FHA: Take a Page from PMI Playbook to Clarify Defect Rules
As private mortgage insurance companies revoked coverage on a growing number of defective loans that defaulted during the financial crisis, new rules were put in place to standardize the claim review process. The Federal Housing Administration continues to face similar issues today and should look to the PMI companies to model their response.
The vast majority of loans are not reviewed for eligibility until a claim is submitted. During this process, loan defects were discovered that made mortgage loans ineligible for insurance, both leaving the insurer on the hook for the buyback, as well as retroactively open to a lawsuit from Department of Housing and Urban Development and the Department of Justice via the False Claims Act.
The recent push by mortgage lenders for clarity on the FHA's loan defect taxonomy reflects mortgage lenders' concerns about how ineligible loans are handled. Rather than reviewing loans for eligibility prior to insuring, the Department of Housing and Urban Development essentially uses the honor system, relying on the certification provided by the mortgage lenders participating in the FHA Direct Endorsement program that the loan is eligible for insurance.
During the mortgage meltdown, PMI companies encountered multiple disputes with mortgage lenders regarding coverage eligibility. In many cases, when a claim was submitted for a defaulted loan, the issuing PMI company would re-underwrite the loan as part of the claim review process. In some of these reviews the PMI company would find eligibility and/or underwriting defects. Because the loan under review was not underwritten in accordance with the guidelines, the PMI company would rescind coverage on the loan.
As defaults continued to rise, mortgage lenders were counting on these PMI policy payouts to cover their losses, and to have these policies negated years after the loan was closed created very real problems. To address the issue, the Federal Housing Finance Agency issued new regulations effective Oct. 1, 2014, requiring all private mortgage insurers to revise their master policies with Fannie Mae and Freddie Mac to provide more uniform, industry-wide insurance standards. As part of this directive, PMI companies must provide mortgage lenders the option to have loans reviewed prior to insuring to receive enhanced rescission relief for loan eligibility and conformity to mortgage insurance guidelines.
Like the FHA, PMI companies also offer mortgage lenders delegated approval to underwrite their own PMI policies. However, mortgage lenders still have the ability to submit loans for review post-closing and pre-insuring to confirm the loan meets the eligibility requirements and ensure coverage will not be rescinded should the loan default.
There are still some caveats that exist, but for the overall process, mortgage lenders taking advantage of this rescission relief process can sleep soundly knowing, at a loan-level, their policy is enforceable should a default occur. If the PMI company doesn't approve the loan for insurance, the mortgage lender now has this knowledge and can mitigate the risk proactively while the loan is newly originated and performing. Perhaps another PMI company will insure the loan, or there may be some corrective action the mortgage lender can take to make the loan eligible for insurance. The bottom line is the mortgage lender now knows the loan's eligibility status at the time of origination and well before they would ever submit a claim.
If this sounds familiar in regards to the FHA, it should. In my early days as a mortgage lender, we submitted our loans to the local the FHA field office for underwriting to ensure the loan was eligible for insurance. As the Direct Endorsement program evolved and the FHA sought to reduce costs, improve approval times and provide more decision-making ability at the mortgage lender level, this practice became extinct. Overall, the Direct Endorsement program has been a huge success, but the elimination of the FHA being engaged in the pre-insuring review process has created some unintended consequences.
Of course, cost is always a consideration in these types of programs. To absorb this additional review process would certainly add expense to the origination of a mortgage loan and would inevitably roll back to the consumer in some form or fashion. However, if managed effectively, the FHA could offer this option to its mortgage lenders on a loan-level review basis, as do the PMI companies, and I believe many mortgage lenders would view the peace of mind this review could provide as being well worth the additional effort and expense.
Taking a page from the PMI sector, not to mention its own history, would go a long way in helping the FHA address mortgage lenders' concerns, not to mention reserve the costly process of legal remedy for true instances of fraud and intentional misrepresentations that do exist.
Phil McCall is chief operating officer of ACES Risk Management Corp.