Testimony

Before the Subcommittee on Oversight and

Investigations, House Financial Services Committee,

House of Representatives

United States General Accounting Office

GAO

For Release on Delivery

Expected at

10:00 a.m. EDT

Monday

September 10, 2001

HOMEOWNERSHIP

Problems Persist With

HUD’s 203(k) Home

Rehabilitation Mortgage

Insurance Program

Statement of Stanley J. Czerwinski

Director, Physical Infrastructure Issues

GAO-01-1124T
Page 1 GAO-01-1124T Homeownership

Madame Chairwoman and Members of the Subcommittee:

We are here today to testify on the Department of Housing and Urban

Development’s (HUD) 203(k) Home Rehabilitation Mortgage Insurance

Program. The 203(k) program was established to help promote the

rehabilitation and repair of housing through a program that combines, in

one insured mortgage, the funds needed to purchase and rehabilitate a

single-family home. The loans are made by banks and other private lenders

from their own funds and are insured by HUD’s Federal Housing

Administration (FHA). The 203(k) program has a history of waste, fraud,

and abuse that resulted in our review of HUD’s oversight of the program

approximately 2 years ago.1

 My testimony today will summarize the

findings and recommendations of our report as well as HUD’s actions on

our recommendations since the report was issued.

In summary, our work showed:

• The 203(k) program is inherently more risky than HUD’s principal singlefamily loan insurance program because its rehabilitation component

makes it more complex and susceptible to misuse. HUD’s Inspector

General and others have noted such risks in 1997 and 1998 reports on the

department’s management of the program.

• HUD was not adequately targeting 203(k) loans and lenders for review,

properly training and overseeing consultants/inspectors, and monitoring

nonprofit organization’s participation in the program. HUD has

implemented three of the four recommendations we made to address

these three areas.

The 203(k) Home Rehabilitation Mortgage Insurance Program is HUD’s

primary program for rehabilitating and repairing single-family homes.2

Because loans insured under this program have characteristics of both

home purchase and construction loans, lenders who want to get a loan

insured under the 203(k) program must follow a more complex process to

approve and disburse the loans than they would under FHA’s other

mortgage loan insurance programs. The program provides borrowers the

 1

Homeownership: Problems Persist with HUD’s 203(k) Home Rehabilitation Loan

Program (GAO/RCED-99-124, June 14, 1999)

2

The Rehabilitation Home Mortgage Insurance program was authorized by section 203(k)

of the National Housing Act, as amended, 12 U.S.C. 1709(k).

Background
Page 2 GAO-01-1124T Homeownership

convenience of financing both the purchase or refinancing of a house and

the cost of its rehabilitation through a single mortgage. Eligible borrowers

may include the owner/occupant, nonprofit organizations, and investors,

although there has been a moratorium on investors’ eligibility since

October 1996.3

 The program protects lenders against financial losses by

insuring a loan for the full value of the rehabilitated home before the

rehabilitation process begins. 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.

Although the 203(k) program was established in its present form in 1978, it

was not widely used until 1994, when HUD began promoting and

streamlining the program to make it more user-friendly for borrowers and

lenders. As a result of these efforts, the number of 203(k) loans that HUD

insured grew from about 4,000 in fiscal year 1994 to over 18,000 in fiscal

year 1997. From this peak, the number of insured 203(k) loans fell to about

10,000 in fiscal year 2000. As of July 31, 2001, the total value of HUD’s

203(k) portfolio was approximately $4.5 billion.

The 203(k) program poses inherent risks because it is much more complex

than HUD’s largest single-family loan program, the 203(b) program. The

203(k) program’s complexity stems from the rehabilitation component of

the program, which (1) relies heavily on estimates, reports, and opinions;

(2) has many underwriting and funding steps; and (3) involves participants

other than the borrower and the lender. For example, to close a 203(k)

loan, a lender must set-aside in an escrow account the estimated funds to

pay for the rehabilitation. A HUD-approved consultant is often needed to

determine the extent of work that must be done to rehabilitate a property

and the estimated cost of that work. In addition, a HUD-approved

inspector is needed to monitor the progress of the rehabilitation and cosign with the borrower any request of escrow funds.

The program’s high degree of risk is also reflected in the poorer

performance of 203(k) loans compared with loans made under the 203(b)

program—HUD’s largest single-family loan program. For example, for

loans made from fiscal years 1994 through 1996, we found that as of

September 30, 1998, the cumulative claim rates for 203(k) loans were

 3

Because of abuses by investors in the program, a moratorium on investor participation

was implemented in October 1996.

The 203(k) Program

Design Is Inherently

Risky
Page 3 GAO-01-1124T Homeownership

almost double the rates for 203(b) loans. A claim results when a loan goes

into default and results in a claim being filed against the insurance fund. In

addition, we found that the 203(k) program was expected to incur net

losses of over $25 million for loans insured in fiscal years 1994 through

1998, while the 203(b) program was expected to incur net gains for the

same period. Consistent with these findings, a 1998 study by HUD

contractors asserted that the 203(k) program posed a high risk of loss to

the department and that this risk had been reflected in high default and

claim rates.

Both internal and outside reviews of the 203(k) program have concluded

that under its current design, the program is susceptible to a variety of

problems. For example, HUD’s Inspector General reported in 1997 that the

program’s design encouraged risky property deals, overstated property

appraisals, and phony or excessive fees. In addition, an internal HUD

study of the 203(k) program identified several inherent program risks,

including the failure of participants to accurately estimate the cost of

rehabilitation or to complete rehabilitation work in an acceptable manner.

We also found that outside reviews of the 203(k) program concluded that

under its current design, the program is susceptible to a variety of

problems. For example, in October 1998, contractors hired by HUD to

study the 203(k) program reported that the department had done little to

reduce the risks of the program. The contractor’s draft report identified

several major risks associated with the 203(k) program, including program

complexity, insufficient lender monitoring, inadequate guidance

concerning consultants, hesitant management direction, and increased

loss potential from nonprofit organizations.

During our 1999 review, we found that HUD had not implemented the

oversight procedures necessary to mitigate the 203(k) program’s unique

risks and potential for abuse. Specifically, we found that HUD was not (1)

adequately targeting 203(k) loans and lenders for review, (2) properly

training and overseeing consultants and home inspectors, and (3)

adequately monitoring nonprofit organizations’ participation in the

program.

HUD’s four homeownership centers are responsible for the general

management of the 203(k) program in their respective regions. The centers

perform technical reviews—desktop audits of loans already insured by

FHA—to determine the quality of underwriting for specific loans. They

Program Risk Noted in

Studies

HUD’s Oversight of

the 203(k) Program

Was Inadequate
Page 4 GAO-01-1124T Homeownership

also conduct quality assurance reviews—in-depth reviews of a lender’s

troubled loans and internal control systems for originating loans—to

assess the lenders’ performance and operations. Although HUD was aware

of the high-risk nature of the 203(k) program, we found that the

homeownership centers did not target 203(k) loans for technical reviews.

Furthermore, concerning the 203(k) loans they did review, they did not

send the detailed results of their evaluations to the lenders. Consequently,

the lenders did not have the information necessary to act on the problems

that were uncovered by HUD’s review. We recommended that HUD

improve its identification of lenders’ underwriting violations, as well as its

notification and penalization of lenders who commit underwriting

violations. HUD has not completed action on this recommendation. HUD,

however, is in the process of hiring a contractor to review the results of its

desk reviews of 203(k) lenders and develop criteria for assessing the risks

associated with 203(k) lenders.

We also found that while the homeownership centers had conducted

quality assurance reviews of lenders participating in the 203(k) program,

they did not specifically target 203(k) loans for review. Officials at two of

the centers said they felt that they did not have staff who were qualified to

evaluate a lender’s underwriting of 203(k) loans. Furthermore, HUD was

unable to tell us how many 203(k) loans had been examined as part of its

quality assurance reviews. We recommended that HUD target high-risk

203(k) lenders for quality assurance reviews. In response, HUD issued

specific procedures in May 2000 for identifying high-risk 203(k) lenders

and targeting them for annual monitoring.

Although consultants and inspectors are key participants in the 203(k)

program, we found that HUD had no uniform criteria for their training,

approval, or evaluation. Consultants and inspectors are used to perform

home inspections, identify health and safety problems, and provide

descriptions of the work to be performed and cost estimates for

homebuyers. In addition to having at least 3 years of specialized

experience, consultants and inspectors must receive training in the 203(k)

program. However, at two of the four homeownership centers we visited,

HUD had not trained any 203(k) consultants and inspectors. In addition,

three of the four centers had not evaluated the performance of their

consultants or inspectors. Finally, we also found cases in which HUD

failed to address consultants’ abuses or incompetence. For example,

according to customer complaints we reviewed, a 203(k) inspector in

Chicago allowed a contractor to receive thousands of dollars for work that

the contractor either did not do or did inadequately. We recommended

that HUD establish strict criteria to ensure that consultants/inspectors are
Page 5 GAO-01-1124T Homeownership

well versed in residential construction/rehabilitation and cost estimating.

In response, HUD issued guidance on July 26, 2000, that sets new

standards and procedures for 203(k) consultants participation in the

program.

Although approved nonprofit organizations can obtain 203(k) loans, we

found that HUD was not adequately ensuring their compliance with HUD’s

guidelines for participating in the program. HUD’s guidelines require the

homeownership centers to recertify nonprofit organizations every 2 years.

However, at three of the four centers we visited, we found no evidence

that the centers had recertified any of their approved nonprofit

organizations. Loans to nonprofit organizations represent a small portion

of the 203(k) program, but the performance of these loans has been

significantly worse than for any other borrower type in the 203(k)

program. We recommended that HUD establish strict criteria for qualifying

and recertifying nonprofit organizations for their continued participation

in the program. In response, HUD issued guidance on March 3, 2000, that

sets uniform standards for nonprofit agencies participation and

recertification in all FHA activities.

In beginning to implement our recommendations, HUD has taken some

positive steps toward tightening its control over the 203(k) program.

However, the inherent risk of this program means that the program

requires continued management attention and further improvements in

oversight.

Madame Chairwoman, this concludes our prepared statement. We are

happy to answer any questions that you or Members of the Subcommittee

may have.

For future contacts regarding this testimony, please contact Stanley

Czerwinski or Paul Schmidt at (202) 512-2834. Individuals making key

contributions to this testimony included Paige Smith, Richard Smith, Steve

Westley, and Alwynne Wilbur.

Contact and

Acknowledgments

(541008)
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