By Ann Mariano

Among the failures at the Department of Housing and Urban Development during the Reagan administration, the agency's handling of a Washington mortgage company called DRG Funding Corp. may prove to be the most costly. Government losses are expected to exceed $300 million. For five years, influential people inside and outside HUD failed to act in the face of warnings from career employees about DRG's alarming rate of defaulted mortgages. One top official, Deborah Gore Dean, sent copies of some warnings to a DRG lawyer, Lynda M. Murphy, who was a close friend. On one, Dean penned what appears to be a mock rebuke: "Lynda Murphy What are we going to do with you?" Dean's attorney, Charles Leeper, said Dean's correspondence with Murphy does not reflect any lack of concern on Dean's part. Rather, he said, it was Dean's way of making Murphy fully aware of DRG's worsening performance. Long after DRG's troubles became evident, DRG was allowed to continue making loans under HUD's co-insurance program, which was designed to preserve affordable rental housing by holding down mortgage costs for developers of apartment buildings. HUD insured 80 percent of each mortgage, reducing the risk for lenders. Foreclosures have forced many buildings to be auctioned off at bargain prices. Finally, after a series of HUD inspector general reports about DRG's problems, the FBI launched a criminal investigation early this year. Internal HUD documents show that some HUD officials feared that if they took strong action against DRG, it would lead to publicity and embarrassment for HUD. In July 1988, HUD official Thomas Casey sent a blunt memorandum to then-HUD Secretary Samuel R. Pierce Jr. about DRG's rising default rate and HUD's reluctance to act. "It is true that disqualifying DRG may attract attention to failures by them and by HUD," Casey warned. "It is also true that if DRG does not improve its financial position, their eventual default and/bankruptcy will draw attention to the same failings as well as HUD's failure to take preemptive actions." Pierce, who had personally intervened in 1984 when lower-level HUD officials were threatening to limit DRG's lending authority, took no action. Four months ago, new HUD Secretary Jack Kemp suspended DRG from the co-insurance program and all other federal programs, drawing just the kind of attention that HUD officials anticipated. Rep. Tom Lantos (D-Calif.), chairman of a House subcommittee investigating HUD, said DRG's co-insured loans would have to head any list of the "most ill-advised ventures of the 1980s." About $1 billion in co-insurance loans are in default, including $700 million in DRG loans. HUD expects to recover no more than 40 percent of the $1 billion once it sells off the properties; on some DRG loans, HUD has recouped only 25 percent of the original mortgage value. "We are dealing with a major hemorrhage of taxpayer funds," Lantos declared to HUD officials during one hearing. DRG is owned and operated by the DeFranceaux family, which has been involved for decades in Washington real estate and banking. DRG's president, Donald DeFranceaux, has declined to comment on DRG's troubles. When the FBI investigation became public, the Georgetown-based company issued a statement saying it "steadfastly denies any wrongdoing." Earlier this week, company spokesmen Diane Pontisso said, "We continue to deny any wrongdoing and that's about all we have to say. We're still here and we're still conducting business." When the co-insurance program began in 1983, HUD sought to minimize its role by putting lenders in charge of handling the paperwork. Lenders, including DRG, received extraordinary authority to make loans without first obtaining HUD approval and without HUD review. Eventually, 55 lenders were given such authority. The lenders were responsible for examining the credit-worthiness of borrowers and making sure of the property's value. They earned fees of up to 4 percent on each loan -- a powerful incentive to inflate the value of the property and, thus, the amount of the mortgage -- and often earned additional fees for processing the loans and collecting mortgage payments. DRG quickly became one of the largest co-insurance lenders. Within 18 months, however, some of its loans were already in trouble. In November 1984, Maurice Barksdale, Federal Housing Administration commissioner at the time, suspended DRG's authority to make loans without HUD approval. He cited "serious breaches" in DRG's lending practices, including inflated appraisals. DRG officials scrambled to appeal Barksdale's decision. Pierce was contacted by Carla A. Hills, DRG's lawyer until early 1986 and HUD secretary in the Ford administration. In May 1985, Pierce rescinded Barksdale's order in a nine-page letter that listed a variety of changes he wanted DRG to make in its operations. Hills has testified that she acted properly, doing nothing more than any lawyer would in representing a client. "In all of this representation, I never had a hint of fraud or intentional wrongdoing from HUD," she told Lantos's subcommittee. DRG's contact with HUD became more frequent and more informal after the company hired lawyer Lynda Murphy, a former HUD employee, according to documents contained in Dean's files. Dean and Murphy were friends before Dean became Pierce's chief aide in 1984. On March 28, 1986, Dean sent Murphy a computer printout showing six DRG loans totaling $63.1 million in default. It was to this printout that Dean attached the handwritten note: "Lynda Murphy What are we going to do with you?" In January 1987, when HUD official R. Hunter Cushing sent Dean an updated list of DRG loans in default, Dean sent it to Murphy and wrote: "Lynda, better keep Hunter under control." Dean's attorney, Leeper, said that HUD officials were aware of Dean's friendship with Murphy. "There are no HUD secrets in documents that Dean forwarded to Murphy," Leeper said. "The documents reflect Ms. Dean's legitimate effort to keep DRG's counsel apprised of DRG's defaulted loans and loans that presented a risk of default, all of which was already known to DRG." While declining to comment on the tone of Dean's notes to Murphy, he said: "Remember that these notes were found in her master correspondence file. Do you really think that Ms. Dean would have directed that a copy of her notes be kept in that file if they have the sinister meaning you now suggest?" Leeper said Dean was concerned about Pierce's decision to overrule Barksdale, which allowed DRG to continue making loans without HUD's prior review. "The documents show that Ms. Dean and other HUD staff were working hard to prevent Mr. Pierce's decision from becoming an embarrassment to HUD," he said. Murphy's office said she was unavailable for comment. She has testified before Congress that it was "reasonable to assume" that Dean helped her in her contacts with HUD. HUD documents from 1986 and 1987 show that officials throughout the agency continued to warn Pierce and his staff about DRG's skyrocketing default rate. HUD's inspector general examined DRG's practices and reported serious deficiencies. In March 1987, HUD officials sent written warnings to DRG about their underwriting practices and management. By early 1988, the company's problems had become severe enough that several top HUD officials held regular meetings to discuss them. At the meetings were Undersecretary Carl D. Covitz; Federal Housing Commissioner Thomas T. Demery, whose office was responsible for the co-insurance program; HUD General Counsel Michael J. Dorsey and Mark Buchman, president of the Government National Mortgage Association (Ginnie Mae), which was guaranteeing securities based on DRG loans. DRG sold securities backed by its loans to earn fees and raise cash for more loans. According to one participant, the meetings sometimes erupted into shouting matches between Demery and Buchman, who was anxious to suspend DRG because Ginnie Mae was paying out millions of dollars to holders of DRG securities that had gone bad. Demery was anxious to keep the company in business if possible to avoid the huge bills his agency faced for DRG loans in default. Demery, who handled some DRG loans as a mortgage broker before joining HUD, said the general counsel's office decided he had no conflict of interest because he had never been a DRG employee. Demery has testified that he knew some people in the department believed he had shielded DRG, but said he did not. His telephone logs show he received many calls from Murphy and DeFranceaux and met with them several times. In April 1988, Covitz gave DRG a 90-day grace period to continue operating, pending the results of an outside audit. Although he felt that DRG's practices were "atrocious," Covitz said in an interview, he still hoped DRG could turn itself around and save HUD from more losses. Now a California developer, Covitz said he still thinks co-insurance is a good idea but that lenders should be required to risk more of their own money. In May 1988, however, it was clear that DRG's problems were getting worse, not better. More than 30 percent of its $1 billion loan portfolio was in default, while the default rate among the other 54 lenders was 5 percent, HUD documents show. Stephen Switzer, an assistant inspector general, recommended that DRG be suspended from making loans until the problems were fixed. On Aug. 31, 1988, Buchman wrote to Pierce and warned him that "the department now has an even more serious problem with DRG than it did a few months ago." He gave Pierce four options, saying he favored sending a letter giving the company 30 days to clear up its problems or face suspension. Pierce agreed. Finally, in September 1988, Ginnie Mae barred DRG from issuing government-guaranteed securities, saying the company's net worth had sunk below minimum levels and it had failed to meet some regular payments to securities holders. Meanwhile, the HUD inspector general had issued new audit reports -- available to the public but not publicly distributed -- alleging that DRG had inflated loan amounts and had violated other regulations. A HUD-prepared "chronology of events," contained in HUD files and released under the Freedom of Information Act, showed that the company has not been in full compliance with HUD rules since late 1984. Then in January, the FBI seized DRG records as part of what it described as an investigation into allegations of theft, bribery, false statements and money laundering. Perhaps the best illustration of the cost of DRG's lending activities is a $47.2 million loan that the company made in 1984 to the developers of a Houston apartment complex known as Colonial House. Only 110 of the project's 1,818 apartments were rented when the buyers of Colonial House applied for the loan. Houston's economy was on the skids, making it unlikely that the rental market would pick up. Normally, these factors would make a lender cautious, but DRG issued the loan. HUD's Barksdale said the large number of empty units alone made Colonial House ineligible for the mortgage. Colonial House owners were soon unable to meet the monthly payments and HUD approved a complicated plan to put the project back on its feet. Dean and Murphy participated in those negotiations, HUD records show. Later, the loan went into default and the property was foreclosed. At auction, it brought $8.9 million, leaving HUD with a $28 million loss. DRG still occupies its Georgetown headquarters. After its loan operations were suspended by HUD, "We had to lay a lot of people off," spokeswoman Pontisso said. In its heyday, the DeFranceaux family was a major player in the Washington mortgage banking industry. George DeFranceaux, 76, Donald's father and founder of the original business, served as chairman of DRG's board early in its history but was never the chief executive officer. He said he could not talk about the family or its business. Anthony Lanier, a former DRG executive, said the younger DeFranceaux is "is a decent guy and it doesn't come through" in news reports on DRG. "I am convinced this debacle is the result of the acrimonious relationship between DRG and HUD, where there definitely were abuses on both sides," Lanier said. "Don DeFranceaux is the victim of his own personality and an immature industry. Don didn't spend the necessary time walking down to HUD to work out the problems."