A temporary HUD employee who conducted her own investigation at night and on weekends after being told to stick to her regular work is credited by top officials at the Department of Housing and Urban Development with uncovering the nation's largest outbreak of HUD fraud.

Sarah Lyon, an appraiser in HUD's District office, provided essential clues that ultimately enabled officials to track more than 250 fraudulent transactions in inner-city District neighborhoods that have resulted in millions of dollars of losses to the increasingly troubled Federal Housing Administration insurance fund.

On her own, she enlisted the help of another HUD employee, Hilton L. Green, then a low-level official in the office of HUD's inspector general. "Sarah came to me and said, 'They won't listen to me. Will you?' " said Green, a decorated Vietnam veteran who fought with the 82nd Airborne Division. Together, they cracked the case.

To date, at least 36 people, with more prosecutions yet to come, have pleaded guilty or been convicted in U.S. District Court in connection with the cases.

Lyon's role in the investigation was pivotal, current HUD officials said, and sheds light on why the scandal grew to such magnitude before it was stopped.

As Lyon found, the central problem at HUD was that it had no reliable system for intercepting fraudulent loan applications before they were approved.

The agency used an antiquated filing-card system that made it difficult to cross-check records to determine patterns of fraudulent activity. Individual departments at HUD operated independently, seldom communicating with each other. And files were quickly sent to federal archives, making it even harder to track key pieces of information.

"We're still dealing with 19th century techniques," said Alfred A. DelliBovi, the current HUD under secretary. "What we've found is that overall there were few management systems in place."

Compounding the problems at HUD was the bureaucratic, political and budgetary climate there through most of the 1980s. Lyon's supervisor would not allow her to pursue her investigation on department time because at a time of staff cuts, he believed she should work on a mounting backlog of unprocessed paperwork.

Later, some of her recommendations for solutions to the problems were rejected, in part, because the lending industry found them burdensome, according to internal department memorandums.

An essential part of the scheme was evasion of District rent control laws. The agency that oversees that law didn't catch the fraud either.Something 'Really Rotten'

Lyon's story began in January 1984, when she was a temporary employee in the local HUD field office, assigned to review mortgage loan guarantee applications. While conducting her reviews, she noticed an odd coincidence: Three Southwest D.C. residents were seeking loan insurance from HUD's Federal Housing Administration on the same day for the same amount of money.

At that time, those kinds of applications typically were receiving a cursory review and nearly automatic approval, but Lyon's interest was piqued.

"How many people do you know in a neighborhood who refinance on the same day for the same amount of money?" she recalled asking herself.

Further inquiry by Lyon revealed that two similar loan packages had arrived in the office that day, for a total of five. She noticed other oddities: The person identified as the owner-occupant of one of the properties was merely a renter there while the real owner was an investor -- and, therefore, ineligible for the federal loan insurance. In addition, the properties had been appraised at values far exceeding what normally would be expected for those areas: $36,000 by her estimate, compared with appraisals of $44,000.

"The whole thing began to smell really rotten," Lyon recalled.

Lyon took the troubling information to her supervisor, Don Hunt, who told her that such inquiries were the job of the agency's inspector general, and directed her to return to her usual tasks, Lyon said.

Hunt, now a realty specialist with HUD's central office, said he "ordered" Lyon to do the investigation initially but when she became overly enthusiastic, he directed her to return to her normal duties.

"She wanted to continue being the FBI, and I needed for her to continue to do her work," Hunt said, adding that the local office at the time was flooded with applications at a rate of 300 a day. He described a scene in which loan-insurance applications were stacked to the ceiling, leaving workers struggling to process the paperwork.

Lyon launched her own investigation. Working at night, on weekends and on her lunch hour, she began studying records, visiting properties and tracing links among the transactions.

Lyon's goal was to examine suspicious transactions and determine the real players behind them: the mortgage companies originating the loans, the purchasers and the real estate brokers.

The paper trail was long and winding, with essential kernels of information divided among at least six different government offices. Some items were available at HUD's local level, others only at the central level. Other information, including land and rent control records, could be obtained only through the District government.

In many cases, the starting point would be a foreclosed property. There were plenty to choose from in the District at that time: The fraud was so widespread that at one point in the early 1980s, about 9 percent of all FHA-insured loans in the District were in default.

Lyon would start by checking reports issued monthly by HUD's loan management office that listed properties in default. The reports listed the names of the property owners, as well as the lenders who serviced the loans. Those names often were misleading because the speculators purchased the properties in other people's names, and the original lenders usually quickly sold the loans in packages to other lenders, who then took responsibility for the loans.

To find the original lenders, Lyon had to turn to little green cards in file cabinets at HUD. Other records she needed were thrown into a nearby box, fastened with rubber bands, and she had to root through hundreds of cards to find the right one.

To examine the original paperwork on suspicious transactions, Lyon had to request files from the federal records archives in Suitland, where they had been sent within months of the closing of the loans, Lyon said.

And to get final estimates of the losses to HUD resulting from such foreclosures, Lyon had to wait for information to be transmitted from property disposition to the insuring department at HUD's central headquarters.

In short, HUD at that time was like a broken car with a locked hood, making it impossible to get inside to see what had gone wrong. "There were no checks and balances, no feedback loop anywhere," Lyon said.

"Human resources were not deployed in a way to promote program integrity," DelliBovi said. "Financial management systems were not integrated to prevent fraud and abuse . . . and that was particularly true in the single-family loan insurance program."

As Lyon's investigation progressed, patterns began to emerge. Certain names and lenders began to crop up over and over again in transactions that were ending in foreclosure, with HUD picking up the tab for the mounting losses.

"It was intriguing to watch the paper trail they left, thinking that nobody would ever find it," Lyon said. "It was so well hidden." Getting Some Help

Rebuffed by her supervisors and discouraged by their reaction to what she was learning, Lyon took her observations to Green, then resident agent for the D.C. area HUD office.

Green was interested in what Lyon had to say. He knew that HUD officials had noticed the bizarre -- and costly -- surge of property foreclosures, and it occurred to him that it might be connected with the patterns Lyon was finding.

"I knew we had a jigsaw puzzle of things happening in the city," Green said. "But the question was how to find the pieces of the puzzle . . . and get support for an investigation."

He also worried about meeting openly at the office with Lyon, who was likely to be viewed by her co-workers as a whistleblower. So Green and Lyon began meeting at night to review notes and make plans. Together they began tracking transactions through the maze of local and federal HUD offices and the District bureaucracy.

Then Green hit the street, examining the real-life consequences of the fraud, visiting decaying apartment buildings throughout the District and talking to tenants to find out what they knew about what had happened.

The patterns in the paperwork and his contacts with renters led Green to believe that a network of real estate speculators in the District was buying properties under rent control, making quick profits by re-selling them at inflated prices through fraudulently obtained FHA insurance, often to straw buyers -- individuals acting as stand-ins for others -- and quickly raising the rents. Often, property management companies oversaw evictions on behalf of owners who preferred not to have much contact with their investment properties.

Green arrived at some properties just as renters who had faithfully paid their rents for years were sadly packing to move from their longtime homes.

"They were all displaced, there were quite a few displaced," Green recalled. "It was depressing, very depressing."

One property made a particular impact on him: It was vacant and gutted, with few interior walls, no plumbing and no wiring, and it had been appraised, and insured by the federal government, for $65,000.

With dismay, Green began to realize that the deterioration was spreading in the city, as speculators expanded their activities from neighborhood to neighborhood, using FHA insurance to make their purchases and allowing the properties to fall into disrepair.

But while Green gathered evidence, he knew he needed something else. He realized that someone in the know had to be persuaded to talk.

In May 1984, Green made an important breakthrough when he found the insider who was willing to cooperate. He contacted an accountant who handled the financial affairs for several of the real estate dealers orchestrating the schemes and persuaded the man to meet with him at the Dutch Pantry restaurant on Route 301 in Bowie. There, the man disclosed that he knew that several fraudulent documents had been submitted to HUD.

"His interview," Green said, "was primary."

Armed with the information from the accountant, Green took what he had learned to top HUD officials. Inspector General Paul A. Adams decided to back the project, and a multi-agency task force was created to investigate the case. Investigators from the FBI, Internal Revenue Service, Veterans Administration and Bureau of Alcohol, Tobacco and Firearms joined forces with HUD agents. The U.S. Attorney's Office in Washington prosecuted the cases.

As their investigation developed, investigators became aware that the scheme was more pervasive than anyone had guessed. Rather than a handful of speculators, investigators learned that hundreds -- loan and settlement officers, lawyers, real estate agents and brokers, and many investors and buyers -- were involved.

On the wall of a room occupied by the task force is a huge multicolored diagram, about four feet by eight feet in size, that is growing and spreading. With arrows and symbols, it tracks the multiple connections between the players, indicating the flow of money and property transactions.

"It's like an octopus," said real estate appraiser Harry A. Horstman III, the expert witness hired by the Justice Department to review the property documents and estimate HUD's losses. "There are so many arms going to so many places."

But even as investigators uncovered increasing evidence of fraud, top HUD officials appeared reluctant to make the changes to the system necessary to prevent it from continuing.

In 1984, for example, Lyon submitted a recommendation through the government's "IDEAS" program, which offers cash rewards to employees who propose ways to save the government money. She suggested that the names of sellers and mortgage companies be added to HUD's default monitoring report to make it easier to track repeat abusers of the program. Thanks but No Thanks

HUD officials responded with a letter that thanked Lyon for her "interest in the IDEAS program." It was accompanied by a form that had check marks in boxes indicating the idea was not "cost beneficial" or "feasible."

An attached letter said the proposal would prove an imposition to lenders and loan-servicing companies.

"Several large-volume mortgagees were contacted by {HUD} and all agreed that the inclusion of the seller's and originating mortgagee's name . . . would be a monumental task requiring unwarranted research," the letter said.

Lyon responded in writing: "This is quite an interesting answer because it is such large-volume mortgagees that appear to possibly be parties to perpetrating fraud . . . . What type of answer would one expect to get from a mortgagee if the mortgagee were doing illegal processes? Does it make sense that they would encourage checks and balances to prevent their fraudulent practices?"

Lyon didn't give up. In 1986, two years after leaving HUD, she resubmitted the same suggestions, and this time they were rejected by then-Deputy Assistant Secretary James C. Nistler in a similar form letter. He said that "the fact that the fraudulent actions were discovered is a sign that our procedures were working."

Nistler's soon-to-arrive right-hand man at HUD, and one of the people charged with helping manage the single-family FHA program, was lawyer Peter Novick, who since has been sentenced on similar charges of defrauding HUD. Novick engaged in the fraudulent activity while a lawyer in private practice in the early 1980s, during a several-year stint between jobs at HUD. Last year, Novick pleaded guilty to making false statements to HUD and was sentenced to one year in a halfway house.

In 1989, Nistler appeared at Novick's sentencing hearing, trying to help Novick obtain a lighter sentence, but the judge declined to hear him. Changes at HUD

Now, under a different administration, HUD officials say they are moving to find ways to curtail fraud. In particular, in 1988, the HUD inspector general recommended that tougher appraisal standards be imposed, which has happened as a result of the savings and loan scandal. HUD also has increased the size of the staff monitoring loans.

The government agency also has been reimbursed by one of the lenders involved in the fraudulent transactions. In July 1988, a Michigan-based lender called Marathon Mortgage Co., formerly known as Modern Mortgage Corp., which was responsible for at least 50 fraudulent loans in the Trinidad neighborhood of the District, agreed to pay a $2 million fine, according to the Marathon attorney who helped negotiate the settlement.

In addition, 29 people involved in the fraud in Washington have been banned or suspended by HUD, which prevents them from participating in FHA programs, according to HUD officials.

The process of loan approval has changed, too. HUD no longer approves loan insurance before it is granted. Instead, since the mid-1980s, under a program known as direct endorsement, lenders are permitted to grant the insurance themselves. Some observers and HUD insiders have questioned whether that program leaves the foxes in charge of the henhouse, but DelliBovi said the agency's fraud problem has decreased since the change was introduced because lenders fear losing their right to process such loans and receive the fees from them.

"Vigilance is the best policy here," DelliBovi said. "That's what we're trying to implement. Programs should do good and not do harm . . . . We don't want that to happen again."

HUD Special Agent Green has become a specialist in uncovering FHA fraud, and he is overseeing efforts to expand the investigations nationwide. Recently promoted to director of the headquarters operation division, Green is using the local FHA fraud investigation as a model for investigators in the rest of the country.

"I've dedicated my life to this because buying a home is the American Dream," Green said. "To take people's homes through fraud is a disgrace."

Green, Adams and Horstman most credit Lyon with doing the original legwork that led to the successful investigations and prosecutions.

Lyon was never hired for a permanent position at HUD, and she left the government agency shortly before the term of her temporary position expired. She now works for the District.

"Sarah fought like a cat and a dog to get somebody to even pay attention," Horstman said. "She was blackballed. It was the whistleblower syndrome."

When she left HUD in mid-1984, her colleagues gave her a going-away party. Among the gifts she was given was an official detective's notebook, emblazoned with her assigned computer log-on number at HUD: 0007.

He said the widespread scheme that resulted in the deterioration and abandonment of many buildings is "like an octopus. There are so many arms going to so many places."