msnbc.com
updated 4/9/2007 5:14:01 PM ET 2007-04-09T21:14:01

As the government’s head of the investigations in the savings and loan industry collapse of the late 1980s and early 1990s, Kenneth Donohue is no stranger to mortgage fraud.

Today, as inspector general for the Department of Housing and Urban Development, Donohue is looking into fraud and abusive lending practices related to mortgages insured by the Federal Housing Administration.

In the past three years, the roughly 650 investigators and auditors in Donohue's office have conducted 190 audits, developed cases leading to some 1,350 indictments and generated some $1.3 billion in restitution orders.

In an interview with MSNBC.com, Donohue reviewed the scope of his office’s work, the root causes of the jump in fraud and abusive lending practices, and his concerns about proposed changes at the FHA in response to the turmoil in the subprime mortgage market.

(Officials of the FHA, a separate agency of HUD, declined MSNBC.com’s request for an interview.)

The following is an edited transcript of Donohue’s remarks:

Why are we seeing more problems with bad mortgages?

I think it’s attributed to what I think is a lack of oversight and aggressive enforcement within the (Federal Housing Administration) portfolios.

My colleagues in the FBI have recently spoken about what they see to be a substantial amount of potential fraud in the commercial paper market — which is what the subprime is. I think they have a more difficult challenge because they’re at the mercy of receiving these referrals from the industry. ... The question is: Do (subprime lenders) work these things out civilly without bringing it to the attention of their shareholders?

FHA is different. We see the portfolios, and we see the folders, and they get referred to us. So we have a better handle on seeing some of this stuff as long as the department cooperates with us.

What has happened to the mortgage lending process that created these problems?

FHA has an outstanding mortgage insurance portfolio of about $396 billion. I’m the first one to say that the lenders, the workout folks, the appraiser — listen, most of them are honest people trying to do an honest day’s job.

But what I found — like I found in the savings and loan industry — is there are those out there that are going to do what they possibly can to bring in the business.

The (mortgage) industry was trying to create additional homeownership. And that’s very nice, and I think that’s a great thing to allow people homeownership. But at what cost? ... I think what happened is that people — unscrupulous people — took advantage of that, and what they did was go out and solicit prospective buyers.

FHA is proposing new rules and procedures. Will these help fix the problem?

There are recommendations in (the proposed Homeownership Act) increasing (insurance) premiums and going back and directing zero down payments. A number of recommendations they’re proposing in this thing give me great concern.

You’ve got to remember something: FHA is not supposed to be profit-driven. They’re a federal program. They’re really designed to reach those people that are first-time buyers.

The potential exists here that much of the subprime paper will be refinanced. So that borrower now comes in contact with another lender, another transaction and potential predatory lending, and then FHA takes that paper over.

A quarter to a third of the portfolio FHA has now is zero down payment. So now the problem you're faced with is you’re now getting paper with subprime risk, and the answer to that is, "Let's just increase the premiums."

Why are zero down payments a problem?

You have a buyer in this country that comes in and wants to buy a spec house and they come back and have no money to put down. So the builder goes back and says, "You have no money for closing cost so we’re going to give you a gift.” It’s a paper transaction the day of closing. They cover all the closing costs, and they call it a gift become of an IRS provision.

So now you’ve got somebody in a house who put no money down, that additional cost that covers that gift rolls into the mortgage. But what you’ve done is you’ve artificially inflated the value of those spec houses and then you give them a very attractive ARM mortgage that’s going to, as we see, accelerate in the next two or three years.

This is a misuse of the gift provision that IRS permitted. IRS did work on this and agreed with us about a year ago and said this is unacceptable. FHA — and that’s a year ago — has yet to eliminate seller down payment assistance, knowing well that this is posing problems for the industry.

The issue with the seller down payment is it was a scam — there’s no other say to say it.

Do you think the worst of the problem in the mortgage market is behind us?

That’s a very good question. You almost have to have a crystal ball. Are we looking at the tip of the iceberg or the iceberg itself? It’s too soon to say.

I think there are things that need to be done. FHA has to realize that there has to be active oversight and enforcement. I don’t see it moving in that direction. My concern is that I see it moving in the other direction.

Like anything else we can project what might happen, but I think there’s things to be done right now that to prevent it from getting worse.

What are some of the key changes that need to be made at FHA?

Mortgage bankers have been creating a predictable model on screening some of these loan applications and that’s good thinking. That’s using technology to your advantage. I think FHA has to weigh in on that. I have not seen that.

I think they have to be active working collaboratively with enforcement and oversight to make sure that these loans are reviewed real carefully. And when the portfolio looks like it has a problem, they have to act on these things.

Something that comes back to the savings and loan industry: They spent a good deal of time trying to work these loans out. And what they ultimately did was they delayed the process, and to the point of its own peril.

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