Critical defect rate rises for first time in over a year

The share of underwriting defects on mortgage applications climbed higher in the first quarter, even as origination volumes fell to their lowest point since 2000, according to a new report. 

Critical defects, defined as an error or flaw that would make the loan uninsurable or ineligible for secondary-market sales, increased for the first time in 15 months to a rate of 1.58% to start 2024, according to the mortgage-software platform Aces Quality Management. 

The number climbed up from 1.53% in the fourth quarter 2023, but marked a decrease from 1.78% a year ago. 

Although historically low, the rise occurred during a three-month period when originations came in at a more than two-decade low, data Aces leaders labeled "troubling."

"Given origination levels in the first quarter of this year, the findings in this report showed greater changes than expected. Historically, defect rates decrease when there is a decline in origination levels; however, that was not the case for Q1," said Aces executive vice president Nick Volpe, in a press release.

"Overall, the data clearly shows that lenders are under increasing pressure to maintain quality amid changing market dynamics," added CEO Trevor Gauthier, who pointed to rises in underwriting and insurance defects as particularly concerning. 

Among the eleven categories measured and reported, borrower income and employment errors sat on top as the leading reason for critical defects with a share of 23.42%. The number, though, represented an improvement from 36.84% three months earlier. 

The next two leading causes shifted quarter to quarter with legal and compliance errors rising to second place with a rate of 16.22%. The share accelerated from 5.26% the prior quarter. Loan documentation posted a defect rate of 14.41%, up from 10.53% three months earlier.

In fourth quarter data, income and employment also finished as the leading defect category, while borrower and mortgage eligibility ranked in second, and assets rounded out the top three.

The more-than-threefold leap in the legal, regulatory and compliance defect rate came across as unusual, as such a surge would normally be accompanied by a major regulatory change, according to Aces. Instead, the upward movement likely occurred as a result of several minor rule changes. 

Other defect categories coming in notably higher was the credit-error rate, which almost doubled to 9.01% from 4.51% quarter over quarter. Insurance defects, covering several types including flood, hazard and mortgage, saw its share rise to 8.11%. For both 2022 and 2023, the insurance defect rate sat under 1%.

Of the first-quarter loans lenders reviewed, 12.45% were refinance originations versus 87.56% purchase transactions. Although the refinance-review share shrank from the prior three months, the defect rate doubled to 18.87%, indicating "degradation" in the type of mortgages that bear extra scrutiny, Aces said. 

On the other hand, lenders increased the percentage of purchases reviewed, but their defect share fell to 81.13%.

Growth in refinance defects also helped lead to an increased rate among conventional loans. Most, if not all, refinances in the first quarter would have been for conventional mortgages. 

Conventional loans finished the quarter with a 58.49% critical defect rate. In the government-lending categories, Federal Housing Administration-backed loans came in at 34.91%, Department of Veterans Affairs-guaranteed applications with 4.72% and U.S. Department of Agriculture-sponsored mortgages had 1.89%. 

Among the total volume of loans reviewed, FHA- and VA-backed applications decreased from the previous quarter.