SINGLE-FAMILY

HOUSING

Stronger Oversight of

FHA Lenders Could

Reduce HUD’s

Insurance Risk

Statement of Stanley J. Czerwinski, Associate Director,

Housing and Community Development Issues,

Resources, Community, and Economic Development Division

United States General Accounting Office

GAO Testimony

Before the Permanent Subcommittee on Investigations,

Committee on Governmental Affairs,

U.S. Senate

For Release on Delivery

Expected at

9:30 a.m., EDT

Thursday

June 29, 2000

GAO/T-RCED-00-213
1

Madame Chairman and Members of the Subcommittee:

We are here to discuss our report that you requested and are releasing today on the Department

of Housing and Urban Development’s (HUD) oversight of lenders that make mortgage loans

insured by HUD’s Federal Housing Administration (FHA).1

During fiscal year 1999 alone, FHA

insured 1.3 million mortgages valued at about $124 billion. While FHA insures lenders against

nearly all losses resulting from foreclosed loans, it relies on the lenders to underwrite the loans

and determine their eligibility for FHA mortgage insurance.

Our review focused on the adequacy of HUD’s policies and procedures for overseeing lenders.

We performed limited tests and analyses to determine whether these policies and procedures

were properly utilized to limit HUD’s insurance risk.

In summary, our work revealed a number of weaknesses in the lender approval, monitoring, and

enforcement efforts performed by HUD’s headquarters and its four homeownership centers.2

• HUD’s process for granting FHA-approved lenders direct endorsement authority---that is, the

ability to underwrite loans and determine their eligibility for FHA mortgage insurance

without HUD’s prior review—provides only limited assurance that lenders receiving this

authority are qualified.

• In addition, while HUD’s homeownership centers have monitored lenders’ compliance with

FHA’s lending requirements, these monitoring efforts have not adequately focused on the

lenders and loans that pose the greatest insurance risks to the Department.

1

Single-Family Housing: Stronger Oversight of FHA Lenders Could Reduce HUD’s Insurance Risk

(GAO/RCED-00-112, Apr. 28, 2000).

2

HUD’s four homeownership centers administer the single-family housing functions in the 50 states, the

District of Columbia, and Puerto Rico. The centers are located in Atlanta, Georgia; Denver, Colorado;

Philadelphia, Pennsylvania, and Santa Ana, California.
2

• Finally, although HUD has taken enforcement actions against lenders with excessively high

default rates, it needs to take further steps to hold lenders accountable for poor performance

and program violations.

Our report makes recommendations designed to improve HUD’s processes for approving lenders

to underwrite FHA-insured mortgages, for targeting lenders and loans for quality control

reviews, and for taking enforcement actions against poorly performing lenders. In commenting

on the report, HUD stated that it generally agreed with the report’s recommendations.

Background

A homebuyer seeking a FHA-insured mortgage must submit a mortgage application to a FHAapproved lender. Once the lender approves the loan, it sends the loan documents to HUD for

approval of FHA mortgage insurance. If the borrower defaults and the lender subsequently

forecloses on the loan, the lender can file an insurance claim with HUD for the unpaid balance of

the loan. As of December 1999, about 10,000 lending institutions were approved to participate in

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

Most FHA-approved lenders are authorized to originate FHA-insured loans, meaning that they

can accept mortgage applications, obtain employment verifications and credit histories on

applicants, order property appraisals, and perform other tasks that precede the loan

underwriting process. Approximately 2,900 of the FHA-approved lending institutions also have

direct endorsement authority, meaning that they can underwrite loans and determine their

eligibility for FHA mortgage insurance without HUD’s prior review. Underwriting refers to a risk

analysis that uses information collected during the origination process to decide whether to

approve a loan. Direct endorsement lenders may underwrite loans that either they originated or

were originated by other lenders. Lenders with direct endorsement authority underwrite

virtually all FHA-insured mortgages for single-family homes.

Direct Endorsement Approval Process Provides Limited Assurance That Lenders Are

Qualified

HUD’s process for granting FHA-approved lenders direct endorsement authority--the ability to

underwrite loans and determine their eligibility for FHA mortgage insurance without HUD’s
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prior review—provides only limited assurance that lenders receiving this authority are qualified.

HUD’s guidance does not adequately define the level of proficiency that lenders must achieve in

order to be granted direct endorsement authority. As a result, HUD’s homeownership centers

have applied the guidance differently and have approved lenders that made multiple and serious

underwriting errors.

FHA-approved lenders seeking direct endorsement authority go through a probationary period

during which they are required to demonstrate acceptable performance in underwriting at least

15 mortgage loans. The mortgages are submitted to and evaluated by HUD’s homeownership

centers before the mortgages are finalized. These evaluations rate as “good,” “fair,” or “poor”

various aspects of the lender’s work, including its analysis of the credit risk posed by the

borrower and the quality of the property appraisal. A “poor” rating indicates that the lender

made underwriting errors that significantly increased HUD’s insurance risk.

While HUD’s guidance requires that lenders seeking direct endorsement authority demonstrate

overall acceptable performance on these evaluations, the guidance is unclear on what

constitutes “acceptable performance.” As a result, HUD’s homeownership centers have

interpreted the guidance differently. For example, the Denver center interpreted the guidance to

mean that lenders had to submit 15 mortgages for which they received at least “good” or “fair”

ratings. In contrast, the Santa Ana center did not have a requirement for the number of “good”

and “fair” ratings that lenders had to achieve.

HUD’s four homeownership centers granted direct endorsement authority to a total of 36 lenders

during the 6 months prior to our 1999 visits to the centers. We reviewed the ratings that each of

these lenders received from the centers for the lender’s evaluation of the credit risk posed by the

borrower. Our analysis showed significant variations in what HUD’s homeownership centers

considered as acceptable performance, reflecting the vagueness and inconsistent application of

HUD’s approval standards. Overall, of the 36 lenders, 8 received no “poor” ratings for the last 15

mortgages they submitted to the centers for review. However, 12 lenders received “poor” ratings

in over a quarter of their last 15 mortgages. The lenders’ errors included their failure to (1)

verify the borrower’s employment and income, (2) ensure that the borrower had sufficient

income to support the monthly mortgage payments, (3) explain delinquent accounts and
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collections on the borrower’s credit reports, and (4) properly calculate the borrower’s debts or

liabilities. We believe that lenders such as these 12 may pose a high insurance risk to the

Department once they begin underwriting and approving loans without HUD’s prior reviews.

To improve HUD’s process for granting lenders direct endorsement authority, our report

recommended that HUD develop specific performance standards for lenders seeking this

authority.

Monitoring Process Does Not Adequately Focus on Riskiest Lenders and Loans

HUD’s homeownership centers use two monitoring tools to ensure lenders’ compliance with

FHA’s lending requirements: (1) on-site evaluations of lenders’ operations, known as lender

reviews, and (2) desk audits of the underwriting quality of loans already insured by FHA, known

as technical reviews. HUD’s guidance stresses the importance of using risk analysis to allocate a

larger share of monitoring resources to program activities that pose the highest risks to the

Department. However, the homeownership centers have not adequately focused their

monitoring efforts on lenders and loans that pose the highest insurance risks.

HUD Has Reviewed More Lenders in Recent Years but Often Not the Riskiest Ones

In recent years, HUD has placed greater emphasis on performing on-site evaluations of lenders’

operations. For example, the number of lender reviews that HUD performed grew from 291 in

fiscal year 1996 to 932 to in fiscal year 1999. HUD’s guidance states that 85 percent of the lender

reviews should be targeted at high-risk lenders. However, we found that the homeownership

centers often did not review the lenders that they considered to pose the highest risks. For

example, the Philadelphia center developed a list of 131 high-risk lenders that it considered to be

a high priority for review in fiscal year 1999. Despite conducting reviews of 228 lenders during

fiscal year 1999, the center reviewed just 39--or about 30 percent--of the 131 lenders on its

priority list. While the other homeownership centers did not have similar priority lists, center

officials told us that they frequently selected for review those lenders that did not pose a high

insurance risk to HUD. For instance, a Santa Ana center official estimated that half of the

reviews the center performed in fiscal year 1999 were of lenders that had few or no early

defaults—that is, loans that defaulted within 24 months. Because loans that default this quickly
5

are an indicator of poor lending practices that may result in insurance losses, HUD considers

them to be an important factor in assessing lenders’ risk.

Homeownership center officials cited inexperienced staff and limited or uncertain travel funds

as reasons why high-risk lenders were not always reviewed. For instance, according to the four

homeownership centers, most of the centers’ 140 staff who conduct lender reviews assumed

their current positions in fiscal years 1998 and 1999--largely from the pool of HUD field staff who

remained unassigned after HUD’s 1998 reorganization. Center officials also told us that they

generally did not allow staff with less than a year of experience to review high-risk lenders

because their inexperience might lead them to overlook serious deficiencies.

Furthermore, although HUD’s guidance states that lenders should be rated and prioritized for

review, the Department has not developed a systematic process for doing so. HUD’s guidance

lists several risk factors that should be considered in targeting lenders for reviews, including

default rates, the late payment of mortgage insurance premiums to HUD, and the volume of

business. But the guidance indicates neither how these factors should be weighted nor how

lenders should be prioritized. As a result, the centers have not targeted lenders for reviews in a

consistent manner. To more effectively monitor lenders’ performance, our report recommends

that HUD develop procedures to identify and prioritize high-risk lenders for lender reviews and

ensure that the homeownership centers consistently apply these procedures.

Selection of Loans for Technical Reviews Was Not Based on Risk

Technical reviews--desk audits that evaluate the underwriting quality of loans already insured by

FHA--are another tool that HUD uses to monitor the performance of lenders. If technical

reviews reveal serious deficiencies, HUD may suspend the lenders’ authority to underwrite FHAinsured loans, among other things.

All four of HUD’s homeownership centers met the Department’s goal to perform technical

reviews on no less than 10 percent of the FHA-insured mortgage loans made during fiscal year

1999. However, the centers have not effectively implemented HUD’s guidance, which states that

technical reviews should be targeted at loans that exhibit high-risk characteristics, such as loans

to borrowers with unusually high expenses relative to their income. Instead, HUD’s
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homeownership centers rely primarily on a random process for selecting loans for technical

reviews. The computer system that supports HUD staff in processing mortgage insurance

randomly selects a certain percentage of each lender’s loans for technical reviews. However, the

system cannot automatically identify and select for review those loans that exhibit high-risk

characteristics. HUD’s four homeownership centers told us that they sometimes manually

selected high-risk loans for reviews but that the large volume of loans that they processed for

FHA insurance, coupled with staffing constraints, made it impractical to do this on a routine

basis. To address this problem, our report recommends that HUD enhance its management

information systems to identify and select, for technical reviews, loans that pose a high

insurance risk to the Department.

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

To hold lenders accountable for program violations or poor performance, HUD may, among

other things, (1) suspend their direct endorsement authority and (2) terminate their loan

origination authority through its Credit Watch program, which is designed to hold lenders

accountable for excessive defaults and insurance claims on FHA-insured mortgages. However,

the homeownership centers have made only limited use of their ability to suspend lenders’ direct

endorsement authority. Furthermore, certain lenders have escaped accountability under the

Credit Watch program.

Homeownership Centers Made Limited Use of Their Ability to Suspend Lenders’ Direct

Endorsement Authority

HUD’s guidance allows the homeownership centers to suspend the direct endorsement authority

of lenders that fail to comply with FHA’s program requirements but provides only general

guidelines for determining which lenders should be subject to this action. Lenders whose direct

endorsement authority is suspended must submit their mortgage case files to the

homeownership centers, which evaluate the lenders’ underwriting decisions before deciding

whether to insure the loans.

Among the four homeownership centers, we found that the Philadelphia center was the only one

that had suspended the direct endorsement authority of any lenders during fiscal year 1999.

Specifically, the Philadelphia center took this action against eight lenders in fiscal year 1999,

citing underwriting violations identified by technical reviews or lender reviews. Although the
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centers suspended relatively few lenders, our analysis of HUD’s technical review ratings for

fiscal year 1999 showed frequent noncompliance with FHA’s underwriting requirements,

indicating that many lenders may be candidates for this action. Specifically, we identified 206

lenders nationwide that, during fiscal year 1999, received “poor” ratings on more than 30 percent

of their reviewed loans for their evaluation of the credit risk posed by the borrower.3

A “poor”

rating means that the lender made mistakes that significantly increased HUD’s insurance risk.

Of these 206 lenders, 131 made 10 or more FHA-insured loans in fiscal year 1999. HUD’s

guidance does not specify the extent of noncompliance with FHA’s requirements that would

warrant the suspension of a lender’s direct endorsement authority. However, in our opinion, the

extent of noncompliance demonstrated by these 131 lenders indicates that they may be

candidates for this action. As of October 1, 1999, HUD’s homeownership centers had not

suspended any of these lenders.

To strengthen HUD’s enforcement efforts against lenders, our report recommends that HUD

clarify and implement guidelines for identifying lenders whose direct endorsement authority

should be suspended.

Lenders Underwriting Loans Originated by Others Escape Responsibility for Excessive Default

and Claim Rates Under HUD’s Credit Watch Program

In May 1999, HUD announced that it would begin to use its Credit Watch program to sanction

lenders with excessive defaults and insurance claims on FHA-insured mortgages. HUD planned

to terminate the loan origination authority of any lender whose default and claim rates on

mortgages insured by FHA during the preceding 24 months exceeded both the national average

and 300 percent of the average rate for the HUD field office serving the lender’s geographic

location. Similarly, HUD planned to place on “credit watch” status the lenders whose default

and claim rates exceeded both the national average and 200 percent of the corresponding HUD

field office average. While on “credit watch” status, the lender can continue to originate FHAinsured loans, but its performance receives greater scrutiny from HUD.

3

The 206 lenders were among the approximately 5,000 lenders that received technical review ratings in

fiscal year 1999 for mortgages they both originated and underwrote.
8

As of April 2000, HUD had completed four rounds of its Credit Watch program. This program

has resulted in the Department’s actual or proposed termination of 64 lenders’ loan origination

authority and the placement of 140 additional lenders on “credit watch” status.

The regulations governing HUD’s Credit Watch program allow the Department to hold

accountable for excessive defaults or insurance claims the lenders that originated the troubled

loans. However, the regulations do not address HUD’s authority to also hold accountable those

lenders that underwrote the loans. When originating mortgage loans, lenders perform such

functions as accepting mortgage applications and obtaining employment verifications and credit

reports on the borrowers. When underwriting mortgage loans, lenders use this information to

determine whether borrowers are able to make their mortgage payments and whether the loans

should be approved. HUD officials told us they recognized that the underwriting lenders

contributed to excessive defaults and insurance claims but that the Credit Watch program’s

regulations did not permit them to take enforcement actions against these lenders. The officials

said they were considering regulatory changes to address this problem.

The results of the first round of the Credit Watch program illustrate the program’s limitations as

an enforcement tool. Of the 33 lenders that HUD terminated during the first round of the

program, 17 relied on other lenders to underwrite the nearly 6,200 loans that they originated and

FHA insured during the 24-month period of analysis. Nevertheless, the underwriting lenders

escaped sanctions under the Credit Watch program.

The Credit Watch program is also facing a legal challenge. In September 1999, one lender whose

authority to originate FHA-insured mortgage loans was terminated by HUD filed a lawsuit

seeking to overturn HUD’s actions. Among other issues, the lender contended that HUD had

exceeded its statutory authority when it issued its Credit Watch regulations and that the manner

in which HUD terminated the lender’s authority had deprived the lender of due process. In

October 1999, a federal district court ruled that HUD’s Credit Watch regulations were invalid and

set aside HUD’s termination of the lender. The court stated that HUD’s statutory authority

requires that after determining that a lender has excessive defaults and claims, HUD must

provide the lender with the opportunity to provide the Department with a plan and timetable for

correcting the defaults. The court stated that HUD had sidestepped its statutory mandate by
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enacting regulations that allowed the Department to terminate a lender’s authority to originate

loans whenever HUD deemed it appropriate because of the lender’s default and claim rates. The

court also concluded that even if HUD had the authority to issue such regulations, the

regulations denied the lender its right to due process. HUD has appealed the court’s decision. In

May 2000, another lender successfully sought a court injunction that prevented HUD from

terminating this lender’s authority to originate FHA-insured mortgages. Our report recommends

that once the legal basis of the Credit Watch program is resolved, HUD revise the program’s

regulations to cover lenders that underwrite FHA-insured loans with excessive defaults and

claims rates as well as those lenders that originate such loans.

-----

Madame Chairman, this concludes our testimony. We would be happy to answer any questions

that you or members of the Subcommittee may have.

Contact and Acknowledgement

For further information regarding this testimony, please contact Stanley J. Czerwinski at (202)

512-7631. Individuals making key contributions to this testimony included Karen Bracey, Karin

Lennon, Stan Ritchick, Paul Schmidt, Steve Westley, and Shana Whitehead.

(385865)
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