A visit from the VA: here are some tips on how to handle a visit from VA's new monitoring unit.

A VISIT FROM THE VA

Here are some tips on how to handle a visit from VA's new monitoring unit.

Last year, Freddie Mac created an investigation unit to detect mortgage fraud. The HUD Reform Act of 1989 gave authority to the federal housing agency to impose $5,000 civil penalties against lenders violating HUD-FHA requirements.

This year, the Department of Veterans Affairs (VA) got into the act by creating a monitoring unit to measure VA-approved lenders' compliance with VA regulations.

What should all this beefed up agency monitoring mean to you? It means too much to ignore. Don't shrug it off as one more ho-hum layer of federal bureaucracy. Failure to measure up can mean expensive requests for indemnification and even the withdrawal of a lender's VA-approval status.

Lender monitoring is clearly becoming a fact of life in the mortgage business. This article is intended to help you learn to live with this new reality. To prepare you for what the VA might be looking for when they conduct a review, this article will examine the organization of the monitoring unit; how the unit selects lenders and loans for review; how the VA conducts those reviews; and how your company should respond if it faces some unpleasant findings as a result of a VA review.

Monitoring mission

In May 1990, the VA's Veterans Benefits Administration established the monitoring unit under the authority of the director of the Loan Guaranty Service. Its mission: "[to] help prevent waste, fraud and abuse in the loan guaranty program by determining lender compliance with governing laws, regulations and policies," according to Hilda Pena, the chief of the monitoring unit.

The monitoring unit has 15 staff members at VA headquarters in Washington, D.C. and has regional offices based in Nashville, St. Paul and Los Angeles. Fifteen monitoring staff to cover the whole country may not sound like much--but these field representatives are expected to successfully complete reviews on 100 to 200 lenders annually.

How do they choose who they will monitor? Leads on who might be a good prospective candidate are obtained from VA regional offices, other federal agencies and from records of borrowers' complaints. Lenders that originate the largest volume of VA business are likely to be reviewed every year. In addition, because the VA maintains data on lender default and claim rates, lenders whose records show a disproportionate number of claims, early payment defaults and zero payment defaults, will certainly be among the 200 lenders selected for review by each regional unit. Therefore, it is essential that your internal control system be capable of detecting early defaults, identifying deficiencies and correcting them before the monitoring staff arrives on your doorstep.

Three to seven days before the review, the VA monitoring unit will notify the lender and fax a list of early payment default cases to be examined. In addition, the lender will be asked to complete a questionnaire concerning its principal activities, business plan and key personnel.

Each on-site review begins with an opening conference between the monitoring staff and the lender's top management. The monitors will explain the review process and discuss background information on the lender's operations. VA monitors generally select approximately 20 cases for careful screening, followed by a page-by-page review of each loan. The monitoring staff carefully compares each loan document to determine inconsistencies and misrepresentations. Legal and origination documents, appraisals and underwriting decisions are carefully scrutinized.

The monitors are trained to spot inconsistencies--for example, applicants with low incomes yet high, cash-on-hand statements; patterns where the same loan officer, underwriter, branch manager, Realtor or builder appear in cases that became early payment defaults. "[Lenders'] loan processing staffs and internal auditors should use these same techniques to verify the quality of [their] procedures" says Gerald Ference, the monitoring unit's assistant to the chief.

Two VA field representatives conduct the on-site review that takes between two and four days. During that time, they call veterans to determine whether they, in fact, made the requisite down payment; decide whether secondary financing was involved in the transaction; and find out whether any false information was knowingly submitted to the VA by the lender's representatives. The monitors also will request reconfirmation by mail of the verifications of employment and deposit; randomly sample credit reports for accuracy; and conduct a quality review of the staff appraisers participating in the VA's new Lender Appraisal Processing Program (LAPP). If the monitors detect signs of false information, they contact employers, vendors and other third parties.

Common findings

What is the new unit's track record to date? Most of the findings concern technical violations. Findings of a more serious nature that can lead to repurchase demands and/or administrative sanctions, however, include:

* omitted or understand borrower

obligations and overstated borrower

assets or income; * forged or fraudulent verifications of

employment and deposit; * forms signed in blank, especially VA

Application for Home Loan

Guaranty forms 26-1802a and 26-1820; * excessive or impermissible fees

collected by the lender; * use of third parties to transmit

employment verifications; * misrepresentations regarding

veteran status or eligibility.

Once the monitor has completed the on-site review and evaluated the findings, an exit conference with the lender takes place. "The purpose of the exit conference," says Chief Pena, "is to discuss the deficiencies noted during the review, let the lender know we will be conducting post-audit reviews off-site and allow the lender an opportunity to respond to our initial findings."

A word of caution: Don't think of the exit conference as a confessional, where lenders admit their discretions, promise to set up new controls and then their problems are solved. It doesn't work that way. Instead, use the exit conference as an opportunity to discover the nature and extent of the VA's findings. If you can easily resolve a misunderstanding, or show evidence to explain your conduct, then do it. If not, listen to what the monitors have to say and tell them that your written response to their printed report will address each finding and will describe the corrective actions to be taken to avoid any recurrence of the cited deficiencies.

Once the field representative completes the on-site and post-audit review, a written report will be submitted to the chief of the monitoring unit in Washington, D.C. The report will detail the findings, document them and suggest recommendations. The monitor's report generally is filed within 30 to 45 days of the site visit.

The chief of the monitoring unit then will evaluate the report and submit it to the director of the Loan Guaranty Service, who then will issue the report to the lender within 60 to 90 days after the site review. To date, some 30 on-site reviews have been completed; the first written reports will be issued to lenders in the fall.

The written report will detail each infraction and identify the section of the VA's rules that were violated. If the infractions are minor, the lender simply may be asked to correct its policies and procedures or amend the company's quality control plans. If loan guarantees were based on false information resulting from the lender's underwriting practices, however, the lender will be asked to indemnify the VA for its losses.

However, it can get even more serious. If the director of the VA Loan Guaranty Service should determine that the violations represent a serious pattern or practice of disregard for VA rules and regulations, the case may be referred to the Office of Inspector General (OIG) to conduct a full-scale audit or investigation. Serious infractions, intentional misconduct and consistent failure to comply with VA policies will result in debarment of employees and principals. Such practices ultimately may lead to the loss of VA-approval status.

Responding to a report

Lenders, of course, have some available means of recourse. First, they should review the report's findings carefully and prepare a written response. This represents a lender's best shot at rebutting the monitor's findings if the findings are considered erroneous. If this opportunity is used wisely, the lender may avoid unnecessary repurchase demands and prevent the imposition of administrative sanctions and loss of the company's approval.

If appropriate, use one or more of the following available defenses:

Contest the facts--Private mortgage insurers as well as Fannie Mae and Freddie Mac impose absolute liability when it comes to mortgage fraud. That is, if there is fraud or false information that adversely affects the loan, these secondary market entities take the position that the lender is liable for all losses, even if the problem was caused by third parties or circumstances beyond the lender's control.

Not so with VA-guaranteed loans. VA loans are incontestable except in cases of fraud caused by the lender. Thus, with VA-guaranteed loans, the monitoring unit must prove that the fraud or false information was caused by some act or omission on the part of the lender. The key here is whether the lender knew or should have known that the information submitted to VA was false. The first line of defense to a monitoring unit request for indemnification, then, is to demonstrate that the lender, like the VA, was a victim of the fraud (and not its cause).

The monitoring unit may have proof, for example, that a Verification of Employment (VOE) is fraudulent--but that does not automatically mean that the lender submitted false information to the agency. If the lender mailed the verification to the applicant's employer, and the employer, as a favor to the applicant, inflated the applicant's salary without the lender's knowledge-- then the lender cannot be held liable for any losses resulting from the underhanded conduct of the applicant or employer. Lenders should contest the facts, wherever possible, by proving that they complied with VA requirements and that the false information was caused by others outside the institutions and beyond the lender's control.

Contest the law--VA requirements change. A particular requirement in effect today may not have been in effect when the loan was originated. Don't accept the monitoring unit's finding on its face, but rather point out the rules that were in effect at the time the loan was made.

Remember too that the VA has 47 regional offices, each with its own specific culture. A "national rule" may have been violated, but if the lender can show that in Los Angeles, for example, the regional office interprets acceptable income/debt ratios more liberally than do national underwriting standards, then the lender may have a defense to a request for indemnification.

Argue harmless error--If neither the facts, nor the law are on your side, don't give up. Sometimes the infraction is technical in nature or did not affect the guarantee of the loan. In such a case, the lender can argue that the error was such that it did not alter the underwriting judgment made on the loan.

For example, the lender may have inadvertently omitted a $1,000 liability when underwriting the loan. If the lender can show, however, that even if the debt were included, the borrower still would have qualified for the loan, then the error was harmless--and the lender would not be required to indemnify the VA for any losses associated with this transaction.

Describe mitigating circumstances--Put the report's findings in the proper context. The monitoring report cites the deficiencies associated with the worst cases in your portfolio. If possible, point out, for example, that your company's default/claims rate is below the VA's national average or that the deficiencies identified in the report were caused by a single loan officer's actions who the company has since dismissed before the monitors arrived for their review. If an economic downturn was the real cause of the defaults, rather than your origination practices, don't hesitate to offer statistics or other evidence supporting these mitigating circumstances. Put your best foot forward and demonstrate that these infractions are the exception, not the rule.

Finally, your written response should include a section that addresses the remedies you have taken or will take to prevent a recurrence of any deficiencies such as:

* firing staff involved in fraudulent

practices; * refusing to do business with

questionable or dishonest builders,

brokers and vendors; * implementing an effective quality

control plan that addresses each of

the deficiencies identified in the

report; * setting up additional training for

loan officers, loan processors and

underwriters.

Don't take the opportunity to respond to the monitoring report lightly. If the report's findings are not fully in accord with the facts, or if they ignore mitigating circumstances, be sure your response corrects those errors and omissions. Provide evidence that establishes that your procedures did not violate VA requirements; that the infractions cited are not directly attributable to the actions or omissions of your company; that the offending actions do not constitute violations of VA rules; or that they were merely technical deficiencies that did not materially affect the underlying cause for default.

The VA's monitoring unit is just now gearing up. The early lender reviews, according to Chief Pena, have been favorable. She has been impressed with lenders' compliance with the program's requirements and the sophistication of their quality control operations. "This is not a `Gotcha' exercise" says Chief Pena. "On the other hand," she says, "if we find violations we will not hesitate to require indemnification and sanction those lenders that violate our rules." Lenders, be warned.

Phillip L. Schulman is a partner with the Washington, D.C. law firm of Brownstein Zeidman and Schomer where he specializes in mortgagee enforcement and compliance matters before the federal agencies.