The Harlem Shuffle

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After spending the last two decades buying and fixing up houses for Long Islanders, Larry Nelson decided this spring that it was time to get into the nonprofit housing business. Launching the Alliance for Individualized Ministries (AIM) and signing up for a federal loan program for rehabbing old dilapidated buildings, Nelson thought only of creating cheap, decent housing for poor families in and around Hempstead. He never imagined he’d be making someone else rich.

Then a contractor friend told him that he knew some people who could help Nelson become a nonprofit development expert. There was just one catch: Nelson would have to go a little farther afield–to Harlem and Brooklyn, in fact. “They told me there were brownstones that I could pick up and help people get affordable housing,” Nelson recalls.

Within the month, a real estate lawyer named Andrew Graynor had set Nelson up with a mortgage company in Farmingdale, Long Island, and a real estate appraiser in Melville. The contractor friend also introduced Nelson to one of Graynor’s clients, a real estate investor named Howard Finger, who found 10 brownstones for him to buy in Upper Manhattan and Brooklyn. Nelson says Graynor even gave him $5,000 per property to cover business expenses. For Nelson, the deal sounded great: He would buy the buildings, rehab them immediately, and transfer the mortgage to new buyers soon after.

But he soon found out that Graynor’s generosity wasn’t quite what he bargained for. In fact, it came at a high price: hundreds of thousands of dollars. That’s the profit that Finger’s real estate company, No Exit Place Realty Corp., made when it sold Nelson the buildings. No Exit Place bought each townhouse cheaply, passing it on to Nelson within a day or two at a substantial markup. In August No Exit Place bought 52 West 126 Street for $130,000, then sold it to Nelson the next day for $262,000. In another transaction, 66 West 126th Street, the realty paid $130,000 and sold it the same day to Nelson for $206,000. (All sale prices in this story are calculated based on property transfer taxes.) So each time he bought a building, Nelson was on the receiving end of someone else’s property flip–and each time, he paid handsomely for the privilege.

All the elements of the deal, from loan to realty company to appraiser to mortgage lender, fit together neatly. Nelson was getting his buildings through insured loans backed by the Federal Housing Administration, courtesy of a unique program that combines both purchase price and rehab costs into one insured mortgage. In consultation with the appraiser, the mortgage company approved loans large enough to meet No Exit Place’s steep asking prices, even though the buildings needed extensive work and had been on the market for much less just days before.

Nelson soon figured out that it wasn’t such a great deal after all. “As a nonprofit organization I really lost money when I should have gone to the seller and not used the middleman,” Nelson says ruefully. “It’s totally legal, but it just didn’t sit right. There was a lot of money to be made.” By May, Nelson was fed up with No Exit Place, Graynor and the contractor friend who started it all. He decided to get out of the deal, demanding that they sell off the properties for him immediately.

“We sell property at a fair market value,” Finger responds. “Right now market value is $250,000 and $260,000, and I sometimes sell under fair market value.”

Graynor, too, says that his real estate clients sell within the going market rate–they just happen to find great deals when they buy property. “[Nelson] may not be getting the same deal that my client got. That is the nature of real estate investment,” Graynor says. “No one is forcing them to buy.” Asked whether he recalls providing $50,000 to Nelson, Graynor responds, “I honestly do not know.”

As a former businessman, Nelson isn’t opposed to realtors earning healthy profits–it’s just that markups of up to 100 percent are a bit more than healthy. His goal was to build affordable housing, but buying these buildings at pumped-up prices meant that his buyers would have to assume high mortgages. The last thing Nelson wanted to be doing in Harlem and Brooklyn was creating housing that residents couldn’t afford, and this deal made him feel like a conduit between realtors and obscene profits. “[These profits] should be channeled to people who need affordable housing, not lining their pockets,” he complains. “In this case, AIM doesn’t walk away a winner. I walk away a supplier.”

In this case, what turned Nelson from a developer into a supplier was FHA’s 203(k) loan program. The program, designed to promote home ownership for poor and middle-income people, is set up to help individuals and certain pre-approved nonprofits afford the risky, expensive project of rehabbing old housing. With the U.S. department of Housing and Urban Development insuring the loans, the program makes mortgages easier to get in neighborhoods where that’s not always simple. It has exploded in recent years: In the New York area, there are nearly 10 times as many 203(k) loans today as there were three years ago.

But for real estate operators, 203(k) has also been easy pickings. In 1998, three Brooklyn-based nonprofits enrolled in the loan program discovered that they had been burned by their mortgage companies, which promised them one-stop housing rehabs but instead hooked them up with overpriced buildings and shoddy construction. Left holding uninhabitable housing and high mortgages they can’t pay, the nonprofits are now in the process of defaulting on 300 properties and $60 million in loans. HUD has launched an investigation into the deals.

Meanwhile, three other out-of-town nonprofits in the program, Family Preservation Center, Word of Life Ministries, and St. Stephen’s Baptist Church, are still fixing up dozens of Harlem buildings. With every building, Graynor’s realty clients paid tiny sums ranging from $20,000 to $165,000, and the nonprofits paid much higher prices days or weeks later–up to $365,000. “They have a nice little network going,” Nelson says. “What they did to me, they’re doing to the next nonprofit and ones after that.”

Three years ago, HUD banned for-profit investors from this program, citing problems with profiteering and corruption. Now, City Limits has learned, for-profit interests are once again profiting mightily from 203(k). The result: overpriced properties in poor neighborhoods, quick-flip speculation, and, in Brooklyn, a chain of expensive defaults. “This is so big and such a mess, it’ll take [HUD] years to figure this out,” says a HUD official close to the Brooklyn investigation. “By that time there will be so many [nonprofits] in default.”

In the process, a HUD program that is supposed to bring new affordable housing to neighborhoods like Harlem and Bed-Stuy has so far primarily made money for the middlemen. Nonprofits that know little about housing get sucked into expensive, complex and risky rehab projects. The loan program has allowed outsiders to cash in, jacking up housing prices and producing $400,000 brownstones and $1,000 rentals that few neighborhood residents can afford. The 203(k) program is supposed to bolster home ownership. Instead, the invasion of the Long Island realties, backed with government money, is pushing housing out of reach–and turning Harlem into a cash machine.

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The federal housing program that made all this possible was devised to plug a hole in the housing finance market, one that makes it hard to renovate old buildings in poor and moderate-income areas. Generally, a developer who wants to buy and fix up a decrepit building has to get two loans: one for the purchase and one for its rehabilitation. But banks are often reluctant to make a double loan on a building that needs a lot of work, especially in neighborhoods like Harlem, explains Matthew Lee, executive director of the Bronx finance industry watchdog Inner City Press. Says Lee, “The bank thinks, ‘What do we get if you don’t pay–a run-down house?'”

So 203(k) essentially works like an insurance fund, making bankers feel more comfortable with these risky loans by putting a government promise behind their cash. Under the program, banks and mortgage companies hand out purchase and rehab loans in one mortgage package of up to about $400,000. Construction must be completed within six months, which is also when the first mortgage payments come due. From a bank’s point of view, the greatest virtue of the program is that if a buyer defaults, the lender gets paid back in full–including costs–from an FHA insurance fund.

The program has been around since 1961, but only recently has it caught on. Nationwide, the program grew from an average of 3,000 loans in the early 1990s to 17,000 in 1996 alone. Locally, it has exploded. In New York City, Westchester, Long Island and Rockland County, there were 134 loans in 1996. Last year, there were 1,128. It will probably get bigger: HUD has been pushing the program with a national promotion tour.
But as early as 1996, HUD’s auditors found that the program is “highly vulnerable to waste, fraud and abuse by investors and nonprofit borrowers.” HUD researchers studied 203(k) loan records from seven states and found abuses in every one of them. Lenders failed to make sure rehab work was completed. Appraisers overpriced property. Nonprofits got overwhelmed, trying to restore too many homes at once. Some contractors, realtors and agents insisted on unusually high fees.

The auditors concluded that the problem with 203(k) rests in its design, which puts too much responsibility for oversight on lenders. As the program is structured, lenders have little incentive to watch the shop, and plenty of reasons to make lots of loans. First, they make their money through the fees and closing costs they get for each loan completed. Second, they’re guaranteed a refund from the federal government if anything goes wrong. Also, the auditors found, the program was ripe for abuse by profit-seeking investors, who could make money whether or not the project ultimately succeeded. Spurred by the report, in late 1996 HUD barred for-profit property investors from the 203(k) program, as it already had done with some other FHA loan programs.

But in New York City, for-profit investors have apparently found a way back into the loop. “They have recreated an opportunity for themselves to make a lot of money,” charges Ginnie Phillips, executive director of Helpline Soul Rescue Ministries in Crown Heights. Her group is one of the Brooklyn organizations now defaulting on their 203(k) loans. As profiteering players return, New York is now seeing practices alarmingly similar to the abuses HUD described in its report.

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Phillips’ journey into real estate hell began with a phone call in 1997. Mortgage Lending of America invited Helpline to buy homes in eastern Brooklyn. The organization had just been accepted to HUD’s list of approved nonprofits for the 203(k) program, but had done only small-scale housing redevelopment.

Mortgage Lending of America vowed to take care of that, introducing the nonprofit to Tri-Metro, a realtor in Ozone Park, Queens, which would buy properties for Helpline and arrange for contractors to rehab them. “They contact the nonprofit and promise to set them up in an affordable housing program,” recalls Phillips. To sweeten the deal, Helpline would get $5,000 in administrative reimbursements from Tri-Metro each time it bought a building with its FHA line of credit. There was just one catch: In the same written agreement with Tri-Metro that guaranteed Helpline the cash, Phillips signed a statement saying she wasn’t allowed to see the buildings before or during construction.

The deal was tempting: armchair housing rehab, with a bonus to boot. Besides Helpline, at least two other groups in Brooklyn bought into the idea. Once the realtor selected the houses for purchase, Mortgage Lending of America sent its outside appraiser, CLA Inc., to green-light the sales price and rehab estimates for the buildings–99 of them in all. The longer Helpline worked with the lender and the realtor, the more expensive the homes became, starting at $70,500 in September 1997 and peaking at $275,000 at the end of 1998. Subsequently, a UPN 9 News investigation in June found that these buildings appeared overvalued. For one five-unit fixer-upper at 706 Essex Street in Brownsville, the group paid $275,000; Channel 9 found that the median price for 40 homes sold in the area that year was $150,000.

For Phillips, agreeing not to see the homes was her biggest mistake–and the detail her realtor relied on. She says Mortgage Lending of America refused to let her see the appraisal records and closing documents, and her request to get a new appraiser was rebuffed. “We were shut out of the process.” Phillips says. “We were unhappy and could not get any information.”

So in late 1998 Phillips hired her own lawyers and broke her contract with Tri-Metro. When she eventually saw the properties, sagging floors and leaky pipes were recurring motifs. Walls were easily punctured, tubs were not supported by the bathroom floors and a tiled shower wall was easily removed, showing daylight through the cracks. Helpline’s independent appraiser and HUD officials who later saw the houses said most of the homes were overappraised–some by as much as 50 percent. Neither Mortgage Lending of America nor CLA returned repeated calls from City Limits.

To repair hundreds of such houses would have been extremely costly, so Helpline and the other nonprofits braced for default. A HUD investigation ensued, and an official close to the investigation tells City Limits that perhaps only 40 percent of the rehab money went into the property. The rest went to fees and other charges, payable to Tri-Metro and its subcontractors.

Including Helpline’s buildings, there are about 300 properties in Brooklyn now defaulting on 203(k) loans. The federal agency is trying to stem the tide: In September, it barred Mortgage Lending of America from the FHA loan program, citing its high default rate–16.8 percent, compared with the 5 percent average for metropolitan-area FHA lenders. But the same HUD official, who asked not to be identified, believes there are already many other defaults waiting in the wings. He estimates that by the time HUD repays all these flops, the agency will be out by about $1 billion.

HUD’s insurance fund is supposed to take run-of-the-mill defaults and the occasional scandal in stride. It’s replenished with a 0.5 percent annual charge passed on to every 203(k) borrower. But any substantial rash of defaults could ultimately lead to an increase in insurance premiums, says HUD. And nonprofits that use 203(k) have other concerns. “If there are investors using the program under the guise of nonprofits, it could led HUD to place more restrictions on the nonprofits,” says David Beer, director of housing development at Neighborhood Housing Services, which has rehabbed nearly 70 buildings through 203(k).

Since Channel 9’s story, another five nonprofits with nearly 200 more properties in New York have reported that they’ve been stuck with poorly rehabbed properties in 203(k) deals. “Nonprofits usually have been victims because they don’t know enough,” Phillips laments. “They’re literally being exploited until they wake up and are left with buildings they can’t sell.”

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Drew Graynor was able to transform Larry Nelson into a nonprofit developer at a blistering pace. The $50,000 that Nelson’s organization got from Graynor for his 10 properties helped Nelson prove to HUD that his group had emergency cash reserves on hand. “He’s the man,” Nelson says of Graynor. “He arranged everything, my banks loans and everything. He introduced me to the mortgage company.”

But the mortgage company that Graynor brought in, Executive Mortgage Bankers Ltd. in Farmingdale, was no peach. Like Mortgage Lending of America, it appears on the National Training and Information Center’s list of the 50 worst lenders in New York City, for one big reason: the company’s 11.4 percent loan default rate. Executive Mortgage, in turn, brought in CLA to validate the high asking prices on Howard Finger’s 10 buildings. That’s the same appraisal company that vouched that Helpline’s shabby homes were worth top dollar.

CLA’s evaluations were crucial to Nelson’s 203(k) deals. In estimating market values, appraisers are supposed to consider the sales prices of comparable nearby properties. If the building in question was itself recently sold, that price also is a key indicator of value. But Finger had paid much less for these properties than he charged Nelson a day or two later, and the high resale prices were all backed up by CLA as the appraiser.

CLA and its owner, Chris Liano, is a common link between Helpline, Nelson and Family Preservation and the other Harlem 203(k) nonprofits. It was Liano’s company that okayed the high-profit flips that enabled realties to cash in, charging FHA-approved nonprofits far more than the realties paid for each building.

In 203(k), as with most other FHA programs, appraisers are supposed to keep a watchful eye on the mortgage process. Their assessments should ensure that prices don’t get out of hand and could keep the resulting projects affordable.

Now, facing hundreds of defaults in Brooklyn, HUD is investigating why New York mortgage lenders have been so generous with its money–and whether their appraisers played a role in overextending the lenders. “This is an issue in New York that we have been looking into–whether or not property was properly appraised,” says John Frelich, director of Quality Assurance in the Philadelphia HUD office, which oversees 203(k) for the Northeast. “The concerns are of high intensity within New York. The New York region is a high-volume 203(k) area and a high-volume area for nonprofits.”

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When contractors showed up one morning last February to start converting the single-room occupancy residence at 58 Edgecombe Avenue, they did what they normally do: turned off the electricity and water, ripped down the doors, and started demolishing the bathrooms. It would have been a typical job if not for one thing: six men lived there. Residents say they were roused from their beds by hammers knocking at their doors around 8 a.m. and summarily thrown out.

Unlike the other tenants, who went off to work, Benny Brown had nothing to do but worry and wait for his Veteran’s Assistance check to come in the mail. He spent the rest of the cold winter’s day wandering the neighborhood, sitting on a park bench, and ultimately going to the hospital with an anxiety attack. The subway served as his home the next night. A day later, he ended up at a city shelter, where he still lives today.

Brown says that ever since the new owner, Family Preservation, bought the building in November 1998, no one collected his $300-a-month rent. “They didn’t want the money,” he says. “They just wanted everybody out.”

After the eviction-by-hammer, Family Preservation found itself on the expensive end of several lawsuits. In the first settlement three tenants got $27,000 each; Brown got $39,000 a few months ago. Lawyers from the SRO Law Project who represented the tenants were jubilant–illegal eviction cases usually bring a couple thousand dollars, at best. Then the city Department of Housing Preservation and Development piled more liabilities on Family Preservation, winning a court order for $33,284 in civil penalties and the concession that the building be reinstated as a low-income SRO for at least two years.

How did a nonprofit come to have $153,284 to pay for one building’s worth of mistakes? And just as important, why didn’t Family Preservation know people were still living at 58 Edgecombe, which it planned to convert into a four-apartment townhouse?

Sam Stith, Family Preservation’s property manager, partly blames himself–but mostly he fingers his realty, a Mineola company called Fix Realty, run by Frank Boccagna. At the time that Family Preservation got into the 203(k) business, it was a small 3-year-old organization with little experience in housing–most of its work had been in providing case management for mentally retarded children and their families.

Buddy Brown got evicted for the simple reason that Stith hadn’t yet seen any of the Harlem buildings that Family Preservation had bought, even though the nonprofit had begun buying them in March 1998. “We had no idea. We’re a hands-off operation–that was the problem,” Stith told City Limits at the time. Fix Realty sold the brownstone to Family Preservation for $345,000, and, Stith says, the realtors promised that the building was vacant. And Fix Realty also arranged for the gut rehab.

“We trusted other people,” says Stith. “Ignorance is no excuse for the law, but we didn’t know.” As for the money, Stith says his “investors”–whom he refuses to name–paid the settlements and penalties just to make the unfortunate situation go away.

There was something else Fix didn’t tell Family Preservation. Two months before the nonprofit bought the building, Fix had acquired it from an estate for $150,000. This wasn’t the only building that Family Preservation bought from Fix. On September 17, Fix bought 355 Pleasant Avenue for $165,000; the next day it sold the property to Family Preservation for $310,000. On October 1, Fix bought 51 Bradhurst Avenue for $27,000, selling it to Family Preservation the next day for $215,000. Each building was in need of a gut rehab.

The same players reappear in all of Family Preservation’s deals. Mortgage Lending of America set up the nonprofit with 203(k) loans. CLA appraised the properties, allowing the mortgage company to approve loans at or near the maximum allowed by FHA at the time. Fix Realty’s law firm was also the same one Nelson had dealt with in his 203(k) loans: Graynor & Graynor, on Mineola Boulevard in Mineola, Long Island.

During 1998, Family Preservation ended up buying at least a dozen Harlem properties using FHA loans, from 10 different sellers. Seven of these sellers–including Knarf Realty, Cazzo Realty, Ring Realty, Marfra Management and NMAD Realty–are clients of Graynor & Graynor.

In more than a dozen cases that can be documented with real estate records, these buildings were flipped: bought by realtors and then sold within days at much higher prices to Family Preservation. One transaction was an impressive double flip: 34 West 126th Street was bought by 1 Exit Place Realty–which shares its address with No Exit Place–on May 7, for $88,000; 1 Exit Place sold it to Cazzo on June 18 for $135,000; and on June 19 Cazzo sold it to Family Preservation for $250,000. In every case, Family Preservation took out its loans from Mortgage Lending of America.

Meanwhile, Fix, Knarf (which is also run by Boccagna) and Cazzo were flipping Harlem properties to two other nonprofits, St. Stephen’s Baptist Church and Word of Life Ministries of Freeport, Long Island. In six cases that can be documented, the transactions told the same story: Mortgage Lending of America handed out loans for buildings that had doubled in price overnight. For example, in June 1998 St. Stephen’s bought 57 West 119th Street for $215,000 from Knarf. The realtors had paid $85,000 for it one day earlier. Cazzo Realty bought a widow’s brownstone at 336 West 145th Street for $20,000 in April, selling it to Word of Life a week later for $225,000.

But Stith says it’s not a problem that his nonprofit paid these big markups. He suggests it’s part of the cost of doing business. Let’s say there’s a building on the market for $90,000, he proposes. “If an investor pays [to buy it], whether out of his pocket or through a loan, and he sells it for $200,000, and it becomes housing, it’s a win-win situation.”

Stith acknowledges that “we overpaid for some buildings” but says that his brownstones will ultimately be worth $400,000. Once the work is finished, Family Preservation expects to rent its apartments out for $700 to $1,000 a month, earning stable income for years to come. “You can make a profit out of the rent, hold onto it for five to six years,” Stith says.

But the bills are already coming due. It’s been more than six months since Family Preservation bought the properties, and the organization now owes mortgage payments to banks even though its buildings are still undergoing reconstruction. Stith isn’t worried about that, either. He reports that his “investors” are covering the mortgage payments. And Mortgage Lending of America doesn’t have to worry about the payments–like most smaller lenders, the company quickly sold the loans to bigger banks for an immediate return on the investment, passing along FHA’s insurance guarantees with the loans.

Family Preservation’s business strategy doesn’t make sense to Martin Hayott, a longtime Harlem resident who has traded in brownstones for many years. When one of his run-down holdings, 166 West 123rd Street, had become “more headache than pleasure,” he unloaded his albatross on Knarf Realty in August at what he thought was a good price, $60,000. Knarf sold it to Family Preservation a day later for $250,000, making $190,000 instantly. Family Preservation’s FHA loan amounted to $327,400, leaving just $77,400 for gut-rehab work.

Hayott isn’t mad about the deal–just puzzled. By his reckoning, it would cost at least $200,000 to make the place livable. On that block, with other vacant buildings nearby, the investment seemed like a bad idea to him. “Who would even spend $250,000 on that particular street and this particular time?” he asks. “Whoever bought that building will never make that money back in their lifetime.”

Harlem’s other nonprofit housing developers, including the formidable Abyssinian Development Corporation, also scoff at the notion of paying $200,000 for a dilapidated brownstone. With that kind of price tag, and another $200,000, they estimate, for a gut-rehab, the finished product would be far too expensive to either sell or rent affordably. Developers and brokers say a more reasonable price for a brownstone in need of gut rehab in early 1998 was about $150,000. But when Family Preservation’s shopping trip began around that time, it was paying an average of $256,000 a pop. Given FHA loan restrictions, that left the organization with an average of $58,500 per property for a complete rehab job–framing, wiring, plumbing and all.

Stith refuses to say how much his organization is spending on each rehab, or how he intends to meet any cash shortfalls. “I know we’re going to make [the money] back,” Stith insists. “I’ve done the numbers. That’s not even a problem.”

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As it recognizes that 203(k) has become a feeding trough, HUD has just recently begun to do something about it. In June, its investigators started snooping around New York, looking into the mechanics of loans and appraisals and inspecting how much money has been set aside for rehab, how long rehabs have taken and how contractors were paid.

That same month, the agency unleashed a set of reforms aimed at cracking down on problem appraisers. Under new rules, appraisers must assess 80 specific features in each property, taking some of the subjectivity out of the process. HUD will retest all its appraisers, subjecting them to spot reviews in the field, and they now face stiffer penalties for infractions. Finally, a new computerized monitoring system will red-flag suspicious loans and appraisals.

Lenders are also coming under scrutiny. Under HUD’s new “credit watch,” lenders with three times the FHA default for a region will face getting suspended or barred from the program. Already, 33 lenders, including Mortgage Lending of America, were barred in late September from making FHA loans.

Perhaps most important, the agency released a new proposed rule in September that would prohibit realty companies that sell to nonprofits from giving them money in connection with those sales, like the fees paid to Helpline and AIM. “We don’t want sellers to induce nonprofits to buy properties [from them] by giving them the down payment,” explains Brenda LaRoche, director of processing and underwriting in HUD’s Philadelphia office.

In part, the measures simply reinstate old safety checks that HUD had abandoned. The agency used to prevent collusion by insisting on a blind appraisal process, where appraisers were selected at random to review prospective FHA loan purchases. That policy was revoked in 1994.

And the measures don’t necessarily go to the heart of the problem with 203(k): that the foxes are guarding the henhouse. HUD uses spot reviews to inspect about one in 10 loans for improprieties nationwide. But it’s the mortgage lenders that are entrusted to check nonprofits and individuals for credit-worthiness, ensure that the construction work is completed, and choose reputable appraisers. Under the new reforms, that won’t change. From the agency’s point of view, looking over everyone’s shoulder–from lender to contractor–is just too expensive.

But FHA has already seen how quickly rampant abuse can crush the sweet dream of homeownership. During the late 1960s and early ’70s HUD was hit by a rash of scams connected to its Section 235 loan program, through which the agency subsidized mortgage payments and, as it does now with 203(k), insured lenders against default. Those vulnerabilities led to many of the same problems now racking 203(k), including over-appraised property and shoddy construction. Poor New Yorkers and low-income home-buyers in cities across the nation abandoned their homes in droves. Fully 18 percent of the homes ended up in default; in Sunset Park alone 100 houses sat vacant. By 1973 the program was pulled.

HUD would do well to heed the lessons it learned then. Strict oversight is expensive-but so are the alternatives.