Loan defect rate tumbles to near-record lows, report claims

Mortgage production defect rates fell into a range near record dataset lows in the last quarter of 2023, an Aces Quality Management trends report published Thursday found.

The fourth quarter saw the overall critical defect rate tick down to 1.53%, despite a challenging origination landscape. On a calendar year basis, the defect rate averaged 1.68%, a nearly 20% decline from 2022.

Improvements were seen in the credit and liabilities underwriting category, while income and employment remained as the most problematic for defects in the fourth quarter, followed by assets and borrower and mortgage eligibility, per the report.

Compared to the prior quarter, the share of total defects in the income and employment category increased to almost 37%. The percentage in the assets category increased to 17.29%.

The notable dip in the overall loan defect rate, marking five consecutive quarters of declines, can be explained by lenders "prioritizing loan quality in the current market to preserve as much revenue as possible," posits Trevor Gauthier, CEO of ACES.

"The market downturn led to operational staff cuts for many lenders, and those reductions certainly impacted QC departments. Lenders' ability to consistently drive down their critical defects in that environment speaks to the power of ACES to help lenders manage loan quality and mitigate risk in any environment," Gauthier said in a press release.

Though a decline in the yearly defect rate seems at odds with reported spikes in five of the nine defect categories tracked in 2023, ACES explains drops in the credit, legal, insurance and loan documentation categories pushed the overall yearly rate downwards.

The company's post-closing review process categorizes file errors using the Fannie Mae defect taxonomy. Defects are indicators, but not necessarily proof, of fraud.

The credit category improved the most year-over-year, declining by 26.56%, followed by 22.59% in legal and 18.89% in insurance. Loan documentation defects improved slightly by 0.97%, the report said.

Federal Housing Administration-insured mortgages made up 23.86% of the file reviews in the fourth quarter and constituted 43.40% of critical defects. Conventional loans were 59.37% of reviews, and 47.17% of defects. Veterans Affairs-guaranteed loans were 14.36% of the quality checks but just 7.55% of the errors.

"Building on the gains made in late 2022, mortgage lenders improved loan quality in both Q4 2023 and for the year overall," said ACES Executive Vice President Nick Volpe. "However, persistent adversity in the form of interest rates and affordability challenges only emphasizes the need for lenders to remain vigilant and protect the integrity of existing loan production."