Guilty Unless Proven Innocent: FHA’s Potential New Enforcement Regime

by K&L Gates LLP
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The use of statistical sampling to evidence compliance violations without actually performing loan level reviews is at the center of a new enforcement regime that the U.S. Department of Housing and Urban Development (“HUD” or “Department”) announced on Tuesday it is considering to monitor and sanction Federal Housing Administration (“FHA”) approved mortgagees. The announcement, published as a Notice in the Federal Register,[1] raises a host of questions, not the least of which is how HUD will implement these proposed enforcement efforts given the potential draconian consequences for FHA program participants.   Those who already perceive that the risks of doing business with the federal government are increasingly excessive, should sit up and take notice. HUD has offered lenders 60 days to comment on the Notice, and lenders would be wise to carefully consider the changes and make their voices heard.

As FHA-approved lenders are aware, the constant evaluation of origination, underwriting, and servicing activities by HUD’s Quality Assurance Division is a given in today’s FHA-insured mortgage loan program. HUD historically has utilized its Quality Assurance Division to evaluate FHA-approved lenders for compliance with FHA requirements through both routine and targeted audits, post-endorsement technical reviews, and monitoring of a lender’s early default/claim rates. In the last few years, particularly since announcing in November of 2012 that an independent actuarial review found the FHA Mutual Mortgage Insurance Fund woefully short of statutorily mandated reserve requirements, HUD has aggressively sought to mitigate the risk of the Fund’s insolvency. In addition to sharp increases in FHA mortgage insurance premiums and drastic changes to the FHA-insured reverse mortgage product, HUD has ratcheted up the amounts of civil money penalties and the number of indemnifications as part of its amplified enforcement efforts.

Tuesday’s Federal Register Notice reveals HUD’s next step in strengthening its oversight function. Specifically, the Department identified four areas of focus as it considers changes to the Quality Assurance process.[2]  Below we summarize each of the four areas for which HUD solicited comments.

Statistical Sampling and Extrapolation
Most significantly, the Notice discloses that HUD is considering establishing a Quality Assurance process that would utilize statistical sampling to estimate the defect rate of each lender’s overall FHA portfolio and then extrapolate the origination defect rate against all lender originations during the sampled time period. Lenders would then be required to compensate FHA for the estimated total risk to FHA resulting from the lender’s origination processes.[3]  HUD has requested comments on the use of, and optimal methodology for, a statistically significant random sample, including the nature of the loans that should be included or excluded from the sample.[4]

The Notice states that the purpose of this process would be to “increase the efficiency of FHA’s post-endorsement review process.”[5]  But, at what cost to FHA lenders? The proposal appears to adopt a theory of liability presently being applied by the Department of Justice against the largest FHA program participants. Now HUD seems to want to use those same enforcement techniques against every FHA lender.  As a result, this announcement raises some alarming questions and concerns.

The Notice lacks any detail regarding the types of deficiencies HUD would evaluate or include in a defect rate under this sampling and extrapolation approach. Would the defect rate be limited to objective criteria, such as overcharged fees? If so, how would a penalty based on such objective criteria apply to a lender’s entire FHA loan population? For example, if borrowers in 4% of the sample size were overcharged by an average of $10 for a particular fee, would 4% of the lender’s entire population be entitled to a refund of the overcharged amount? Would HUD require that the lender remit this amount in the form of a penalty to HUD?

In addition, will HUD also consider establishing a defect rate for the many subjective FHA origination and underwriting criteria that require a weighing of factors to determine a borrower’s eligibility for FHA financing? For example, how would HUD establish a defect rate concerning a lack of sufficient compensating factors, when no two borrowers share the exact same credit profile? Creating or applying a defect rate to a lender’s entire portfolio based on subjective criteria, without a loan-level examination of the circumstances involved in the underwriting of loans not included in the sample, raises fundamental questions about the fairness and accuracy of the proposed approach. Moreover, the level of care a lender would have to exercise in originating and underwriting every single FHA loan would be magnified if the risk that even a small error could be extrapolated to the lender’s entire FHA portfolio.

Statistical sampling requires a valid sample. How will the Department build a sampling model that is appropriately random and statistically accurate? To date, HUD has focused its sampling efforts on an adverse selection of loans with early payment defaults. What changes should HUD consider in amending its current sampling procedures to ensure statistically valid results? The Notice specifically requests comments on the composition of the sample and the methodology for creating a statistically significant random sample. 

Origination Quality Standards
Second, HUD is considering whether to establish a threshold risk tolerance for loan manufacturing, or loan deficiencies. The Notice posits that such a standard might set a maximum threshold for the percent of loans with defects, or unacceptable patterns of recurring defects that, when surpassed, would automatically subject that lender to additional oversight, or trigger enforcement action.[6]

This proposal also raises several questions regarding HUD’s contemplated implementation of risk tolerance levels. For example, on what types of loan deficiencies would the tolerance be based? For subjective underwriting criteria that require a loan-level analysis of the borrower’s individual credit file, how would defects be determined, tolerances be set, and thresholds be applied? Is it premature to establish such risk tolerances for underwriting defects unless and until HUD establishes more clear, objective standards regarding underwriting defects? Establishing a threshold risk tolerance may also have unintended consequences. If faced with the threat of enforcement action, lenders might amend their origination activities to ensure the maximum tolerance is not exceeded, which could limit access to credit as lenders further tighten underwriting policies based on the tolerance. Without corresponding clarity with regard to underwriting requirements and what constitutes a deficiency, lenders could potentially face fair lending concerns in the process of managing to the deficiency tolerance.

Changes to Annual Reviews and Comparisons of Early Defaults and Claims
Third, as required by statute, the Department currently reviews lenders’ rate of early defaults and claims for FHA-insured loans originated and underwritten by FHA-approved lenders. The Notice announces that HUD is examining how, within the current parameters, the review and comparison may achieve an improved assessment of a mortgagee’s performance.[7]  One example provided by the Department requests comments on whether FHA should establish a specific standard of defaults and claims that mortgagees should not exceed within a given construct. Such a standard, states the Notice, could be based on FHA’s review of all mortgagees’ performance in the area, thus undertaking the statutorily required comparative review, but would also be based on certain specified criteria that reflect generally accepted practices of prudent and responsible lending.[8]

Many things remain unclear. On what additional criteria would HUD base its review of early defaults and claims? How would these criteria interplay with HUD’s evaluation of a lender’s percentage of early defaults and claims to determine whether to pursue enforcement action against a particular lender? What, if any, penalties would HUD pursue if the contemplated standards are exceeded? What interplay, if at all, would this proposal have with HUD’s current Credit Watch program? 

Appropriate Consequences for Loan Defects
Finally, the Notice solicits comments from the public and industry participants on what types of origination or compliance defects found through HUD’s Quality Assurance process should be subject to indemnification or other administrative remedies or a combination of responses by HUD.[9]

As indicated above, in recent years, HUD has become more aggressive in the penalties it seeks to impose for origination defects. Specifically, lenders have experienced an increase in the defects for which HUD pursues indemnification, as well as an increase in the number and amount of civil money penalties HUD seeks to impose through its administrative action authority. For example, historically a loan over-insured by a few hundred dollars as a result of a miscalculation of the maximum mortgage amount resulted in a request that the lender buy down the loan by the over-insured amount. Recently, the Department has pursued indemnification for this error. The Notice provides the industry with a unique opportunity to address directly its position on what loan origination defects are severe enough to warrant indemnification, as well as comment on those compliance issues for which indemnification, which often results in the payment of hundreds of thousands of dollars to HUD for each loan indemnified, is too harsh a penalty. 

The Notice states that HUD also welcomes comment on all issues related to its Quality Assurance process and how this process may be improved.[10]  Any changes the Department initiates as a result of its review of the Quality Assurance process will be prospective only, and will not apply to any pending claims, reviews, or enforcement actions.[11]  It is unclear from the Notice, however, how HUD will implement these proposals. Will it pursue amendments to the National Housing Act? Will it amend its own regulations, or issue Mortgagee Letters announcing changes? No timeline was offered for implementation of these changes.

*           *           *           *           *

As discussed above, action on any of these four areas could have a significant impact on FHA lenders. The enforcement mechanisms outlined in the Notice would represent additional steps by the Department to improve FHA’s safety and soundness and to transfer the risks associated with FHA-insured loans from the Department, and thus the American taxpayer, to FHA-approved lenders. The Notice solicits comments from industry participants and others with an interest in the FHA program. It is imperative that FHA lenders provide comments, raise questions, and demand clarity on how HUD intends to implement the changes. Future participation in the FHA program demands no less.

The Notice can be found here.  Comments are due by September 9, 2013.[12]   If you have any questions regarding the Notice, or would like assistance in preparing comments to HUD regarding the changes the Department is considering, please contact Phil Schulman, at phil.schulman@klgates.com or (202) 778-9027, or Krista Cooley, at krista.cooley@klgates.com or (202) 778-9257.

Notes:
[1] See 78 Fed. Reg. 41,075 (July 9, 2013).

[2] Id. at 41,076.

[3] Id.

[4] Id. at 41,077.

[5] Id. at 41,076-41,077.

[6] Id. at 41,076.

[7] Id.

[8] Id.

[9] Id.

[10] Id. at 41,077.

[11] Id. at 41,076.

[12]  Id. at 41,075.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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