~ FannieMae Lender Relationships

SellingMaintaining Eligibility

Section 301.01

Chapter 3. Maintaining EligibilityAfter we approve a lender to sell mortgages to us, we require it to maintainits eligibility. To do this, the lender must comply with the terms of theMortgage Selling and Servicing Contract, any separate agreements we haveexecuted, and the provisions of this Guide. If it does not, we have the rightto terminate the contractual relationship for cause.

This Chapter concentrates on the lender's specific administrativeresponsibilities and business obligations that must be covered in the overallconduct of its mortgage operations.

Section 301Internal Audit andManagement ControlSystems

Section 301.01Quality AssuranceSystem

The lender must maintain adequate internal audit and management controlsystems to assure that the mortgages are originated, sold, and serviced inaccordance with sound mortgage banking and accounting principles; guardagainst dishonest, fraudulent, or negligent acts; and guard against errors andomissions by officers, employees, or other authorized persons. Some of thekey components of these audit and control systems are a quality assurancesystem to evaluate and monitor the overall quality of mortgage production, athird-party origination management system to monitor the performance ofany third party originators the lender uses, a delinquent loan servicingsystem, a bankruptcy monitoring system, and a foreclosure monitoringsystem. A lender that fails to maintain adequate quality control measures willbe in breach of its Mortgage Selling and Servicing Contract. This sectiondiscusses the quality control measures that relate to a lender's mortgageselling activities, while those that relate to a lender's servicing activities arediscussed in Part I, Section 301, of the Servicing Guide.

We have our own quality assurance system to evaluate the quality ofmortgages we purchase and to conduct underwriting and servicing reviewsfor defaulted mortgages. More information about post-purchase under-writing reviews may be found in Section 301.03 below. Early paymentdefault and post-foreclosure underwriting reviews are discussed in theServicing Guide.

Every lender requesting Fannie Mae approval must have a quality assurancesystem in place-and must agree that the system will function for as long asthe lender continues to do business with us. A lender's quality assurancesystem must address the lender's most critical business needs. We recognizethat there is no single, optimal quality assurance plan that will satisfy everylender's needs; therefore, we encourage each lender to think creatively andto use a broad risk management perspective in developing and/or changingits quality assurance approach. This Section discusses our minimumrequirements for a lender's quality assurance system. If a lender sells usmortgages originated by a third party, the lender's quality assurance systemmust also include steps to assure that the third-party originations arequality originations that satisfy our mortgage eligibility and underwritingrequirements, as discussed in Section 301.02 below. Any lender that would

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like to discussoptions for customizingits approach to qualityassuranceshould contact its underwriting consultant in its lead Fannie Mae regionaloffice.

The purpose of a quality assurance system is to verify the existence andaccuracy of legal documents, credit documentation, and property appraisalsthat a lender uses to reach its underwriting decisions.The lender'ssystem must assure that mortgages conform to the lender's policies, are ofa quality acceptable to institutional and secondary market investors, complywith insurer or guarantor requirements, and meet specific Fannie Maerequirements.

Most quality assurance systems apply to post-closing mortgage reviews.However, since pre-funding reviews provide more timely feedback to theorigination staff and can prevent the consideration of misrepresentedinformation in the mortgage origination process, we strongly encourage alender to include them as part of its quality assurance system.

The first step that a lender should take in developing a quality assurancesystem is the creation of a written plan to identify the specific risks itintends to measure, monitor, and manage and the nature and significance ofeach identified risk. This risk identification can be particularly important inhelping the lender decide on the appropriate balance between pre-funding,post-closing, and contractor-performed quality assurance reviews. Forexample, if a lender identifies a particular source of business as high-risk(based on the mortgage product, property location, or type of origination),it may decide that it is more appropriate to conduct pre-funding reviews fora sample of mortgage originations that fall into the identified high-riskcategory. Similarly,if a lender determines that there is a high risk for inflatedappraisals for particular types of mortgages or for properties located incertain geographical areas, the lender may decide to substitute automatedvaluation models for a relatively large sample of mortgages (or properties)that fall into this category instead of using review appraisals for a smallersample.

A lender must include in its written quality assurance plan a generaloverview of its policies on quality assurance, its commitment to qualityassurance, the plan objectives, and the specific risks that will be monitoredand managed. The plan must cover the full scope of the lender's mortgageoriginations-all channels of production, all mortgage products, allunderwriting methods, all employees involved in the origination process,and all vendors or contractors involved in the origination process. A lenderthat acquires Desktop Underwriter-processed mortgages from other lendersshould make sure that its quality assurance system includes appropriateverifications to assure that any conditions specified in the UnderwritingFindings report have been satisfied and to confirm that the data from theclosed mortgage agrees with the documents and all Desktop Underwriterreports that are in the transferred underwriting file. At a minimum, thelender's quality assurance plan must address staffing and the use of

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~FannieMae Lender Relationships

SellingMaintaining Eligibility

Section 301.01

contractors, the mortgage selection process, the mortgage review process,and reporting and record retention requirements. Our requirements andsuggestions for each of these operational areas are provided below:

A. Staff"mg and use of contractors. The lender's written qualityassurance plan must identify (and provide the reporting structure for) thedepartment and staff that will be responsible for managing the qualityassurance system. To preserve the integrity of the process, all qualityassurance operations (including those related to establishing, monitoring,and enforcing procedures)-regardless of the scope, timing, or type of thelender's quality assurance reviews-must be independent of the production,underwriting, and closing departments. If a lender's quality assurancesystem is part of a reporting structure that also includes production,underwriting, or closing activities, the lender must be able to justify use ofthe reporting structure by explaining how it leads to the more effectivemanagement of specific risks. In addition, the lender must properly trainemployees and provide detailed standard operating procedures to allemployees who will be involved with, or affected by, the quality assurancesystem.

A lender may outsource some of the quality assurance processes. We expectany contractor the lender uses to have a general understanding of automatedunderwriting systems. If the lender uses a contractor to perform qualityassurance functions, we will hold the lender fully accountable for the workperformed by its contractor. The lender's written quality assurance planmust include guidelines for monitoring and measuring the quality of acontractor's work to assure that the work satisfies not only the lender'srequirements, but also Fannie Mae's. The lender must also have staff andprocedures in place to evaluate the work product of the contractor and totake appropriate action based on the findings that the contractor identifiesin the mortgage reviews it performs.

B. Mortgage selection process. The lender's written quality assuranceplan must include specific information about the lender's mortgagesampling process, including the types and frequency of selections. Thelender must have a defined process for selecting mortgages for a qualityassurance review. This process must take into consideration the lender's size,production channels, and geographical areas of operations. We recommendthat the plan include provisions for both random and discretionaryselections. In addition, we encourage the lender to include in its samplingnot only new production, but also distressed mortgages (such as those withearly payment defaults). We may also designate specific review requirementsfor certain mortgage products.

. For random selections, a lender must select 10% of the residentialmortgages that it originates or acquires from a third party. Themortgages selected must be representative of the lender's overall bookof business, include the different types of mortgages that the lender

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offers, and represent mortgages originated by each branch office or bythird-party originators, automated undelWriting systems (includingDesktop UndelWriter), and electronic commerce. A lender may chooseto use statistical sampling instead of the standard 10% samplingmethod-as long as it works with us to structure the statistical-basedsampling system. In addition, a lender that wants to use its pre-fundingreviews to satisfy our random selection requirements may do so if it firstworks with its Fannie Mae undelWriting consultant to determine theextent to which the pre-funding reviews can be counted.

For discretionary selections, the lender should base its selections onspecific needs. Discretionary selections may relate to higher-riskmortgages that involve unusual or unique processing, undelWriting, orappraisal techniques; to mortgages processed by a particular branchoffice, staff person, contractor, third-party originator, or appraiser, ifthere is concern about patterns that have been identified in otherreviews or about delinquency rates; to mortgages secured by propertieslocated in areas that have high delinquency rates; etc. A lender mustalways use discretionary selections to supplement (not replace) randomselections.

We generally require that a lender select mortgages for quality assurancereviews on a monthly (or more frequent) basis-and that the reviews becompleted within 90 days of the selection. There may be some instances inwhich a less frequent review might be acceptable. For example, a lenderthat has a low volume of originations may ftnd it more appropriate to selectits quality assurance reviews on a quarterly basis. A lender that wishes toselect mortgages for quality assurance reviews less often than monthlyshould contact its lead Fannie Mae regional office to request permission todo so. If a lender is unable to complete a quality assurance review within 90days after the mortgage was selected for review, it must include in theoriginal undelWriting me an explanation of why there was a delay incompleting the review.

C. Mortgage review process. The lender's written quality assuranceplan must discuss the lender's processes for evaluating and monitoring theoverall quality of its mortgage production and describe the lender'sreverification procedures. The review process should consist of a review ofclosing documents for completeness and accuracy, a reverification ofundelWriting documents (including a data integrity review for DesktopUndelWriter-processed mortgages), a review of the appraisal (or propertyinspection report), and an evaluation of the undelWriting decision.

Closing Documents-The lender must review each of the closingdocuments for completeness and accuracy. Closing documents include therecorded security instrument and any applicable riders or addenda; thenote; the assignment of the mortgage; the mortgage insurance certificate orpolicy, the VAloan guaranty certificate, the RHSloan note guarantee, or theHUD Indian loan guarantee certificate, as applicable; title evidence; plat or

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~FannieMae Lender Relationships

SellingMaintaining Eligibility

Section 301.01

survey; truth-in-lending disclosure; HUD-l uniform settlement statement;and evidence of hazard and, if applicable, flood insurance. In addition, thelender should specifically review any conventional mortgage insurancecertificate or policy to determine that adequate coverage was obtained andthat any contingencies specified by the MI were met.

Underwriting Documents-The lender must reverify the accuracy andintegrity of the information used to support the lending decision for anymortgage selected for a quality assurance review. Documentation that mustbe reverified includes that initially obtained to provide information aboutthe borrower's employment, income, assets, and credit history. If necessaryto obtain responses to requests for verifications, a lender should obtain, atthe time of loan application, the borrower's written authorization forinformation to be released for reverification purposes. All reverificationdocumentation must be retained in the lender's individual underwriting file,although reverifications that lead to quality assurance findings should also bedocumented in the lender's quality assurance records. For DesktopUnderwriter-processed mortgages, the reverification of information alsoincludes a data integrity review to determine that the data entered intoDesktop Underwriter is complete, accurate, and matches information foundon the documents in the underwriting file. (This data integrity reviewrequirement means that a lender's quality assurance staff will need to haveaccess to, and be proficient in the use of, Desktop Underwriter.)

. The lender must reverify the borrower's income, employment, andasset information directly with the source of the originaldocumentation. Generally, the reverification should be in writing;however, verbal reverification may be accepted in some cases, if thelender documents the conversation in writing and includes thatdocumentation in the underwriting file. A lender may supplement itsreverification procedures by using alternative information sources onthe Internet or information available from databases maintained by stateor local licensing authorities or other third parties. If the lender obtaineda borrower's written permission to request copies of his or her federalincome tax returns directly from the IRSin case they were later neededfor a quality assurance review, the lender should decide whether torequest the reverification from the IRSbased on the circumstances ofthe individual case.

The lender must reverify the borrower's credit history by obtaining anew "in-file" credit report from a source other than the original creditreporting agency. It is not necessary for the lender to obtain a newcredit report for a Desktop Underwriter-processed mortgage-unlessdata in the credit report that was evaluated by Desktop Underwriterincluded significant errors and the lender's underwriter ignored the dataerrors when he or she evaluated the borrower's credit history outside ofDesktop Underwriter. (By using a borrower's social security number,credit report providers can also provide fraud checks or fraud alerts

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Section 301.01 Selling

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along with the "in-file" credit report. A lender should consider using thisservice to identify invalid or illegally used social security numbers.)When the borrower's credit history was initially evaluated by using aNontraditional Residential Mortgage Credit Report, the lender mustreverify each of the credit references on that Report.

The lender must reverify the data integrity for a Desktop Underwriter-processed mortgage-by checking the data that was entered intoDesktop Underwriter for the borrower's name, property address,property type, mortgage term, mortgage type, loan purpose, loan-to-value ratio, and the source of the documentation that was used todetermine the borrower's ability to repay the mortgage and comparingthat data to the information that appears on the actual documents in theunderwriting file.

The validation of data integrity for a mortgage that received an"approve/eligible" recommendation or was referred to the lender'sunderwriter for a final decision should ensure that (1) all data matchesthe source documentation, (2) documentation exists to support all ofthe data that was used to underwrite the mortgage, and (3) the"matches" Qn Desktop Underwriter's liability and real estate ownedreconciliation worksheets are accurate (including any amounts that wereomitted from the underwriting analysis). If this validation processreveals material discrepancies between the data that DesktopUnderwriter used and the data from the source documents-and thediscrepancies are not within the tolerances permitted by the Guide toUnderwriting with Desktop Underwriter-the mortgage must be re-underwritten using the correct data. If the results of the re-underwritingindicate that the mortgage was not eligible for delivery to us-or thedata on which the closed mortgage was based results in a DesktopUnderwriter recommendation of anything other than "approve/eligible"(or one of the "Expanded ApprovallEligible" categories)-the lendermust decide whether the mortgage was actually eligible for delivery toFannie Mae.

- If the lender decides that the file includes adequate documentationto compensate for any referral or to indicate that the mortgage waseligible for delivery, it should document the underwriting file toreflect its decision (without taking any further action).

If the lender decides that the mortgage was not eligible for deliveryto us or that any conditions for approval were not satisfied, thelender should advise its lead Fannie Mae regional office of thesefindings.

Property Fieldwork Documents-For 10%of the mortgages it selects for aquality assurance review, the lender must reverify the appraisal (or propertyinspection) by ordering a review appraisal (or property inspection) to checkthe work of the original appraiser. This selection does not have to be the

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~ FannieMae Lender Relationships

SellingMaintaining Eligibility

Section 301.01

result of a random sampling, rather it may be made on the basis of therelative risk of the mortgage (especially if the lender uses an automatedvaluation model as its sampling tool). The review appraisal (or propertyinspection report)-which may be either a new retrospective appraisal (orproperty inspection) or a field review-should be prepared by an appraiserwho is not affiliated with the original appraiser (or appraisal firm). ForDesktop Underwriter-processed mortgages, the review appraisal (orproperty inspection) must be consistent with the level of review that wasconducted after Desktop Underwriter's recommendation was received. OurDesktop Underwriter Quantitative Analysis Report (Form 2055) or anotherform of the lender's choice may be used to document a new retrospectiveappraisal; the Desktop Underwriter Property Inspection Report (Form2075) can be used to document a new property inspection. Our ResidentialAppraisal Field Review Report (Form 2000) may be used to report theresults of a field review. At a minimum, a field review should include anexterior inspection of the subject property and the comparables and ananalysis (with emphasis on the accuracy of the factual data on the appraisalreport or the property inspection report).

The lender may reverify the appraisal (or property inspection) for theremaining"90% of the mortgages it selects for a quality assurance review byconducting a desk review. The lender's staff person who performs the deskreview does not have to be an appraiser, but needs to be familiar with basicappraisal theory so that he or she can assess the market risk, determinewhether the property supports the loan-to-value ratio, and prescribecorrective action in the underwriting process when problems arediscovered. Automated valuation models are good tools to use to determinevalue assessments for desk reviews. We encourage lenders to use suchmodels in their desk reviews to compare the value stated in the appraisalreport against the model valuations. If the lender notes significantdiscrepancies between the appraisal report and the model valuations, itshould order either a field review or a new retrospective appraisal report(or a property inspection report, if applicable).

Underwriting Decision- The lender must determine that the mortgage wasproperly underwritten and that sound underwriting judgments were made.Manually underwritten mortgages must be reviewed for compliance withour mortgage eligibility criteria, as well as with our underwriting guidelinesand standards. The lender also must determine that any conditions theunderwriter established were satisfied and that the information on thesettlement statement reflects compliance with the closing instructions forthe mortgage.

Generally, the lender's quality assurance process for mortgages underwrittenthrough Desktop Underwriter is simplified. It will vary depending onDesktop Underwriter's recommendation.

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Section 301.01 Selling

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. If the mortgage received an "approve/eligible" recommendation, the *

quality assurance review focuses on validating the data integrity of the *

mortgage me. It is not necessary to order a new credit report for the *

borrower; however, the borrower's qualifying income and assets should *

be verified and recalculated. The review should confirm that all of *

the requirements of Desktop Underwriter's verification messages or*

approval conditions were satisfied and that the actions taken to satisfy*

them were adequatelysupported by appropriate documentation. *

. If the mortgage received an "approve/ineligible," recommendation, the*

quality assurance review should validate the data integrity of the*

mortgage me and address the specific mortgage eligibility criteria that*

the mortgage failed to meet, as identified by Desktop Underwriter. The*

review must determine whether the me includes other sufficient written *

documentation to support the underwriter's decision to approve the*

ineligible mortgage and confIrm that all of the requirements of Desktop*

Underwriter's verification messages or approval conditions were*

satisfied and that the actions taken to satisfy them were adequately*

supported by appropriate documentation. *

. If the mortgage received a "refer/eligible" recommendation, the quality*

assurance review should validate the data integrity of the mortgage me*

and address the reasons for referral to the lender's underwriter and the *

steps he or she took to resolve or compensate for the conditions *

resulting in the referral. It is not necessary to completely re-underwrite*

the mortgage. For example, if the only reason for a referral is that the*

borrower's debt-to-income ratio is too high, the quality assurance review*

needs only to address the qualifying ratio and does not need to include a*

confIrmation that the borrower's credit met all of our other *

underwriting guidelines. However, if Desktop Underwriter was unable*

to complete its risk analysis because the me did not include enough*

information, the review should concentrate on the missing information*

that the lender subsequently obtained. The review must also address*

whether the me includes sufficient written documentation to support*

the underwriter's decision to approve the referred mortgage (with, in this *

example, the higher qualifying ratio) and the compensating factors that*

were used to justify that decision. The review should also confIrm that *

all of the requirements of Desktop Underwriter's verification messages *

or approval conditions were satisfied and that the actions taken to satisfy *

them were adequately supported by appropriate documentation. *

. If the mortgage received a "refer/ineligible" recommendation, the*

quality assurance review should validate the data integrity of the*

mortgage me, address the reasons for referral to the lender's *

underwriter and the steps he or she took to resolve or compensate for*

the conditions resulting in the referral, and address the specific*

mortgage eligibility criteria that the mortgage failed to meet (as*

identifIed by Desktop Underwriter). The review must confIrm whether *

~ FannieMae Lender Relationships

SellingMaintaining Eligibility

Section 301.01

the lender has a negotiated contract that provides for the delivery of a .mortgage with the characteristics in question and whether the file includes.sufficient written documentation to support the underwriter's decision .to approve the referred ineligible mortgage and the compensating .factors that were used to justify that decision. If Desktop Underwriter .was unable to complete its risk analysis because the file did not include .sufficient information, the review should concentrate on the missing .information that was subsequently obtained. The review should confirm .that all of the requirements of Desktop Underwriter's verification .messages or appraisal conditions were satisfied and that the actions .taken to satisfy them were adequately supported by appropriate .documentation. .

. If the mortgage received a "refer with caution" recommendation or oneof the "Expanded Approval/Eligible" recommendations, the qualityassurance review should validate the data integrity of the mortgagefile and address the reasons for the referral to the lender's underwriterand the steps he or she took to resolve or compensate for the conditionsthat resulted in the referral. If the mortgage received one of the"Expa.nded Approval/Ineligible" recommendations, the review must alsoaddress the specific mortgage eligibility criteria that the mortgage failedto meet (as identified by Desktop Underwriter) and determine that thefile includes sufficient written documentation to support theunderwriter's decision to approve the ineligible mortgage and thecompensating factors that were used to justify that decision. WhenDesktop Underwriter was unable to complete its risk analysis becausethe file did not include sufficient information, the review shouldconcentrate on the missing information the underwriter subsequentlyobtained and used in deciding to approve the mortgage. The reviewshould also confirm that all of the requirements of DesktopUnderwriter's verification messages and conditions were satisfied andthat the actions taken to satisfy them were adequately supported byappropriate documentation.

. If the mortgage received an "out of scope" recommendation, thequality assurance review should be consistent with the reviewperformed for a manually underwritten mortgage.

D. Reporting and record retention. The lender's written qualityassurance plan should set out the method (and timing) of reporting reviewfindings and the parties to whom such reports are sent, as well asprocedures for maintaining accurate and detailed records of the results of itsquality assurance reviews and documenting all corrective actions taken.Although we do not specify an exact format for the lender's reports, weexpect the lender to design its reporting procedures in a way that assuresthat the reports will be useful as an internal management tool for evaluatingand monitoring the quality of the lender's mortgage production.Management reports should cover quality assurance findings at a high level,

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Section 301.02 Selling

Section 301.02Monitoring Third-PartyOriginations

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by focusing on serious findings and any broad trends that are revealed bythe review process, while identifying mortgages or issues that need specificcorrective actions. An effective quality assurance process will enable thelender to accumulate a great deal of valuable information over time; weencourage a lender to take advantage of this by capturing the informationelectronically so that it can be used for trend and performance analyses.

We require that the results of quality assurance reviews be reported to thelender's management on a regular basis, preferably within 30 days after areview is completed. The lender should have in place procedures to ensurethat all significant issues identified through the quality assurance reviewprocess are satisfactorily resolved. If the lender identifies an issue thatsignificantly affects our risk for a mortgage the lender sold to us, the lendermust notify us immediately, and then provide a written report of thefindings and corrective actions being taken to its lead Fannie Mae regionaloffice within 30 days. We will work closely with the lender to evaluate thefacts of the case and come up with an appropriate solution.

A lender must retain all written and electronic records that are created aspart of the quality assurance review process for a minimum of three years.These records include documentation of quality assurance review fmdings,as well as documentation related to any corrective actions that are taken.The lender must provide us a copy of its records if we request it to do so.

A third-party origination is any mortgage that is completely or partiallyoriginated, processed, underwritten, packaged, funded, or closed by anentity other than the lender that sells the mortgage to us (or its parent,affiliate, or subsidiary)-such as a mortgage broker or correspondent. We donot consider a mortgage that is originated and/or funded by a lender'sparent, affiliate, or subsidiary to be a third-party origination-unless theparent, affiliate, or subsidiary uses the services of a broker or correspondentto perform some or all of the loan processing functions. If a lender entersinto a contract with a third party known for the quality of its underwriting(such as a mortgage insurer) to help the lender avoid backlogs inunderwriting its mortgage originations, we will not consider the mortgagesto be third-party originations.

A lender is responsible for ensuring that any mortgages originated andprocessed by third parties that it sells to us meet our eligibility criteria andare originated in a sound manner. Before entering into an agreement with athird-party originator, a lender should satisfy itself that the third-partyoriginator is capable of producing quality mortgages. This can beaccomplished by reviewing the third-party originator's capabilities-including an analysis of its fmancial condition, a review of personnelresumes and references, and an evaluation of its historical performance. Wesuggest that a lender document its arrangements with third-party originatorsby a contractual agreement that includes specific warranties related to the

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