Last updated: May 15, 2018

Why are Defective Loans Increasing?

A recent study offered by Aces Risk Management (ARMCO) revealed that defective mortgage loans are increasing nationwide. Defective mortgages speak directly to the quality of mortgages that are originated. Several factors are influencing this trend.

First, let’s examine what a defective mortgage is, then consider the state of the current mortgage market. After that, we can tackle what forces or conditions are affecting the critical defective rate.

What is a Defective Mortgage?

The overwhelming majority of mortgages have no issues once the borrower’s application has been assessed and approved. This is a credit to lenders’ underwriting processes as well as the regulatory requirements for transparency and borrower protection.

There are still some mortgages that have problems even after these rigorous checks and processes that can end the deal. These are known as defective mortgages.

A defective mortgage is one with a critical flaw that makes it either uninsurable or ineligible for sale on the secondary mortgage market. These flaws can go undiscovered during application and closing. Critical defects are often discovered afterwards, during the post-closing review for quality control as part of the underwriting process.

Obviously, defective mortgages can make for confused and unhappy borrowers.

The Current Situation

According to the ARMCO Mortgage Trends QC Trends Report, the critical defective rate on mortgage loans has increased for the third consecutive quarter, starting in late 2016. The critical defective rate is the number of mortgages that possess a critical loan defect compared to the overall body of approved mortgages.

The ARMCO report studied 90,000 mortgage loans as a statistical sample using the Fannie Mae loan defect taxonomy. Loan defects as defined by Fannie Mae can include missing asset documentation, borrower eligibility, eligibility for a specific mortgage program, and the like.

From Q1 2017 to Q2, the critical defective rate increased by +9%. That brings the overall critical defective rate to 1.61% of all mortgages. In other words, for every 62 mortgages there is 1 with a critical loan defect. That number has doubled since Q3 2015 (0.77%).

Purchase Loans

The main reason for the current increase in the critical defective rate is the growth of purchase loans. Borrowers are looking to buy homes in larger numbers than in previous years as interest rates stay competitive and affordability increases. Purchase loans historically have disproportionately possessed the highest frequency of loan defects. Therefore, as more purchase loans are originated in the mortgage market, the critical defective rate is naturally going to go up.

Using the loan defect taxonomy definitions from Fannie Mae, the highest loan defect was borrower eligibility.

Mortgage lenders need to be aware of and ready to confront the defective mortgage trend. There is no substitute for thorough, detail-oriented underwriters who have the support of a conscientious organization that has experience with complex loan files.

Pacific Union Financial

Pacific Union Financial, LLC is a full-service mortgage lender providing originations and loan servicing across the United States. A private held direct lender with Fannie Mae, Freddie Mac, and Ginnie Mae approval, we originate loans through our Retail, Wholesale, and Correspondent channels. Let us know how we can help you expand your business.