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 2003. 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 99-15). 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 default/claim-rate. II. The Effect of a Branch Office Termination 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 jurisdiction. (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 industry. 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 requirements. 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 circumstances. 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 [email protected], and Booth may be reached by phone at (202) 778-9112 or e-mail at [email protected].