Critical defects increase as refi market fades

Mortgage lenders generated more defective loans in the second quarter, reflecting the transition from a refinance to a purchase market, according to ACES Quality Management’s latest critical defect report.

The critical defect rate climbed to 2.27% in the second quarter of 2021, ending the trend of improvement in the previous two quarters. In the most recent quarter, it was 2.01%, according to the report published on Tuesday. For the coming months, the expectation is that the rate may be volatile.

The report is based on post-closing quality control data from around 100,000 unique records. Defects are categorized using the Fannie Mae loan defect taxonomy.

Nick Volpe, executive vice president of ACES, said that as the market continues to transition to primarily purchase transactions, lenders should expect continued volatility over the next few quarters and, therefore, keep a close watch on defects for the foreseeable future.

“Given the uncertainty of 2022’s market and increasing regulatory pressures, lenders must ensure their existing QC and compliance programs are leveraging automation to maximize loan quality and mitigate risk.”

Volpe mentioned volume stabilizations and declining unemployment numbers as silver linings in the second quarter findings. However, he cited the effect of inflation on interest rates as potentially dampening the outlook.

The defect category that needs some attention from mortgage lenders is income/employment, which made up 32% of all defects, the highest share since ACES began tracking defects by category. In the previous quarter, it was 31.4%.

The second category in critical defects was loan documentation (12.5% of the total), followed by borrower and mortgage eligibility (10.4%) and legal/regulatory/compliance (10.4%). The assets category made up 10% of all critical defects in the second quarter, down 2.37 basis points from the prior quarter. However, liabilities nearly doubled in defect share, to 6.67% of the total.

According to the report, defects in the appraisal category also more than doubled to 5.42% in the second quarter. ACES said appraisal issues are well documented, with most of the concern centered around rising appraisal costs, long turnaround times, and a shortage of qualified appraisers.

“Property appreciation is still very strong, but the appraisal process becomes more important in a purchase-driven market. Rising defects in the appraisal category indicate lenders should increase their risk and quality control efforts in this area,” the report said.

Conventional loans represented 72.25% of all defects in the second quarter, compared to 74.50% from the previous quarter. FHA defects share went from 19.44% to 21.99% in the same period. VA represented 3.14%, and USDA/RHS was 2.62%.

Improvements in conventional lending defect rates are essential given that these loans have dominated the market for the past 18 months, said ACES.

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