Critical defect rate of closed loans spiked in 2Q due to COVID-19

Critical defects found in closed mortgage loan files were at their highest since 2018 in the second quarter, due to conditions created by the pandemic, a review conducted by Aces Quality Management found.

The overall critical defect rate was 1.88% for the second quarter, up from 1.56% in the first quarter and 1.72% in the second quarter of 2019.

"While evidence of COVID-19's impact on loan quality was present in the first quarter data, the second quarter is where 'the COVID effect' becomes truly apparent, resulting in the highest critical defect rate observed since the fourth quarter of 2018," when it was at 1.93%, said Aces Executive Vice President Nick Volpe.

"One of the biggest drivers of this increase was the rise in income/employment-related defects — a wholly unsurprising outcome given the challenges nearly all employers faced in transitioning to a remote working environment," he added.

Normally when rates decline, so do critical defects, since two lower risk loan types are usually trending at the same time: refinances and conventional purchase financing, Aces said.

However, pandemic-related job losses became a distinguishing event in the second quarter.

The U.S. government and American companies combined employed roughly 152 million people in February, according to Bureau of Labor Statistics data. By the end of April, that was down to 130 million, driven by shutdowns and COVID-derived restrictions.

"The breadth and speed of job losses were simply overwhelming, and the interest rate environment, government injection of stimulus, increasing housing values and other positive macroeconomic factors were simply overwhelmed by COVID," the Aces report said.

It was no surprise that most of the critical defects were found in the income and employment category. (Aces uses Fannie Mae's loan defect taxonomy to categorize its findings.) The company found that, of all the 2Q originations with defects, 30.19% were income and employment related, up nearly 12% from the prior quarter's 18.35%.

Loans with defects attributed to assets took up a 12.26% share (up from 10.09% in the first quarter) while credit made up 18.87% (up from 17.43%) of all 2Q loans with defects. The increase in these categories is likely a function of the secondary market requiring verifications of income and employment closer to when the loan is supposed to close. Lenders are often reverifying employment on the closing date.

"This adds complexity to an already hurried process, and the difficulty is compounded by most employers being in a work-from-home situation themselves," the Aces report said.

Legal defects was the only other category with a quarter-to-quarter increase, to 9.43% from 6.42%.

The remaining seven defect categories all declined in the second quarter compared with the first, including appraisals, which fell to a 4.25% rate from 5.5%. But Aces attributed that to the increase in loans with property inspection waivers granted by the agencies because of the pandemic.

Meanwhile, the number of reviews Aces performed because of early payment defaults continued to soar in the third quarter, up 197% compared with the pre-pandemic levels of 2019. In the second quarter, this was up 139%.

And it is just "too early to predict when EPDs will peak," Aces CEO Trevor Gauthier said. "Any continued rise is likely to exacerbate long-term default and loss rates, signaling that lenders must remain vigilant of the risks this might pose to their organizations."