WASHINGTON — The Federal Housing Administration appears to have made progress in improving how loans are evaluated for minor defects, possibly removing an obstacle to growth of the FHA single-family program.
Among the factors holding back FHA growth has been lenders’ fear of liability for underwriting mistakes and other errors in the wake of high-profile enforcement actions.
But the agency has earned praise for changes unveiled in May to its loan defect taxonomy, which alerts lenders to mistakes that could subject them to penalty. The prior system was criticized for flagging too many potential errors on loans, thereby discouraging lenders from participating. But the improvements, including a new automated loan review system, are seen as providing a more streamlined method for identifying defects.
Scott Olson, executive director of the Community Home Lenders Association, said the new FHA automated loan review system is "clearly an improvement from our members' perspective."
"As with any major overhaul, there are a lot of moving parts, so there are probably still a few minor areas where there is room for improvement. But overall, it is definitely a positive impact in providing more clarity and certainty," Olson said.
The threat of liability for underwriting errors has been a hindrance to FHA growth, at a time when the Trump administration is holding back on reducing FHA premiums.
Lenders’ risk of liability has been of particular concern in light of the Department of Justice’s use of the False Claims Act to penalize FHA lenders for underwriting errors since the crisis.
But Secretary of Housing and Urban Development Ben Carson has been sensitive to lenders’ concerns about the FHA taxonomy and False Claims Act cases, and a more streamlined system for catching defects is seen as a step toward a correction for the compliance regime.
The new automated loan review system rolled out in May, which complements the loan defect taxonomy, “is supposed to ensure that lenders won’t be severely penalized for small errors and address the uncertainty of enforcement actions," Kevin Stevens, director of the FHA's Home Mortgage Insurance Division, said in a speech earlier this month at a National Council of State Housing Finance Agencies conference in Washington.
The FHA began developing a loan defect taxonomy several years ago in response to the False Claims Act litigation the Justice Department filed against FHA lenders, which resulted in large fines and prompted many banks to exit the FHA single-family mortgage program.
The FHA uses the automated loan review process to detect origination errors that need to be fixed. "It makes clear how FHA will rank errors from a quality control aspect" and provides certainty for lenders, Stevens said.
"Lenders are using this and we are getting very good feedback from lenders," he added.
The FHA also has a formal appeals process so lenders can appeal if they disagree with an FHA finding.
In a recent housing policy paper, former FHA Commissioner Carol Galante called on the FHA to continue "building on the success of its development of its loan defect taxonomy and Loan Review System."
The "FHA must address the remaining ambiguity and uncertainty with regard to lender liability for errors in the origination of FHA loan," according to the paper Galante co-wrote with Nathan Shultz, facility director at the Terner Center for Housing Innovation at the University of California-Berkley. Galante is a distinguished professor at the Terner Center for Housing Innovation.
The industry has been swift to praise the changes to the loan defect taxonomy.
"The loan review system is a significant improvement in FHA's quality control process," said Tamara King, the Mortgage Bankers Association's vice president of residential policy and member engagements, in an interview. "Lenders do find this is a more friendly system.”
Yet King said further revisions are needed to provide more specificity on how lenders can correct defects flagged by the system. The loan defect taxonomy has four tiers of defects based on severity. "To be fully effective in providing lenders certainty regarding False Claims Act risk, additional changes are still required to include the assignment of specific remedies for each tier of defect severity," she said.
Indeed, analysts predict further policy changes to make False Claims Act enforcement more to the industry’s liking.
“We continue to expect the Trump administration to soften the enforcement paradigm related to the FCA through certification clarifications and implementation of the FHA’s defect taxonomy,” Isaac Boltansky and Lukas Davaz, Washington policy analysts at Compass Point Research & Trading, wrote in a Jan. 10 note.
“These changes, once finalized, should modestly lessen lingering legal liability concerns for FHA lenders," the note said. "We caution, however, that lenders are unlikely to materially shift strategy based solely on administrative changes as the FCA has a 10-year statute of limitations and is therefore subject to changes in the political winds.”
Brian Chappelle, co-founder of Potomac Partners, said that lenders "are getting used to the loan defect taxonomy" but that the FHA is somewhat confined in determining the frequency of enforcement actions.
“The Justice Department decides when to bring FCA cases and that is beyond FHA's control," he said.