HUD Steps Up Credit Watch

Mr. Schulman, a frequent speaker at mortgage industry events, is an attorney in the Washington office of Kirkpatrick & Lockhart. This is an excerpt from an article advising lenders about developments in the FHA credit watch program.

In an effort to reduce losses in connection with Federal Housing Administration-insured mortgage loans, and in compliance with the National Housing Act, 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. It has since issued numerous Mortgagee Letters clarifying the department'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% 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% to 200% between September 2002 and June 2003.

When HUD proposes a termination of a mortgagee, it affords the mortgagee an opportunity to oppose the termination and defend its default/claim rate. The department has expressed willingness to consider mitigating factors in determining whether 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's 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 the department's credit watch termination initiatives work, including the scheduled threshold reductions, the effect of a branch office termination, the 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 be ready to both take preventive action in order to avoid a notice of proposed termination and to defend their default/claim rates in the event that HUD proposes termination of branch offices.

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.

When evaluating a lender's performance, the department 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 that 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 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.

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, the department 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, however, and after HUD has extracted the information from FHA Connection, the information on which HUD relies may be incorrect.

In order to ensure that HUD relies on accurate servicing information, a lender that receives 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.

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