For years "net branching" has offered a way for retail mortgage banks to boost production without increasing costs. But the Department of Housing and Urban Development has found that the practice is leading to violations of its regulations and is cracking down.

HUD can fine lenders found to have engaged in prohibited practices or revoke their licenses to originate FHA loans.

According to a source close to HUD, the department is investigating several mortgage lenders and expects to take an enforcement action within the next several months. Through its investigation over the last two years, the agency has discovered several mortgage banks that have 15 or more branches that do not comply with its rules, this source said.

HUD recently stepped up its enforcement and oversight of net branches. In May it issued a letter to FHA lenders to clarify its rules and to warn that the department is aware of violations.

In a net branching arrangement, a big lender acquires a smaller retail lender or broker, and the management of the acquired firm agrees to continue paying its expenses, including rent. The net branch closes loans in the parent company's name, its workers usually become employees of the bigger company, and the profits produced by the branch are split between the branch and the mortgage bank.

This arrangement allows the larger company to boost its volume without having to invest in new employee training, infrastructure, or other overhead.

In many cases, however, the financial records from the net branch are kept separate from those of the larger firm, and there is usually an agreement that if things do not work out, the relationship can be severed.

Under HUD regulations, only lenders that have been approved by the department may originate or service mortgages insured by the FHA insurance fund, which is administered by HUD. But in some net branching arrangements, FHA-approved lenders have joined up with unapproved originators that use the approved company's HUD mortgagee number to originate FHA loans, sources said.

HUD requires that all the employees of a net branch be employees of the lender it is part of, and that they be employed exclusively by that lender. But, according to the source close to HUD, some lenders have been approaching brokers and smaller lenders and offering to form partnerships in which the smaller companies would act as a branch office but would not put the employees of the smaller firm on the bigger firm's payrolls.

The result, critics say, is that FHA loans are effectively being originated by third parties. That is a violation of HUD rules.

"HUD cannot have a situation where the large lenders simply say, 'It's not my fault, look to this independent contractor,' " said the source close to HUD. "If the independent contractor isn't FHA-approved, HUD doesn't have a basis to take an action." Taxpayers end up on the hook for bad loans, since the claims are paid out of an insurance fund, he said.

Bud Carter, senior director of residential finance at the Mortgage Bankers Association, said it supports the recent warning letter.

"It levels the playing field by requiring all lenders that originate FHA loans to be approved," he said. "HUD found a number of instances where unapproved lenders were originating FHA loans, and that's not acceptable to them, and it's an unfair advantage over our members, which are FHA approved."

Mr. Carter said MBA members reported frequent instances of such practices in the Texas market and some areas of the Midwest.

"I think there's a big need to be alarmed if you're a company that doesn't have a significant net worth, or if you are paying [the net branch employees] on 1099, not on W2," said Dan Ashbrook, vice president of wholesale lending at Guild Mortgage in San Diego. W2 is the Internal Revenue Service form for employees whose taxes are withheld by their employers, while 1099 is for independent contractors who are paid the full amount and have to pay taxes on their own.

"There are a lot of companies out there that have 40 or 50 net branches but everyone is being paid individually, out of separate checking accounts, and they don't get any benefits," which does not fit into HUD's definition of a net branch, Mr. Ashbrook said. He added that Guild Mortgage attorneys are looking over the letter, but he said he doubts it will affect the company's operations.

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