Forward on reverse: Marketing reverse mortgages 101--Education seniors and their advisors

Forward on reverse: Marketing reverse mortgages 101--Education seniors and their advisors

December 28, 2004

Lenders Beware: HUD Steps Up Credit Watch TerminationsPhillip L. Schulman Esq. and Emily BoothHUD, FHA, National Housing Act, FHA Insurance Fund, branch offices,
In an effort to reduce losses in connection with Federal Housing
Administration-insured mortgage loans, and in compliance with the
National Housing Act, 12 U.S.C. § 1735f-11, the U.S.
Department of Housing and Urban Development reviews the rate of
early defaults (i.e., loans in default for 90 days or more) and
claims on FHA-insured loans originated by approved mortgage
lenders. In September 1998, HUD promulgated regulations setting
forth the circumstances under which it will propose termination of
a lender's FHA Origination Approval Agreement due to high
default/claim rates (see 24 C.F.R. Part 202). It has since issued
numerous Mortgagee Letters clarifying HUD's intent and setting
forth the numeric thresholds required for termination. Until
recently, a lender's default/claim-rate had to exceed both the
national average and 300 percent of the local HUD field office
average in order to trigger a proposed termination action. On Sept.
25, 2002, HUD issued a Mortgagee Letter in which it announced that
it will gradually reduce the credit watch termination threshold
from 300 percent to 200 percent between September 2002 and June
When HUD proposes termination of a mortgagee, it affords the
mortgagee an opportunity to oppose the termination and defend its
default/claim rate. HUD has expressed willingness to consider
mitigating factors in determining whether a termination action is
appropriate in any given instance, and some lenders have avoided
branch terminations due to a showing of unique circumstances.
Nevertheless, it appears that most proposed terminations have
become effective, absent a lender showing that the
default/claim-rate on which HUD relied in proposing the action is
inaccurate. Termination of a branch office will prohibit that
branch from originating FHA-insured loans in a particular
jurisdiction for six months. Given the declining threshold, it is
now more crucial than ever that lenders understand how HUD's credit
watch termination initiatives work, including the scheduled
threshold reductions, effect of a branch office termination,
appeals process, defenses to a proposed termination and
reinstatement of FHA approval, and preventive measures that may
help avoid a proposed termination altogether. Lenders should take
advantage of HUD's Neighborhood Watch system to monitor their own
default/claim-rates and prepare to take preventive action in order
to avoid a notice of proposed termination and defend their
default/claim-rates in the event that HUD proposes termination of
branch offices. These matters are addressed below.
I. How the Credit Watch Termination Initiatives Work and
the Scheduled Threshold Reductions
In order to originate FHA-insured loans, a lender must obtain an
Origination Approval Agreement from HUD. Under this agreement, a
lender is authorized to originate single-family mortgage loans and
submit them to HUD for FHA insurance endorsement. In order to
minimize losses to the FHA Insurance Fund, however, HUD may
terminate a lender's Origination Approval Agreement for any
registered branch office based on that branch office's poor
origination performance, as reflected by the default/claim-rate of
its FHA-insured loans in a particular geographic area. Such action
is separate and apart from any action taken by the Mortgagee Review
Board (see 24 C.F.R. § 202.3; also see Mortgagee Letter
99-15). Since the first evaluation of lenders' default/claim-rates,
which was for the 24-month period ending on March 31, 1999, HUD has
terminated the Origination Approval Agreements of 120 branch
offices, representing 109 mortgagees.
A. HUD's Evaluation of Lender Performance
According to its regulations, HUD may terminate a lender's FHA
approval when the lender has a default/claim-rate for loans
endorsed within the preceding 24 months that exceeds 200 percent of
the default/claim-rate within the geographic area of the nearest
HUD field office to the branch under review, and the rate also
exceeds the national default/claim-rate. To this end, every three
months, HUD reviews the rate of lenders' defaults and claims on
FHA-insured single-family mortgages endorsed within the preceding
24 months (see 24 C.F.R. § 202.3; also see Mortgagee Letter
When evaluating a lender's performance, HUD will analyze the
lender's loan portfolio to determine whether its poor statistical
performance is based on the location of the loans originated, the
types of loans originated, or both. Because lenders who originate
loans in underserved areas are likely to have higher
default/claim-rates than lenders that originate loans in
higher-income areas, the Office of Management and Budget (OMB) has
established underserved census tracts, which are defined according
to whether incomes are a certain percentage below the area's median
income. HUD will compare the default/claim-rates of lenders that
originate loans in underserved areas to other lenders that
originate loans in the same underserved areas. HUD will also
consider the types of loans insured (e.g., 203b, 203k or 223e) to
determine whether a lender makes high-risk loans such that it
should be compared only to other lenders that make the same types
of loans.
Although the regulations grant HUD the authority to terminate a
lender's FHA origination approval when the lender's
default/claim-rate exceeds 200 percent of the local HUD field
office average, prior to issuing the first set of proposed
termination letters in mid-1999, HUD indicated that it would focus
on lenders with particularly high default/claim-rates and use a
termination threshold of 300 percent; however, it reserved the
right to lower the threshold to 200 percent in future rounds (see
Mortgagee Letter 99-15). Until recently, HUD had proposed
termination of lenders based on high default/claim-rates only where
their default/claim-rates exceeded both the national average and
300 percent of the local HUD field office average.
B. Scheduled Reductions
On July 27, 2002, HUD issued Mortgagee Letter 2002-16, which HUD
indicated would serve as notice that the credit watch termination
threshold would remain constant at 300 percent of the field office
default/claim-rate. HUD stated that from that point forward,
"Notice will only be issued when the threshold is changed and will
be issued at least 60 days in advance of the effective date of the
change." (emphasis added). On Sept. 25, 2002, however, HUD
announced the implementation of a reduction in the threshold (see
Mortgagee Letter 2002-20). Despite its pledge to give lenders
60-days notice before lowering the termination threshold, HUD gave
lenders only five-days notice of the first scheduled decrease,
which was effective on Sept. 30.
In Mortgagee Letter 2002-20, HUD indicated that reductions to
the credit watch termination threshold are scheduled to take place
gradually over a one-year period, as follows: 24-Month
Period Ending Date Termination Threshold
06/30/02---300 percent
09/30/02---275 percent
12/31/02---250 percent
04/31/03---225 percent
06/30/03---200 percent
HUD indicated that, after June 30, 2002, the threshold will
remain constant at 200 percent of the local HUD field office
II. The Effect of a Branch Office
When HUD terminates a mortgagee's branch office, that office is
precluded from originating FHA loans within the area served by the
HUD field office listed in the notice of termination for a minimum
of six months from the effective date of the termination. The
mortgagee's authority to purchase, hold, or service FHA-insured
mortgages, however, is not affected. In addition, the mortgagee may
submit to HUD for FHA insurance endorsement any loans that were
approved by a Direct Endorsement underwriter, that are covered by a
firm commitment issued by HUD, or that closed prior to the
effective date of the termination. While transactions at earlier
stages of processing may not be submitted for insurance, they may
be transferred for completion of processing and underwriting,
either to another mortgagee or to another branch office of the
mortgagee that is authorized to originate FHA-insured mortgages in
that area. It is important to note that HUD publishes lists of
mortgagees that have had their Origination Approval Agreements
terminated both in the Federal Register and on HUD's Website (see
Mortgagee Letter 99-15).
III. The Appeals Process, Defenses to a Proposed
Termination Action, and Reinstatement
A. The Appeals Process
If HUD determines that a mortgagee's default/claim-rate exceeds the
applicable threshold, it will issue a notice informing the
mortgagee that HUD is proposing termination of a specific branch or
branches and provide a list of the FHA-insured loans that defaulted
or resulted in a claim in the preceding 24 months. The notice will
inform the mortgagee that its Origination Approval Agreement for
the named branch(es) will terminate 60 days from the date of the
notice, unless the mortgagee appeals the determination within 30
days. A mortgagee may appeal a proposed termination within the
30-day window by submitting a written response, requesting an
informal hearing, or both. Given the threat to a mortgagee's FHA
origination authority and the seriousness of a termination
proceeding, including the publicity that would attach to an actual
termination, we recommend that any defense include both a written
submission and a request for an informal hearing. Mortgagees would
be wise to seek representation of counsel given that HUD will be
represented by an attorney from the General Counsel's Office. After
considering a mortgagee's defense, HUD will issue a decision in
writing stating whether the proposed termination has been sustained
or withdrawn.
B. Defenses to a Proposed Termination Action
While some defenses are available in opposing a proposed
termination action, it appears that most proposed terminations are
sustained absent a showing that HUD's calculation of the lender's
default/claim-rate for the stated time period was inaccurate. In
determining a lender's default/claim-rate, HUD relies on servicing
entities to report loan status timely and accurately through FHA
Connection or the EDI system. If a servicer reports the status of a
loan after the cut-off date chosen by HUD and after HUD has
extracted the information from FHA Connection, however, the
information on which HUD relies may be incorrect. For example,
suppose the cut-off date for credit watch termination purposes is
Dec. 31, 2002, the servicer last reported that a particular loan
was 90 days delinquent on Nov. 30, 2002, and HUD pulls this
information from FHA Connection on Dec. 31, 2002. HUD would presume
that the loan is 90-days delinquent as of that date; however, the
servicer may report on Jan. 1, 2003 that the borrower made a
payment and brought the loan to less than 90 days delinquent on
Dec. 1, 2002. HUD would not have received the later-reported
information and would not know that the loan was no longer
delinquent, as defined by HUD, on the Dec. 31 cut-off date. That
loan, however, should be removed from the list of defaulted loans
used to calculate the lender's default/claim-rate.
In order to ensure that HUD relies on accurate servicing
information, a lender who receives a notice of proposed termination
should obtain the payment history for each loan listed in the
termination notice directly from the servicer in an effort to
ensure that each loan was in fact 90 days delinquent on the cut-off
date. Where reported loans were less than 90-days delinquent, the
lender should recalculate its default/claim-rate and furnish the
supporting documentation to HUD. If a lender can bring the number
of defaults and claims below the applicable threshold, HUD will
likely withdraw the termination action.
While it may be difficult to overcome a proposed termination
absent evidence that HUD relied on incorrect servicing information
in calculating a lender's default/claim-rate, many lenders have
appealed proposed terminations and argued that exigent or unique
circumstances beyond the lender's control caused the high
default/claim-rate. In formulating a defense to a proposed
termination, a lender should consider the following:
(1) Location: While the OMB has designated certain underserved
census tracts that HUD will consider prior to issuing a notice of
proposed termination, a designated census tract may be insufficient
to characterize properly the loans cited in the termination notice.
For example, all of the cited loans may have been originated in a
particular zip code where the median income is far below that of
the designated census tract. Similarly, a lender may originate
loans in a metropolitan area that is not characterized as an
underserved census tract, but that has a wide disparity of incomes
depending on the particular location within the metropolitan area.
Under such circumstances, it would be important to determine
whether the loans cited in the notice of proposed termination were
all originated in a particular location that should not be compared
to other locations within the same HUD field office
(2) Patterns and Practices: A lender should determine what, if
any, similarities exist among the loans cited in the notice of
proposed termination. For example, was the same seller, real estate
agent, loan correspondent, loan officer, processor, underwriter or
appraiser involved in the cases? If so, what effect did such
similarities have on the loans at issue, and do the subject
individuals or entities still work for or with the lender?
(3) Underwriting: A lender should re-underwrite each loan cited
in the notice of proposed termination, in order to determine
whether all underwriting guidelines were met. For example, were the
borrowers' qualifying ratios within the benchmark guidelines of 29
and 41 percent, and, if not, were there sufficient compensating
factors to justify approval of the loans? The lender should also
determine whether there was any indication in the files that the
loans would become early payment defaults.
(4) Quality Control: A lender should review its quality control
procedures to ensure that they comply with FHA requirements, as
well as review quality control reports issued over the past few
years to determine whether they identified any weaknesses or
deficiencies in the company's origination or underwriting
practices. A lender should determine if they have made significant
changes to its quality control procedures and whether such changes
have had a positive effect on the lender's default/claim-rate.
(5) Fraud: In some termination proceedings, lenders have
indicated that they were the victims of fraud in the cases cited in
the notice of proposed termination. In such cases, lenders outlined
the steps that they took after identifying the fraud (e.g. firing
personnel, terminating relationships with real estate agents,
appraisers and/or others, and reporting findings to HUD), and
assured HUD that procedures had been implemented to avoid similar
problems in the future. In considering whether fraud existed in any
of the files cited in the notice of proposed termination, a lender
should retain its obligation to report fraud or misrepresentation
to HUD.
(6) Transfers or Streamline Refinances: In some cases, a notice
of proposed termination has included loans that did not belong to
the lender or that the lender had streamline-refinanced. For
example, where a lender orders an FHA Case Number and then assigns
the loan to another lender before closing, the lender must request
that HUD transfers the case number to the new lender. Otherwise,
HUD's records will show the original lender as the originating
entity, and they will be held accountable if that loan goes into
default. In addition, where a lender streamline-refinances a loan,
it should not be held responsible for origination or underwriting
functions in which it did not participate.
(7) Factors Beyond the Lender's Control: Finally, a lender
should identify the reasons why the loans cited in the notice of
proposed termination went into default or had claims paid, and
determine whether such reasons were beyond the lender's
anticipation or control. Such reasons may include, among others,
serious illness resulting in a borrower's inability to work or
incurrence of unexpected medical costs, unexpected loss of
employment, divorce resulting in a reduction of income, or death.
Note, however, that while HUD's regulations and Mortgagee Letter
99-15 both expressly state that HUD will consider relevant reasons
beyond a mortgagee's control that contributed to the high
default/claim-rate, HUD has taken the position that unforeseen
circumstances leading to default are a common occurrence for all
lenders. It therefore typically focuses on whether a particular
lender or group of borrowers faced an especially high ratio of
unforeseen circumstances or circumstances that are unusual in the
C. Seeking Reinstatement
When a mortgagee's Origination Approval Agreement is terminated,
the mortgagee must wait at least six months before applying for
reinstatement. A mortgagee will be eligible for reinstatement if
HUD determines that the underlying causes for termination have been
remedied. The mortgagee must submit a written request describing
any actions taken to eliminate the cause or causes of the poor loan
performance that led to termination, including any changes in
operations and/or personnel, as well as obtain an independent
review by a certified public accountant of the terminated office's
operations and mortgage production. The CPA's review must include
the FHA-insured mortgages cited in the termination notice, and the
CPA must furnish a report identifying the underlying cause for the
mortgagee's high default/claim-rate. As part of its request for
reinstatement, the mortgagee must also submit a written corrective
action plan addressing each of the issues identified in the CPA's
report, along with evidence that the plan has been implemented (see
Mortgagee Letters 99-15 and 00-17). A mortgagee's request for
reinstatement should be submitted to the Director of HUD's Office
of Lender Activities and Program Compliance.
IV. Preventive Measures
As indicated above, HUD announced that it will gradually reduce the
termination threshold until June 2003 (see Mortgagee Letter
2002-20). The current threshold, as of Sept. 30, 2002, is 275
percent. On Dec. 31, 2002, the threshold will drop again to 250
percent, and by March 31, 2003, the threshold will be 225 percent.
Finally, on June 30, 2003, the threshold will become 200 percent,
where it will remain.
Because the termination threshold is sinking fast, many lenders
have expressed concern over how to prevent proposed terminations of
their branch offices altogether. Two possibilities should come
immediately to mind. First, every FHA lender should monitor its
branch offices' default/claim-rates through HUD's Neighborhood
Watch system, which is part of the Web-based FHA Connection and was
designed as an early warning system that provides users an
opportunity to review their default and claim data by product type
and geographic area. Second, lenders should take care to engage in
stringent quality control in an effort to measure performance and
determine compliance with insurer, guarantor, and investor
In addition to monitoring Neighborhood Watch and engaging in
stringent quality control, many lenders have considered voluntary
termination of those branches with high default/claim-rates in
anticipation of receiving a notice of proposed termination from
HUD. Some lenders have merged such branches into other branch
offices that have FHA authority in the relevant jurisdictions,
while other lenders have simply terminated such branches and opened
new ones in their stead. These types of preventive measures have
enabled lenders to gain better control over loan performance and
avoid conflict with HUD.
The preceding article is for informational purposes only.
Nothing herein is intended or should be construed as legal advice,
or a legal opinion applicable to any particular set of facts or to
any individual's or entity's general or specific
Phillip L. Schulman Esq. and Emily Booth are employed by Kirkpatrick & Lockhart LLP.
Shulman may be reached by phone at (202) 778-9027 or e-mail at, and Booth may
be reached by phone at (202) 778-9112 or e-mail at