Better volume, profits reduce critical defects in mortgage files

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The critical defect rate for closed mortgage loans continued its decline in the second quarter, as lenders benefited from increased loan volume and profitability, an Aces Risk Management study found.

For the first time since the third quarter of 2016, the critical defect rate dropped for two consecutive quarters. Higher volume and profits factor in, providing less incentive for some lenders to cut corners to keep production up.

However, a greater share of Federal Housing Administration-insured mortgages reviewed by ARMCO were found to have critical defects in the files.


Critical defects were found in 1.72% of loans that closed during the second quarter, down 5.5% from the first quarter's 1.82% and 9% from the 1.93% peak in the fourth quarter of 2018. In the second quarter of 2018, the critical defect rate was 1.71%.

Mortgage volume began outpacing prior expectations during the first half of 2019 as interest rates declined. Meanwhile, originator profitability rose, reaching an average of $1,675 per loan in the second quarter — and that grew to an average of $1,924 in the third quarter, according to the Mortgage Bankers Association.

Volume fluctuations typically cause challenges for lenders, which often respond to sudden spikes and dips by adjusting their labor forces through layoffs, downsizing, re-allocating staff and hiring.

"These changes upset the status quo and usually result in more defects, because staff instability increases errors and oversights," Nick Volpe, ARMCO's chief strategy officer, said in a press release. "When lenders adapt, usually when the market steadies, defects decrease. It is therefore safe to say that when lenders use technology that improves their scalability, they increase profitability faster than those who rely on manual processes."

However, the share of FHA files where a critical defect was found following a post-closing review grew in the second quarter compared with the first quarter. FHA originations made up just under 28% of the files reviewed but 48.25% of those had a critical error. In the first quarter, FHA was a higher percentage of reviews, nearly 30%, with 46.5% of those having a critical error.

While income and employment remained the largest category of findings, the 18.9% was well below the first-quarter level of 27.8%. Documentation errors fell to 15.8% from 24.1%.

However, problems regarding assets rose to 17.8% from 11.1% and eligibility errors rose to 14.7% from 6.5%, ACES said.

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. Critical defects raise a red flag for the possibility of mortgage fraud, although not a definite finding of any unscrupulous behavior.

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