2020 will be remembered as an anomaly of a year, with the effects of COVID-19 rippling through nearly every aspect of the economy. While the mortgage industry experienced record loan volume, the pandemic created circumstances that impacted loan quality and exposed lenders to greater risk. As we close the books on 2020, analysis of post-closing QC data from the second quarter shows the industry has yet to feel the pandemic’s full effect on loan quality — meaning lenders shouldn’t consider themselves out of the woods just yet.
According to ACES’ Mortgage QC Industry Trends Report for 2Q 2020, COVID’s impact on the market hadn’t truly reared its head until the second quarter when it unleashed a 1.88% critical defect rate, the highest since 4Q 2018, and an unrelenting rise in early payment defaults. Though these defects appeared in credit and assets categories, the main culprit behind the skyrocketing critical defect rate was unemployment, with The Bureau of Labor Statistics reporting a loss of 22 million jobs between February and April 2020. In 2Q, characteristic changes that would normally drive a decline in the overall critical defect rate didn’t. On the flip side, the industry also saw one of the most attractive mortgage environments in years. Put simply, it’s difficult to find an area of the economy that the pandemic hasn’t impacted in one way or another.
As a result of the extraordinary conditions created by the pandemic, lenders grappled with new requirements from the agencies, often reverifying income and employment on the same day as closing. These requirements, coupled with the challenge of maintaining a remote workforce, caused documentation issues to become a main driver of defects in income and employment, illustrating further complications to an already hurried process and increasing lenders’ risk of error. Lenders were forced to pivot on a dime — making it entirely possible that compliance defects will have a larger share in future quarters.
With purchase originations expected to hit record highs in 2021, refinance activity will slow. New advances in a COVID-19 vaccine spring hope that the pandemic’s end may soon be in sight, which could surge employment, kickstart the economy and spur homebuyers to take advantage of enticingly low interest rates.
It’s worth noting that even though refinances are typically less complex than purchases, lenders still faced significant loan quality issues and operational challenges due to COVID-19. Without knowing exactly when the economy will return to its pre-pandemic state, it’s likely that lenders will be coupling the challenges presented by the pandemic with the already complicated, expensive and inherently more risky process associated with purchase transactions.
Thus, when purchase activity begins to flood the market, the risk of loan defects could skyrocket as well, resulting in higher-than-normal volatility. Depending on their severity, defects could trigger loan buy backs or repurchase requests, which remains unfavorable for lenders despite the revenue gains they’ve experienced from record volume.
Given the increase in critical defect rates and other conditions, early payment defaults represent an area of risk exposure to lenders. In the second half of 2020, the industry saw EPDs rise by nearly 200%, compared to pre-pandemic levels, with the potential to increase loss rates and long-term defaults. Borrowers who have fallen behind on payments may also be unable to pay down delinquent amounts or return to their contractual payments altogether. It’s still unknown when EPDs might peak, how correlated they are to the CARES Act forbearances, or when and how the agencies might react.
COVID-related legislation continues to move rapidly, and the start of a new administration could bring fresh changes to existing regulations, making a moving target of compliance. The possibility of extended work-from-home policies and government-mandated shutdowns could carry these operational challenges into a broad swath of 2021.
Proactivity will be lenders’ best course of action against 2021’s challenges. Reducing the rate of defects and minimizing repurchase risk will require lenders to closely monitor their loan data to catch errors as soon as possible, even implementing operational changes to mitigate defects earlier in the origination process.
With a multitude of risks on the horizon, the need to prioritize loan quality cannot be overstated, since as lenders aim to get more done faster, the potential for error dramatically increases. The shift to a purchase market will introduce new opportunities for loan defects that, left unchecked, will spell trouble for lenders in the form of costly loan buy backs. If they are planning to stay ahead of the curve in the new year, lenders will need to ensure loan quality remains top of mind.
