Critical defects in mortgage files reach highest level in years

The critical mortgage loan file defect rate for 2020 was the highest since Aces Quality Management started tracking this data in 2016. Loan documentation findings played a significant role in the increase, the audit technology provider found.

Such issues, which are indicative of manufacturing process errors, were second last year to income and employment as sources of critical defects found in post-closing reviews of mortgage files conducted by Aces. Loan documentation problems were found in 16.6% of the files examined, up from just under 15% for 2019.

This increase was driven by pandemic-related difficulties and are symptomatic of manufacturing-related defects overall, Aces said.

While the overall defect rate for the full year 2020 was the highest ever, at 1.97%, that number came in lower than the fourth quarter rate of 2.09%, which was actually an improvement over the third quarter's 2.34%. Aces' executive team was rather positive regarding the annual results given that, for example, in the fourth quarter of 2019, the critical defect rate was 1.73% and in 2018, it was 1.81%.

Loan defects are a red flag for, but not proof of, mortgage fraud.

"It would be easy to say the last two quarters of 2020 were dismal, but considering the pandemic, unemployment and critical defect rates, our fourth quarter findings are buoyant," said Aces CEO Trevor Gauthier in a press release. "Critical defect rates and early payment defaults will continue to be areas to watch closely, particularly as lenders respond to the changing landscape of 2021 and more borrowers come out of forbearance."

Mortgage originations broke records in 2020 and the last two quarters of the year in particular, which can also contributed to problems in loan files.

About $4.5 trillion in mortgage volume was originated last year, with $1.35 trillion in the third quarter and $1.34 trillion in the fourth, according to Fannie Mae.

The loan documentation defect rate actually declined quarter-to-quarter at the end of 2020, to 14.75% from 18.75%, but it was still the third largest category of critical defect for the period, behind income and employment and legal, regulatory and compliance issues, which surged during the period to 21.3% in the fourth quarter from 8.5% in the second quarter.

Aces uses the Fannie Mae loan defect taxonomy to categorize its findings.

"Amidst a positive interest rate environment and an improving economy, the critical defect rate moderated in the fourth quarter," Nick Volpe, executive vice president, said in the report. "The marginal decrease in critical defects is the first step in what we hope to be a downward trend."

The critical defect rates on both a full-year and fourth-quarter basis were disappointments because they were higher than in the past. But it should be understood in context with what happened last year, he said.

"If you had said back in April 2020 that we would come out of the pandemic with record-breaking volumes and only see slight increases to mortgage defects — despite unemployment reaching all-time highs and major parts of the economy being shut down for 12-plus months — I believe most in our industry would have been happy with that," Volpe said.