FHA BY THE BOOK BY PHILLIP L. SCHULMAN AND EMILY J. BOOTH

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1 Compliance FHA BY THE BOOK BY PHILLIP L. SCHULMAN AND EMILY J. BOOTH T wo years ago, the Federal Housing Administration (FHA) couldn t get a date. Now its phone is ringing off the hook. In the wake of the subprime meltdown, for the first time in a long time, mortgage lenders are showing interest in the FHA a program Congress created more than 70 years ago to meet the needs of underserved borrowers with impaired credit. The Department of Housing and Urban Development (HUD) now boasts a considerable portfolio. The number of FHAinsured loans increased 126 percent in the first Lenders new to the FHA quarter of 2008 as compared with the first quarter program need to be aware of of 2007, and the FHA s market share is now at 10 the main missteps that can percent up from 2 percent in 2005, according to land them in trouble. Here are Inside Mortgage Finance. Countless lenders are some tips on the 10 most seeking HUD approval to make FHA loans for the common mistakes made by first time, and lenders that previously shied away FHA lenders. from the FHA in favor of private-market lending programs are expressing renewed interest in FHA. HUD officials have indicated that, as a result, HUD is receiving nearly 500 FHA applications per month from lenders seeking to originate FHA loans, and many lenders report that FHA loans now dominate their business. Along with the increase in FHA business, however, comes an increase in compliance responsibilities.

2 FHA lenders must be intimately familiar with HUD s complex web of requirements and ensure compliance to avoid potentially onerous sanctions or penalties that ultimately could prove fatal to their businesses. This article looks at recent changes to FHA s single-family programs, summarizes the types of enforcement mechanisms HUD has at its disposal, and highlights the top-10 pitfalls that tend to trip up lenders and result in sanctions. History In 1934, Congress created the FHA to boost an impoverished housing industry. In 1965, the FHA was consolidated into HUD. The FHA acts as a mortgage insurer on FHA loan transactions to encourage lenders to make loans to higher-risk applicants whose income and down-payment capacity are less than ideal. The FHA now is the largest insurer of mortgages in the world, according to HUD s Web site for the FHA ( While the FHA s popularity waned in recent years and the government loan program lost significant market share, lenders once again are turning to the FHA to fill the subprime void. Many industry participants, however, attribute the FHA s recent growth spurt not only to lenders need for a replacement subprime outlet, but to the recent increase in FHA loan limits from $362,790 to $729,750 as well as to regulatory improvements to HUD s single-family programs. These factors are all cited in an April 2007 issue paper published by the Mortgage Bankers Association (MBA), entitled FHA Empowerment. For example, HUD recently: Announced that, for the next year, HUD will waive its 90-day waiting period for FHA loans secured by properties that lenders acquired through foreclosure, even if a lender is not a state-chartered or federally chartered institution; Expanded its FHASecure initiative to allow lenders to refinance delinquent adjustable-rate mortgage (ARM) loans and offer new subordinate financing where the combined loan-to-value (LTV) ratio exceeds the FHA loan-to-value ratio and maximum mortgage amount; Eliminated seller-paid down-payment assistance; Proposed a regulation that would reverse its current policy on late-case endorsement requirements and reinstate its previous standards that, if finalized, would require lenders to submit payment histories with FHA case binders and document a six-month consecutive-payment history for late-case endorsement loans where the borrower missed a payment; and Clarified that a non-fha-approved broker may receive payment from the borrower for services rendered, but it may neither participate in the loan origination process nor receive any payment from the FHA-approved lender. Such initiatives demonstrate HUD s desire to make its programs more user-friendly and dispel criticism that FHA cannot While the FHA s popularity waned in recent years and the government loan program lost significant market share, lenders once again are turning to the FHA to fill the subprime void. keep pace with the conventional market. The apparent goal is to render the FHA more accessible while still protecting the integrity of the Mutual Mortgage Insurance Fund. Despite the recent surge in FHA business, FHA programs remain bureaucratic and rules-based when compared with other lending programs. You can t really blame HUD, though. After all, the FHA is for all intents and purposes an insurance company. It provides a lender with 100 percent protection against the risk of loss resulting from a borrower default. In turn, HUD expects a lender to comply with all FHA single-family program requirements. In order to ensure that lenders follow these rules, HUD performs periodic reviews of FHA lenders, and a lender s failure to follow the applicable rules may lead to demands for indemnification and/or civil money penalties, or even to a loss of FHA approval. Thus, as more lenders flock back to FHA programs, it is imperative they ensure their employees understand the FHA rules and remain committed to strict compliance. In addition to the various hoops a lender must jump through just to participate, HUD imposes innumerable loanlevel requirements pertaining to, among other things: loan amount; property type; credit history; employment and income; cash investment in the property; loan documentation; and fees. HUD enforces FHA requirements through a number of different mechanisms and takes action against lenders for violations of the rules. While adherence to the rules may seem grueling at times, noncompliance could have disastrous consequences. HUD s enforcement mechanisms HUD routinely audits FHA lenders approximately once every 18 months, in our experience to determine their compliance with applicable rules and to identify those representing a high risk to the Mutual Mortgage Insurance Fund. HUD uses a Credit Watch Termination initiative to hold single-family lenders accountable for poorly performing loans that they originated or underwrote. Specifically, if the branch office of a lender has a default/claim rate for loans endorsed within the preceding 24 months in a particular geographic area that exceeds both the national default/claim rate and 200 percent of the default/claim rate within the geographic area reviewed by HUD, HUD may terminate that branch office s authority to originate single-family mortgage loans at that location for a period of six months, with reinstatement possible at the expiration of the six-month period. In addition to using the Credit Watch Termination initiative to preclude lenders with poor loan performance from originating FHA loans, HUD refers cases needing follow-up to: 1) the Office of Fair Housing and Equal Opportunity, which handles fair lending issues; 2) the Office of Consumer and Regulatory Affairs, which handles alleged violations of the Real Estate Settlement Procedures Act of 1974

3 (RESPA); 3) HUD s Enforcement Center, which initiates suspension and debarment actions; 4) the Mortgagee Review Board (MRB), which has authority to take various types of administrative action against a lender and impose civil money penalties; 5) the Office of the Inspector General (OIG), which typically receives referrals when HUD suspects fraud or illegal activities; or 6) a state licensing agency, including the secretary of state, real estate commissioner, Appraisal Review Board, Department of Banking or Bar Association. FHA compliance audits usually are resolved at the local HUD level through the lender s indemnification of loans or modified business practices, although HUD often refers cases to the MRB and refers some cases to the Office of Fair Housing and Equal Opportunity, Office of Consumer and Regulatory Affairs, Enforcement Center, OIG and state licensing agencies. In our experience, HUD most often relies on one of four mechanisms to monitor lenders and impose penalties for noncompliance with FHA rules: the Quality Assurance Division (QAD), the MRB, the OIG and through exclusionary action (i.e., suspension, debarment or a limited denial of participation [LDP]). Now let s look at a list of the top-10 things that will earn a lender a visit from HUD or turn a mere visit into an enforcement proceeding. The top-10 list The FHA requirements to which a lender must adhere both in establishing its corporate and branch office locations and in making any given loan are rigorous and, to some, seemingly endless. Nevertheless, the issues appear to overlap in many enforcement proceedings. In our experience, the top-10 most common HUD allegations involve the following: Sources of funds improper documentation of the source of funds, including the earnest money deposit, gift funds and large deposits to bank accounts; Borrower credit imprudent judgment regarding a borrower s ability to repay a loan, including unwise decisions regarding general creditworthiness, failure to consider non-purchasing spouses liabilities, failure to verify properly Social Security numbers and failure to document the borrower s ability to handle increased payments in connection with interestrate buydowns; Qualifying ratios and compensating factors failure to have sufficient, documented compensating factors to justify loan approval to borrowers with high qualifying ratios; Income and employment documentation failure to properly document gaps in employment and/or nontaxable, part-time or overtime income; General data integrity failure to ensure that file documentation supports information entered into an automated underwriting system; The economic and reputation risks associated with a HUD enforcement action are great, especially in this declining mortgage market. Quality control failure to maintain and/or implement a compliant quality-control plan; Late submission of upfront mortgage insurance premiums failure to remit upfront mortgage insurance premiums to HUD within 10 days of closing or funds disbursement; Late submission of endorsement packages to HUD for FHA insurance failure to submit loans to HUD for endorsement in a timely manner; Maximum mortgage amounts failure to calculate the maximum mortgage amount correctly, thereby resulting in an over-insured loan; and Net branching failure to adhere to FHA s branch office requirements, such as ensuring the FHA-approved lender is responsible for all branch operating expenses. These common areas that trigger enforcement or other sanctions demonstrate HUD s focus on both objective requirements (e.g., the calculation of the maximum mortgage amount) and subjective underwriting criteria (e.g., a borrower s creditworthiness). It is imperative that FHA lenders stay apprised of all current FHA guidelines and ensure that their staffs fully understand and appreciate the relevant requirements. The economic and reputation risks associated with a HUD enforcement action are great, especially in this declining mortgage market. Following is a summary of the most common types of enforcement actions and the potential penalties associated with them. The most common enforcement actions As noted earlier, the most common types of HUD/FHA enforcement actions are: 1) QAD proceedings; 2) MRB proceedings; 3) OIG audits; and 4) suspension, debarment or LDP proceedings. Q UALITY A SSURANCE D IVISION PROCEEDINGS HUD has four Homeownership Centers (HOC) throughout the United States, located in Atlanta; Denver; Philadelphia; and Santa Ana, California. Each HOC has its own QAD that performs routine audits of lenders within the HOC s jurisdiction. A QAD audit typically is done on-site in the lender s home or a branch office and includes a sample of defaulted loan files. A lender should expect to undergo a QAD review approximately once every 18 months. If the QAD assessment identifies suspected violations during a particular lender review, QAD staff usually will issue a findings letter giving the lender an opportunity to respond to the allegations in writing. QAD allegations typically relate to loan-level processing and underwriting deficiencies. These can include missing or incomplete verifications of employment and deposit, a failure to document adequately the borrower s source of funds invested in the transaction, approval of a borrower with high qualifying ratios in the absence of sufficient documented compensating factors or with poor credit history, or a miscalculation of the maximum mortgage amount.

4 In any case where the QAD rejects the lender s defenses to the allegations, the QAD may require the lender to indemnify HUD for the loan. Indemnification in this context means that, in the event the holder of the loan makes a claim to HUD, the lender will reimburse HUD for any losses it incurs on the loan, including interim costs related to property maintenance, management and taxes. In a case where HUD sells a property for substantially less than its market value, thereby causing HUD s maintenance costs, taxes and other expenses incurred while the property is in its inventory to far exceed the sum HUD receives when it sells the property, the lender may incur a substantial loss under an indemnification agreement. In some cases, depending on the nature of the violation, the QAD may require a principal reduction to the outstanding mortgage balance or refunds of fees to borrowers. M ORTGAGEE R EVIEW B OARD PROCEEDINGS MRB cases are more serious than QAD proceedings. The MRB meets once every two months, and consists of the five highest-ranking HUD officials the assistant secretary for housing/fha commissioner, the general counsel, the president of Ginnie Mae, the assistant secretary for administration and the chief financial officer. The MRB usually receives cases from two sources: QAD monitors who believe that the perceived violations are too numerous or too serious to be handled at the local level; or the OIG. There are a variety of program violations that could result in a referral to the MRB, including, for example: 1) the same types of deficiencies discussed earlier in connection with the QAD; 2) operation without HUD approval or proper branch office registration; 3) improper handling of escrows; 4) failure to submit annual audited financial statements; 5) failure to satisfy ongoing requirements for FHA approval concerning, for example, net worth, liquidity, warehouse lines of credit, and payment of application and annual fees; 6) submission of false information to HUD in any transaction; 7) employment or retention of officers, partners, directors, principals or employees who have been suspended, debarred or subject to an LDP; or 8) a violation of RESPA. When the MRB decides to take a case, it issues a notice of violation to the lender and gives it time to respond in writing, as well as an opportunity to meet with MRB staff to discuss the findings. Unlike the QAD, which can merely require indemnifications, principal reductions and refunds for perceived FHA violations, the MRB has the authority to take much more serious actions against a lender. For instance, it may: MRB cases are public, and the industry knows which lenders are subject to MRB proceedings and the outcomes of the cases. impose civil money penalties up to $7,500 per violation, or $1,375,000 for all violations committed during any oneyear period; suspend or terminate a lender s FHA approval; issue a letter of reprimand; place a lender on probation; or enter into a settlement agreement under which the lender is likely to both pay civil money penalties and indemnify HUD for a number of loans. Moreover, any action by the MRB, including a settlement agreement, results in publication in the Federal Register, and some actions may result in direct notification to other agencies. Thus, MRB cases are public, and the industry knows which lenders are subject to MRB proceedings and the outcomes of the cases. O FFICE OF I NSPECTOR G ENERAL PROCEEDINGS Much like the QAD, OIG auditors review lenders by visiting their offices, reviewing loan files and interviewing employees. After completing a review of any particular lender, the OIG conducts an exit conference with the lender, after which it prepares a draft report of its findings, including recommendations to the FHA commissioner for penalties against the lender. OIG findings typically mirror those at the QAD and MRB level, and often also include allegations of predatory lending or RESPA violations. A lender has an opportunity to submit a written response to the draft report. The OIG then considers the response and issues a final report of its findings and recommendations. The OIG sends the final report to the FHA commissioner and publishes it on the OIG s Web site. The FHA commissioner may or may not refer the case to the MRB for enforcement action. Notably, the OIG does not take any action against lenders. It merely issues findings and makes recommendations to the FHA commissioner. A final OIG report therefore constitutes no more than a preliminary set of findings and recommended penalties, and it is within the MRB s discretion whether to initiate an enforcement proceeding. Having said that, an OIG report should not be taken lightly. Not only is it a public document, but the allegations tend to be serious, and the likelihood of a resulting MRB action is high. S USPENSION, DEBARMENT AND LIMITED DENIALS OF PARTICIPATION HUD relies on different mechanisms to restrict an individual s or entity s participation in HUD and other federal programs for a specified period of time when HUD believes the allegations are severe enough to warrant a total severing of business ties. These mechanisms are intended to protect the public and the federal government, not for purposes of punishment, and HUD more often imposes them against individuals (e.g., the underwriter responsible for the loans cited in an MRB proceeding) than against entities. First, HUD may suspend or debar an individual s or entity s ability to do business with the federal government. A

5 suspension may be for as long as 12 months and a debarment may be for three years or longer, depending on the nature of the violations. Both types of action prohibit a person or entity from participating in most federal domestic programs, and both may extend to affiliated persons or entities. In addition to suspension or debarment, HUD may impose an LDP on an individual or entity. An LDP, which may last up to 12 months, extends only to participation in the HUD program under which the wrongdoing occurred. HUD, however, has discretion to extend it to other programs as well. While HUD considers a number of factors in determining whether exclusionary action against an individual or entity is appropriate, the primary question is whether the individual s or entity s actions were so severe as to affect the individual s or entity s present responsibility. Unfortunately, HUD does not define the term present responsibility, although HUD officials, in our experience, tend to consider prior bad acts and generally use the term loosely to refer to how the individual or entity presently conducts business with HUD and whether the individual or entity is trustworthy. If HUD determines that a person is not presently responsible, then HUD may elect to suspend or debar the wrongdoer, or impose an LDP. Final thoughts This is a crucial time for the FHA. HUD is struggling to expand the availability of FHA financing to borrowers injured by the lingering mortgage crisis while simultaneously bolstering its requirements to protect the Mutual Mortgage Insurance Fund. As mortgage lenders once again look to the FHA to expand homeownership and increase their FHA loan portfolios, and as HUD seeks to accommodate the increase in FHA business, enforcement is once again on the rise. Lenders must be careful to ensure compliance with HUD s lender and loan eligibility criteria and to keep apprised of new FHA requirements. The economic and reputation risks associated with noncompliance are significant, and lenders can do without any additional strain in this market. MIB HUD is struggling to expand the availability of FHA financing to borrowers injured by the lingering mortgage crisis while simultaneously bolstering its requirements to protect the Mutual Mortgage Insurance Fund. Phillip L. Schulman is a partner and Emily J. Booth is an associate in the Mortgage Banking/Consumer Finance Group of K&L Gates LLP, Washington, D.C. They can be reached at phil.schulman@klgates.com and emily.booth@klgates.com. REPRINTED WITH PERMISSION FROM THE MORTGAGE BANKERS ASSOCIATION (MBA)