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TESTIMONY OF

MARCH 16, 2000 

Mr. Chairman and Members of the Subcommittee, today I will present to you the Office of Inspector General’s (OIG) views on the Department of Veterans Affairs (VA) Loan Guaranty Program. I will focus on Loan Guaranty Housing Credit Assistance Program Accounting, audits and investigations of Loan Guaranty Program Fraud, attributes of defaulted home loans, and the Loan Guaranty Service’s quality control system.

Housing Credit Assistance (HCA) Program Accounting

At the end of Fiscal Year (FY) 1999, the Housing Credit Assistance (HCA) program loan guaranty liability totaled $5.8 billion, and direct loans receivable and foreclosed properties awaiting sale totaled about $3.6 billion; program subsidy costs totaled $890 million for the year. The Department substantially completed corrective actions on conditions we reported on in prior years concerning serious weaknesses in direct loan portfolio, loan sales accounting, and Credit Reform subsidy model issues. Following the end of FY 1999, VA also began processing HCA program expenditures directly through VA's core financial system to resolve a Federal Financial Management Improvement Act noncompliance issue.

However, material internal control weaknesses remain that impede timely completion of financial statements and reduce the effectiveness of safeguards over HCA program resources. These six weaknesses are:

• The HCA General Ledger System is not compliant with Federal financial systems requirements.

• Detailed foreclosed property information in HCA program systems was not periodically reconciled to the HCA control accounts.

• About $30 million of refunded loans which were processed at VA Regional Offices was not recorded in the HCA General Ledger System.

• Time lags existed in recording program transactions in HCA general ledger accounts.

• The liability for loan guarantees and related Credit Reform subsidy re-estimates could not be prepared timely because of HCA program and financial system weaknesses.

• Weaknesses in oversight of the contractor managing VA's $1.8 billion direct loan portfolio increased the Government's vulnerability to losses.

The Veterans Benefits Administration had a number of organization and system changes underway to address the internal control weaknesses. Management officials informed us that their goal is to complete all corrective actions by the end of FY 2000. Timely implementation is important. Accurate, reliable, and timely financial reports are essential to enable managers to carry out their fiduciary and stewardship responsibilities to VA beneficiaries and the public. Without them, the HCA financial statements will continue to be prepared untimely and are vulnerable to error. Additionally, program assets and resources may not be efficiently used or adequately safeguarded.

A goal of the Office of Inspector General is to ensure that all indications of serious criminal matters, impacting the loan guaranty program, are thoroughly investigated and referred to the Department of Justice or appropriate state agency for prosecution. The Office of Inspector General is conducting proactive and reactive reviews of defaulted and foreclosed VA loans to identify possible loan origination fraud and property management fraud.

Loan Origination Fraud

Loan Origination fraud occurs in VA’s home loan program. Loan origination fraud results when incorrect or falsified information is used to obtain or sell a guaranteed or insured mortgage. The Office of Inspector General’s proactive and reactive reviews of defaulted and foreclosed VA loans have focused on certain geographical areas with high default rates. As a follow-on to this review of high default areas, we audited the underwriting practices of six lenders (three in North Carolina and three in Georgia). We found potential fraud indicators in four of the six audits, in which lenders may have underreported the borrowers’ dependents (which requires more family income) and may not have disclosed some of the borrowers’ debts in the loan analysis. We also identified other practices that may or may not have been intentional but which contributed to the perception that the applicants were acceptable risks. The cases involving possible fraud are under investigation by our office. An example of a recent investigation is:

• A joint investigation by VA OIG, U.S. Postal Inspection Service, and HUD OIG resulted in the arrest of four individuals on charges that they engaged in a loan origination fraud scheme for properties with loans being guaranteed by VA and HUD. An attorney and a real estate agent were both arrested after an investigation disclosed that they submitted documents to the Government which contained false information regarding applicant’s income, assets, and liabilities. Also arrested was an individual formerly employed by a new home developer after investigation disclosed that the individual allegedly produced fraudulent Internal Revenue Service W-2 forms and other employment verification documents for the potential homebuyers. The fourth person arrested thus far was a real estate appraiser, arrested after it was disclosed that the individual allegedly appraised properties above market value. With the appraised value of the home inflated, the mortgage bank was able to issue a loan for greater than the actual value enabling the buyer to pay off personal debt with the difference. Although the total loss to the Government is unknown at this time, the exposure is in excess of $1.2 million. The investigation continues.

Investigations into property fraud focused mostly on equity skimming. Equity skimming fraud involves profiting by assuming or purporting to assume existing loans, renting the homes to tenants, not making payments, and stealing the rental proceeds while the loan foreclosure is being processed. For example:

• An individual was sentenced to 78 months’ imprisonment, a fine of $15,000, and court ordered restitution in the amount of $571,000 after conviction at a jury trial on charges of equity skimming, mail fraud, bankruptcy fraud, and money laundering. A VA OIG investigation disclosed that the individual fraudulently assumed 61 properties with mortgages guaranteed by VA or insured by HUD, rented the homes, and kept the rent monies for himself without making the required mortgage payments. His actions caused all of the loans to go into default and eventual foreclosure. In addition, he delayed foreclosure proceedings by filing multiple bankruptcies under fictitious names. He deposited and withdrew large sums of cash, so that he could launder the illegal proceeds of the scheme.

The Office of Inspector General reviewed the effect of the implementation of VA’s Housing Credit Assistance program policies on loan defaults. Our review found that:

1. Loans made to active duty service members defaulted more often than loans made to veterans, and also tended to default earlier in the loan period. Service members may be more prone to default on loans due to several factors, including: inexperience at handling debt and difficulty in coping with mortgages when transferred to other duty stations or after being discharged.
2. Loan defaults were also higher in vicinities with declining home values. Borrowers in those vicinities were having difficulty dealing successfully with mortgages or disposing of properties when their income was curtailed. For properties we reviewed, the average loss in value from the original appraisal to the liquidation appraisal was about 19 percent. There is little that VA can do to prevent losses and reduce defaults in vicinities with declining home values.

Loan Guaranty Service’s Quality Control System

A recent review of Loan Guaranty Service’s quality control system concluded that several quality control conditions required management attention:

Loan Guaranty Service Management had not Periodically Updated Their Management Control Plan or Completed Internal Control Reviews

Loan Guaranty Service management had not updated their Management Control Plan, identifying high-risk areas in over 5 years nor had they completed required Internal Control Reviews of those areas in over 3 years. Internal Control Reviews are a primary method of identifying waste, fraud, and abuse.

Loan Guaranty Services recently revised Statistical Quality Control program had not identified a significant number of deficiencies concerning compliance with Loan Guaranty Services policy and procedures.

The Lender Monitoring Unit had not issued timely reports identifying loan underwriting deficiencies. We found that the Monitoring Unit actively reviewed lender underwriting and sent timely draft reports to Loan Guaranty Services management, but management had not issued timely final reports to the lenders. For Fiscal Year 1999, the Monitoring Unit had completed eight evaluations and draft reports, but as of August 1999, Loan Guaranty Services management had not issued any of the reports. The reports are important because they frequently result in improved underwriting and in lenders indemnifying VA for egregious underwriting resulting in foreclosure or VA having to pay the guarantee. Lenders indemnify VA for the guaranteed amount of the loan resulting from egregious underwriting, currently a maximum of $36,000.

Oversight of Direct Loan Servicing Needed Improvement

VA’s oversight of the contractor servicing VA’s direct loans had not ensured that loans were actively serviced. In June 1997, Loan Guaranty Service contracted for the servicing of its direct loan portfolio. As of September 30, 1999, the portfolio included about 29,000 direct loans with an unpaid principal balance valued at $1.8 billion. About 3,200 of these loans, with an unpaid principal balance valued at $209 million, were in serious default. VA defines seriously defaulted loans as those that are 5 or more months delinquent. The borrowers who are in serious default would need to pay $36 million to clear their outstanding delinquencies.

Our review of a sample of seriously defaulted direct loans revealed a number of contractor performance deficiencies.

• In 67 percent of the cases tested, the contractor had not actively serviced the loans.

• In 33 percent of the cases, the contractor had not timely referred seriously defaulted loans for foreclosure.

• In 24 percent of the cases, the contractor had not routinely monitored bankruptcy cases.

The 3,200 seriously defaulted direct loans in the portfolio included about 1,700 with an unpaid principal balance valued at $110 million, where the borrower had filed for bankruptcy protection. Foreclosure action had not yet been initiated on the remaining 1,500 seriously defaulted loans, with an unpaid principal balance valued at $99 million. On the loans in our sample where the contractor had not made a timely foreclosure referral, the average delinquency was 11 months, with an average unpaid principal balance of $66,900. The average amount necessary to clear the delinquencies on these loans was $6,400. For the loans where the bankruptcy was not routinely monitored, the average delinquency was 47 months, with an average unpaid balance of $72,400. The average amount necessary to clear the delinquencies on these loans was $27,000.

In June 1997, at the time loan servicing was outsourced, Loan Guaranty Service had established a Portfolio Loan Oversight Unit (PLOU) to monitor the contractor’s performance. We found that the PLOU currently relies on the contractor’s self-generated reports to evaluate its performance. However, the contractor’s reports contained data that the PLOU can not validate. The PLOU also planned quarterly site visits to the contractor’s headquarters, but due to limited travel resources only two visits were made during FY 1999. We also found that Loan Guaranty Service did not monitor the servicing of potential foreclosure and bankruptcy cases to ensure appropriate and timely action was taken to prevent unnecessary loss of government funds.

As Loan Guaranty Service reorganizes and, in some instances outsources, its activities, it is essential that program integrity is maintained through close oversight of not only its own operations, but those of contractors and program participants as well.

This completes my statement Mr. Chairman. I would be pleased to answer any questions you and the committee may have.

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