Fewer critical defects in closed mortgages, but income errors rise

While the critical defect rate for closed mortgage loans fell on a quarter-to-quarter basis, there were increases in income and packaging-related deficiencies, an Aces Risk Management study found.

"The first quarter revealed the loan quality correction we anticipated after the fourth quarter, but while there are many positives related to the overall market's upturn, we saw an increase in defects related to key underwriting and eligibility functions," said Nick Volpe, chief strategy officer for ARMCO. "This continues a trend that persisted the entirety of 2018. Lenders shouldn't take this lightly."

The critical defect rate dropped to 1.82% in the first quarter, down from 1.93% in the fourth quarter, but up from 1.72% in the first quarter of 2018. Critical defects raise a red flag for the possibility of mortgage fraud, although not a definite finding of any unscrupulous behavior.

The drop in mortgage rates during the first three months of the year likely resulted in the quarter-to-quarter improvement in defect rates. In the second half of 2018, when the critical defect rate spiked, mortgage interest rates also rose, leading to fewer refinance transactions and lower origination volume, ARMCO noted.

However, critical defects related to income and employment made up nearly 28% of ARMCO's findings, up from over 20% for mortgages closed in the fourth quarter of 2018.

Aged, missing or unsatisfactory income documents produced nearly two-third of those defects, while another 27% resulted from a mismatch in the income-to-employment calculation.

Over 24% of the files had loan package documentation errors, up from 15.5% in the first quarter. Nearly three-quarters of packages with this finding had problems with the closing/title documents.

"Documentation-related defects tend to fluctuate more quarter-to-quarter than other categories and can be more pronounced in a purchase-driven market," the ARMCO report said. "This is due to the greater document-related requirements of purchase loans. Purchase transactions are generally more complex than refinances and take longer to close. Therefore, more documents tend to expire with purchase transactions."

The lower rates increased the number of borrowers that can consider refinancing, including many that closed their loans in the last three years, ARMCO noted. However recent volatility in rates reduced that number by 2 million, a Black Knight report said.

Going forward, because of the likely return of a refinance market, critical defects should also continue to decline. But there is a catch.

"Refi-dominant markets can have a positive impact on defect rates," said Phil McCall, president of ARMCO. "But when volume goes up, individual workloads increase, turn times extend and mistakes tend to increase. Lenders who leverage technology wisely scale much better and expose themselves to fewer losses as a result."

The findings were based on post-closing quality control data from over 90,000 unique loans from the first quarter and categorized using Fannie Mae's loan defect taxonomy.