Mortgage defect rates likely to improve, Aces says

Mortgage manufacturing quality continued to improve during the first quarter, a bright spot in an industry that tolerates a certain level of misrepresentations at times of tight margins and low volume.

The critical defect rate was 1.78% in the first quarter, down from 1.84% in the fourth quarter and an all-time high of 2.47% in the third quarter of 2022, according to post-closing quality control file reviews conducted by Aces Quality Management. For the same period last year, the defect rate was 1.93%. The reviews use Fannie Mae's defect taxonomy to categorize errors.

"While the drop in origination volume has challenged the industry, it has also enabled underwriting and QC teams to be more diligent with each loan file, resulting in higher loan quality," Nick Volpe, executive vice president, said in a press release. "The continued decline in the overall critical defect rate on the heels of last year's historic high indicates lenders have not let the desire for volume override the need to reduce errors and mitigate risk."

While a manufacturing defect is not necessarily a sign of mortgage fraud, it means the lender likely cut corners and it could be a red flag for malfeasance.

Manufacturing defects can also lead to a repurchase demand from Fannie Mae or Freddie Mac, which have been on the upswing in recent months.

In the first quarter, total volume of $333 billion was down from $409 billion in the fourth quarter and $708 billion on a year-over-year basis, according to the Mortgage Bankers Association.

Lenders took a pre-tax, per-loan net loss of $1,972 in the first quarter, an improvement over the fourth quarter's record $2,812 per-loan loss, MBA data cited by Aces found. That further declined to $534 pre-tax per-loan in the second quarter, helped by a reduction in expenses to $11.044 for each origination.

"We expect this [defect] data to continue to improve in the coming quarters," said Aces CEO Trevor Gauthier. "Making strategic investments in tech and optimizing operations — especially in [quality control] — can have a significant impact on protecting existing revenue amidst challenging market conditions."

Most of the mortgage industry layoffs have been carried out and that should help quality, the Aces report noted, adding "the industry is now clearly in the space where the strong are trying to eat the weak."

Another consideration for the future regarding defect rates is new prefunding and post-closing procedures that went into effect on Sept. 1 from Fannie Mae.

"With the recent changes to Fannie Mae's prefunding QC reviews and post-closing QC cycle times, time will tell in the following quarters how diligent lenders have been in maintaining loan quality and investor requirements," Volpe commented.

Defects related to income and employment data remained by far the single largest finding by Aces, at 31.5% in the first quarter. But that is an improvement from 36.9% in the fourth quarter.

Assets were the next most common finding, at 16.5%, but that is also better than the 18.1% of these defects found in the fourth quarter.

Borrower and mortgage eligibility related defects also showed a marked reduction in occurances, to 8.7% from 14.1% in the fourth quarter, when it was the third most cited finding.

On the other hand, legal and regulatory compliance rose to No. 3 most cited defect in the first quarter, to 12.6% from 5.4%.

Loan documentation defects increased to a rate of 10.2% from 9.4%; liabilities to 7.9% from 6.7%; and credit to 5.5% from 4%.

Defect rates also tend to be higher in a purchase market, as misrepresentations are made in order to get the buyer into the house. On the other hand, when refinancings are need driven, defects can be higher for those loans as well.

The Aces data showed that purpose-related defect rates were in line with the share of files reviews. Approximately 83.1% of the files looked at were purchases, and the share of all loans with a defect was 82.4%.

By product type, Federal Housing Administration-insured loans had an outsized defect rate, 33%, versus the percentage of files reviewed, 20.4%. It is also true to a lesser extent for Veterans Affairs-guaranteed mortgages, 13.2% and 12.3% respectively.