FHA Should Look to Fannie for Help Defining 'Defect'
Grousing about regulatory change is a common occurrence in the mortgage industry. However, lenders have valid concerns regarding the defects in the Federal Housing Administration's loan defect taxonomy, as the consequences of the shortcomings will have a significant impact on them. The FHA should take the concerns voiced by lenders seriously, view them as an opportunity for refinement and act accordingly.
Nearly one year after the Department of Housing and Urban Development announced its proposed new loan defect taxonomy, lenders are pushing the Federal Housing Administration to revise the taxonomy to provide better clarity regarding what constitutes a material defect that would deem a loan ineligible for insurance.
Providing better clarity on defect severity levels will provide lenders the ability to self-determine a loan's FHA eligibility before submission, and will ultimately save taxpayers money because they won't be funding Department of Justice investigations into FHA loan submissions that were executed in good faith but, due to imprecise guidelines, were not eligible for insurance.
FHA lenders are not looking for a shortcut; they simply want clear rules by which to operate. Their concern is not without merit, as the distinctions between the four severity levels, or tiers, outlined by the FHA are decidedly indistinct.
Tier 1, the highest severity level, deals mainly with fraud, inconsistencies and/or incurable regulatory violations. Tiers 2 and 3 deal with errors that, "even if identified and corrected, would lead the loan to be unapprovable" due to having exceeded approval limits and/or failure to comply with loan guidelines. The problem lies with the inherent judgment call that has to be made in determining whether a defect should be categorized as a Tier 2 (more severe) or Tier 3 (less severe) defect.
Tier 2 defects meet these criteria by a large margin, and Tier 3 defects do so by small margin. What's lacking is a clear definition of what the FHA considers to be small and large. At what point does a "large" degree of loan guideline failure enter into the realm of a Tier 1-worthy defect? Furthermore, where does a Tier 3 defect end and a Tier 4 defect (i.e., an error that doesn't negate insurability) begin? To further complicate matters, the FHA notes that these margins of error between Tier 2 and Tier 3 may not apply in all cases and that the FHA reserves the right to revise these margins at its discretion.
The lack of clarity regarding defect severity reporting has financial consequences for lenders. Loans submitted to the FHA for insurance that are later found to be ineligible fall under the purview of the False Claims Act, and as recent settlements between the Department of Justice and several lenders demonstrate, the financial penalties for this statute are staggering. With this inherent risk, lenders need black-and-white guidelines regarding the defects that would make a loan ineligible for the FHA insurance.
The severity levels as currently defined pose a serious challenge for lenders. Furthermore, when contrasted against the severity levels outlined in Fannie Mae's taxonomy, both the severity of the problem and the simplicity of the solution become crystal clear. In contrast to the FHA severity levels, Fannie Mae has established two main severity levels — critical, which means the loan is ineligible for purchase, and non-critical, meaning the loan is eligible for purchase despite the defect. When it comes down to what truly concerns Fannie, it's whether the defect makes the loan ineligible for purchase.
According to Fannie Mae's definition, a critical defect, also known as a significant defect, is one that would have affected the price of the loan at purchase or would have prevented the loan from being purchased had the defect been known. To aid lenders in making this determination, Fannie Mae requires lenders to evaluate the defect across areas spanning from borrower eligibility to the form or execution of Fannie Mae-related documents.
To its credit, Fannie Mae has continued to refine its loan defect taxonomy, with its most recent clarification issued in late 2015. This ongoing commitment to improvement, education and transparency is a model that could serve the FHA well as it works with lenders to improve its current taxonomy and severity level definitions.
Phil McCall is chief operating officer of web-based mortgage quality control and audit technology provider ACES Risk Management Corp.