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Checkbook sanctions: the HUD Reform Act of 1989: the stakes have suddenly gotten higher - and more costly - for FHA origination violations.

Checkbook Sanctions THE HUD REFORM ACT OF 1989

Borrowers casually inform a loan officer that their builder is supplying them with funds "under the table" to cover their down payment and closing costs in connection with a Federal Housing Administration (FHA)-insured loan.

A broker, in the presence of a loan officer, suggests that the borrower accept a loan from the seller and supply the loan officer with a phony gift letter to show the source of funds for the down payment.

In another FHA transaction, the lender never meets with the borrowers; instead, all contact with the borrowers is handled by the real estate agent or through the mail.

Under a new federal law, these and similar scenarios spell serious check-book trouble for lenders. FHA-approved mortgagees now face fines of up to $5,000 per violation. The HUD Reform Act of 1989 has raised the stakes for lenders participating in this federal insurance program.

Suddenly, these not so completely uncommon practices can result in real money penalties: more than ever, FHA lenders need to assure themselves that origination and servicing procedures comply with FHA's rules.

HUD Reform Act of 1989

In record time, the House and Senate pushed through the U.S. Housing and Urban Development Reform Act of 1989, giving Secretary Kemp the weapons he requested to wage war on program participants who don't know the rules or choose to ignore them.

A key component of the new statute is civil money penalties. Signed into law on December 18, the new law authorizes HUD will be authorized to levy a $5,000 fine per violation, up to a maximum $1 million a year, for any one of the following offenses: * Transferring an FHA loan to a

lender not approved by HUD; * Failing to segregate escrow funds or

deposit them in a federally-insured

institution; * Using escrow funds for improper

purposes; * Violating any contract or agreement

with HUD; * (Submitting false information or a

false certification to HUD in connection

with an FHA-insured loan; * Hiring individuals suspended or

debarred from HUD programs; or * Violating any written program


These money penalties are in addition to already available civil or criminal remedies, and may be imposed whether or not the HUD Secretary takes other administrative sanctions, (e.g. withdrawal of approval, debarment and other sanctions).

What else does the new law mean for lenders? It means, for example, that permitting a borrower to hand-carry a verification form, or omitting known liabilities or failing to conduct an interview with an applicant will cost mortgagees up to $5,000 per infraction. A single loan transaction can engender multiple infractions, which conceivably means fines of tens of thousands of dollars on a single transaction, plus indemnification if HUD pays an insurance claim. Similar penalties apply to multifamily lenders, Section 202 lenders, GNMA issuers and Title I home improvement lenders.

A mortgagee must knowingly violate HUD rules to be subject to a fine. The act defines the term "knowingly" as having actual knowledge or acting with deliberate disregard of the truth. That means a lender may not hide his or her head in the sand and claim ignorance. However, if a third party concealed facts, so that the lender, like HUD, was a victim of the fraud, the lender would not be subject to a penalty. Finally, fines may be imposed only after the lender has been provided an opportunity for a full evidentiary hearing, with appeal rights to federal court.

Money penalties are just one of the weapons the law gives HUD to combat fraud, waste and mismanagement. The Mortgagee Review Board (MRB), formerly a creature of regulation, now is codified. The MRB consists of the highest ranking officials at HUD, whose sole mission is to sanction mortgagees for violating FHA rules. The MRB already has the authority to suspend or withdraw a lender's FHA approval. The act strengthens these already impressive powers in several ways.

First, the reform package sets mandatory sanctions. Suspension of a lender's approval, for example, "shall last not less than six months" and withdrawal of approval "shall not be less than one year." The board may impose a permanent withdrawal for egregious and willful violations.

The act requires the HUD Secretary to establish and publish in the Federal Register a description of the causes of an administrative sanction. If the existing regulatory format is any indicator, the "new and improved" MRB can be expected to withdraw a lender's FHA approval for any of the following offenses: * HUD forms signed in blank, especially

Form 92900 the application

for mortgage insurance; * Failure to conduct face-to-face interviews

with borrowers; * Knowledge that the borrower did

not make the required down payment

or borrowed the funds

necessary for closing the loan; * Use of interested parties, such as

brokers, sellers, builders or applicants,

to transmit verifications of

employment and deposits; * Lack of a written quality control plan

for origination and servicing; * Knowledge that borrower assets

have been overstated or liabilities

underreported; * Kickbacks paid to brokers; * Falsified credit documents; * Failure to transmit in a timely manner

funds received from borrowers

for mortgage insurance premiums;

and * Knowledge that strawbuyers were

used to obtain FHA insurance.

Furthermore, the MRB will now, for the first time, be granted cease and desist authority. Whenever the MRB determines that there is "reasonable cause to believe that a mortgagee is violating, has violated, or is about to violate" a law, regulation or any other written requirement, the Secretary may issue a temporary order requiring the mortgagee to cease and desist from any alleged misconduct for a period not to exceed 30 days. The cease and desist authority is automatic and will be imposed before the MRB meets to decide a lender's fate.

While the act permits lenders to apply to federal district court to have the order set aside, that will provide small comfort compared with the negative publicity and loss of business that are almost certain to follow from such severe sanctions. Of course, such legal actions will mean substantial costs in time and money. It won't be long before HUD begins flexing its new statutory muscles - and the ripples will be felt throughout the industry.

The HUD Reform Act also removes the informality that was involved in requesting a waiver of regulations and handbooks. Now, only the Secretary or an Assistant Secretary may grant an exception to HUD's rules. Any waiver of regulations or handbooks must be in writing, must specify the grounds for approval, with notice published in the Federal Register.

Congress and the HUD Secretary shared an important and commendable goal in devising this provision: the elimination of favors to special interest groups. The lack of flexibility, however, may end up hurting the very people it was intended to benefit.

HUD Handbook 4000.4 for example, specifies that a direct endorsement lender who is placed on probation may not close a loan without first submitting the loan to HUD for precommitment review. This sounds fine. The problem is that any borrower whose loan had previously been approved and was awaiting settlement will be out of luck (because that loan will have to be sent to HUD for precommitment approval). In the past, a HUD field office could accommodate borrowers by waiving the handbook requirement. Under the new law, a waiver will take weeks, more likely months. The lack of a flexible and rational system for meeting the public's needs may well be replaced with a bureaucratic nightmare.

The act prescribes appraisal standards for all property insured by the FHA. It also requires consultants receiving payment for influencing HUD employees to register with the Secretary, a simple enough system - if it works - that might have avoided a mile-high stack of unattractive headlines during the last year.

Finally, private investor-owners seeking FHA insurance, for other than second homes, now are ancient history. While investors are only a small portion of FHA's business, they are a significant source of its troubles. In 1988, investors accounted for only 2.5 percent of FHA's business, but roughly 15 percent of its losses. Convinced that the agency does not exist to provide profit opportunities for private investors, HUD has wanted to rid the program of private investors for a long time. The new act grants Secretary Kemp this wish.

Impact on lenders

In their enthusiastic rush to reform HUD, Congress and the administration have left a number of questions unanswered and raised as many more. Let's consider several concerns we must face in the months ahead.

The need to focus on the bad actors - Civil money penalties against mortgagees make sense when lenders knowingly falsify documentation or participate in submitting false information to HUD. Fines do serve as punishment and deterrents to others. Very often, however, it is the loan officer, broker, builder, investor or other third party who has engineered the scam and been the one to profit by it. Interestingly, and unfortunately, the new legislation makes no provision for directly penalizing the bad actors. Civil money fines apply only to mortgagees, not to individuals or third parties.

Lenders have for years complained that HUD enforcement efforts were focused solely on lenders, who are viewed as the "deep pockets." The reform act does nothing to dispel that theory. That is neither fair nor wise. If a seller or broker improperly provides a borrower with funds, then that seller or broker too should be subject to a $5,000 fine. Congress did address this very issue in the Title I home improvement program. There, dealers, loan brokers and those that assist in taking an application are subject to civil money penalties. If reform is the agenda, then HUD needs to expand its enforcement actions to include the parties that actually perpetrate the fraud.

Handbooks elevated to the status of law - Heretofore, handbooks were merely guidelines, offered to provide greater detail and assistance in understanding statutory and regulatory requirements. With HUD's newly acquired authority to impose civil fines on lenders that violate handbook provisions, handbooks have been elevated to the status of law. Lenders can only have problems with this unlikely development.

Regulations must be promulgated pursuant to the Administrative Procedures Act. That means they are subject to notice and comment procedures before becoming law. No such protections exist for handbooks (probably because the need never seemed evident as long as handbooks were just that and no more). HUD issues handbooks without benefit of public notice or opportunity to respond. Many of the mortgage insurance handbooks at HUD are outdated and have been superseded by even less formal and more loosely promulgated mortgagee letters and field office bulletins. It is fundamentally unfair to penalize lenders for failing to comply with informal guidelines that are often antiquated, ambiguous and incomplete.

If HUD actually intends to fine lenders for violating handbooks, then the department has an obligation to adopt a "notice and comment" procedure. Notice and comment at the very least would offer HUD an opportunity to modernize its operations, to benefit from industry insights and to solicit ideas for further reform.

Cease and desist authority should be used sparingly - For nearly 15 years, the Mortgagee Review Board has operated effectively without resorting to cease and desist authority. Although HUD did not request such expanded authority, the act permits the MRB to shut down a lender's activities before the lender has had an opportunity to rebut the charges. While the MRB must provide the lender with a hearing within 20 days to contest the order, or the option of going to federal district court to enjoin the action, that is small consolation for the loss of business and reputation that such an extreme measure will engender. HUD must provide clear guidance as to when such sanctions will be imposed. Cease and desist authority should be used only as a last resort and then under the most limited of circumstances.

Need for evenhandedness - Congress has bestowed on HUD a vast new array of fire power. The artillery certainly should assure compliance with program requirements. Yet fairness requires a cease-fire until HUD establishes clear ground rules that will ensure the evenhanded application of sanctions. In determining the amount of the civil money penalty, the act requires HUD to take into account such factors as the gravity of the offense, the history of prior offenses, the ability to pay, injury to the public, benefits received and deterrence of future violations. Lenders who violate HUD rules should received similar penalties for like offenses. Mowing down offenders machine gun-style violates the notion of equity - that the punishment still should fit the crime.

What can the Industry do?

The HUD Reform Act is a warning that sloppy procedures, failure to adhere to written rules and cheating will not be tolerated. Lenders are on notice that lack of attention to detail or an urge to cut corners will carry a high price.

Lenders are not defenseless. Consider these suggestions in order to avoid these new, harsh penalties: * Training - Lenders must train

employees to recognize fraud. Loan

officers, processors and underwriters

who are alert to fraud will

recognize loans that appear suspicious.

Watch for down payments

other than cash; high income borrowers

with no credit history;

young borrowers who have accumulated

a large amount of unsubstantiated

assets; verifications of

employment or deposit that have

not been found; an address or profession

that is inconsistent with the

information on the loan application;

credit reports that show liabilities

that were omitted from the preliminary

application; documents altered,

whited out or showing other evidence

of alterations on the face of

documents; a post office box used

as an employer's or depository's

address; or an answering machine

at a salaried applicant's place of

business. Any one of these warning

signs may be easily explained, but

one or more should alert employees

to take particular care when originating

these loans. An early

warning system should help prevent

civil money penalties and enforcement

proceedings by HUD's

Mortgagee Review Board. * Communication is critical - Loan

officers, processors and underwriters

should share relevant

information about questionable

loans or suspicious parties to the

transaction. Quality and the free

flow of information prevent fraudulent

practices and avoid penalties

and administrative sanctions. * Prosecute those who commit fraud - If

management finds that their

employees or vendors have

engaged in fraud, the lender should

fire not only the employee, but also

should be ready to prosecute the

offender. If the lender must repurchase

a loan or indemnify HUD, the

lender should take civil action

against the former loan officer, seller,

broker, appraiser or other

interested party. If the mortgage

banking community is serious about

reducing and preventing the imposition

of administrative sanctions,

they must be prepared to prosecute

those who commit fraud. * Implement effective quality control - It

is time to dust off the quality

control plans that you put in desk

drawers after you submitted them to

FNMA and HUD. Why? Because

effective quality control helps management

set standards, measure

performance, determine compliance

with insurer, guarantor and investor

requirements - in short, helps

avert penalties and sanctions.

Your audit team, independent of your production and underwriting staff, should review an adequate sample of FHA loans. The critical first step is identifying those loans that seem the most likely candidates for fraud or violation of FHA requirements. Review every loan that had a zero payment, for example, or went into default in the first six months, or was foreclosed in the first year. (HUD tracks early payment defaults and claim payments by originating lender - you should get this information from HUD.) Concentrate on high loan-to-value loan ratios, older rather than newer loans, adjustable rate mortgages (ARMs), graduated payment mortgages (GPMs), loans in economically depressed regions of the country, and especially loans purchased from correspondents. If a pattern of fraud develops (i.e., involving the same loan officer and real estate agent), expand the sample to all loans having the same characteristics.

In your review, verify that legal and credit documentation exists and is accurate. Look carefully at the quality of the appraiser and the underwriting decisions. Be sure to select loans from all brokers, loan officers and processors. Adverse, rather than random sampling is the key to avoiding administrative sanctions. Management should require written findings each month so it can move quickly to correct deficiencies.

Congress has given Secretary Kemp the tools he requested to carry out his reform program. As a result, a higher premium will be placed on lender accountability. The Housing Reform Act of 1989 carries a steep price tag no lender can afford to ignore.

Phillip L. Schulman is a partner with the Washington, D.C. law firm of Brownstein Zeidman and Schomer and was formerly an assistant general counsel with HUD in charge of enforcement and compliance programs.
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No portion of this article can be reproduced without the express written permission from the copyright holder.
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Author:Schulman, Phillip L.
Publication:Mortgage Banking
Date:Feb 1, 1990
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