Citing evidence of abuse, the Department of Housing and Urban Development has temporarily stopped making a popular type of rehabilitation loan to investors.

The move follows an investigation by the agency's inspector general that found many investors and nonprofit groups - aided by mortgage lenders - are misusing the program and exposing the government to unwarranted risk.

The so-called 203(k) program finances the purchase and renovation of aging homes, often in the inner city. Though most such loans are made directly to individual homeowners, about 15% in the past year were made to investors, who fix up the properties and then resell or rent them.

In the fiscal year ended Sept. 30, more than 17,000 203(k) loans were made to homeowners and investors. That was a 17-fold increase from a few years ago, thanks to the Clinton administration's aggressive promotion of the loan program. Last week's suspension does not affect loans made directly to homeowners or to nonprofits.

The inspector general found irregularities with most of the 449 loans it examined, according to HUD.

The problems ranged from a lack of down payments to overstated appraisals to failure to complete rehabilitation work.

"Unless some immediate action is taken, we predict substantial future losses to the FHA fund from or because of these types of borrowers," said a July 15 memorandum from the Atlanta District Office of the Inspector General to Nicolas P. Retsinas, assistant secretary for housing and federal housing commissioner.

Jim Park, executive assistant to the Federal Housing Commissioner, emphasized the moratorium on investor rehabilitation loans is temporary. The administration continues to believe that investors and developers can play "an important part in community revitalization, (and) in moving into communities where people are not willing to live and fixing things up," Mr. Park said.

HUD will convene a meeting of industry groups by mid-November to discuss how the program should be changed to prevent investor abuse, he added.

The report from the inspector general suggested that mortgage lenders either looked the other way or deliberately falsified borrower information, in exchange for the program's high fees.

One large, unnamed lender, for example, repeatedly circumvented HUD rules to assist unqualified borrowers in obtaining loans and charged them ineligible fees, the report said.

Jack Quan, president of Unity Mortgage Corp., Atlanta - one of the investigated companies - said his company did not knowingly skirt any HUD rules. The inspector general found that rehabilitation work had not been done on four investor-owned properties financed through Unity, while the lender certified it had.

Mr. Quan said the projects were unfinished because the investor had committed suicide. The properties had been vacant for a year when the inspector general inspected them, he said, and during that time some of the improvements had been destroyed by vandals.

Lenders earn higher fees and interest rates on the rehabilitation loans than on other mortgages insured by HUD's Federal Housing Administration program. Indeed, HUD's heavy reliance on lenders to ensure that the loans meet the program's specifications was cited as a flaw that makes the 203(k) program particularly risky.

The inspector general recommended that HUD prohibit investors from participating in the rehabilitation loan program, as well as monitor the effectiveness of new procedures for approval of nonprofit borrowers.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.