The Federal Housing Authority ....................................................................... 31

A. Origin and Structure ....................................................................................... 31

B. The Changing Face of FHA ............................................................................ 32

(1) The 1980’s: Coming to Grips With Mortgage Fraud .............................. 32

(2) Problems with the ‘‘Reinvention’’ of HUD under the

Clinton Administration ............................................................................... 33

(a) Liberalization of Controls Over Direct Endorsement Lenders .......... 34

(b) HUD 2020 Management Reform Plan ................................................. 35

(c) Soaring Defaults and Foreclosures ....................................................... 36

(d) HUD’s Response .................................................................................... 36

(i) Loss Mitigation Program ................................................................... 37

(ii) Credit Watch ...................................................................................... 38

(iii) The Homebuyer Protection Plan ..................................................... 39

(iv) Fraud Protection Plan ...................................................................... 41

(v) Mortgage Credit Scorecard Project ................................................... 42

V. Agency Criticisms of HUD ................................................................................. 43

A. General Accounting Office .............................................................................. 43

(1) GAO on HUD’s Lack of Lender Oversight .............................................. 43

(a) Approval of Lenders to Receive DE Authority .................................... 43

(b) Monitoring of Lenders ........................................................................... 44

(i) On-Site Lender Reviews ..................................................................... 44

(ii) Post-Endorsement Technical Reviews ............................................. 44

(c) Enforcement Actions Against Lenders ................................................. 45

(i) Suspension of DE Authority .............................................................. 45

(ii) Credit Watch ...................................................................................... 46

(iii) Mortgagee Review Board ................................................................. 47

(d) Agency Comments ................................................................................. 47

(2) HUD’s Lack of Appraiser Oversight ........................................................ 48

(a) HUD Has Limited Assurance That Appraisers Are Familiar

With FHA’s Appraisal Requirements ................................................... 49

(b) HUD’s Monitoring of Appraisers Is Limited ....................................... 49

Page

IV

(c) HUD Sanctioned Few Poorly-Performing Appraisers ......................... 52

(d) HUD Has Not Aggressively Enforced Its Policy on

Lender Accountability For Appraisals ................................................. 53

B. HUD’s Office of the Inspector General .......................................................... 54

(1) Post-Endorsement Technical Reviews ..................................................... 55

(2) Post-Endorsement Field Reviews of Appraisals ..................................... 56

(3) Quality Assurance Reviews ...................................................................... 57

VI. HUD’s False Promises to the Subcommittee ................................................... 57

(1)

PROPERTY ‘‘FLIPPING’’: HUD’S FAILURE TO

CURB MORTGAGE FRAUD

EXECUTIVE SUMMARY

In September 1999, under the chairmanship of Senator Susan M.

Collins, the Permanent Subcommittee on Investigations commenced an investigation into the practice of property ‘‘flipping.’’

The term refers to the purchase and quick resale of a home at a

huge mark-up, often with little work done to improve the property,

in order to create the false illusion of a robust real estate market

though the use of phony paperwork and deceptive sales practices.

The practice of ‘‘flipping’’ poses significant risks to low-income,

first-time home buyers, and may affect the overall stability of a

neighborhood.

A series of newspaper articles in the Baltimore Sun reported that

flippers had purchased rundown houses over a 3-year period and

resold them—sometimes within hours—to unsuspecting buyers.

After reviewing this issue, Subcommittee staff came to suspect that

flipping was occurring not only in Baltimore but also around the

United States. During the Subcommittee’s 9-month investigation

into this subject, staff investigators interviewed over 100 witnesses,

including home buyer victims, real estate brokers, lenders, and attorneys involved in mortgage flipping cases, as well as government

officials, community activists, and other stakeholders. These investigative efforts confirmed that the phenomenon of flipping is not

simply a local, State, or even regional problem. It is, rather, a significant nationwide problem.

Although the purchase and quick resale of a house at an increased price are not in and of themselves unlawful, the practice

can cross into illegality when documents are falsified in order to

lure lenders or buyers into investing more money in a house than

it is actually worth. In order to finance the transaction, such unscrupulous sellers may also make arrangements to secure a mortgage that is insured by the Federal Housing Authority (FHA). The

principal advantage to having an FHA-backed mortgage is that if

the buyer defaults, the government will reimburse the lender for

almost the entire amount of the loan. As a result, where the FHA

backs mortgages, there is minimal risk in lending money to marginally qualified borrowers. Designed as a means to facilitate loans

to low-income families with little credit history, this system is

sometimes subject to abuse where unscrupulous sellers are concerned: Too often, the process results in the Federal Government

either insuring questionable loans or simply subsidizing mortgage

fraud.

2

1 HUD’s Government-Insured Mortgages: The Problem of Property ‘‘Flipping’’, hearings before

the Permanent Subcommittee on Investigations, Committee on Governmental Affairs, 107th

Congress, 1st Session (June 29–30, 2000) [hereinafter ‘‘Hearing record’’], at 3.

The Subcommittee’s investigation culminated in 2 days of Congressional oversight hearings on June 29 and 30, 2000. Among the

witnesses who testified were three purchasers of flipped homes:

Lisa Smith, a New York City police officer, and single mother;

Sonia Pratts, a health care assistant from Hollywood, Florida; and

Steekena Rollins, a day-care service provider from Chicago, Illinois.

All three spent their entire life savings to buy into the American

dream of home ownership, only to have their experience transformed into a nightmare. As Chairman Collins said in her opening

statement:

‘‘I find it very troubling that so many citizens in our Nation’s cities have been victimized by the predatory practices of unscrupulous real estate agencies, appraisers, and

lenders. But what I find most appalling is that the Federal

Government has essentially subsidized much of this

fraud.’’1

The Subcommittee also heard testimony from the Hon. Barbara

A. Mikulski, a U.S. Senator from the State of Maryland; Stanley

J. Czerwinski, Associate Director, Housing and Community Development Issues, Resources, Community, and Economic Development

Division, U.S. General Accounting Office (GAO); William C. Apgar,

Assistant Secretary for Housing and Federal Housing Commissioner, U.S. Department of Housing and Urban Development

(HUD); and Susan Gaffney, Inspector General, U.S. Department of

Housing and Urban Development (HUD).

Senator Mikulski testified that the flipping problem in Baltimore

was indeed ‘‘horrifying.’’ She noted that every time a homeowner

defaulted on a house, the FHA would have to foreclose on the property and the homeowner could lose as much as $40,000—ultimately

leaving the Federal taxpayer with liability. Senator Mikulski also

testified that after learning of the flipping problem in Baltimore,

she met with then-HUD Secretary Andrew Cuomo to discuss possible solutions. Subsequently, two separate task forces were established to investigate the flipping epidemic, and to prevent additional foreclosures from occurring.

In April 2000, HUD joined forces with the Department of the

Treasury to form the Joint Task Force on Predatory Lending and

the Baltimore Predatory Lending Task Force. The Joint Task Force

(JTF) consists of representatives from consumer, civil rights, community, and industry groups, as well as State and local governments. The Baltimore Task Force (BTF) was launched to gather information on the cause and extent of mortgage frauds and resulting

foreclosures, and to develop information that benefits Baltimore

and serves as a programmatic reform throughout the Nation. FHA

imposed a 90-day moratorium on foreclosures of FHA-insured loans

in Baltimore City, which enabled HUD to send what it described

as a ‘‘Swat Team’’ of officials to Baltimore to identify fraud or predatory practices involved in FHA-backed loans before foreclosure

and to help as many homeowners as possible avoid foreclosures.

3

At the request of Senator Collins and Representative Rick Lazio

(R–NY), GAO prepared a report entitled, ‘‘Single Family Housing:

Stronger Oversight of FHA Lenders Could Reduce HUD’s Insurance Risk.’’ Stanley Czerwinski—accompanied by Robert Procaccini, Assistant Director for FHA Insurance Programs, and Paul

Schmidt, Assistant Director for Single-Family Housing Programs— appeared before the Subcommittee to discuss GAO’s findings.

As the GAO officials made clear, FHA is the principal provider

of Federal mortgage insurance, and is also the major lending

source for first-time, low-income, and minority home buyers. As

such, the agency relies on approximately 10,000 lenders to carry

out its mission, and about 2,900 of those lenders are granted ‘‘Direct-Endorsement’’ (DE) authority. This means that these lenders

can gather and process loan information, underwrite the loans, and

make eligibility determinations, all without prior HUD review.

Given HUD’s reliance on private lenders and the authority they

are given to act on HUD’s behalf, oversight is essential. GAO’s review found problems with HUD’s oversight of the program. Specifically, GAO identified problems in three particular areas: (1) HUD’s

process for granting FHA-approved lenders DE authority provides

only limited assurance that the lenders are in fact qualified; (2)

HUD’s monitoring of lenders does not adequately focus on the lenders and loans that pose the greatest insurance risks to the Department; and (3) HUD has not taken sufficient steps to hold lenders

accountable for poor performance and program violations.

Senator Collins noted that the problems GAO identified in this

report were long-standing issues of which HUD had already been

advised in prior audits and reports. Despite this history of studies

calling attention to the problem, however, no apparent progress

had been made to remedy the deficiencies. In 1993, for example,

HUD’s Office of the Inspector General (OIG) completed an audit of

FHA’s single-family mortgage program and found that HUD’s postendorsement reviews did not consistently ensure quality underwriting. In 1997, the GAO evaluated the appraisal process and

found that HUD was not adequately monitoring appraisers—as

well as that the agency was not moving effectively against faulty

appraisers. Finally, in 1999, the GAO issued yet another report on

the subject. Entitled ‘‘Single-Family Housing: Weaknesses in

HUD’s Oversight of the FHA Appraisal Process,’’ this study similarly found that: (a) HUD was still not doing a good job monitoring

the performance of appraisers; (b) HUD was not holding appraisers

accountable for the quality of their appraisals, and (c) the Department had limited assurance that its appraisers were in fact knowledgeable.

On June 30, 2000, the Subcommittee heard from FHA Commissioner Apgar who testified about the steps HUD has taken to combat flipping, and what assistance the agency would provide to help

victims of mortgage fraud recover. Specifically, he identified Credit

Watch, a performance-based lender monitoring and enforcement

system that was launched in May 1999, and the Homebuyer Protection Plan, a more comprehensive and thorough appraisal process

that FHA implemented in 1998. He also testified that:

‘‘HUD will move aggressively to force lenders to restructure inflated mortgages that result from fraudulent apVerDate 11-MAY-2000 08:24 Oct 05, 2001 Jkt 000000 PO 00000 Frm 00007 Fmt 6633 Sfmt 6633 75382.TXT SAFFAIRS PsN: SAFFAIRS
4

2 Hearing record, supra, at 45.

praisals or the so-called property flips. We will push the

loan back to the lender and make him responsible for producing a loan that the borrower can afford. If not, the FHA

will intervene directly and make the loan right for the borrower.’’ 2

Despite these assurances, however, more than a year later this

promised relief has yet to appear. Apgar, a Clinton Administration

appointee, left HUD early in 2001 after the change in administrations. Apgar’s promises to the Subcommittee, and to borrowers

across the country, now appear to have been empty ones. According

to HUD official Laurie Maggiano, in fact, the law prevents HUD

from forcing lenders to reduce loans that FHA insures. On May 14,

2001, during a Senate field hearing in Baltimore, Maryland,

Maggiano advised Senator Mikulski that in Apgar’s Subcommittee

testimony, ‘‘FHA perhaps over committed what it was able to deliver.’’ In those cases where HUD did ask lenders to reduce loans, these

institutions simply refused, being under no legal obligation to comply. After receiving numerous complaints from community activists

and nonprofit housing agencies that HUD had failed to deliver on

the promises made during the tenure of HUD Secretary Andrew

Cuomo, both of Maryland’s Senators spoke with HUD’s new Secretary, Mel Martinez, about the problem. As a result of these discussions, Secretary Martinez appointed Maggiano to coordinate

HUD’s response to the problems in Baltimore. The agency is currently considering policy and regulatory changes that would make

properties that have been sold within a specific time period ineligible for FHA insurance.

Throughout the Clinton Administration, HUD was made aware

on numerous occasions of these problems and vulnerabilities in its

FHA program, and of the Department’s faulty oversight of mortgage programs. Instead of cracking down on poor performing lenders, however, the agency did little or nothing to stop such abuses.

The unfortunate result of this failure is that unscrupulous sellers,

effectively subsidized by FHA-backed loans, made property-flipping

victims out of many of the very people whom HUD’s program was

supposed to help attain the American dream of homeownership.

The victims of property flipping depended on HUD to protect

them from the predatory sales and lending practices revealed by

the Subcommittee’s investigation. Unable to obtain the conventional mortgages needed to buy their homes, these low-income

Americans had no alternative but to turn to FHA-supported programs in order to gain any access to the housing market. HUD has

a duty to protect such home buyers and to help keep them from

becoming the victims of fraudulent sales and lending practices.

HUD also has an obligation as to safeguard the integrity of the insurance fund, which could be imperiled should sloppy oversight of

loan-guarantee practices leave the fund responsible for covering the

cost of many millions of dollars’ worth of bad loans. Unfortunately,

HUD failed, under the Clinton Administration, to fulfill these responsibilities. Moreover, the Department mischaracterized the assistance it was able to provide to those home buyers who fell victim

5

3 In its consumer education materials, the Federal Trade Commission (FTC) uses the term

‘‘loan flipping’’ to describe a slightly different predatory lending practice. The term ‘‘loan flipping,’’ as it is defined by the FTC, denotes a lender’s practice of encouraging a borrower to repeatedly refinance his loan, often to borrow more money. Each time the borrower references,

of course, he pays additional fees and interest points, which ultimately increase the borrower’s debt.

to fraudulent practices in the poorly-overseen lending environment

that HUD had for so long permitted to exist. America’s low-income

home buyers deserved better, and it is gratifying to see Secretary

Martinez and other senior HUD officials taking an active role in

overseeing efforts to fix these problems.

I. Introduction

A. What is Flipping?

The Subcommittee’s investigation has exposed a national problem with ‘‘flipping,’’ 3 which is a highly complex phenomenon involving multiple players who conspire to defraud home buyers,

lenders, and—in the case of Federal Housing Administration

(FHA)-backed loans—the Federal Government itself. Flipping involves the purchase and quick resale of homes at a huge price

mark-up, often accompanied by little (or only cosmetic) work to improve the properties, in order to create the false illusion of a robust

real estate market through the use of phony paperwork and deceptive sales pitches. Flipping poses significant risks to low-income,

first-time home buyers, and may affect the overall stability of local

neighborhoods.

In a typical ‘‘flipped’’ transaction, an investor purchases a dilapidated house in a marginal neighborhood. This investor then makes

cosmetic and temporary improvements to the house, such as carpeting over rotting wood floors or painting over termite damage. At

this point, the investor teams up with a realtor who markets the

house as a ‘‘total rehab’’ property—as, at first glance it may appear

to be—to a first-time, unsophisticated, low-income home buyer. The

realtor persuades the buyer to trust him by repeatedly assuring the

buyer that he will handle all aspects of the sale on the buyer’s behalf and may persuade the buyer to save money by declining to obtain a home inspection, to retain counsel, or otherwise to protect

himself. If the buyer questions the value of the house, the investor

and realtor can simply point to a deliberately inflated appraisal apparently showing that the house indeed was worth the asking

price.

Having gained the trust of the purchaser with the help of such

misrepresentations, the realtor then steers the buyer towards a

lender with whom the realtor also has ‘‘an arrangement.’’ This

lender arranges for the buyer to obtain a mortgage loan—sometimes through manipulation of the buyer’s financial information or

the acceptance of phony gift letters documenting non-existent down

payments. Finally, the investor and realtor may themselves retain

an attorney to represent the buyer at the closing. Instead of protecting the buyer’s interest, however, this attorney’s function is to

reassure the buyer of the legitimacy of the transaction, and convince him to sign all of the closing documents.

After the buyer moves into the house, of course, he discovers that

the ‘‘total rehab’’ is in fact a crumbling relic. The buyer is forced

6

4 Bruce E. Foote, Housing Analyst, Domestic Social Policy Division, Congressional Research

Service, FHA Loan Insurance Program: An Overview, Order Code RS20530 (March 30, 2000),

at 4. 5 Id. at 2.

to make repairs and simultaneously struggle to make monthly

mortgage payments on a property, the actual value of which is significantly less than the mortgage itself. The end result for the

buyer is often default and, ultimately, the loss of his home through

foreclosure. In the end, the buyer is left with no house and a tarnished credit rating, while the neighborhood is left with a vacant,

deteriorating house. The flippers, by contrast, collect the profit

from the sale of the house at an unjustifiably inflated price after

having made only a modest or nominal investment.

Although the purchase and quick resale of a house at an increased price is not itself unlawful, the above scenario illustrates

how this practice can cross the line into illegality when documents

are falsified and misrepresentations made in order to lure buyers

and lenders into investing more money in a house than it is actually worth. Flippers who get FHA backing for their buyers’ mortgages, moreover, are able to encourage lenders to put up the full

amount of the loan, confident that if the buyer defaults, the government will bail them out. Lenders, appraisers, and other parties

who are guilty of such practices may be barred by the U.S. Department of Housing and Urban Development (HUD) from participating in federally financed or insured business. In order to be

barred, however, they first have to be caught.

B. FHA’s Single Family Insured Program

FHA’s program for insuring loans for the purchase of single-family housing involves a number of elements, and operates according

to criteria as follows:

• Eligible Loan Purposes: FHA-insured loans may be used

to purchase single-family detached homes, town homes,

row houses, two-to-four family buildings, manufactured

homes and lots, and condominiums in developments approved by FHA. Loans may also be used to: Build a

home; to repair, alter, or improve a home; to refinance

an existing home loan; to purchase and improve a home

simultaneously; or to install a solar heating and cooling

system or other weatherization improvements.4

• Borrower Eligibility: FHA-insured loans are available to

owner-occupants who can demonstrate the ability to

repay them according to the terms of the contract. Parties who are in default on previously FHA-insured loans

are not eligible for new loans unless this default is

cleared or the borrower can show that the default was

caused by circumstances beyond his control. Likewise,

persons who have previously defaulted on non-FHA insured loans are not eligible for FHA-insured loans.5

• Maximum Mortgage: Mortgage limits for FHA-insured

loans are set on an area-by-area basis. The limits are

indexed to the lesser of two benchmarks: The median

home price for the area, or the size of loans that may

7

6 Id. at 2–3. 7 Id. at 3. 8 Id.

9 Id. at 3–4. 10 Id. at 4. 11 Id. at 5.

be purchased by the Federal Home Loan Mortgage Corporation (commonly known as Freddie Mac).

The maximum mortgage limits for FHA-insured loans

are 87 percent of the Freddie Mac limits. (Since the

Freddie Mac loan limits may change at the beginning of

January each year, the FHA mortgage limits may also

change annually.) As of January 1, 2001, the mortgage

limits for FHA-insured loans are $239,250 for one-family

properties, $306,196 for two-family properties, $370,098

for three-family properties, and $459,969 for four-family

properties. Mortgage limits for loans in Alaska, Guam,

Hawaii, and the Virgin Islands may be adjusted up to

150 percent higher. Freddie Mac limits determine the

upper and lower FHA limits while the median home

price often determines the actual FHA limit for a given

area.6

• Loan Term: FHA-insured loans may be obtained for

mortgages with terms of up to 30 years. In special cases,

low-income borrowers may be eligible for 35-year loans

to make the mortgage more affordable.7

• Down payment: In general, the down payment is 3 percent of the first $25,000 of the property value, 5 percent

of the value between $25,000 and $125,000, and 10 percent of the value in excess of $125,000.8

• Owner Occupancy: Generally, for loans closed on or after

December 15, 1989, borrowers must intend to occupy

the property as a principal residence. FHA may sell

property that it has acquired as a result of default or

foreclosure to either owner-occupants or to investors. (In

some cases, those borrowers may obtain FHA-insured

loans.) 9

• Program Funding: The FHA home mortgage insurance

program is funded by the MMIF, which in turn is funded by the payment of FHA mortgage insurance premiums, interest earnings, and proceeds from the sale of

homes that have been acquired through foreclosure on

FHA-insured loans. The MMIF is authorized to fund all

operations of the mortgage insurance program, including administrative costs.10

• Interest Rates: The interest rate on FHA-insured loans

is negotiated by the borrower, seller, and lender. The

borrower has the option of selecting either a loan with

an interest rate that is fixed for the life of the loan, or

a loan on which the rate may be adjusted annually,

known as adjustable rate mortgages (ARMs).11 The

number of ARMs that FHA may insure in a single year,

8

12FHA is funded under two statutory titles of the National Housing Act (12 U.S.C. 1703).

Title I is funding for loans for mobile homes and improvements. Title II is funding for all other

FHA programs. Subcommittee staff telephone interview with Judy Heaney, community Builder,

U.S. Department of Housing and Urban Development (June 16, 2000). 13 U.S. Department of Housing and Urban Development, Mortgagees’ Handbook, 4000.2 REV–

2, Chapter 6, Section 6–20, at 6–22, 6–23 (July 1991). 14Foote, supra, at 5. 15 Id. 16See 24 CFR § 203.402. 17Foote, supra, at 5.

however, is limited to 30 percent of the total number of

mortgages insured under FHA’s program for conventional housing loans during the preceding fiscal year.12

The interest rate for ARMs may be adjusted annually by

a 1 percent increase or decrease from the rate in effect

during the preceding year, with a lifetime change of a

5 percent increase or decrease from the rate reflected on

the note.13

• Underwriting Guidelines: FHA-insured loans must be

underwritten in accordance with the accepted practices

of prudent lending institutions and FHA requirements.

The FHA credit analysis worksheet is used to examine

the applicant’s personal and financial status, monthly

shelter expenses, funds required for closing expenses, effective monthly income, and debts and obligations. As a

general rule, the applicant’s prospective housing expenses should not exceed 29 percent of his or her effective monthly income. The applicant’s total obligations,

including proposed housing expenses, should not exceed

41 percent of gross effective monthly income. Credit is

automatically denied to applicants whose credit report

indicates a delinquency of 90 days or more on a nonFHA-insured loan, or foreclosure on such a loan in the

past 3 years.14

• Credit Limits: The volume of FHA insurance commitments is subject to a fiscal year ceiling set by Congress.

During fiscal year 2000, FHA was permitted to make insurance commitments totaling no more than $140 billion.15

• Reimbursement of Lenders: FHA reimburses 100 percent

of the unpaid principal balance of a FHA-backed mortgage as of the date of default, as well as any costs or

fees that may accrue during the time the lender must

spend disposing of the property.16

• Program Activity: During fiscal year 1999, FHA

underwrote $113.2 billion in insurance to insure the

purchase or refinancing of 1,219,928 housing units. At

the end of fiscal year 1999, FHA had $411.5 billion in

insurance in force. From its inception in 1934 through

the end of 1999, FHA has insured nearly 27.9 million

home loans at a mortgage volume of about $1,258 trillion.17

9

18Direct Endorsement is authorized under § 203(b) of the National Housing Act, codified at

12 U.S.C. § 1709(b),(1). Program regulations are located at 24 C.F.R. §§ 203.5 and 203.255. The

program is administered by HUD’s Office of Housing-Federal Housing Administration. See U.S.

Department of Housing and Urban Development, Direct Endorsement (visited June 13, 2000),

http://www.hud.gov.progdesc/direct-r.html [hereinafter, ‘‘HUD, Direct Endorsement’’] at 2. 19 U.S. General Accounting Office, GAO/RCED–00–112, Single Family Housing: Stronger Oversight of FHA Lenders Could Reduce HUD’s Insurance Risk (April 28, 2000), at 7–8. 20Office of the Inspector General, U.S. Department of Housing and Urban Development, Audit

Report # 00–SF–121–001, Single Family Production Home Ownership Centers (March 30, 2000)

[hereinafter ‘‘HUD/OIG, Single Family Production Home Ownership Centers’’], at 1.

C. Overview of PSI’s Investigation

The Subcommittee began this investigation with the establishment of a preliminary inquiry in September 1999, pursuant to Rule

1 of the Subcommittee Rules of Procedure. The objective of this

preliminary inquiry was to evaluate the scope and nature of the

mortgage flipping problem across the country. The Subcommittee’s

work thus built upon the efforts enforcement agencies and an investigation by Baltimore Sun reporter John O’Donnell, who is widely credited with exposing the problem of flipping in Baltimore.

Since that time, Subcommittee staff members have interviewed

more than 100 witnesses, including home buyer victims, real estate

brokers, lenders, and attorneys involved in mortgage flipping cases,

as well as government officials, community activists, and other

stakeholders. In addition, Subcommittee staff reviewed hundreds of

records documenting specific property flips. These investigative efforts confirmed that the phenomenon of flipping is not simply a

local, State, or even regional problem, but rather is a Nation wide

crisis.

II. The ‘‘Players’’ in a Flipping Transaction

A. Lenders

Lenders must obtain approval from HUD to participate in FHA’s

mortgage programs. In addition to an application form and fee,

lenders must submit to HUD documentation showing that they

meet FHA’s requirements for lending experience, financial worth,

and adequacy of facilities. As of December 1999, approximately

9,950 lending institutions had been approved to participate in

FHA’s mortgage insurance programs for single-family homes. Most

of these lenders are authorized only to originate FHA-insured

loans, meaning that they can accept mortgage applications, obtain

employment verifications and credit histories on applicants, order

appraisals, and perform other tasks that precede the loan underwriting process. Approximately 2,900 of the FHA-approved lending

institutions, however, have so-called ‘‘Direct Endorsement’’ (DE)

authority 18 in addition to loan origination authority. Such lenders

can underwrite loans and determine their eligibility for FHA mortgage insurance without HUD’s prior review.19

Prior to 1983, FHA staff reviewed and approved, or ‘‘underwrote,’’ most loans prior to insurance endorsement. In 1983, FHA

delegated DE authority to approved lenders. As a result, lenders

with Direct Endorsement authority became responsible for virtually all aspects of the loan origination, underwriting, and closing

process.20 HUD describes DE as the mechanism that enables HUD/

FHA-approved lenders to consider single-family mortgage applications without first submitting paperwork to HUD, thereby enabling

10

21 HUD, Direct Endorsement, supra, at 1. 22 U.S. Department of Housing and Urban Development, Single Family Direct Endorsement

Program, 4000.2, at Appendix 4 (Mortgagee’s Certifications). 23 HUD, Direct Endorsement, supra, at 1. 24 U.S. Department of Housing and Urban Development, Handbook 4000.4 REV–1, Single

Family Direct Endorsement Program, Chapter 1 (December 1992), § 1–2, at 1–1, 1–3, and 1–4.

(For an examination of the adequacy of HUD oversight of high-risk loans and lenders, see infra,

at Part V.) 25 HUD/OIG, Single Family Production Home Ownership Centers, supra, at 1. 26 Id. at v.

FHA-insured mortgages to be processed as rapidly as other mortgages.21

The DE underwriting and endorsement process requires the

lender to determine that a property is acceptable for mortgage insurance by completing an analysis of the property to determine its

eligibility for endorsement and the maximum mortgage amount.

The lender must also complete a credit analysis of the borrower to

determine his or her creditworthiness. An underwriter must review

the appraisal report and mortgage credit analysis, and then certify

or approve the loan package itself. The lender must execute a

‘‘mortgagee’s certification’’ to HUD stating that:

‘‘I, the undersigned, as authorized representative of

————, mortgagee, at the time of closing of this mortgage, certify that I have personally reviewed the mortgage

loan documents, closing statements, application for insurance endorsement, and all accompanying documents. I

hereby make all certifications required for this mortgage

as set forth in HUD Handbook 4000.4.’’ 22

The lender then submits the loan case binder to HUD, which conducts a pre-endorsement review of the binder. This pre-endorsement review concludes with endorsement of the mortgage for an acceptable submission through completion of a ‘‘Mortgage Insurance

Certificate,’’ which it issues to the lender.23 After insurance endorsement, HUD reviews select properties and mortgage credit

analyses through the post-endorsement technical review and onsite lender review processes described below. Theoretically, the percentage of such cases reviewed depends upon the quality of past

underwriting and servicing problems on earlier loans.24

Lenders have an obvious and significant financial interest in loan

approval. In order to limit the risks inherent in transferring so

much responsibility to lenders, FHA implemented new procedures

to monitor Direct Endorsement lenders, primarily through pre-closing status reviews, pre-endorsement loan screening, post-endorsement technical review, and on-site lender monitoring.25 Such evaluation tools fall into four basic types, as follows:

• Pre-closing reviews: When new lenders apply for DE approval, they are initially placed on ‘‘pre-closing’’ status.

This means that HUD reviews their loan packages prior

to closing to determine whether the lenders have the capacity to originate and underwrite loans properly in accordance with FHA guidelines.26

• Pre-endorsement loan screening: Endorsement contractors working for HUD are required to ensure that FHA

loan file documents are both accurate and complete

11

27 Id. 28 HUD/OIG, Single Family Production Home Ownership Centers, supra, at 51–52. 29 Id. at iv. 30 Id. 31Prior to 1994, HUD-approved appraisers were referred to as ‘‘Fee Appraisers,’’ and the list

of HUD approved appraisers was referred to as the ‘‘Fee Appraiser Panel.’’ 32Subcommittee staff telephone interview with James Smith (June 6, 2000); Subcommittee

staff telephone interviews with Frank DiGiovanni (May 17–18, 2000). 33 U.S. Department of Housing and Urban Development, Mortgagees’ Handbook, 4000.2, Chapter 2, § 1–10 (July 1991), at 2–5. 34 In 1988, when asked why lenders should be allowed to select their own appraisers for liability-free HUD insured mortgages, Representative Barnard (D–GA) responded that ‘‘[t]he lender

wanted to have as much control of the transaction as possible—which included the appraiser.’’

Frank DiGiovanni, Chronological History of Appraisal in the Chicago Area, Including HUD/

FHA Data, (received May 23, 2000).

prior to issuing Mortgage Insurance Certificates to the

originating lenders.27 The contractors basically determine that certain key loan documents are in the file

prior to insurance endorsement. The contractors must

also verify the accuracy of certain loan information as

included in the loan file documents and as input into

HUD’s automated system by lenders. The contractors

are required to verify that some loan documents are in

every file, while other loan documents—such as gift letters—are only required under certain circumstances.28

• Post-endorsement technical review: This involves reviewing a sample of cases after insurance endorsement in

order to ensure compliance with HUD underwriting and

appraisal requirements.29

• On-site lender monitoring: HUD’s Quality Assurance Divisions perform on-site monitoring reviews, also called

field reviews, of Direct Endorsement lenders to identify

and correct poor origination practices.30

B. Appraisers

FHA originally required appraisals to be an independent check

on the value and condition of the property for which a borrower

was seeking an FHA-insured mortgage. Until 1994, for each proposed mortgage, HUD selected, on a rotational basis, an appraiser

from HUD’s FHA ‘‘Appraiser Fee Panel’’ to appraise the property.31

To be placed on this panel, HUD required appraisers to demonstrate a high level of experience and be knowledgeable about the

appraisal process and property standards that homes being considered for FHA-insured mortgages must meet. HUD closely monitored Fee Panel appraisers by field reviewing at least 10 percent

of their appraisals yearly. In addition, HUD trained Fee Panel appraisers in order to ensure that homes for which FHA insurance

was being sought were safe, sound, and sanitary.32 Under this system, the lender completed an ‘‘Application for Property Appraisal

and Conditional Commitment,’’ and then contacted its local HUD

office to receive a case number and the name of an appraiser.33

In December 1994, HUD implemented regulations mandated by

1990 amendments to the National Housing Act that transferred appraisal selection responsibilities from FHA staff to Direct Endorsement lenders.34 Under this system, which is commonly known as

the ‘‘Lender Select’’ appraisal system, HUD disbanded the list of

12

35Subcommittee staff telephone interview with Frank DiGiovanni (May 27, 2000). 36 Id. 37See Bill Rumbler, Shady Deals Alleged in FHA Appraisal System, Chicago Sun-Times (September 28, 1997). 38Subcommittee staff interview with Robert Skovera in New York City, N.Y. (June 8, 2000).

Skovera said that it was impossible to accommodate some of the requests he received were impossible because the property did not justify the specified increase. 39 U.S. General Accounting Office, GAO/RCED–00–112, Single-Family Housing: Weaknesses in

HUD’s Oversight of the FHA Appraisal Process (April 16, 1999) [hereinafter, ‘‘GAO, FHA Appraisal Process’’], at 2. 40GAO, FHA Appraisal Process, supra, at 2. 41 Id. at 3. 42 Id. at 3.

HUD-approved appraisers and delegated responsibility for selecting

them to the Direct Endorsement lenders themselves.

The DE lenders are now allowed to select any appraiser licensed

by the State in which he practices.35 According to one appraiser,

this delegation has permitted lenders discretion to employ the

least-qualified appraisers for their FHA-backed mortgages.36 (In Illinois, for example, an apprentice appraiser with little experience

is nevertheless licensed.) The lender discretion permitted by the

Lender Select program, it appears, has also encouraged real estate

agents to pressure lenders to choose certain appraisers—and not

others—to evaluate their properties, too often thereby obtaining appraisals of sub-par properties at inflated values.37 One appraiser

interviewed by Subcommittee staff also opined that in his experience, it was not unusual for banks to request that the appraised

value of a property be increased.38

Overall, the results of the Lender Select program have been less

than satisfactory. A 1999 report by the General Accounting Office

(GAO) found that ‘‘HUD was not doing a good job of monitoring the

performance of appraisers’’ 39 and ‘‘is not holding appraisers accountable for the quality of their appraisals.’’ 40 The report concluded that ‘‘HUD has not aggressively enforced its policy to hold

lenders equally accountable with the appraisers they select,’’ 41 and

that ‘‘HUD has limited assurance that the appraisers on its roster

are knowledgeable about FHA’s appraisal requirements.’’ 42

C. Inspectors

FHA does not presently require home buyers to obtain a home

inspection as a prerequisite to obtaining an FHA-backed mortgage,

nor has it ever required that they do so. Prior to 1996, FHA provided home buyers with advisories regarding interest rates, discount points, loan fraud, and lead-based paint. In December 1996,

FHA announced that it would begin highlighting the need for home

buyers to obtain home inspections through distribution of a separate form entitled, ‘‘Importance of Home Inspections.’’ This form explained to the buyer the benefits of arranging for a professional inspection of the home, but also advised that ‘‘[t]here is no requirement that you hire an inspector.’’ (FHA required the buyer to sign

and date this form on or before the date of execution of the sales

contract, but it did not require retention of the form in the FHA

endorsement binder.)

In June 1998, FHA announced as part of its Homebuyer Protection Plan that it would replace the ‘‘Importance of Home Inspections’’ form with a new form entitled ‘‘For Your Protection: Get a

Home Inspection.’’ This updated form advises the buyer that FHA

13

does not guarantee the value or condition of the property; that an

appraisal is not the same thing as a home inspection; and that the

borrower has the right to have the house inspected by a professional home inspector. (In contrast to the previous form, this new

form must be retained in the FHA insurance endorsement binder.)

FHA also allows home buyers to finance at least a portion of the

cost of a home inspection through the FHA-backed mortgage that

they obtain.

On May 12, 1999, Representative Rick Lazio (R–NY) introduced

H.R. 1776, the American Home Ownership and Economic Opportunity Act of 2000. This bill, among other things, would require

GAO to conduct a study regarding the inspection of properties purchased with FHA-backed mortgages. The proposed study would

evaluate such issues as: The feasibility of requiring inspections of

all properties purchased with FHA-insured loans; the monetary impact of such a requirement on the FHA insurance fund and home

buyers; and the impact of mandatory inspections on the process of

buying a home. This bill passed the House by a 417–8 vote on April

6, 2000, and was referred to the Senate Committee on Banking,

Housing, and Urban Affairs. Although the Banking Committee

passed some of the portions in the bill, the mandatory inspection

provision was not.

III. The Nationwide Scope of Flipping

To illustrate the truly nationwide epidemic that is flipping, Subcommittee staff developed case studies of various flipping schemes

in cities throughout the United States. These case studies provide

a glimpse of how such frauds are perpetrated as well as the financial and emotional toll that often results.

A. New York City: The Story of Lisa Smith

(1) Victim of Mortgage Flipping

Lisa Smith is a New York City police officer and a single mother

of three who sought to move her family out of their apartment and

into a house. She testified before the Subcommittee on the first day

of its flipping hearings.

Smith was a first time home buyer when she responded to an advertisement in a local newspaper by Lenders Realty, a real estate

agency specializing in the sale of foreclosed properties. The former

manager of Lenders described it as being a speculative business

that acquired houses, primarily foreclosures, for investment purposes. After purchasing the houses, the former manager said, Lenders would renovate and sell them.

After Smith contacted Lenders, its representatives showed her a

house located at 145–08 123rd Avenue in the Queens neighborhood

of South Ozone Park. Lenders representatives, whose names Smith

cannot recall, told Smith that the house had been completely renovated during the 3 years it had been vacant. They also told Smith

that they would assist her with everything related to the closing

of the property. When Smith expressed concern about her lack of

understanding of the process of purchasing a house to the Lenders

representatives, all of whom were women, they told her that she

could trust them because they would not deceive another woman.

After Lenders representatives showed her the house, they informed

14

43Telephone interview with Lisa Smith (June 15, 2000). 44The appraiser who valued Smith’s house at this price did not specifically remember appraising her house. However, he recalled that Smith’s lender, Alliance Mortgage Banking Corporation, had in the past asked him to increase the appraised value of properties. He did not consider Alliance, however, to be one of the worst offenders in this respect: Some other lenders were

worse. Subcommittee staff interview with Robert Skovera in New York City, N.Y. (June 8,

2000). 45 At least one court has noted that the days of caveat emptor in real estate are gone. See

Gibb v. Citicorp Mortgage, Inc., 518 N.W.2d 910, 918–19 (Neb. 1994). The Subcommittee staff’s review of case law evaluating real estate sales contracts containing ‘‘as is’’ provisions suggests

a recent weakening of the protection such clauses bestow upon the property seller, particularly

where a sale has been predicated on fraud or misrepresentation. Furthermore, ‘‘as is’’ clauses

are standard, boilerplate inclusions in real estate contracts for the purchase of existing houses,

and it is unlikely that Smith would have been able to sign a contract that did not contain the

clause. See, e.g., Subcommittee staff telephone interview with Charles Dale, Congressional Research Service (May 9, 2000). 46Subcommittee staff interview with Lisa Smith in New York City, N.Y. (June 8, 2000). 47Subcommittee staff interview with Howard Krin in New York City, N.Y. (June 8, 2000). 48Subcommittee staff interview with Robert Skovera in New York City, N.Y. (June 8, 2000).

her that if she did not enter into a contract immediately, the house

would be sold to another buyer.43

On May 5, 1997,44 Smith duly signed a sales contract to purchase the house for $129,000. The seller, AllBorough Inc., had purchased the property in December 1996—only 5 months previously—

for merely $50,000. Significantly, Smith’s sales contract contained

an ‘‘as is’’ clause declaring that Smith had inspected the property,

was thoroughly acquainted with its condition, and agreed to purchase it in that present condition.45 The contract also stated, however—somewhat inconsistently—that the seller agreed to pay for

all necessary repairs. (According to Smith, no such payments for

repair ever occurred.)

Smith’s contract and its rider also contained clauses regarding

title inspections and the purchaser’s right to have a termite inspection. Smith signed a form advising her of the importance of a home

inspection; she did not, however, check either of two boxes appearing on the form indicating that she intended to have a home inspection or waive this right. Smith did not obtain an inspection of

the house because Lenders representatives told her that Lenders

had already paid for an inspection, which had revealed that the

house was in good condition.46 This apparently was not true. The

former manager of Lenders told Subcommittee staff that it was not

part of the company’s business practice to have inspections performed, and that Lenders routinely arranged only for appraisals of

properties it sold—not inspections.47 (Furthermore, Robert Skovera, who had appraised Smith’s property at the request of her

lender, told Subcommittee staff that if Lenders had characterized

his appraisal as a home inspection, that would have been a misrepresentation.48)

As a New York Police Department (NYPD) employee, Smith is

entitled to receive free legal services from the Police Benevolent Association (PBA). However, Lenders representatives falsely told

Smith that the PBA attorney whom she had arranged to represent

her at the closing had disparaged her, thereby persuading Smith

to replace this attorney with someone Lenders selected for her, an

attorney by the name of Goodman. Goodman, Lenders representatives informed Smith, would represent her during the homebuying

process free of charge. According to Smith, the lawyer repeatedly

assured her that he was acting in her best interest. When she tried

15

49Subcommittee staff interview with Lisa Smith in New York City, N.Y. (February 1, 2000). 50Subcommittee staff telephone interview with Lisa Smith (June 12, 2000). 51 Id. 52The Subcommittee’s investigation has revealed that Lenders ceased operating in January

2000.

to ask him questions about the sales contract, however, he told her

not to worry and to sign the document.49

In connection with the purchase of the house, Smith signed a gift

affidavit representing that Bernard Tadell, which the affidavit described as a cousin of Smith, would provide her with $4,100 in gift

money at the closing to use in the purchase of the house. In fact,

Tadell is not Smith’s cousin, but rather the father of two of her

children. He also did not give her any money for use in the purchase of the house.50 Smith explained to Subcommittee staff that

a Lenders representative gave her a blank affidavit to sign, and

told her that all home buyers receiving FHA insured mortgages

must sign such gift letters as a mere formality. Smith’s new attorney, Goodman, was present during this exchange. Smith asked him

if it was permissible for her to sign the affidavit, and he assured

her that it was. (Additionally, one of the female Lenders representatives reassured Smith that completing the form was not illegal.)

Smith thus took the affidavit to Tadell and asked him to complete

it. He did so, but, at Lenders’ direction, left the dollar amount

blank. Smith also signed the gift affidavit, then returned it to

Lenders.

In retrospect, Smith wishes she had not signed the affidavit, but

contends that she did so because she felt that her lawyer would not

instruct her to break the law.51 In addition, it is noteworthy that

when Subcommittee staff provided Smith with a copy of the gift affidavit, she was surprised that the affidavit did not reflect her

recollection of its contents. She recalled that Lenders representatives had told her that the purported gift amount would be limited

to between $500 and $1,000, not the $4,100 that is listed on the

affidavit (and was apparently added after she and Tadell had both

signed it). Furthermore, she did not recognize the handwriting on

the affidavit apart from Tadell’s signature itself, and the bank account information listed on the document was fictitious.

In July 1997, Smith closed on the house. Lenders arranged for

Alliance Mortgage Banking Corporation to finance Smith’s mortgage,52 which was guaranteed by the FHA. No one ever explained

the different types of mortgages available to her. (When Subcommittee staff first interviewed Smith, she had no idea what

‘‘FHA’’ meant despite having obtained an FHA-backed mortgage.)

Although her attorney, Goodman, represented Smith at the closing,

his principal role was simply to urge her to sign all of the closing

documents; he was of no help in explaining what she was signing.

Not surprisingly, Smith encountered numerous problems after

moving into the house. The basement flooded constantly and raw

sewage backed up into the house. Smith called Lenders several

times to complain about this problem, but she never received any

response. When Smith gave Subcommittee staff a tour of the house,

the odor in the basement was overwhelming due to this constant

problem of sewage flooding. A contractor she consulted informed

her that the problem was essentially unfixable. Moreover, the roof

16

53Subcommittee staff interview with Lisa Smith in New York City, N.Y. (February 1, 2000). 54Subcommittee staff interview with Lisa Smith in New York City, N.Y. (May 5, 2000).

of the house leaked, inadequate insulation resulted in her having

to pay monthly heating bills of between $400 and $500, the siding

needed replacement, and the floor was falling apart. Smith was

particularly upset about problems with the windows in the house

because Lenders representatives had told her that they were brand

new. After moving in, however, she discovered that they were not;

in fact, she was forced to cover the windows with plastic because

of the cold drafts they let in during the winter.53

Smith could not afford to make the repairs necessary to render

this decaying house habitable despite her attempts to do so by obtaining two additional loans: In May 1998 from The Money Store

for approximately $12,000 at an interest rate of 11.49 percent, and

the second in February 1999 from Madison Home Equities for approximately $45,000 at an interest rate of 14.21 percent. Ultimately, Smith could not afford to continue making the payments

on her mortgage as well as on these additional loans. On advice

from her new PBA counsel, therefore, she stopped making mortgage payments in December 1999 and, in March 2000, abandoned

the house altogether. Smith has moved her family back into an

apartment. As a result of her resulting financial situation, she has

declared bankruptcy. Smith has also been served with a summons

for defaulting on the first of her three mortgages.54

Lisa Smith’s case highlights the typical elements of a mortgage ‘‘flipping’’ case. Although Smith is a police officer with an associate’s degree in liberal arts from LaGuardia Community College in

New York, she was by no means a sophisticated home buyer, and

was unable to navigate the complex financial transaction of buying

a house without guidance. Nor did she know that, as a general

matter, prospective home buyers hire their own representatives to

protect their interests. This naivete ́ rendered her vulnerable to the

high pressure tactics—and outright deception—employed by Lenders, Alliance Mortgage Banking Corporation, and attorney Goodman, whom Lenders itself selected to represent her.

To make matters worse, Smith was at that point in her life particularly vulnerable. She had recently terminated what she described as an abusive relationship with the father of her youngest

child. This relationship had caused tremendous emotional distress

for Smith and her children, and while she was trying to purchase

a house, her family was undergoing counseling and trying to put

the pieces of their lives back together. Smith wanted to be able to

prove to herself that she could increase the quality of life for her

family. Smith’s confusion and her reliance upon the ostensible ‘‘professionals’’ at Lenders, Alliance, and in the form of attorney Goodman thus contributed to her victimization at their hands.

(2) Problems of HUD Oversight

Unfortunately, inadequate oversight by the U.S. Department of

Housing and Urban Development also played a role in this story.

A preliminary review of Alliance Mortgage Banking Corporation’s

records reveals that its foreclosure rate is notably higher than New

York State’s average foreclosure rate. HUD’s Office of Lender Activities, in fact, determined that 7 percent of Alliance’s loan origiVerDate 11-MAY-2000 08:24 Oct 05, 2001 Jkt 000000 PO 00000 Frm 00020 Fmt 6633 Sfmt 6633 75382.TXT SAFFAIRS PsN: SAFFAIRS
17

55See Office of Lender Activities, U.S. Department of Housing and Urban Development, Review of Alliance Mortgage Banking Corporation (June 25, 1999). 56See generally HUD/OIG, Single Family Production Home Ownership Centers, supra. 57 Hearing record, supra, at 21. 58Pursuant to FHA guidelines, the applicant’s total obligations—including proposed housing

expenses—should also not exceed 41 percent of monthly gross income. Smith’s monthly obligations were calculated by the underwriter to be $1,248.41, however, or 34.365 percent of her gross

monthly income. 59 Credit Decisions, Inc., report prepared for Alliance Mortgage Banking (May 5, 1997).

nations default within the first year—nearly double the 3.62 percent average for New York State.55 (The FHA national average

foreclosure rates for the first three quarters of 1999 was even

lower: 2.20 percent.56) While Subcommittee staff were unable to determine what percentage of Alliance’s foreclosures occurred on

FHA-insured loans, there were clear red flags that should have

suggested to HUD that Alliance might be a problem. HUD should

have scrutinized more closely the loans made—on its behalf, and

with its guarantee—by a lending institution with such a poor foreclosure record.

During the hearing, Senator Collins asked Ms. Smith how she

chose the lending institution:

‘‘Q: How did you select the bank for your mortgage?

A: I didn’t select a bank. Lenders selected the bank.’’ 57

(Lenders’ affinity for Alliance may, in fact, derive from more than

simply a shared interest in taking advantage of home buyers such

as Lisa Smith. Subcommittee staff were advised by Robert Skovera,

Smith’s appraiser, that the former owner of Lenders is also a principal at Alliance Mortgage Banking Corporation. Subcommittee

staff has so far been unable to confirm this allegation, however.)

FHA uses several formulas to assess whether a borrower should

qualify for an FHA-insured mortgage. For example, an applicant’s

prospective housing expenses should not exceed 29 percent of gross

monthly income. Smith’s gross monthly income was $3,632.75. Her mortgage payment was $1,061.41, however, which totaled 29.218

percent of her gross monthly income—that is, just above the

threshold that should suggest problems under FHA’s guidelines.

Smith had an adjustable rate mortgage, moreover, so while she

only just exceeded the 29 percent level at the outset, any increase

in mortgage interest rates would have pushed her increasingly into

the danger zone.58

Moreover, pursuant to FHA guidelines, credit should automatically be denied to applicants whose credit report indicates a delinquency of 90 days or more on a non-FHA insured loan. While

Smith’s report does not reflect a delinquency in excess of 90 days,

the report does indicate that she might well be a credit risk. Specifically, it noted: ‘‘Serious delinquency; derogatory public record or

collection; proportion of revolving balances to revolving credit limits

is too high; frequent delinquency.’’ 59

All in all, therefore, Smith thus fell into the category of prospective home buyers who barely meet the FHA guidelines and whose

loan applications, if predicated on a adjustable rate mortgage,

should be evaluated on the basis of potential future increases to

minimize foreclosures. Ordinarily, therefore, a lender would have

approached her mortgage with great caution—or have simply refused to loan her the money needed to make this purchase. BeVerDate 11-MAY-2000 08:24 Oct 05, 2001 Jkt 000000 PO 00000 Frm 00021 Fmt 6633 Sfmt 6633 75382.TXT SAFFAIRS PsN: SAFFAIRS
18

cause FHA backed the loan, however, there was no risk to the

lender, freeing it to become a costless participant in the mortgage

flipping fraud perpetrated against Smith—with the Federal taxpayer picking up the tab when bankruptcy and foreclosure overtook

her.

B. Chicago: The Easy Life Realty Story

Subcommittee staff interviewed eight Chicago home buyers, each

of whom purchased a home from either a real estate agency known

as Easy Life Realty (ELR) or Ace Realty, its successor. Richard

Nelson and Louis Prus owned both businesses. Prus and Nelson

began working together in the early 1970’s by forming the Easy

Life Real Estate and Management System, Inc., with the intention

of managing and selling properties owned by others. In the 1980’s,

they began to acquire, renovate, and sell houses that needed only

cosmetic repairs. In the 1990’s, they began to acquire distressed

properties that needed much more rehabilitation, such as replacement of mechanical systems, before they could be sold. Nelson and

Prus referred to this as their ‘‘REO,’’ or Real Estate Owned, program. One of Prus’s goals was for ELR to become the dominant

real estate agency in each of several specific ethnic markets. At its

peak, ELR employed a sales force numbering between 40 and 50

salespersons.

ELR acquired properties through its sales force. A salesperson

would locate and purchase a dilapidated property on ELR’s behalf

using funds approved by Nelson. Prus and Nelson claim that the

salesperson handled everything from planning and implementing

the rehabilitation work to marketing and selling the property.

(ELR’s role, he said, was merely to finance the venture.) Upon the

sale of the property, the salesperson accordingly earned a large

percentage of the profit, usually 40 percent. Unfortunately, because

the salesperson had to cover any rehabilitation costs out of his anticipated share of the profit, this arrangement provided the salesperson with powerful incentives to minimize rehabilitation costs.

(In some cases, in fact, it may have led salespersons actually to

supply down payment money to prospective purchasers who would

otherwise not qualify for a mortgage, thus helping the salesperson

reap his percentage of the sale—although Nelson and Prus profess

ignorance regarding this practice.) Nor did ELR bother to obtain

building permits for the rehabilitation work it conducted on the

properties the Subcommittee examined. As a result, the City of

Chicago conducted no inspections to ensure that the rehabilitation

work was done properly, or at all.

In 1996, HUD threatened to bar Nelson and ELR from participating in FHA programs as a result of allegations that ELR had

provided funds to purchasers to use as down payments and had falsified documentation. Nelson and ELR entered into a settlement

agreement with HUD pursuant to which Nelson paid a $35,000

penalty. In exchange, HUD agreed to permit ELR to continue participating in FHA programs.

A number of the home buyers with whom Subcommittee staff

spoke are named plaintiffs in a pending Federal class action

against Nelson, Prus, ELR, and Ace. This civil lawsuit, which was

filed in August 1997, alleges violations of the Racketeer Influenced

19

and Corrupt Organizations (RICO) Act, the Fair Housing Act, and

the Civil Rights Act, as well as violations of State fraud and consumer protection statutes. The complaint avers that the defendants

committed these violations by systematically defrauding residents

of the overwhelmingly minority Austin community in Chicago during the last decade through various means, including: Running

false and misleading real estate advertising; misrepresenting the

condition of the properties that they sold; exerting inappropriate

control over plaintiffs’ financing for their purchases; discouraging

or preventing plaintiffs from obtaining independent attorneys; inspectors or other safeguards in the home purchase process; engaging in inflated pricing; performing or controlling dangerously shabby construction work; and committing outright bank fraud. Some

105 persons have joined the plaintiff class.

Nelson and Prus each asserted their Fifth Amendment privilege

against self-incrimination in response to Subcommittee subpoenas

compelling their appearances at depositions.

(1) Stekeena Rollins

Stekeena Rollins purchased a 95-year-old home located at 130

North Latrobe Street in Chicago along with her mother, Shirley

Rollins. Stekeena is a high school graduate who completed some

course work at a community college in Chicago. Since graduating

from high school, she has worked as a bank teller, in child care,

and as a nursing home assistant. She was a 21-year-old single

mother when she purchased the house. Like Stekeena, her mother

Shirley was also a first time home buyer. Although Shirley had attended 2 years of high school, she did not graduate. Instead, she

completed 2 years of trade school, and 3 months of college studying

food service. She was 49 years old at the time she bought the

house, and had custody of five grandchildren. Her employment history includes jobs at child care facilities, factories, and schools. As

of June 2000, Shirley had been unemployed since 1998.

The Rollinses first became aware of ELR in June 1995, when

they saw one of its advertisements in the Chicago Sun-Times proclaiming, ‘‘Kiss Your Landlord Goodbye!’’ After seeing the advertisement, they visited ELR’s office where they met Peter Sandow,

a real estate agent. They told him that they wanted to purchase

a house large enough to allow Stekeena to operate a day care center from their home. Sandow showed them several homes in the

Austin neighborhood of Chicago, but the Rollinses specifically told

him that they did not want to live in Austin because of their concerns about local levels of violence and drug activity. Sandow then

showed them a house that he said was in Oak Park, an upper-middle class neighborhood adjacent to Austin. This house, which had

been converted into two separate flats, had been damaged in a fire,

was leaning to one side, and obviously needed a great deal of work.

Nevertheless, it was large enough to meet their needs (including

their hopes of operating a day care center there), and Sandow assured the Rollinses that pursuant to an unspecified Federal program, ELR would thoroughly rehabilitate the house, pay for an inspection, and provide a lawyer to represent them at closing.

Pleased to hear this, the Rollinses relied upon his assurances in deciding to purchase the house. Accordingly, on July 21, 1995, they

20

60Subcommittee staff interview with Shirley and Stekeena Rollins in Chicago, Illinois (March

28, 2000). 61Deposition of Shirley Rollins, at 79:13 (December 3, 1999). 62Subcommittee staff telephone interview with Valencia Lockhart (June 1, 2000).

signed a contract for the purchase of the house for $119,000, after

paying $500 as an ‘‘earnest money’’ deposit.60

The purchase contract Stekeena and her mother signed in July

1995 did not include any provisions relating to home inspections.

Around the time they signed the contract, however, they also

signed a HUD form encouraging them to obtain a home inspection,

as well as an Illinois Association of Realtors form advising them of

their right to request such an inspection. Stekeena stated both to

Subcommittee staff and during her deposition in the pending civil

action that, prior to closing, she asked Sandow whether she needed

to do anything to finalize the sale of the house. Sandow told her

that ELR would supply a lawyer to represent her at closing, an inspection of the home, and an examination of the home by a termite

control company. Stekeena relied on his representation that ELR

would follow through on these promises, and did not question

whether ELR had actually taken any of these steps prior to closing.

Moreover, the Rollinses were given a form to sign, entitled ‘‘Illinois

Association of Realtors: Residential Real Property Disclosure Report’’ which did not indicate any defects to the property. (The seller

of the property also signed this disclosure form; not a single problem was highlighted on it.)

In August, the Rollinses discovered through a family friend that

the house was actually located in the Austin neighborhood, not in

Oak Park. When Shirley confronted Sandow with this discovery, he

replied that they could not renege on their agreement to purchase

the house because they were ‘‘locked in’’ as a result of signing the

sales contract. He also told her that, if she tried to get out of the

sale, she would never get another FHA-backed mortgage.61

Just prior to closing, Sandow explained that because the

Rollinses were first-time home buyers, the Federal Government

would provide them with $6,000 to use as a down payment. To take

advantage of this program, Sandow told the Rollinses to enlist the

assistance of someone with a bank account whom they could trust.

The Rollinses secured the aid of 24-year-old Valencia Lockhart, a

family friend. Sandow accompanied Lockhart to the bank, where he

gave her $6,000 in cash. At Sandow’s direction, Lockhart deposited

the cash into her account, then immediately purchased a cashier’s

check for $6,000 made payable to Stekeena. After the completion

of this transaction, Sandow paid Lockhart $50 in cash for her assistance.62 Lockhart then executed a phony gift affidavit documenting her alleged gift to the Rollinses. Although the Rollinses’

signatures appear on this affidavit, they do not remember signing

it, and the signatures do not match their signatures on the sales

contract or closing documents.

The Rollinses closed on their house on September 29, 1995. At

the closing, the Rollinses saw an appraisal valuing their house at

$119,000, a termite inspection certificate indicating that there was

no visible termite damage, and the results of a roof inspection indicating that the roof was in good condition. The appraisal had been

conducted by James Koechle, who was subsequently indicted by a

21

63Subcommittee staff interview with Stekeena and Shirley Rollins in Chicago, Illinois (March

28, 2000). 64Deposition of Shirley Rollins, at 70:14 (December 3, 1999). 65 A Direct Endorsement lender has the authority to underwrite mortgages for FHA insurance

purposes without FHA approval prior to closing. 66Letter from Emelda Johnson, Deputy Assistant Secretary for Single Family Housing, U.S.

Department of Housing and Urban Development, to the president of Dependable Mortgage, Inc.

(August 9, 1996).

Federal grand jury in the Northern District of Illinois on January

26, 2000 for submitting inflated appraisals to mortgage lenders in

an unrelated mortgage-flipping scheme.

Documents the Rollinses signed at their closing include a HUD– 1 Settlement Statement reflecting a down payment that included

the ostensible ‘‘gift’’ from Lockhart. Richard Nelson, co-owner of

ELR and owner of the house, signed through his attorney a form

called the Addendum to the HUD–1 Settlement Statement. This

form certified that Nelson had not paid or reimbursed the Rollinses

for any part of the down payment for the purchase of the house— despite the fact that ELR, through Sandow, had provide them with

$6,000 through the sham transaction with Lockhart. (The Rollinses

also signed this form, thereby falsely attesting that they had not

received any cash from the seller for any portion of the down payment.) In addition, the Rollinses signed a form indicating that they

understood they were purchasing the house ‘‘as is.’’ Although the Rollinses’ signatures on the gift affidavit and the

Addendum suggest some level of complicity in the very fraud that

victimized them, Stekeena maintains that she relied completely on

assurances by Sandow that she was not doing anything inappropriate, that ‘‘everybody does it’’ in this manner, and that this was

simply the way houses were normally purchased. The lawyer ELR

provided to represent the Rollinses at closing, Carl Palladinetti, reinforced these misrepresentations: Rather than providing legal advice, he simply advised them to sign each document placed before

them without offering any meaningful explanation of what they

were signing.63 (During her deposition in the civil action, Shirley

testified that, at the closing, she also noted about five documents

with signatures purporting to be hers which she had not signed.

When she pointed this out to the attorney, he responded that she

had probably forgotten about it. Then he said, ‘‘Anyway, I have a

boat to catch,’’ and continued passing papers to her for signature.64)

Stekeena and her mother obtained an FHA-backed mortgage

from a HUD-approved Direct Endorsement (DE) lender 65 called

Dependable Mortgage, Inc. This lender, however, was apparently

already emerging as a potential problem. Within a few months of

the Rollinses’ closing, in fact, HUD felt compelled to notify the

president of Dependable Mortgage in a letter dated August 1996,

that the company’s rate of early payment defaults and claims on

FHA insured mortgages was in excess of 200 percent of the normal

rate. Specifically, with regard to loans endorsed in 1995, as of June

30, 1996, Dependable’s overall FHA mortgage default rate was

11.49 percent, while the FHA default rate for lenders under the

jurisdiction of the Chicago HUD office was only 2.15 percent, and

the national FHA default rate only 2.66 percent.66 For this reason,

HUD advised that it intended to terminate Dependable’s authority

22

67Subcommittee staff telephone interview with Janice Ligon, Office of Lender Approval and

Recertification, U.S. Department of Housing and Urban Development (May 7, 2000). 68Deposition of Deborah Tanke, at 120:1–5 (March 8, 2000). 69 Hearing record, supra, at 57. 70 Id.

to originate FHA mortgages within 60 days. (According to HUD

staff, after HUD threatened to impose these sanctions, Dependable

apparently voluntarily surrendered its Direct Endorsement authority in June 1997, sold its loan portfolio, and ceased operation.67)

Interestingly, Deborah Tanke, who was president of Dependable

at the time the Rollinses purchased their house, apparently personally notarized the false gift affidavit documenting the alleged gift

from Lockhart. In her deposition, however, Tanke claimed to have

no independent recollection of having done this, and could only surmise that she assisted in the Rollinses’ closing because Dependable

was shorthanded at the time.68 After disbanding Dependable Mortgage, Tanke and another employee formed another loan company

which was then outside the reach of a HUD debarment.

During the Subcommittee’s hearings on mortgage flipping, Chairman Collins advised Senator Durbin that Tanke was still operating

in the loan business in Chicago—a fact which Senator Collins

found to be very disconcerting. FHA Administrator Apgar professed

to be unaware of that development, as indicated by the following

exchange:

‘‘Q: What about the lender?

A: The lender disappeared.

Q: Well, we [the Subcommittee] found them.

A: What?’’ 69

Senator Collins told him that the lenders involved in the Rollins

episode ‘‘are still operating in the loan business in Chicago. So we

will help you find them.’’ 70

A FHA credit analysis ‘‘worksheet’’ is used to examine an applicant’s personal and financial status, monthly shelter expense,

funds required for closing expenses, effective monthly income and

debts and obligations. As noted above in connection with the Smith

case, an applicant’s prospective housing expenses should not exceed

29 percent of gross effective monthly income. An analysis of the

Rollinses’ mortgage application indicated that the prospective housing expenses equaled exactly 29 percent of their gross monthly income. According to Stekeena, however, the amount listed as their

monthly income on this form was overstated: It had been falsely inflated by approximately $600 per month, which was described as

‘‘rental income.’’ Stekeena said she was unaware that this false income amount

had been included on her loan application, which she did not read

before signing because ‘‘it was just another form.’’ Surely not by coincidence, the falsely-attributed additional ‘‘income’’ was precisely

the amount required to make the Rollinses appear to meet the 29

percent threshold. Under FHA guidelines, in other words, they

should not have received the loan: Without such false ‘‘rental income’’ paperwork to pave the way for a government-backed loan,

ELR would not have been able to sell the Rollinses the house.

At the Subcommittee hearing, Senator Collins asked Ms. Rollins

about this issue:

23

71 Hearing record, supra, at 28. 72 Id. 73Subcommittee staff interview with Stekeena and Shirley Rollins in Chicago, Illinois (March

28, 2000). 74Deposition of Stekeena Rollins, at 35:3–6 (December 8, 1999). 75Subcommittee staff interview with Stekeena and Shirley Rollins in Chicago, Illinois (March

28, 2000). 76 Id. 77 In December 1997, the Chicago Community Economic Development Association repaired

and retrofitted the Rollinses’ furnace pilot light system, insulated the attic, installed a smoke

detector, and repaired doors. These efforts cost the Rollinses almost $2,500.

‘‘Q: Did you, in fact, receive $618 in rental income every

month?

A: No.

Q: Did you put that number on the form?

A: No.

Q: Did you tell anyone to put that number on that form?

A: No.

Q: And you weren’t even aware that that number had

been put on the form to make it appear that you

qualified for the mortgage?

A: No.’’ 71

After the Rollinses had signed all the papers at the closing,

Sandow told them that ‘‘house sitters’’ were staying at the house

and instructed the Rollinses to go to the house, ask these persons

for the keys, and request that they leave.72 When the Rollinses arrived there, they observed drug paraphernalia scattered around the

house. The alleged ‘‘house sitters’’ also refused to leave, and a 2-

hour argument ensued. In the end, these persons agreed to leave

when Shirley’s son arrived at the house. The ‘‘house sitters’’ were

apparently drug dealers: To this day, almost 5 years later, strangers still periodically visit the Rollinses’ house seeking to purchase

drugs there.73

The Rollinses had visited the house three times before closing,

but ELR representatives had never allowed them to see the entire

house due to what they characterized as ‘‘ongoing construction’’. When the Rollinses arrived at the house after closing, the reason

for this refusal became clear: They observed termites swarming everywhere—on the front and back porches, inside the house, and in

the garage. A subsequent telephone call to the company that conducted the termite inspection proved fruitless; a representative of

that company simply advised them that ELR often painted over

possible termite infestation, thereby preventing its detection by a

normal inspection. This termite damage was so severe, in fact, that

Stekeena fell on the front porch and severely hurt her leg.74

The Rollinses also soon began discovering other problems with

the house. Contrary to Sandow’s representations, the house was

not suitable for a day care center because it did not meet city

standards. Stekeena’s business application was accordingly denied.75 (A substandard furnace in the basement caused leaks.76 A

gas company representative told them that the pipes used on the

furnaces were old, were not originally designed to be gas pipes, and

appeared to be connected in a slipshod fashion.77) A gap also developed between the wall and the floor in the living room, actually

creating an opening to the outside through which snow and rodents

entered the house. Other problems with the house included water

24

78Subcommittee staff interview with Stekeena and Shirley Rollins in Chicago, Illinois (March

28, 2000). 79Subcommittee staff telephone interview with Stekeena Rollins (May 1, 2000). 80 Id. 81Deposition of Stekeena Rollins, at 128:12–17 (December 8, 1999). 82Subcommittee staff telephone interview with Stekeena Rollins (May 1, 2000).

leaks, sewage backups in bathrooms, and faulty electrical wiring.78

An attorney who is attempting to renegotiate the Rollinses’ mortgage also told them that the house had been illegally converted

into a two-flat structure.79

The Rollinses complained numerous times to ELR about the condition of their house. In response to their first complaints, ELR

sent workmen to the house on approximately five occasions. These

workmen repaired water damage to the first floor bedroom and dining room ceilings, and damage that had resulted from pipes freezing due to lack of insulation. They also painted the front porch to

cover boards that had been damaged by rot, replaced the first- and

second-floor carpets that had suffered water damage, and stabilized

the collapsing back stairway.80 Eventually, however, ELR stopped

responding to the Rollinses’ continuing complaints.

After the Rollinses finally contacted the FBI about ELR in January 1996, ELR resumed contact. Indeed, Sandow contacted them in

April, offering them season tickets to the Chicago Bulls games and

informing them that he would treat them to dinner if they stopped

complaining. The Rollinses rejected these offers. Louis Prus, one of

the owners of ELR, then stopped by to look at the house with his

wife, but nothing resulted from his visit.81

By October 1999, the Rollinses were 2 or 3 months behind in

their mortgage payments, but they have not made payments since

June 2000 on account of a HUD moratorium on foreclosures of

properties sold by ELR, and because of efforts by their attorney to

renegotiate the terms of their mortgage.82

Investigation by Subcommittee staff has revealed that a nonprofit organization called Pride Allied Educational Program had

purchased the Rollinses’ house from HUD for $11,430 in April

1995. Richard Nelson, co-owner of ELR, purchased the house from

Pride Allied for $14,000 on May 5, 1995. Nelson sold the house 5

months later to the Rollinses for $119,000. Thus, although the owners of ELR have produced checks purporting to show approximately

$52,000 in repairs made to the house prior to the Rollinses’ closing,

it is unlikely that even this dollar volume of repairs increased the

house’s market value in such a short period of time. Because ELR’s

records do not delineate in detail the types of repairs conducted on

the house, moreover, it is unclear whether or not any repairs were

actually made.

(2) Other Easy Life Realty Victims

The stories of the remaining ELR victims are remarkably similar

in that they all made nominal down payments which ELR representatives supplemented with significant cash payments. ELR

steered each victim to a lender of its choice, and, with one exception, provided the victim with an attorney to represent him or her

at closing. In addition, each victim experienced major problems

with the structural soundness and satisfactions of his home, which

ELR failed to rectify.

25

83Subcommittee staff telephone interview with Sonia Pratts (June 16, 2000). 84Subcommittee staff interview with Carlos and Sonia Pratts in Hollywood, Florida (April 16,

2000).

C. South Florida: The Story of Sonia and Carlos Pratts

Sonia Pratts and her husband Carlos purchased their home at

6121 Jackson Street in Hollywood, Florida, from New Southwest

Properties, Inc. (NSP) for $80,000 on February 20, 1998. NSP had

purchased the property on September 2, 1997 from HUD for only

$40,000.

Sonia received an associate’s degree in liberal arts from Boricua

College in Brooklyn, New York. She has also taken pharmacy

courses through ICS International Correspondence School, phlebotomy courses at Broward Community College, and counseling

courses at Florida Bible College. Sonia formerly worked as a ‘‘ward

clerk’’ and ‘‘certified nurse.’’ In this capacity, she cared for premature, HIV-positive, and drug-addicted infants by performing

such tasks as maintaining a sterile environment, monitoring medication and supplies inventory, bathing and weighing the infants,

and preparing discharge and transfer paperwork. As a result of a

back injury she suffered during the course of her employment, however, Sonia now works as a patient care assistant at a health care

system surgical department, performing such tasks as drawing

blood, transporting patients between departments, and bathing,

dressing, and feeding patients. Her gross monthly income at the

time she and Carlos purchased the house was roughly $1,200.

Carlos has a sixth-grade education. He was working as a driver/

warehouse worker at Little Guys Food Service at the time he applied for their mortgage. (Sonia was eliminated from their loan application for the house because she had filed for bankruptcy nearly

10 years earlier after her ex-husband abandoned her and their

three children.) In addition to his gross monthly salary of approximately $1,700, he was receiving Supplemental Security Income of

$521 per month because he had been diagnosed as schizophrenic.

He is presently unemployed.83

The Prattses had been saving to purchase a residence for several

years. In October 1997, as they were driving through various

neighborhoods looking at houses, they saw a sign posted in front

of a house offered for sale by ERA Homeland Realty Corporation.

The Prattses called the number on the sign and subsequently met

with two realtors, P. Alias Thomas and ViJayan V. Thomas. The

Thomases steered the Prattses away from the house that had initially attracted their attention to the house on Jackson Street that

they ultimately purchased. The realtors then introduced the

Prattses to Joe Kuruvila who, in addition to owning ERA Homeland Realty, also owned NSP which owned the Jackson Street property.84

The Prattses told Kuruvila that they wanted a property that

needed no repairs because they were using their entire savings for

the down payment, and would have no funds left over for renovations. When Kuruvila showed them the house on Jackson Street,

the Prattses realized it was in the process being repaired. In response to their inquires, Kuruvila assured them that the property

had no structural problems and no code violations. This was unVerDate 11-MAY-2000 08:24 Oct 05, 2001 Jkt 000000 PO 00000 Frm 00029 Fmt 6633 Sfmt 6601 75382.TXT SAFFAIRS PsN: SAFFAIRS
26

85 Id. 86 Id. 87 Id. 88Subcommittee staff telephone interview with Sonia Pratts (April 24, 2000). 89 Id.

true. At one point, Carlos drove by the house and noticed a code

violation taped to the door.85 City of Hollywood records confirm

that a notice of code violations was posted on the Jackson Street

property in October 1997. These code violations consisted of failing

to obtain the requisite building permits for an addition to the property and for replacement of a window. (The city mailed NSP a letter via certified mail, return receipt requested, in November 1997,

notifying it of the violations. The city again posted a noticed of the

violations on the property in January 1998.) When Carlos confronted Kuruvila about the code violations, Kuruvila reassured him

that all the necessary repairs would be completed, and that the

code violations would be remedied.86

On December 20, 1997, the Prattses signed a contract for the

purchase of the Jackson Street residence. This contract included a

rider that subsequently became the subject of much controversy.

This rider disclosed to the Prattses that NSP and ERA Homeland

Realty were 100 percent shareholders of their mortgage lender,

Hollywood Mortgage Corporation. In other words, Joe Kuruvila

owned not only the Prattses’ lender, but also the seller and the real

estate agency. (A third entity listed on the rider as owning Hollywood Mortgage, Northeastern Properties, Inc., is also owned by Joe

Kuruvila.) The Prattses told Subcommittee staff that when they

signed the rider, they did not realize the relationship among the

listed companies or the significance of Kuruvila’s common ownership of them.87

The rider also provided that ‘‘[i]t is expressly understood that the

property is sold ‘as is’, without any warranty to the purchaser, either express or implied’’ as to the property’s zoning, its condition,

freedom from defects, or fitness for any particular use or purposes.

The Prattses contend that neither Kuruvila nor the Thomases explained this clause to them, and that they thus attached no particular significance to it when they signed the rider.88

Shortly after he signed the sales contract, Carlos signed a HUD

form entitled, ‘‘Importance of Home Inspection.’’ This form advised

that FHA does not warrant the value or condition of a home, and

encouraged the buyer to obtain an independent home inspection.

Carlos indicated on the form that he chose not to have a home inspection performed. As with the ‘‘as is’’ clause, the Prattses attached no substantive significance to their waiver of a home inspection, particularly in light of Kuruvila’s repeated assurances regarding the rehabilitation work that he was performing on the house.89

At their closing on February 20, 1998, the Prattses received virtually no explanation regarding the documents that they were

being given to sign. They simply signed everything put in front of

them because they trusted Kuruvila. They used their personal savings in order to provide the $3,900 they paid as a down payment

and in order to cover closing costs; this was money they had been

accumulating over a 2- or 3-year period.

27

The Prattses financed the balance of the purchase price through a 30-year mortgage in the principal amount of $79,959. Carlos executed an ‘‘escrow buy down agreement’’ which provided that in ex- change for payments of $962.70 each from NSP and Hollywood

Mortgage, the Prattses’ interest rate would be 5.75 percent for the

first year of the mortgage term, with a corresponding payment of

principal and interest of $572.84 per month. For the second year

of the mortgage term, the interest rate would be 6.75 percent, with

a corresponding payment principal and interest of $518.61 per

month. For the remainder of the mortgage term, the interest rate

would be 7.75 percent, with a corresponding payment of principal

and interest of $572.84. (This paperwork, as well as a clause in

their sales contract, notified the Prattses that they were obtaining

a variable rate mortgage. Sonia admits that she knew that they

were obtaining a variable rate mortgage, but she says she did not

believe that the rates would increase.)

The annual taxes for the property at the time of the sale were listed at $1,187.00. The monthly payment of these taxes, plus

monthly premiums for FHA mortgage insurance and fire insurance,

increased the Prattses’ total monthly payments for the first year of the mortgage to $669.20. After the first 2 years of their mortgage

term, their total monthly payments were scheduled to rise to

$796.00 per month, as indicated on a document Carlos signed entitled ‘‘Acknowledgment of Estimate of Total Monthly Mortgage Payment.’’ The FHA credit analysis worksheet is used to examine an applicant’s personal and financial status, monthly shelter expense,

funds required for closing expenses, effective monthly income, and

monthly debts and obligations. As a general rule, the applicant’s

prospective housing expenses should not exceed 29 percent of their

gross effective monthly income. An analysis of Carlos Pratts’s gross monthly income of $2,254.00 per month divided by the initial

monthly mortgage payment of $669.20 indicates that his housing

expenses were approximately 29.68 percent of his gross monthly income—in excess of the threshold suggested by the FHA guidelines.

The Prattses have experienced serious problems with the house

despite the fact that Kuruvila told them that it had been completely rehabilitated. The roof—which Kuruvila told them was

new—is rotting, collapsing, and leaking in several places. As a result, the ceilings have begun to crack and fall. When Subcommittee

staff visited the house, they noted apparent water damage to the

ceilings in a bedroom and back room of the residence. The staff also

verified that the house has suffered rodent infestation as well as

significant termite damage. (The living room, in fact, has a hole in

the ceiling through which Sonia claims rat feces enter the room.)

The addition, the rear of the house has substantial water damage

and is built on top of the septic tank, which is a violation of City

of Hollywood Construction Code and Health Department rules. The

roof fascia is rotted and has many gaps through with rats and

birds have gained entrance. The wiring also does not appear to be

adequate, and several outlets are nonfunctional. So far, the

Prattses have spent over $2,500 of their own money for various repairs, and there is no end in sight: An independent engineer they

hired to evaluate the house advised them that they would need to

28

90Subcommittee staff telephone interview with Jim Ward (April 18, 2000); interview with Carlos and Sonia Pratts, in Hollywood, Florida (April 16, 2000). 91Subcommittee staff telephone interview with Everett Lawson (June 19, 2000); interview

with Carlos and Sonia Pratts, in Hollywood, Florida. (April 16, 2000).

spend between $40,000 and $50,000 to bring it into compliance

with the city building code—and that they would have to raze part

of the house altogether.90

After the Prattses moved into their home, they received a letter

from the City of Hollywood informing them of the outstanding

building code violations on the property. The violations occurred

long before either Kuruvila or the Prattses owned the house but

the Prattses, as current owners, were responsible for ensuring compliance.91

When the Prattses questioned Kuruvila about the outstanding

fines for the code violations, he assured the Prattses that he would

pay them, but to date he has failed to do so. The Prattses have

filed a civil complaint in State court against Kuruvila in an attempt to resolve this matter. In addition, the Real Estate Division

of Florida’s Department of Business and Professional Regulation

has filed an administrative complaint against Kuruvila in his status as a real estate broker—and against his companies, NSP and

Homeland ERA Realty—alleging fraud in conveying this property

to the Prattses.

An appraiser named Raymond G. Wood conducted the appraisal

of the Prattses’ house that Kuruvila submitted in order to obtain

FHA endorsement of their mortgage. This appraisal estimates that

the fair market value of the Prattses’ house was $82,000 as of January 8, 1998, and indicates that ‘‘the subject property conforms to

all applicable minimum HUD/VA standards.’’ Wood’s appraisal also

declares that the house is in overall average condition and that it

has some new windows, a new roof, and new ceilings, although central air conditioning and appliances needed to be installed. Many

of these claims were clearly false at the time. Wood told Subcommittee staff that he did not remember the property in question

but that he had done ‘‘hundreds’’ of appraisals for Kuruvila until

last fall, when he stopped because Kuruvila was very slow to pay

him.

(Nor were these apparent misrepresentations the only problem

with Wood’s appraisal of the Prattses’ house. In addition, the ‘‘comparable’’ property that Wood used to establish the value of the

Prattses house appears also to have been a property ‘‘flipped’’ by

Joe Kuruvila. Kuruvila purchased this property, located at 6028

Fillmore Street in Hollywood, for $43,200 from HUD on August 15,

1997. He sold it approximately 3 months later on November 19,

1997, for $81,000 to a buyer who had obtained an FHA-insured

mortgage. Coincidentally, Wood conducted the pre-closing appraisal

on the Fillmore Street property, subsequently also using it as the

property against which to assess the purported value of the

Prattses’ home.)

D. Norfolk

A flipping scheme run by Wendell Chick in Norfolk, Virginia, illustrates the extent to which smaller cities are also susceptible to

flipping frauds—and how such activities can inflict great harm

29

92See United States v. Wendell Chick, Case No. 2:97CR00124–001 (E.D. Va. Dec. 15, 1997)

(judgment).

upon entire neighborhoods. Wendell Chick was a real estate broker

and principal in multiple companies he utilized to inflate the value

of properties he had purchased, minimally rehabilitated, and then

resold. (Chick is currently serving a 60-month prison sentence as

a result of his 1997 guilty plea to Federal wire fraud and money

laundering conspiracy charges that arose from this conduct.) 92

Between May 1993 and April 1997, Chick owned or controlled

corporations through which he purchased approximately 34 properties in relatively poor condition in Norfolk, Portsmouth, and

Chesapeake, Virginia. The purchase price of these properties

ranged from $9,000 to $69,900, with an average price of approximately $30,500. Chick and his associates executed and recorded

deeds purporting to convey the properties from one Chick-controlled company to another. Each time the properties were ‘‘sold’’

to a new company Chick controlled, their prices were inflated incrementally in order to create the illusion of a steadily increasing

market value. These property transfers were solely paper transactions; no money ever changed hands, and the properties never

left Chick’s control.

Once a property’s value had been sufficiently inflated by these

means, Chick and his associates recruited purchasers whom they

helped obtain mortgage loans through fraudulent means. Typically,

Chick and his cohorts made cash, loan, and credit card payments—

generally totaling several thousand dollars—to or on behalf of each

of these purchasers, who thereupon falsely attested on their sales

contracts that they had paid ‘‘earnest money’’ deposits on the properties out of their own funds.

Chick caused his purchasers to submit 34 different fraudulent

mortgage applications for loans totaling approximately $2,746,564.

(Nineteen of these loans were FHA insured.) Chick and his associates used a number of means to obtain such loans: They submitted

to the lenders copies of checks that falsely purported to be ‘‘earnest

money’’ deposits made by the purchasers; they paid outstanding

credit accounts on behalf of the purchasers; and they provided

funds to the purchasers to deposit into bank accounts in order to

inflate apparent balances—thus leading lenders to believe that the

purchasers were more solvent than was in fact the case. (To explain the source of funds in the purchasers’ accounts, Chick produced forged gift letters and prepared fictitious certificates of title

to motor vehicles, as well as receipts documenting non-existent

sales of those vehicles to third parties.) In addition, at the loan

closings, Chick and his associates themselves made the cash payments required of the purchasers.

Apparently, Chick also misled lenders about HUD policy. In express contravention of HUD policy, for example, Chick told buyers

that although they had to represent to the lenders that they intended to live in the houses they were buying, in actuality HUD

‘‘didn’t care whether they lived there only 1 day.’’ Most of the HUD

settlement statements also listed false debts secured by the properties.

30

93 Among these conferences was a HUD forum in Los Angeles on May 3, 2000. This conference

featured an address by a member of the Joint Task Force, case studies on predatory lending,

participation by a variety of local and national industry representatives, and a consumer panel

that included AARP, Bet Tzedek Legal Services, the Consumers Union, the Southern California

Consumer Law Center, and Neighborhood Housing Services of Los Angeles. The focus of this

event was the effect of predatory lending on elderly communities. During the conference, Subcommittee staff discussed the problem of flipping with various stakeholders.

E. Southern California

While exploring such problems of mortgage fraud, Subcommittee

staff attended a number of conferences devoted to assessing the impact of—and preventing—predatory lending practices.93 Among

other events, Subcommittee staff attended the monthly meeting of

the Los Angeles Housing Task Force. This group, which includes

representatives from HUD/OIG, the Los Angeles Police Department, the California State Bar, the Southern California Consumer

Law Center, and the Los Angeles Sheriff’s Department, was created to combat mortgage fraud in the State of California. The task

force discussed how Los Angeles has been successfully targeting

mortgage fraud through training and consumer awareness.

According to these experts, local and Federal law enforcement

have traditionally been reluctant to prosecute flipping and other

types of mortgage fraud cases because they are highly technical

and difficult to prove. Many local district attorneys told Subcommittee staff that they required special training in order to acquire the level of understanding necessary to prosecute these cases

(much as was the case with Medicare fraud cases in the late

1980’s). In response to this need for training, Manuel Duran, a consultant for the Southern California Consumer Law Center, successfully lobbied for the passage of a bill through the State legislature

that imposes a $2 surcharge on each property deed filed in the

State. The funds this surcharge generates are used to train law enforcement to investigate and prosecute mortgage fraud cases.

Duran and members of the task force reiterated their belief that

the answer to combating mortgage fraud lies in training law enforcement to prosecute these highly specialized criminals. (These

officials indicated that pre-purchase counseling for homeowners is

not by itself an adequate response, inasmuch as it rarely provides

an effective deterrent to mortgage criminals.)

According to Nicholas Aquino—a Supervising Investigator who

heads the Real Estate Fraud Section of the Los Angeles County Department of Consumer Affairs, which is responsible for addressing

real estate fraud complaints—southern California has been plagued

by an increasing number of mortgage fraud cases that have been

perpetrated through the use of stolen identities. Investigating and

prosecuting flipping, particularly when victims’ misappropriated

identities are used for straw purchases, is complicated for law enforcement officials because the victims may not actually know that

they have been victimized until long after the ‘‘flip’’ occurs. (Meanwhile, evidence becomes stale, and witnesses forget key details

about the transactions at issue. This places special burdens upon

prosecutors.)

Aquino sees flipping as being a ‘‘huge’’ problem in Los Angeles

County. In one scheme that is currently under investigation, for example, perpetrators placed advertisements in local newspapers and

canvassed neighborhoods offering low-income, first-time home buyVerDate 11-MAY-2000 08:24 Oct 05, 2001 Jkt 000000 PO 00000 Frm 00034 Fmt 6633 Sfmt 6601 75382.TXT SAFFAIRS PsN: SAFFAIRS
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94Subcommittee staff telephone interviews of Nicholas V. Aquino, Supervising Investigator,

Real Estate Fraud Section, Los Angeles County Department of Consumer Affairs (February 2

and June 14, 2000). 95See David Rosenzweig, ‘‘Thirty-Nine Charged in Crackdown on Fraud in FHA-Backed

Loans,’’ Los Angeles Times (December 16, 1999), http://www.latimes.com/news/state/199912/

16t000114613.html. 96Office of the Inspector General, U.S. Department of Housing and Urban Development, Audit

Memo. # 00–SF–121–0802, Internal Audit—Single Family Housing: Los Angeles Area Office and

Santa Ana Home Ownership Center (April 6, 2000), at 4. 97See Rosenzweig, supra.

ers the opportunity to purchase a house. The individuals who responded to the offer completed a mortgage application, only to be

told that they did not qualify for a loan. The perpetrators then

used the victims’ identification data on the mortgage application to

purchase houses themselves, using the victims’ names. These properties were then resold at inflated prices.94

In December 1999, a Federal grand jury charged 39 persons with

obtaining more than $110 million worth of fraudulent FHA insured

loans through the execution of multiple fraudulent schemes

through Allstate Mortgage Company.95 Allstate set up straw companies to enter into purchase agreements to acquire apartment

buildings, typically worth $100,000 to $180,000. It then hired its

own appraisers who inflated the value of the buildings, usually

from $100,000 to $150,000 greater than the actual market value of

the properties. (Allstate also instructed appraisers to certify that

properties contained four residential units even though many had

more than four units. It knew that under HUD’s single-family insurance program the Department insured only mortgages on properties with four or fewer units.) Allstate then recruited low-income

individuals to serve as straw buyers and apply for FHA mortgages

in amounts equal to as much as $150,000 above the actual property

values in question. As the FHA-insured loans were being arranged,

Allstate simultaneously closed on its original purchase of the properties for the actual price, pocketed the difference between its purchase price and the taxpayer-insured loan proceeds, and then sold

the fraudulent loans to legitimate mortgage companies.96

The Federal grand jury charges stemmed from a concentrated

probe by teams of HUD/OIG auditors, FBI agents, and IRS agents

in Southern California. At a news conference announcing the indictment, HUD Inspector General Susan Gaffney suggested that

these charges were only ‘‘the tip of the iceberg.’’ The U.S. Attorney

for the Central District of California noted that this type of fraud

‘‘takes money from needy parents who dream of providing a house

for their children and puts it into the pockets of people who have

been licensed as professionals, but who really are just greedy criminals.’’ 97

IV. The Federal Housing Authority

A. Origin and Structure

The Housing Act of 1934 established FHA in order to broaden

home ownership, protect lending institutions, and stimulate the

building industry. By insuring lenders against loss on home loans,

FHA contributed to the institution of the 30-year mortgage as a

standard mortgage product. When HUD was created in 1965, FHA

became an agency of HUD. All FHA programs are administered

32

98 U.S. Department of Housing and Urban Development, About Housing (visited June 19,

2000) http://www.hud.gov/fha/fhaabout.html. 99Foote, supra, at 1. 100Subcommittee staff telephone interview with Joe Rothchild, Office of Evaluation, Office of

the Comptroller, U.S. Department of Housing and Urban Development (June 16, 2000). 101Foote, supra, at 4. 102Subcommittee staff telephone interview with Joe Rothchild, Office of Evaluation, Office of

the Comptroller, U.S. Department of Housing and Urban Development (June 16, 2000). 103Foote, supra, at 4. 104 Id. 105Office of the Inspector General, U.S. Department of Housing and Urban Development,

Semiannual Report to the Congress (October 1, 1985-March 31, 1986) [hereinafter ‘‘HUD/OIG,

1985–86 Semiannual’’], at 6.

through the HUD Office of Housing.98 Since its inception in 1934,

FHA has insured nearly 27.9 million loans.99 FHA is organized into

four major mortgage insurance fund activities. The largest activity

is the Mutual Mortgage Insurance Fund (MMIF), which provides

single family housing insurance.

The MMIF was designed to be actuarially sound and self-supporting. In fiscal year 1987, however, the fund barely broke even,

and in 1988 the MMIF suffered its first net loss. In 1989, the

MMIF’s income remained insufficient to cover losses.100 The MMIF

had about $4 billion in reserves at the end of fiscal year 1987.

Thanks to its slide into deficits, however, by the end of fiscal year

1991, the MMIF reserves had shrunk to $871 million.101

In 1991, as a result of these problems, Congress authorized HUD

to increase FHA insurance premiums in order to keep the fund solvent. Prior to that time, on a 30-year mortgage, a borrower paid

a one-time Mortgage Insurance Premium (MIP) of 3.8 percent of

the amount borrowed. As of July 1, 1991, however, the borrower

had to pay an additional annual premium of 0.5 percent in addition

to the 3.8 percent one-time payment already required.102

In 1994, Congress enacted legislation to change the MIP calculations again in order to reflect the risk of the loans being insured.103

For any loan insured on or after October 1, 1994, therefore, the

borrower pays an up-front mortgage insurance premium of 2.25

percent of the loan amount. Thereafter, the borrower pays an annual insurance premium the amount and duration of which are determined by the size of the down payment: (a) a borrower who

makes a down payment in excess of 10 percent will pay an annual

insurance premium of 0.5 percent of the loan balance for the first

11 years of the loan; (b) a borrower who makes a down payment

of 5 percent to 10 percent will pay an annual premium of 0.5 percent for the first 30 years of the loan; and (c) a borrower who

makes a down payment of less than 5 percent will pay an annual

premium of 0.55 percent of the loan balance for 30 years.104

B. The Changing Face of FHA

(1) The 1980’s: Coming to Grips With Mortgage Fraud

Fraud involving FHA-backed mortgages for single-family residences, unfortunately, is nothing new. A 1986 HUD/OIG semiannual report, for example, described a case in which a house in

Milwaukee was purchased for $13,950 and resold to an unqualified

buyer for whom the seller had falsified a gift letter as evidence of

a down payment to secure an FHA-backed mortgage. The buyer defaulted, the lender foreclosed on the house, and the FHA insurance

fund suffered a loss of $43,100.105 (This case looks very much like

33

106Office of the Inspector General, U.S. Department of Housing and Urban Development,

Semiannual Report to the Congress (April 1986-September 1986), at 5. 107 HUD/OIG, 1985–86 Semiannual, supra, at 7. 108The Office of Housing is the office within HUD—under the direction of the Under Secretary for Housing/Federal Housing Commissioner—that carries out FHA programs. 109 1985–86 Semianual, supra, at 8.

the mid/late-1990’s case studies identified by the Subcommittee’s

investigation.) Another type of scheme that was prevalent in the

1980’s involved ‘‘equity skimming.’’ Equity skimming is the term

used to describe frauds in which an investor who acquires a property, rents it to tenants, and then collects rent payments while not

making the mortgage payments. The investor eventually allows the

property to go into foreclosure, but only after he has collected

enough rent to amortize his equity in the property.106

In response to such reports of widespread and growing abuse of

the FHA mortgage program, HUD Secretary Samuel Pierce announced the formation of HUD’s Single Family Task Force in fiscal

year 1985. The mission of the Task Force was to conduct reviews

of single family policy issues and analyze data from loans endorsed

since 1980. On April 3, 1986, Secretary Pierce announced that the

Task Force had issued a report recommending, among other things,

that: (i) HUD should aggressively pursue sanctions against those

who abuse HUD programs, including seeking deficiency judgments

against defaulting mortgagors; (ii) HUD should publicize actions

taken against mortgagors, mortgagees, and others who abuse HUD

programs; and (iii) the Mortgagee Review Board should take a

firmer stand against mortgagees who violate HUD programs.107

In addition to implementing the Task Force recommendations,

the HUD Office of Housing issued internal directives requiring

closer monitoring of early defaults on FHA-backed mortgages and

lender claims as a means of detecting fraudulent schemes.108 The

Office of Housing duly stepped up its enforcement efforts in order

to focus quickly upon imprudent lenders and other parties, and to

impose stringent monetary and administrative sanctions. That office also agreed to make instrumental programmatic changes to

curb fraud, such as requiring detailed reviews of mortgage applications for previously owned HUD properties and eliminating a property owner’s ability to refinance his mortgage by taking all the cash

equity out of a property.109

(2) Problems With the ‘‘Reinvention’’ of HUD Under the Clinton

Administration

A number of developments have occurred since 1992 that gravely

damaged the monitoring and oversight systems HUD had implemented in order to protect its Single Family Insured Programs

against fraud and abuse. In February 1993—in the first flush of

‘‘Reinventing Government’’ enthusiasms promoted by Vice President Gore—HUD Secretary Henry Cisneros initiated a ‘‘reinvention’’ effort to make HUD more efficient and, apparently more importantly, to show Congress that HUD should not simply be dismantled.

34

110 HUD/OIG, Single Family Production Home Ownership Centers, supra, at 1. 111 U.S. Department of Housing and Urban Development, Mortgagee Letter 95–7 (January 27,

1995), at 1–6. 112 Id. at 1. 113 Id. at 1–2. 114 Id. at 2. 115 Id. at 2. 116 Id. at 4.

(a) Liberalization of Controls Over Direct Endorsement

Lenders

In 1995, FHA issued Mortgagee Letter 95–7, which significantly

liberalized Direct Endorsement lender underwriting requirements.110 HUD claimed that these changes would eliminate unnecessary barriers to home ownership, provide the flexibility to underwrite creditworthy nontraditional and underserved borrowers, and

clarify certain underwriting requirements so that they are not applied in a discriminatory manner.111 Significant changes implemented by this letter included the following:

• Elimination of 5-year test for income stability: Previously, only those sources of income reasonably expected to last for at least 5 years could be included in

determining the borrower’s income for qualifying purposes. The letter reduced this standard to an income expectation of 3 years.112

• Recognizing income from overtime and bonuses: Previously, bonuses and overtime over a 2-year period (received or expected) could be counted as income. After

the promulgation of Mortgagee Letter 95–7, periods of

less than 2 years could be considered for income calculations.113

• Recognition of part-time income: Jobs consisting of less

than a 40-hour work week can now be considered for income calculations. (The lender must determine, however, that the continuance of this income is likely.) 114

• Elimination of child care as recurring debt: Child care

is no longer considered in the computation of debt-to-income ratios because, according to HUD, most families

assessing their financial priorities will find alternate

means of caring for their young children if such costs

become burdensome.115

• Use of automated underwriting systems and use of artificial intelligence in underwriting: HUD approved lenders

were also given permission to use automated underwriting systems for approving FHA-insured mortgages

as long as the criteria were met for loan approval. (Artificial intelligence systems may be used for loan approvals only, and loans rejected by an artificial intelligence

system must be reviewed by a human underwriter.) A

DE underwriter must still execute the normal documents required on FHA-insured mortgages.116

• DE approval for branch offices: Once a lender obtains

unconditional DE status for any one of its offices, addiVerDate 11-MAY-2000 08:24 Oct 05, 2001 Jkt 000000 PO 00000 Frm 00038 Fmt 6633 Sfmt 6601 75382.TXT SAFFAIRS PsN: SAFFAIRS
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117 Id. at 5. 118 Id. 119 U.S. Department of Housing and Urban Development, press release, ‘‘Cuomo Announces

Historic Management Reforms For HUD To Stamp Out Waste, Fraud and Abuse and Improve

Performance’’ (June 26, 1997), http://www.hud.gov/pressrel/pr97-109.html, at 1. 120 Id.

tional branch offices that become approved to do business with HUD are now automatically granted DE approval.117

• Alternative documentation—revised instructions: If a

former employer is no longer in business at the time of

the underwriting, and if a verification of past employment cannot thus be made, the underwriter need only

verify by telephone all current employment. Also, the requirement that the lender obtain bank statements covering the most recent 3-month period for bank statement transactions can now be met merely by obtaining

the two most recent two bank statements. (The lender

may also utilize an electronic retrieval service for W–2

and tax return information, although it cannot charge

the borrower for this service.) 118

(b) HUD 2020 Management Reform Plan

The HUD ‘‘reinvention’’ effort expanded further—with rather

problematic results—under Secretary Andrew Cuomo. On June 26,

1997, Secretary Cuomo announced a new management reform plan

for HUD.119 The plan—dubbed ‘‘HUD 2020’’—aimed to transform

HUD from what Cuomo called ‘‘the poster child for inept government that has been plagued for years by scandal and mismanagement’’ into ‘‘a new HUD, a HUD that works.’’ 120 The 2020 Management Reform Plan included several specific steps: The creation of

a new Enforcement Division to fight waste, fraud, and abuse; the

consolidation of over 300 HUD programs and activities into 71; the

establishment of a new financial information management system;

and the reduction of the size of HUD’s staff from 10,500 to 7,500

by the end of the year 2000. In addition, the 2020 Management Reform Plan called for the consolidation of all single-family operations

from 81 locations across the country into three Home Ownership

Centers (HOCs). (The number of HOCs was later increased to four;

they are presently located in Philadelphia, Pennsylvania, in Atlanta, Georgia, in Denver, Colorado, and in Santa Ana, California.)

The Real Estate Assessment Center (REAC) is responsible for assessing the overall physical and financial condition of HUD’s vast

housing portfolio, theoretically enabling HUD better to target its

monitoring and enforcement resources. Because other HUD organizations are so dependent upon its work, REAC was the linchpin of

HUD’s 2020 Management Reform Plan.

REAC’s functions regarding HUD’s Single Family Insured Programs, however, are largely limited to appraiser oversight. REAC’s

Single Family Appraisal Quality Assessment Team (QAT) conducts

reviews of appraisals for FHA-insured single family homes. The

reviews assess the accuracy and completeness of FHA appraisal reports in order to reduce the probability of costly and unexpected repairs to home buyers. (Inadequate appraisals make it that much

36

121 U.S. Department of Housing and Urban Development, Single Family Appraisal Quality Assessment (visited June 19, 2000), http://www.hud.gov/reac/products/prodsfa/cfm, at 1. 122 U.S. General Accounting Office, Oversight of FHA Lenders: Single Family Housing, GAO/

RCED–00–112 (April 28, 2000), at 6. 123 HUD/OIG, Single Family Production Home Ownership Centers, supra, at iii. 124Mortgage Bankers Association, National Delinquency Survey for the 4th Quarter of 1999

(last modified March 29, 2000), http://www.mbaa.org/marketdata/nds/0499.html, at 1.

harder for home buyers to become aware of extensive repairs that

may be required to make their homes habitable. If they purchase

housing in ignorance of such defects, they may be unable to afford

the costs these problems impose, and are thus much more likely

subsequently to default on their FHA-insured mortgages.) In addition, the QAT created a standard for appraisal knowledge by requiring appraisers to pass the FHA appraiser examination in order

to be eligible to perform FHA appraisals. These activities support

the reforms initiated in the Homebuyer Protection Plan, which ‘‘reinvented’’ FHA’s appraisal process.121

(c) Soaring Defaults and Foreclosures

Between fiscal years 1997 and 1999, the number of single family

mortgage loans that FHA insured grew from approximately

800,000 to nearly 1.3 million—a 63 percent increase. (For these 3

years combined, FHA insured over 3 million mortgages with a total

value of $292 billion.) 122 This dramatic increase in endorsements,

however, has been accompanied by a similar increase in delinquency and foreclosure rates. In fact, as the HUD/OIG reported in

2000, there has been

‘‘an increase of over 50 percent in FHA loan foreclosure

rates over the last 5 years from 1.45 percent in 1994 to

2.20 percent through three quarters of 1999. Similarly,

Mortgage Banker Association data shows an increase of

over 18 percent in FHA delinquency rates (from 7.26 percent to 8.57 percent) during the same period.’’ 123

The Mortgage Bankers Association National Delinquency Survey

report for the fourth quarter of 1999 explains further that,

‘‘[t]he inventory of loans in foreclosure at the end of the

quarter declined for conventional loans, but rose for FHA

and VA loans. The percentage of FHA loans in foreclosure

increased 3 basis points to 2.01 percent.’’ 124

Thus, although FHA points to the aggregate increase in American

home ownership as a measure of success, the associated rise in defaults and foreclosures HUD has permitted through lax oversight

suggests that FHA is subjecting the MMIF to greater risks by endorsing mortgages made to unqualified borrowers. Findings by both

the U.S. General Accounting Office and HUD’s/OIG support this

conclusion.

(d) HUD’s Response

In response to these criticisms, then-Secretary Cuomo simply denied the accuracy of the figures produced by MBA, and quoted by

the OIG, that indicate this steady rise in FHA defaults and foreclosures. Implicitly acknowledging the criticism, however, HUD has

announced a series of programs designed to curb fraud and waste

in the Single Family Insured Program, as follows:

37

125Office of the Inspector General, U.S. Department of Housing and Urban Development,

Audit Report # 99–DE–121–0001, Department of Housing and Urban Development’s Loss Mitigation Program (September 30, 1999) [hereinafter ‘‘HUD/OIG Loss Mitigation Program’’], at 1. 126Office of the Inspector General, U.S. Department of Housing and Urban Development,

Semiannual Report to the Congress (April 1, 1999-September 30, 1999), at 10.

(i) Loss Mitigation Program

Until April 1996, FHA-insured homeowners who encountered

financial difficulties had the benefit of the FHA Assignment Program, which was designed to provide temporary relief for mortgagors who experience financial difficulties resulting in mortgage

default. The relief offered by this program was in the form of a

mortgage assignment to HUD with a forbearance plan that offered

reduced or suspended payments for a period of up to 36 months.

The Assignment Program was terminated in April 1996 by the

Balanced Budget Downpayment Act. Its replacement, FHA’s Loss

Mitigation Program, is designed to reduce the number of foreclosures and the costs associated with foreclosures. Under this program, lenders are compensated for using one of five loss mitigation

tools to help borrowers in default avoid foreclosure:

• Special forbearance: This allows a period of reduced (or

even suspended) payments for the borrower, and is designed to provide relief to borrowers with temporary financial problems.

• Mortgage Modification: This results in the lowering of

the interest rate, or the extension of the term of the

mortgage, so as to reduce monthly payments to affordable levels for the mortgagor. Mortgage modifications

are designed for borrowers who have recovered from financial distress, but whose net income has permanently

dropped from its level prior to default.

• Partial claim: This provides what is essentially a second

loan on the property. In such cases, FHA pays the

amount necessary to cure the default, and a promissory

note is issued to secure repayment of the partial claim.

The second loan is interest free, and need not be paid

until the first mortgage matures, is prepaid, or the borrower vacates the property.

• Preforeclosure sale: In these cases, a borrower’s home is

sold prior to foreclosure and the borrower is relieved of

his mortgage obligation. The borrower’s debt is forgiven.

• Deed-in-lieu of foreclosure: This provides for voluntary

transfer of the deed to the lender; used primarily when

pre-foreclosure sale fails.125

As part of the HUD 2020 Management Reform, the National Servicing and Loss Mitigation Center became fully operational in Oklahoma City in February 1998. This Center consolidated HUD’s loss

mitigation function into a single centralized office and created a

single point of contact for lenders and borrowers.126

Unfortunately, HUD had difficulty in ensuring proper oversight

even over the programs it developed in order to mitigate the foreclosure problems caused by its failure properly to oversee its FHAbacked single-family loan program. A September 1999 HUD Office

38

127 HUD/OIG, Loss Mitigation Program, supra, at i. 128Servicing lenders must report to HUD monthly on the current status of all loans that are

in default for 90 days or more. The SFDMS is the only database that stores and maintains default status codes. HUD’s only other means of obtaining default status data is from the Government National Mortgage Association default data, which is compiled on a quarterly basis, or by

calling the lender directly to determine the status of individual FHA loans. See generally HUD/

OIG, Loss Mitigation Program, supra, at 23–24. 129 William Apgar, Federal Housing Commissioner, U.S. Department of Housing and Urban

Development, remarks at HUD/OIG Manager’s Conference (June 7, 2000). 130See Capitol Mortgage Banker, Inc. v. Cuomo, 77 F.Supp. 690 (D.Md. 1999).

of the Inspector General (HUD/OIG) report, for example, found that

the utilization of home retention and loss mitigation tools had increased dramatically in the preceding year. The report, however,

also found a lack of program oversight and weaknesses in the monitoring of mortgagees.127 Specifically, the report found that HUD

needed to improve its review of loss mitigation claims, and its monitoring and oversight of lenders’ use of loss mitigation tools. Furthermore, the HUD/OIG also raised concerns that HUD’s ability to

effectively monitor the FHA loan portfolio is compromised because

of inaccurate and incomplete information contained within its Single Family Default Monitoring System (SFDMS).128 Unreliable default status information, which it transmitted by servicing mortgagees to HUD, clearly makes it difficult to assess the potential risk

and cost to the FHA insurance fund.

(ii) Credit Watch

Credit Watch is a computer system HUD implemented in May

1999 to evaluate the performance of lenders and track loans they

have made so that, even when a loan is sold to another lender and

later goes into default, the originating lender for that loan will be

credited with the default.129 Credit Watch is designed to enable

HUD to terminate the loan origination authority of lenders with

excessive defaults and insurance claims on FHA-insured mortgages. Pursuant to the program, HUD may terminate the loan

origination authority of any lender whose default and claim rates

on FHA-insured mortgages during the preceding 24 months exceeds both the national average and 300 percent of the average

rate for the HOC serving the lender’s geographic location. (Similarly, HUD may place on ‘‘credit watch’’ the lenders whose default

and claim rates exceeds both the national average and 200 percent

of the corresponding HUD field office average.) While on credit

watch, a lender can continue to originate FHA-insured loans, but

its performance receives greater scrutiny from HUD. Because the

program regulations pertain only to lenders that originated the

troubled loans, however, HUD does not always hold accountable

the DE lenders that underwrote and approved the loans.

The first round of Credit Watch terminations occurred on September 15, 1999, when HUD ended its relationship with 26 FHA

lenders because they had default/claim rates that exceeded the national rate and 300 percent of the HOC rate. Another 100 lenders

were placed on the Credit Watch list for monitoring. One of the 26

FHA lenders, Capitol Mortgage Banks, Inc., however, successfully

challenged HUD’s authority to take this action in Federal court in

Baltimore.130 Specifically, the court found that FHA exceeded its

authority in terminating that lender, and declared the Credit

Watch basis for termination was unlawful and invalid. The court

39

131 U.S. Department of Housing and Urban Development, press release, ‘‘Cuomo Announces

New Initiative to Protect Consumers from Buying HUD-Insured Homes with Undetected Defects’’ (June 10, 1999) [hereinafter ‘‘June 10, 1999 press release’’] http://www.hud.gov/

pressrel/pr99–99.html. at 1 132 June 10, 1999 press release, supra, at 1. 133 Id. 134 Id.

also ruled that HUD must in the future give lenders an opportunity to take corrective action before termination occurs. For these

reasons, the court ordered the reinstatement of Capitol Mortgage

Bankers as an FHA-approved lender.

The decision was appealed by HUD, and in September 2000, the

Fourth Circuit Court of Appeals in Richmond, Virginia ruled that

HUD had acted appropriately and overturned the District Court

decision. In July 2001, the Senate Appropriations Committee included language in the fiscal year 2002 Veterans Affairs-HUD Appropriations Bill, S. 1216, that would allow HUD to review early

defaults and claims, and if appropriate, result in the automatic suspension or termination of poor performing mortgagees.

(iii) The Homebuyer Protection Plan

In June 1998, HUD announced a new Homebuyer Protection

Plan ‘‘to improve home appraisals for over 1 million families who

purchase homes each year with HUD-insured mortgages.’’ 131 HUD

described this plan as featuring six key components:

• A new consumer education campaign about appraisals

and inspections conducted by HUD, the National Association of Realtors, and the Mortgage Bankers Association of America.132

• Mandatory testing of all appraisers to determine whether

they are qualified to perform FHA appraisals. Approximately 30,000 private appraisers around the Nation,

who perform mandatory appraisals before the sale of

every home financed with an FHA mortgage, will be

tested. Appraisers failing this test will not be certified

to perform FHA appraisals until they pass the exam,

which is intended to help ensure that appraisers know

and understand FHA requirements.133

• More thorough and reliable appraisals designed to uncover significant defects in homes.134 HUD sought to accomplish this change through revision of its comprehensive valuation package (CVP), which consists of three

parts. Its first part is the Uniform Residential Appraisal

Report (URAR), which was not modified. The second

part is the ‘‘Valuation Conditions—Notice to the Lender’’ form (‘‘VC sheet’’), which the appraiser is required to

complete to reflect readily observable information relevant in determining the property’s ‘‘as-repaired’’ value.

HUD revised the VC sheet to reflect more specific conditions relevant to determining whether the property

meets HUD’s Minimum Property Standards or Requirements (MPS/MPR), but HUD nevertheless maintains

that the requirements of the new VC sheet are not materially different from the previous version of the VC

40

135Office of the Assistant Secretary for Housing-Federal Housing Commissioner, U.S. Department of Housing and Urban Development, Mortgagee Letter 99–32 (November 12, 1999) [hereinafter ‘‘Mortgagee Letter 99–32’’], http://www.hudclips.org/sub—nonhud...MLET&u=./

hudclips.cgi&p=1&r=28&f=G, at 1. 136 June 10, 1999 press release, supra, at 1. 137Office of the Assistant Secretary for Housing-Federal Housing Commissioner, U.S. Department of Housing and Urban Development, Mortgagee Letter 99–18 (June 28, 1999) [hereinafter

‘‘Mortgagee Letter 99–18’’], http://www.hudclips.org/sub—nonhud...MLET&u=./

hudclips.cgi&p=1&r=43&f=G, at 2. 138 June 10, 1999 press release, supra, at 1. 139 Id. 140 Id. 141Mortgagee Letter 99–32, supra, at 2

sheet.135 The third and final part is the Homebuyer

Summary, which the appraiser must prepare if he notes

any MPS/MPR nonconformity on the property.

• Mandatory disclosure of detected home defects to home

buyers through the Homebuyer Summary.136 The appraiser must sign the Homebuyer Summary and provide

it as part of the CVP to the lender. The lender is then

responsible for providing each prospective borrower with

the Homebuyer Summary when the appraiser has noted

a nonconformity on the property. The lender’s Direct

Endorsement underwriter must review the Homebuyer

Summary to assure that it is complete. Borrowers must

receive the Homebuyer Summary at least 5 days prior

to the loan closing, and must sign and date it to acknowledge their receipt. (The lender must also include

a copy of the summary in the case binder it submits to

FHA for insurance endorsement.) Repair items must be

completed prior to the loan closing.137

• Automated evaluation of appraisals. HUD will establish

a system that enables it to collect appraisal data electronically and to track trends in appraisal quality. The

new system is designed to enable HUD to perform highspeed computer-generated reviews of the performance of

all appraisers, so that appraisers found to make inaccurate appraisals can be spotted and targeted for further review and possible enforcement action. HUD has

developed a series of statistical indicators to help target

its appraiser oversight activities, particularly its field

review activities. These indicators work by comparing

home values derived by appraisers and the techniques

used to establish the values. Individual indicators are

then combined into a single appraisal score using a statistically-derived weighting system.138

• Stricter enforcement action to suspend poorly performing

appraisers from working for FHA.139

Although at the time of its announcement, HUD planned to

phase in all aspects of the Homebuyer Protection Plan ‘‘over the

next few weeks[,]’’ 140 HUD ultimately delayed until March 1, 2000

implementation of the regulatory changes relating to its enforcement actions against appraisers who perform appraisals that are

not in compliance with FHA requirements.141

41

142Mortgagee Letter 99–18, supra, at 2. 143 June 10, 1999 press release, supra, at 1. 144Mortgagee Letter 99–18, supra, at 2–3.

In addition, under HUD’s plan, home buyers are now required to

sign and date a new informational form entitled, ‘‘For Your Protection: Get a Home Inspection,’’ before they purchase a home with an

FHA mortgage.142 (This form replaced the ‘‘Importance of Home Inspections’’ form that was previously required.) According to HUD,

this new form ‘‘advises [home buyers] in plain English to get a

home inspection in addition to an appraisal.’’ 143 It informs buyers

that FHA does not guarantee the value or condition of the property, that an appraisal is not a home inspection, and that the borrower has the right to have the house inspected by a professional

home inspector. For all transactions involving FHA mortgage insurance on existing property, the home buyer must sign and date

this form on or before the date that the sales contract is executed.

The lender must also include a copy of the signed and dated form

in the case binder it submits to FHA for insurance endorsement.144

(iv) Fraud Protection Plan

HUD’s Fraud Protection Plan is an outgrowth of its Baltimore

Task Force. Working with Senator Mikulski as a result of constituent complaints and reports that appeared in the Baltimore

Sun, HUD launched the Baltimore Task Force in April 2000. Its

purpose was to gather information on the cause and extent of mortgage frauds and resulting foreclosures, and to develop recommendations that would both benefit Baltimore and serve as a

model for FHA programmatic reform throughout the Nation. FHA

declared a 90-day moratorium on foreclosures of FHA-insured loans

in Baltimore, which enabled HUD to send a so-called ‘‘SWAT

Team’’ of departmental officials to Baltimore to identify fraud or

predatory practices involved in FHA-backed loans before foreclosures and to help as many homeowners as possible avoid foreclosures. HUD staff intensively reviewed case files for the 350 FHA

borrowers in Baltimore who had received a notice of intent to foreclose after January 1, 2000, and found evidence of fraud or predatory lending in 50 to 60 cases. To help defaulting Baltimore homeowners avoid foreclosure, FHA attempted to contact all borrowers

facing impending foreclosures in order to better focus resources on

loss mitigation assistance. In ‘‘Hot Zone’’ areas, which it defines as

areas with high concentrations of FHA foreclosures, FHA undertook to establish teams of loss mitigation specialists to work with

lenders and borrowers to ensure that every effort is made to help

families remain in their homes. In addition, FHA contacted the corresponding lender for each borrower to ensure that the lenders

were properly evaluating borrowers and offering appropriate foreclosure avoidance options.

At its public forum in Baltimore on May 19, 2000, HUD announced its Fraud Protection Plan, which seeks to apply the Baltimore Task Force’s recommendations to the rest of the country. The

Plan has two primary foci: (1) Providing relief to FHA borrowers

who are already in default, especially those who have been victimized by abusive lending practices; and (2) strengthening FHA enVerDate 11-MAY-2000 08:24 Oct 05, 2001 Jkt 000000 PO 00000 Frm 00045 Fmt 6633 Sfmt 6601 75382.TXT SAFFAIRS PsN: SAFFAIRS
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dorsement and fraud detection procedures to prevent predatory

practices from occurring in the first place.

To achieve its first goal of assisting FHA borrowers already in

default, HUD proposed to issue vouchers for fund foreclosure avoidance counseling at HUD-approved locations. By expanding the

availability and improving the quality of such counseling, HUD

sought to help homeowners make better use of currently available

loss mitigation tools, such as mortgage modification and partial

loan forgiveness.

For FHA borrowers saddled with inflated mortgages that stem

from inflated appraisals, HUD plans to direct mortgage lenders to

write down their mortgages to a level consistent with fair market

appraisals. In situations where the lender refuses to honor this demand, FHA intends to intervene, cancel the existing mortgage, and

refinance the property with a mortgage at the fair market value.

The FHA insurance fund would bear the cost of redeeming the

mortgage at the fair market value, and it is estimated that the cost

in Baltimore alone could reach $30 million. In addition, HUD will

instruct lenders to issue a ‘‘credit repair’’ letter, which is designed

to help ensure that the victim’s credit record is not harmed simply

because the victim fell prey to fraud and predatory lending practices. HUD also intends to send teams of loss mitigation specialists

to ‘‘Hot Zones’’ with high default and foreclosure rates, in order to

ensure that every effort is made to help families remain in their

homes.

To achieve its second goal of stopping predatory practices from

undermining FHA’s ability to promote housing opportunity, FHA

will implement an automated system to review the sales price history of properties prior to FHA insurance endorsement. This may

be one of the Plan’s most promising initiatives, insofar as such a

system would reveal when a house purchased for a very low price

is quickly resold for a much higher price. Through such tracking

of the warning signs of a potential ‘‘flip,’’ officials would be able to

intervene much more rapidly to both protect victims and punish

wrongdoers. In addition, FHA will form additional ‘‘SWAT Teams,’’

modeled on the Baltimore effort, to target abusive appraisal practices in Hot Zones around the country. (FHA also intends to suspend abusive real estate brokers from future participation in FHA

programs, although it has not provided any specific information regarding how it plans to accomplish these suspensions.) Additionally, FHA intends to study its data on housing sales with an eye

to developing early warning indicators of foreclosure ‘‘Hot Zones.’’

Finally, FHA is launching a new Appraisal Watch system modeled after the Credit Watch system now targeted to lenders. The

goal of Appraisal Watch is to identify appraisers with a record of

faulty appraisals and abusive practices, terminate them from FHA

programs, and, if appropriate, pursue legal action.

(v) Mortgage Credit Scorecard Project

The Mortgage Credit Scorecard Project is a new automated underwriting system that gives credit scores for lenders. To accomplish this, it establishes lender profiles to be used to evaluate loan

information that has been entered into the automated underwriting

system. At present, one third of all FHA loans are processed

43

145Federal Housing Administrator William Apgar, remarks at HUD/OIG Manager’s Conference (June 7, 2000). 146Subcommittee staff telephone interview with Judy Heaney, Community Builder, U.S. Department of Housing and Urban Development, Chicago, Illinois (June 16, 2000).

through this system, and the number of mortgages processed

through the system is expected to increase to 50 percent within the

next year.145 (According to HUD, this reform is still in the ‘‘drawing board’’ stage.146)

V. Agency Criticisms of HUD

A. General Accounting Office

(1) GAO on HUD’s Lack of Lender Oversight

Recent cases of mortgage fraud across the country have raised

concerns about HUD’s oversight of FHA-insured lenders. For example, in December 1999, HUD’s Office of the Inspector General and

the Department of Justice announced criminal charges against 39

California mortgage lenders, real estate professionals, and other

persons they accused of obtaining more than $110 million in fraudulent FHA-insured loans. At the request of Senator Collins and

Representative Rick Lazio (R–NY), GAO prepared a report entitled, ‘‘Single Family Housing: Stronger Oversight of FHA Lenders Could

Reduce HUD’s Insurance Risk.’’ GAO’s report addressed the following questions: (1) How well

does HUD ensure that lenders granted DE authority by FHA are

qualified to receive such authority? (2) To what extent does HUD

focus on high-risk lenders in monitoring the lenders participating

in FHA’s mortgage insurance programs? (3) To what extent is HUD

holding lenders accountable for poor performance? To address these

questions, GAO reviewed the activities of HUD headquarters and

its four Home Ownership Centers located in Atlanta, Georgia; Denver, Colorado; Philadelphia, Pennsylvania; and Santa Ana, California.

(a) Approval of Lenders to Receive DE Authority

HUD’s process for granting FHA-approved lenders DE authority

provides limited assurance that lenders receiving this authority are

in fact qualified. According to HUD’s guidance, FHA-approved lenders seeking DE authority must demonstrate ‘‘acceptable performance’’ in underwriting at least 15 mortgage loans, which undergo

evaluations, known as preclosing reviews, by HUD’s HOCs. The

guidance does not, however, define what would constitute overall

acceptable performance on the 15 loans.

In the absence of such a clear definition, the various HOCs have

interpreted what constitutes acceptable performance differently,

and their standards for approving lenders for DE authority have

thus been inconsistent. In the 6 months prior to GAO’s 1999 visits,

for instance, the HOCs granted DE authority to a total of 36 lenders. While many of these lenders had demonstrated proficiency in

underwriting mortgages, many others made multiple and serious

underwriting errors. Overall, 12 of the 36 lenders had received 4

or more ‘‘poor’’ ratings from the HOCs for their last 15 preclosing

reviews.

According to GAO, the vagueness and inconsistent application of

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gram. GAO recommended that HUD improve the process for granting lenders DE authority by developing specific standards for overall acceptable performance in pre-closing reviews and ensuring that

the HOCs comply with these standards.

(b) Monitoring of Lenders

(i) On-Site Lender Reviews

Contrary to HUD’s guidance, the HOCs’ monitoring of lenders

does not adequately focus on the lenders and loans that pose the

greatest insurance risks to HUD. On-site evaluations of lenders’ operations—known as lender reviews—are one of HUD’s primary

tools for assessing the quality of lenders’ mortgage-lending practices. HUD’s guidance states that 85 percent of the lender reviews

should be targeted at high risk lenders, while 15 percent should be

selected randomly. HUD’s guidance also stresses the importance of

using risk analysis to allocate a larger share of monitoring resources to program activities that pose the highest risk to HUD.

GAO found that lender reviews by HUD have increased in recent

years, as HUD has placed greater emphasis on performing on-site

evaluations of lenders’ operations.

Nevertheless, GAO found that the HOCs have often not bothered

to review the lenders and loans that they themselves consider to

present the highest risks. For example, although the Philadelphia

HOC conducted reviews of 228 lenders during fiscal year 1999, it

reviewed only 39 of the 131 high-risk lenders (about 30 percent)

that it had designated as high priorities for review that year. HUD

officials told GAO that the lack of experienced staff and limited

travel funds impeded HUD’s ability to visit and review the riskiest

lenders—although the HOC apparently had no problem devoting

staff and financial resources to reviewing 189 lower-risk lenders instead of increasing the proportion of high-risk ones it evaluated.

GAO also noted that HUD placed too much emphasis upon meeting

numeric goals (e.g., being able to claim a higher aggregate number

of lenders reviewed) instead of actually targeting high-risk loans.

GAO recommended that HUD more effectively monitor lenders’

performance by developing procedures to identify and prioritize

high-risk lenders for review and ensuring that the HOCs consistently apply these procedures.

(ii) Post-Endorsement Technical Reviews

Desk audits to evaluate the underwriting quality of individual

loans already committed to FHA insurance by DE lenders—known

as post-endorsement technical reviews—are another important

lender oversight tool. The large majority of HUD’s technical reviews are performed by firms under contract with the HOCs. Technical reviews that reveal deficiencies may result in HUD requiring

the lenders to compensate it for financial losses, or in HUD simply

suspending the lenders’ DE authority.

Although all four HOCs met HUD’s goal to perform technical reviews of no less than 10 percent of all loans insured in fiscal year

1999, they generally did not target these reviews either toward

loans that exhibit high-risk characteristics, or toward loans that

were made by high-risk lenders, such as those with known performance problems. The HOCs also did not comply with HUD guidVerDate 11-MAY-2000 08:24 Oct 05, 2001 Jkt 000000 PO 00000 Frm 00048 Fmt 6633 Sfmt 6601 75382.TXT SAFFAIRS PsN: SAFFAIRS
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ance specifying that all loans by newly approved DE lenders should

be subject to technical reviews. As a result, according to GAO, underwriting practices that significantly increase HUD’s insurance

risk may be going undetected.

One reason for this failure to target risky loans and lenders is

that HUD’s computer system currently cannot automatically identify and select high-risk loans for review. HUD has advised GAO

that it is developing a ‘‘mortgage scorecard’’ computer system

which, it believes, will make identification of high-risk loans easier.

Another problem GAO found concerned HUD’s oversight of the

contractors that conduct the bulk of its technical reviews. Each

such contract contains specific performance standards expressed as

the maximum accepted percentage of reviews that can contain significant errors, or omissions. GAO found that three of the four

HOCs were not tracking the contractors’ work against these standards. Without this information, the HOCs were not in a position to

provide the contractors with adequate performance feedback or, if

necessary, to enforce the contracts’ performance clauses.

GAO recommended that HUD develop procedures and enhance

FHA’s management information systems in order to identify and

select for technical review loans and lenders within each HOC jurisdiction that pose a high insurance risk to HUD. GAO also recommended that HUD comply with guidance to perform technical

reviews of all the FHA-insured loans that are made by lenders that

possess newly granted DE authority. In addition, GAO recommended that HUD track the performance of contractors conducting technical reviews against performance standards in the

contracts, and take appropriate actions against contractors whose

performance is not acceptable.

(c) Enforcement Actions Against Lenders

To hold lenders accountable for program violations or poor performance, HUD may (1) suspend their DE authority, (2) terminate

their loan origination authority through its Credit Watch program,

or (3) take enforcement action through its Mortgagee Review

Board. Despite the availability of these measures, GAO found that

HUD has not taken sufficient steps to hold lenders accountable for

poor performance and program violations.

(i) Suspension of DE Authority

Although HUD’s guidance allows the HOCs to suspend the DE

authority of lenders who fail to comply with FHA’s underwriting

requirements, the HOCs have made only limited use of this authority. In fiscal year 1999, for example, the Philadelphia HOC suspended the DE authority of eight lenders—but it was the only HOC

to suspend any lenders. Furthermore, HUD’s technical review ratings for fiscal year 1999 showed that lenders frequently failed to

comply with FHA’s requirements, suggesting that many other lenders may by candidates for suspension.

GAO also found that the HOCs had not developed consistent criteria for evaluating lenders’ ratings for mortgage credit analysis

and suspending lenders’ DE authority. Nearly 20 percent of the

loans subject to HUD technical reviews received ‘‘poor’’ ratings for

mortgage credit analysis, meaning that the lenders were found to

46

have made mistakes in evaluating the borrowers’ credit worthiness

that significantly increased HUD’s insurance risk. This proportion,

however, apparently understates the problem. In its own assessment, GAO identified 206 lenders that received ‘‘poor’’ ratings for

their mortgage credit decisions in more than 30 percent of the

loans HUD reviewed in fiscal year 1999. On the basis of this sample, a HUD review of all of the lenders’ fiscal year 1999 loans

should have found that the percentage of poor ratings exceeded 30

percent.

Despite the high proportion of ‘‘poor’’ ratings, moreover, the

HOCs took little action against the problem lenders. Of the 206

lenders identified by GAO as having received poor ratings, 131 had

made 10 or more FHA-insured loans in fiscal year 1999. As of October 1, 1999, however, the HOCs had not suspended the DE authority of any of these 131 problem lenders. Accordingly, GAO recommended that HUD strengthen its enforcement efforts by clarifying and implementing guidelines for identifying lenders whose

DE authority should be suspended.

(ii) Credit Watch

As noted previously, HUD implemented its Credit Watch program in May 1999 in order to terminate the loan origination authority of lenders with excessive defaults and insurance claims on

FHA-insured mortgages. Specifically, 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 HOC 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, a lender can continue to originate

FHA-insured loans, but its performance receives greater scrutiny

from HUD. (Because the program regulations pertain only to lenders that originated the troubled loans, however, HUD does not always hold accountable the DE lenders that underwrote and approved the loans.)

HUD officials recognize that DE lenders contributed to excessive

defaults and insurance claims, but that the Credit Watch program

did not extend to DE lenders. HUD officials have also indicated

that HUD has considered regulatory changes in order to solve this

problem. Among other issues, the lender challenging the program

has contended that HUD has exceeded its statutory authority when

it issued its Credit Watch regulations and that the manner in

which HUD terminated the lender’s authority deprived the lender

of due process. In October 1999, a U.S. District Court ruled that

the regulations were invalid and set aside HUD’s termination decision. The decision was appealed by HUD, and in September 2000,

the Fourth Circuit Court of Appeals in Richmond, Virginia ruled

that HUD had acted appropriately and overturned the District

Court decision.

In July 2001, the Senate Appropriations Committee included language in the fiscal year 2002 Veterans Affairs-HUD Appropriations

Bill, S. 1216, that would allow HUD to review early defaults and

47

claims, and if appropriate, result in the automatic suspension or

termination of poor performing mortgagees.

GAO recommended that, once the legal basis for the Credit

Watch program is resolved, HUD revise these regulations to cover

DE lenders that underwrite FHA-insured loans with excessive default and claim rates, as well as those lenders who originate such

loans.

(iii) Mortgagee Review Board

HUD’s Mortgagee Review Board can impose administrative actions against FHA lenders who commit program violations. Most of

the Board’s actions result in settlement agreements, which require

lenders to indemnify improperly originated loans, pay fines, and/or

take actions to prevent future lending violations.

GAO found, however, that the Mortgagee Review Board’s process

for sanctioning lenders is overly time consuming. Administrative

actions against FHA lenders who commit program violations frequently take more than 1 year to impose. As a result, some of these

lenders continue making FHA-insured loans for 1 year or more

after FHA has identified them as violators before being held accountable for past violations. HUD does not maintain guidelines for

the time it should take the Board to take enforcement actions

against lenders.

(d) Agency Comments

HUD responded that, while it did not always agree with the

GAO report’s characterization of its practices and procedures for

overseeing FHA lenders, it generally agreed with GAO’s recommendations. Among HUD’s specific objections, however, were

the following:

• HUD took issue with GAO’s statement that its selection

of loans for post-endorsement technical review was not

based on risk. HUD maintained that it performs technical reviews of all higher default-rate type loans.

• HUD disagreed with GAO’s finding that it was not monitoring the performance of technical review contractors.

(GAO responded that it had not, in fact, claimed that

HUD did no monitoring.)

• HUD commented that GAO’s discussion of technical

lender reviews did not adequately recognize that its targeting guidance requires HOC staff to consider several

factors in addition to lenders’ default and claim rates.

• HUD disagreed with GAO’s recommendation that it

clarify and implement guidelines for identifying lenders

whose DE authority should be suspended. HUD said

that it has threatened suspension in several dozen cases

in an attempt to improve lenders’ performance. According to HUD, the threat of a suspension has proven to be

a constructive and successful means of improving lenders’ performance.

• Finally, HUD agreed with GAO’s recommendation to revise its Credit Watch program to hold both loan underVerDate 11-MAY-2000 08:24 Oct 05, 2001 Jkt 000000 PO 00000 Frm 00051 Fmt 6633 Sfmt 6601 75382.TXT SAFFAIRS PsN: SAFFAIRS
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writers and loan originators accountable for excessive

default and claim rates.

(2) HUD’s Lack of Appraiser Oversight

The purpose of an FHA appraisal, which is required for each

property the agency insures, is (1) to determine the property’s eligibility for mortgage insurance on the basis of its condition and location, and (2) to estimate the value of the property for mortgage insurance purposes. In performing these tasks, the appraiser is required to identify any visible deficiencies impairing the safety,

sanitation, structural soundness, and continued marketability of

the property and to assess the property’s compliance with FHA’s

other minimum property standards. According to HUD guidance, if

an appraiser finds noncompliance with these standards, he should

include in his appraisal report an appropriate and specific action

to correct the deficiency.

On-site assessments of completed appraisals, known as field reviews, are HUD’s principal tool for monitoring the performance of

the appraisers on FHA’s roster. In conducting a field review, a

HUD official or contractor visits the appraised property to evaluate

all aspects of the appraisal, including whether the value determination was reasonable and whether all needed repairs were identified. The field reviewer is required to document these findings on

a standard HUD form and recommend a score using a scale from

1 to 5 to assess the quality of the appraisal (with 1 being unacceptable and 5 being excellent).

The four Home Ownership Centers are expected to play important roles in HUD’s oversight of the FHA appraisal process. According to HUD, its Real Estate Assessment Center is responsible

for analyzing and tracking appraisal quality and appraiser performance, and its Enforcement Center is responsible for sanctioning appraisers, mortgage brokers, and lenders who do not comply with HUD’s requirements.

On June 1, 1999, HUD announced a Homebuyer Protection Plan

that HUD intended to implement in order to improve the FHA appraisal process. Specifically, the plan: (1) requires that appraisals

include a more thorough basic survey of the physical condition of

homes; (2) requires lenders to inform potential home buyers of defects found during appraisals; (3) requires appraisers to recommend

complete, detailed inspections of homes if the appraisers find significant problems with the properties; (4) allows up to $300 of home

inspection costs to be financed through FHA mortgages; and (5) imposes stricter accountability on appraisers and tougher sanctions

on those who act improperly, including fines and potential prison

sentences. HUD’s announcement did not identify a specific timetable for implementing the plan.

Pursuant to a congressional request, GAO reviewed FHA’s appraisal process, focusing on (a) how HUD ensures that appraisers

on its roster are qualified to perform FHA appraisals; (b) how well

HUD is monitoring the performance of the appraisers on its roster

and implementing procedures for addressing consumers’complaints

about FHA appraisals; (c) the extent to which HUD is holding appraisers accountable for poor-quality FHA appraisals; and (d) the

extent to which HUD is holding lenders responsible for the quality

49

of the FHA appraisals they use. On April 16, 1999, GAO presented

its findings in a report entitled, ‘‘Single-Family Housing: Weaknesses in HUD’s Oversight of the FHA Appraisal Process.’’

(a) HUD Has Limited Assurance That Appraisers Are Familiar With FHA’s Appraisal Requirements

Only appraisers approved by FHA may evaluate homes for FHA

insurance endorsement purposes. To be eligible for FHA’s roster of

approved appraisers, appraisers must be State licensed or certified

in accordance with the minimum criteria established by the Appraiser Qualifications Board of the Appraisal Foundation. The

Qualifications Board’s minimum licensing criteria require that appraisers have 90 hours of classroom education in subjects related

to real estate appraisals, have 2,000 hours of appraisal experience,

and pass the Qualifications Board’s endorsed examination or an

equivalent examination.

Unlike appraisals for conventional mortgages, appraisals for

FHA-insured mortgages must include an assessment of the properties’ compliance with FHA’s property standards as well as appropriate and specific actions to correct conditions not in compliance

with these standards. In addition, the value that an appraiser assigns to a property must reflect its value with all the required repairs completed.

HUD relies largely on the States’ licensing process to ensure that

appraisers are qualified. The States’ minimum licensing standards,

however, do not include proficiency in FHA’s appraisal requirements. In conjunction with its Homebuyer Protection Plan, HUD

developed a new appraisal report, known as the ‘‘valuation condition’’ report, to record the results of appraisals. The new report

lists specific physical conditions for which the appraiser should

check, and requires the appraiser to recommend whether a complete home inspection or some other type of more specific inspection (e.g., electrical, roofing, or structural) should be conducted.

HUD will require lenders to provide a summary of this appraisal

report to home buyers so that they will have information about

needed repairs and recommended inspections.

HUD has also implemented a requirement that appraisers pass

a test on FHA appraisal requirements and procedures in order to

be deemed qualified to appraise FHA-backed properties. Some

questions remain about the efficacy of this solution, however. During the Subcommittee’s investigation, staff was informed by a number of experienced appraisers that the new FHA-required test is

much too easy to pass. Moreover, some appraisers were permitted

to take the test in an ‘‘open book’’ setting. Under the circumstances, therefore, it is hard to tell whether this test will appreciably increase the quality of appraisals at FHA-backed properties.

(b) HUD’s Monitoring of Appraisers Is Limited

GAO found that HUD was not doing a good job of monitoring the

performance of appraisers, thereby limiting its ability to assess the

quality of appraisals used to qualify properties for FHA-insured

loans. For example, the Philadelphia and Denver HOCs’ records for

126 field reviews that rated appraisals as ‘‘poor’’ showed that HUD

50

nonetheless approved mortgage insurance for 96 of the homes covered by these unsatisfactory reviews. (In 37 of the 96 cases, the

field reviews were performed after mortgage insurance had been

approved.)

Specifically, GAO found that weaknesses existed in the scope of

field review coverage. In September 1997, HUD established a policy

requiring its field offices and their successors, the HOCs, to conduct field reviews of no less than 10 percent of the appraisals conducted within their jurisdictions. In fiscal year 1998, HUD performed about 81,000 of these reviews, but three out of the four

HOCs did not meet the 10 percent requirement in fiscal year 1998.

HUD also did not conduct field reviews of the work of many of the

appraisers with the highest workloads. For example, HUD did not

field review the work of thousands of appraisers who conducted 10

or more FHA appraisals during the period from October 1, 1997,

through June 30, 1998. While HUD’s procedures do not require

field reviews for appraisers doing a higher volume of appraisals,

higher-volume appraisers presumably inherently have less time to

spend on any particular appraisal. Since HUD never bothered to

assess the performance of these high-volume appraisers, however,

it had little assurance that those appraisers were conducting accurate and thorough work.

Philadelphia and Denver HOC officials told GAO that several

factors contributed to problems with field review coverage. These

factors included: (1) HUD’s reliance upon contractors to conduct

field reviews and the unavailability of contract funds during the

first several months of the fiscal year; (2) the reassignment of personnel during HUD’s reorganization, which, in some instances, left

no one responsible for ordering field reviews; and (3) the lack of

emphasis that some field offices placed on field reviews once they

knew their functions would be transferred to the HOCs.

GAO also found that many field reviews were not timely—a problem that appears to have gotten worse over time. Although HUD

guidance states that timeliness is essential to ensure quality field

reviews, half of the field reviews conducted in fiscal year 1998 did

not occur until at least 77 days after the appraisals had been performed. In six of HUD’s field office jurisdictions, the corresponding

figure was 140 days or more. (By contrast, HUD reported in fiscal

year 1997 that all field reviews were being completed within 45

days of the appraisals.) Philadelphia and Denver HOC officials

plausibly told GAO that the reduced timeliness of field reviews

made it difficult to prevent the approval of FHA mortgage insurance for loans based on faulty appraisals and reduced the usefulness of field review reports as a monitoring and enforcement tool.

In addition, GAO found that HUD’s oversight of field review

contractors was limited. At the Philadelphia and Denver HOCs,

HUD staff did not routinely visit appraised properties to verify the

observations of field review contractors or take other measures systematically to evaluate the contractors’ performance. Officials at

both the Philadelphia and Denver HOCs told GAO that they rarely

conducted such evaluations because they lacked sufficient staff and

travel resources. As a result, they neither tracked the percentage

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147 HUD’s policy guidance stresses the importance of evaluating the work of field review contractors and states that 5 percent of every contractor’s work should be reviewed and rated on

scale from 1 to 5 (with 1 being unacceptable and 5 being excellent). The purpose of this rating

system is to document performance problems and justify disciplinary actions against field review

contractors, if necessary.

ated contractors’ performance with a numerical rating system.147

(Because HUD found it difficult to monitor such a large number of

contracts—estimated at 250—it planned to contract out the field

review function to a small number of large appraisal firms. It also

planned to have HUD staff perform quality assurance reviews of

the contractors.)

Moreover, GAO found that the Philadelphia and Denver HOCs

did not fully implement HUD guidance on handling and tracking

consumers’ complaints, including those relating to appraisals. In

October 1998, HUD officials told GAO that the Philadelphia HOC

was developing a set of written procedures for all four HOCs to follow. GAO found that the Philadelphia and Denver HOCs did not

have complaint tracking systems containing the information required by the December 1997 policy memorandum. Both HOCs

maintained logs showing, among other things, the HOC official assigned to follow up on a complaint and the date the follow-up action was completed. These logs did not include other required information, however, such as the nature of the complaint, the actions

taken to address it, or the final disposition of the complaint. (If

made available, this information would enable HOC management

readily to determine the frequency of different types of complaints

and ensure that all complaints were being resolved in an appropriate manner.) As a result of GAO’s work, however, HUD implemented changes to help ensure the recording of this information.

According to departmental officials, these changes have greatly improved the HOCs’ ability to handle complaints.

GAO concluded that the weaknesses it found in HUD’s oversight

of the FHA appraisal process increased FHA’s risk of insuring

properties that are overvalued or whose owners may default on

their FHA-insured loans because of unexpected repair costs. The

consequence of this increased risk is higher potential losses to

FHA’s insurance fund. GAO recommended that HUD achieve better

field review coverage of FHA’s appraiser roster by (1) ensuring that

each HOC reviews the required percentage (currently 10 percent)

of the FHA appraisals conducted annually within its geographic jurisdiction, and (2) requiring that when selecting appraisals for field

review, HUD staff give higher priority to the work of appraisers

who have done a substantial number of FHA appraisals but have

not been field-reviewed within the past year. GAO also recommended that HUD make field reviews of appraisals more timely by

establishing a process to ensure that HUD staff obtains copies of

appraisal reports and perform field reviews prior to FHA’s approval

of mortgage insurance. In addition, GAO recommended that HUD

better assess the quality of appraisal field reviews by insuring that

a portion of each field review contractor’s work is verified through

on-site evaluation of properties reviewed by the contractor.

In commenting upon GAO’s recommendation that HUD achieve

better field review coverage of FHA’s appraiser roster, HUD indicated that it would implement a revised field review process by

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July 1, 1999, to improve its sampling and targeting of appraisers

for field review. In response to GAO’s recommendation that HUD

conduct on-site evaluations of a portion of each field review contractor’s work, HUD indicated that it would begin performing supervisory reviews of contractors in conjunction with a national field

review contract scheduled to begin in July 1999. Implementation of

both of these changes was delayed until March 2000. HUD disagreed with GAO’s recommendation to improve the timeliness of

appraisal field reviews by obtaining copies of the appraisal reports

and performing field reviews prior to loan closings and the approval of FHA mortgage insurance. HUD indicated that the collection of all appraisals and the performance of field reviews before

the approval of mortgage insurance would be impractical and inconsistent with HUD’s Direct Endorsement Program, which allows

qualified mortgagees to process and close FHA loans without prior

review by HUD. In turn, GAO modified this recommendation to reflect the fact that it may be difficult for HUD to field review appraisals before the lenders close on the loans.

(c) HUD Sanctioned Few Poorly-Performing Appraisers

GAO found that HUD was not holding appraisers accountable for

the quality of their appraisals. A poor field review score (i.e., a

score of 1 or 2 on the abovementioned 1 to 5 scale) indicates that

the appraiser did not adequately support the value assigned to the

home, overlooked serious repair conditions, and/or made other errors and omissions that could result in an unacceptable insurance

risk to FHA. A poor field review rating indicates that HUD’s HOCs

may impose an administrative sanction, called a limited denial of

participation, that bars an appraiser from participating in FHA

programs for up to 1 year. HUD’s policy states that appraisers who

receive two or more poor scores in field reviews during any 12-

month period should be issued a limited denial of participation

temporarily prohibiting them from conducting further FHA appraisals for a period of time determined by FHA.

Despite the danger of allowing poor appraisers to continue conducting FHA appraisals, however, appraisers who received two or

more poor ratings in field reviews were frequently not prohibited

from conducting additional FHA appraisals. During the first three

quarters of fiscal year 1998, 246 of the 5,768 field-reviewed appraisers within the Philadelphia and Denver HOCs’ jurisdictions

received two or more poor field review scores. As of the end of that

fiscal year on October 1, 1998, however, HUD had issued limited

denials of participation to only 11 of those 246 appraisers.

GAO found that poor record-keeping by HUD field offices was the

primary reason for the HOCs’ inability to pursue enforcement actions against other poorly performing appraisers. HUD’s policy was

apparently to sanction appraisers only when there existed substantial evidence and documentation of performance that is less than

acceptable. Philadelphia and Denver HOC officials told GAO, however, that a lack of supporting documentation had hampered their

efforts to sanction appraisers. GAO verified this assertion through

its review of appraisers’ files at both the Philadelphia and Denver

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ports supporting the poor field review scores recorded in HUD’s

files were missing altogether.

GAO concluded that HUD’s ability to sanction poorly-performing

appraisers was seriously impaired by the loss or misplacement of

records prior to and during HUD’s field consolidation. Consequently, hundreds of appraisers whose work may be creating an

unreasonable underwriting risk for FHA apparently continued to

conduct appraisals for FHA-insured mortgages.

(d) HUD Has Not Aggressively Enforced Its Policy on Lender Accountability for Appraisals

HUD’s policy is that lenders are responsible, equally with the appraisers they select, for the accuracy and thoroughness of appraisals. In October 1994, HUD issued regulations implementing a legislative provision that allowed lenders to choose the appraisers of

properties to be insured by FHA. While the legislation did not address this issue, HUD’s regulations stated that lenders who selected their own appraisers were equally responsible, along with

the appraisers, for the accuracy, integrity, and thoroughness of the

appraisals. In May 1996, HUD repealed these regulations as part

of a larger Federal effort to reduce the regulatory burden of participating in government programs. According to HUD, the regulations

were not necessary because many of the standards in the regulations were already in HUD’s handbook guidance and mortgagee letters issued to lenders. Despite the repeal, therefore, it remained

HUD policy to hold lenders accountable for the actions of the appraisers they select.

Accordingly, HUD issued mortgagee letters to lenders in November 1994 and again in May and November 1997 reiterating its policy that lenders were equally responsible for the quality of appraisals. HUD’s Deputy Assistant Secretary also indicated that the failure of a lender voluntarily to resolve the appraisal deficiencies

raised by HUD would result in enforcement action against the

lender—including probation and suspension.

Nevertheless, according to GAO, HUD did not aggressively enforce this policy because of disagreement within HUD over its authority to do so. In May 1998, the Philadelphia HOC requested that

HUD’s Mortgagee Review Board sanction a lender who refused to

correct property deficiencies that an appraiser had overlooked. This

was the first case of this type that had been referred to the Board.

Ultimately, however, the Board never reviewed or acted on this request because its staff was concerned that HUD might now have

the authority to hold a lender accountable for the quality of an appraisal simply because the lender selected the appraiser in question. As a result, HOCs became reluctant to refer similar cases to

the Board.

To improve HUD’s oversight of lenders participating in FHA’s

programs, GAO recommended that HUD (1) determine the extent

of its authority to hold FHA-approved lenders accountable for poorquality FHA appraisals performed by the appraisers they select

from FHA’s roster, and (2) issue policy guidance that sets forth the

specific circumstances under which HUD may exercise this authority. HUD responded that it would target for monitoring those lenders that used poorly performing appraisers.

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148Office of Inspector General, U.S. Department of Housing and Urban Development, Semiannual Report to the Congress (October 1, 1999-March 31, 2000) [hereinafter ‘‘HUD/OIG, 1999– 2000 Semiannual’’], at 2. 149The OIG’s Housing Fraud Initiative (‘‘HFI’’) is described as ‘‘a proactive law enforcement

effort using a unified approach to the detection and prosecution of fraud in HUD programs.’’ HUD/OIG, 1999–2000 Semiannual, supra, at 12. HFI seeks to combine OIG audit and investigative resources with the investigative and prosecutive skills of the Federal Bureau of Investigation (FBI) and U.S. Attorney’s Offices in designated Federal judicial districts in order better to

root out fraud in HUD-funded activities. HFI was the result of concern by members of the House

Appropriations Subcommittee on VA, HUD, and Independent Agencies that HUD funds may not

be reaching those needing Federal assistance due to pervasive fraud. HFI began in October 1998

with the designation of six Federal judicial districts to serve as initial HFI sites. 150 Id. at 2.

B. HUD’s Office of the Inspector General

HUD’s/OIG, led by Inspector General Susan Gaffney, has been

vocal in its criticism of HUD’s management of the Single Family

Mortgage Insurance Program. The OIG notes that HUD has undertaken major structural and organizational changes in single family

operations over the last 5 years. These changes include the consolidation of field operations into the four HOCs, significant staffing

cuts in headquarters and field operations, and the delegation to

contractors of major portions of its workload. During this period of

change, the single family program has been particularly vulnerable

to fraud, waste, and abuse. Fortunately, a high mortgage insurance

premium structure, FHA’s abandonment of traditional insurance

fund mutuality principles, and a very strong economy in the late

1990’s enabled FHA easily to meet its capital reserve requirements.

An economic downturn, however, could seriously affect the financial well-being of FHA’s mortgage insurance fund.148

Over the past 2 years—through audits, investigations, and its

Housing Fraud Initiative,149—the HUD/OIG has examined nearly

every aspect of the single family program. All in all the OIG feels

that its work clearly demonstrates (1) a high incidence of fraud,

waste, and abuse in FHA’s single family operations, and (2) a clear

need for HUD to tighten controls over this multi-billion dollar

mortgage-insurance program.150

In 1999, HUD/OIG audited the Loss Mitigation Program. This

audit found a growing use of loss mitigation tools by servicing lenders, but a lack of program oversight by HUD staff. Loss mitigation

tools, of course, are intended to help prevent foreclosures. Yet,

while the use of these tools has more than tripled in fiscal year

1999, HUD’s foreclosure rates continue to rise. The National Delinquency Survey conducted by the Mortgage Bankers Association

showed a 39 percent rise in FHA foreclosure rates over 5 years,

from 1.45 percent at the end of calendar year 1994 to 2.01 percent

at the end of calendar year 1999. During the same period, MBA

data show an increase of about 19 percent in FHA delinquency

rates, from 7.26 percent to 8.61.

The OIG acknowledged that HUD has developed two measures

that may strengthen the FHA program. One is the Homebuyer Protection Plan, which is designed to protect borrowers from bad appraisals. The other is the Credit Watch program, which is discussed at length above, which terminates lenders with excessive

default rates from FHA programs. Both plans, however, are relatively new, and thus a thorough evaluation has not yet been done.

Moreover, although the Homebuyer Protection Plan is making

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151 Id. 152 Id. at 4. 153 Id. 154 HUD/OIG, Single Family Production Home Ownership Centers, supra at 7. 155 HUD/OIG, 1999–2000 Semiannual, at 4.

strides to improve the quality of appraisals, the enforcement aspect

of the plan has been slow to develop. The Credit Watch Program

will also take action only against those lenders with the most egregious default record. Very few actions have been taken to date,

and—as discussed in more detail above—two actions terminating

lenders have led to serious legal challenges by the lenders. Moreover, neither of these initiative substitutes the need for HUD staff

to better monitor lender performance.151

HUD/OIG’s audit and investigative work have disclosed that

HUD’s current procedures for monitoring lenders and conducting

oversight of contractors are less than effective. In HUD/OIG’s view,

this lack of oversight clearly contributes to fraud and abuse of the

FHA Single Family Program. This is because FHA’s mortgage insurance risk depends almost exclusively on the reliability of work

performed by its DE lenders, who underwrite nearly all FHA insurance. FHA mitigates its risk through lender oversight. Three important HUD monitoring tools should be working to prevent the insurance of fraudulent loans: Post endorsement technical reviews of

loan underwriting documentation, field reviews of appraisals, and

quality assurance reviews of lenders. When used effectively, these

tools can highlight problem loans or lenders. The OIG has found,

however, that HUDs monitoring was not properly focused upon

lender and appraiser high risk indicators. Instead, HUD merely

emphasized meeting numerical review goals set forth in its Business and Operating Plan.152

(1) Post-Endorsement Technical Reviews

Post-endorsement technical reviews underwriting and property

appraisals are key controls in monitoring DE lenders. These technical reviews typically consist of a desk review of FHA case documentation after insurance endorsement to assess lender compliance

with HUD underwriting and appraisal requirements. HUD has retained contractors to perform most of this work at a price ranging

from $15 to $35 per case.153 If the technical review discloses an improper endorsement or other problems, then HUD staff is supposed

to take remedial actions—e.g., seeking identification from lenders

for loans not meeting FHA endorsement criteria or referring lenders to the Quality Assurance Division for on-site review.154

The OIG, however, found that HUD relied too uncritically upon

the work of these contractors and did not do enough to review contractor performance. The effects of such over-reliance were demonstrated in a recent case in which Allstate Mortgage Company

fraudulently originated over 400 FHA loans totaling $97 million.

Seventeen of these loans had undergone post-endorsement reviews

by a contractor. The contractor found no significant problems with

these loans, even though the loan files showed obvious fraud indicators. None of these 17 cases had even been re-examined by HUD

contract monitors.155

The OIG’s reexamination of 151 post-endorsement reviews found

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156 Id. at 32. 157 Id. at 4. 158 Id. at 5. 159 HUD/OIG, Single Family Production Home Ownership Centers, supra at 38. 160 Id. 161 Id. at 39. 162 HUD/OIG, 1999–2000 Semiannual, supra, at 5.

rors. Thirty-two reviews failed to identify significant fraud indicia.156 The OIG review found several reasons why HUD’s controls

over the post-endorsement technical review process were not providing meaningful results. These included: The presence of inexperienced staff in critical HUD control positions; increased loan volume accompanied by the allocation of fewer staff members for monitoring lenders; the lack of clear operating policies or procedures for

HOC operations; outdated handbooks; emphasis on quantitative

goals; and the existence of financial disincentives for contractors to

find problematic endorsements. Even when significant technical review problems were noted, the OIG found HUD implemented few,

if any, corrective actions.157

(2) Post-Endorsement Field Reviews of Appraisals

Another critical control feature is the systematic testing of property appraisals by HUD. The DE lender selects the appraiser that

sets the value of the property for FHA insurance. With the high

loan-to-value ratio of most FHA loans, an accurate appraisal is critical to minimizing HUD’s insurance risk. HUD’s procedures call for

field reviews of 10 percent of all appraisals,158 and 5 percent of

each appraiser’s work.159 In addition, all appraisers receiving a

‘‘poor’’ rating during the post-endorsement technical review process

are supposed to be subject to field review.160

The OIG found, however, that the HOCs did not have a systematic procedure for selecting appraisals for review to ensure that the

required 5 percent of each appraiser’s work was reviewed. This is

because the HOCs did not have contracts for field review of appraisals in all areas of their jurisdictions. Moreover, lenders did not

always provide a second copy of the appraisal (as they were required to do) and appraisal reports were not always complete—

though this apparently did not stop the HOCs from accepting the

cases instead of rejecting them. In addition, the OIG found that the

HOCs’ primary emphasis was upon being able to declare that they

had completed their goal of completing field reviews of 10 percent

of the total appraisals. Little emphasis, it seems, was put on ensuring that the program was working properly.161

Even when field reviews disclosed problems with appraisers,

HUD failed to use the results to take action. Branch chiefs at three

of the four HOCs told the OIG that they did not have enough staff

to monitor appraisers or to sanction poor performers. As a result

of these deficiencies, HUD lacks assurance about the quality of appraisals supporting loans processed and approved by lenders.162

For example, as of March 30, 2000, two appraisers named in a

criminal indictment returned against the principals of Allstate

Mortgage Company in December 1997—appraisers who apparently

provided numerous fraudulent appraisals—had not been removed

from HUD’s approved appraiser listing, issued a limited denial of

57

163The individuals indicted included Douglas Estrada (the president and owner of Allstate

Mortgage), Victor Noval (the owner of Noval and Associates and four other companies used in

straw purchases), Shirley da Silva (Noval’s ex-wife), James Weatherley (a former Oakland Raiders football player who located properties and straw buyers), Louis Valladares (a loan officer

at Allstate Mortgage) and Alberto Jose Rivas (another loan officer at Allstate Mortgage Company). Allstate Mortgage was not itself indicted, and action by the Mortgagee Review Board appears to be pending the results of the criminal case against the principals. PSI staff has learned

that the two appraisers are both engaged in plea negotiations with the U.S. Attorney’s Office. 164 HUD/OIG, Single Family Production Home Ownership Centers, supra, at 42. 165 Id. at 43. 166Office of Inspector General, U.S. Department of Housing and Urban Development, Semiannual Report to the Congress 5 (October 1, 1999-March 31, 2000). 167Office of Inspector General, U.S. Department of Housing and Urban Development, Semiannual Report to the Congress 32–33 (October 1, 1999-March 31, 2000).

participation, or debarred.163 HUD’s lack of action against problem

appraisers is also evident from its own numbers. According to

HUD’s Single Family Data Warehouse information system, during

the 2-year period ending September 30, 1999, 15,526 appraisals received ‘‘poor’’ desk review ratings. However, 13,007, or 83.8 percent, of these appraisals were never subjected to field review.164 Instead, these poor ratings were entered into HUD’s database without any subsequent action.165

(3) Quality Assurance Reviews

A third important control over DE lender activity is on-site monitoring reviews. These reviews, which are conducted by the HOCs’

Quality Assurance Divisions (QADs), are intended to identify and

correct poor origination practices. After completion, the QADs communicate their review results to lenders and request written responses. Lenders are asked to explain the problems noted, list actions taken to prevent future problems, and/or agree to indemnify

HUD for possible losses associated with improperly originated

loans.

This process, too, appears to have been impeded by poor HUD

oversight. While the QADs are supposed to focus upon lenders with

high default and foreclosure rates, the OIG discovered that the

QADs instead reviewed numerous low-risk lenders because this

permitted them more easily to claim that they had met HUD’s numeric review goals. Even when the QADs identified deficiencies

during on-site reviews, they did not follow-up when lenders failed

to respond to their findings and recommendations.166 The OIG also

determined that the Approval/Recertification/Review Tracking System (ARRTS) HUD uses to track the status and results of QAD reviews contained significant errors, and therefore did not provide

sufficient accountability for audit and staff evaluation purposes.167

VI. HUD’s False Promises to the Subcommittee

The Subcommittee’s hearings on the subject of mortgage flipping

focused upon these and other related problems of HUD oversight

of the FHA-back single family loan program. Faced with this criticism—and the numerous GAO and Office of Inspector General findings during the past several years demonstrating HUD’s failure

properly to protect the program against fraud, waste, and abuse—

FHA Commissioner Apgar reassured the Subcommittee in sweeping terms on June 30, 2000 about the steps HUD has taken to combat flipping the assistance his agency would provide to help victims

of mortgage fraud.

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168 Hearing record, supra, at 45.

In his testimony, Apgar discussed Credit Watch and the Homebuyer Protection Plan as being particularly promising initiatives,

but took particular pains to promise that HUD would in fact compel the restructuring of mortgages the value of which had been

artificially inflated by ‘‘flipping’’ schemes of the sort outlined hereinabove. Specifically, Commissioner Apgar declared that:

‘‘HUD will move aggressively to force lenders to restructure inflated mortgages that result from fraudulent appraisals or the so-called property flips. We will push the

loan back to the lender and make him responsible for producing a loan that the borrower can afford. If not, the FHA

will intervene directly and make the loan right for the borrower.’’168

Despite his promises, however, this promised relief had yet to appear more than a year later. When Apgar, a Clinton Administration appointee, left HUD early in 2001 along with Secretary Andrew Cuomo, nothing had been done.

The Subcommittee has since learned that Apgar’s promises to

the Subcommittee, and to borrowers across the country, appear to

have been empty ones. According to information provided to the

Subcommittee by HUD official Laurie Maggiano, in fact, Apgar

couldn’t possibly have followed through on his sweeping reassurances because the law prevents HUD from forcing lenders to reduce

loans that FHA insures. On May 14, 2001, Maggiano advised Senator Barbara Mikulski that in Apgar’s Subcommittee testimony a

year previously, ‘‘FHA perhaps over committed what it was able to

deliver.’’ Apgar’s disingenuous promises, therefore, stand perhaps

as the final legacy of Secretary Cuomo and his fellow Clinton Administration appointees at the Department of Housing and Urban

Development—a legacy of lax oversight and poor management

upon which the Subcommittee Minority hopes new HUD Secretary

Mel Martinez and the Bush Administration will be able greatly to

improve.

Æ