NATNews Blog > July 2016 > ​Loan Application Defect and Fraud Risk Reaches Historically Measured Low Point

    ​Loan Application Defect and Fraud Risk Reaches Historically Measured Low Point

    7/7/2016 10:12:07 AM
    The First American Loan Application Defect Index, which estimates the frequency of defects, fraudulence and misrepresentation in the information submitted in mortgage loan applications, decreased 2.7 percent in May as compared with April and decreased by 9.9 percent as compared with May 2015. The Defect Index, which reflects estimated mortgage loan defect rates over time, by geography and by loan type, is down 28.4 percent from the high point of risk in October 2013.
    The Defect Index continues to decline, reaching a historically measured low point. Apart from the increases in risk in 2013 and early 2015, the Defect Index has been consistently trending lower since inception. As we reported in March, loan production expenses have been increasing, which reflects the industry's investment in technology and improved standards, as well as greater demand for compliant loan production processes.
    According to Mark Fleming, chief economist at First American, additional data from the Mortgage Bankers Association shows that underwriters are taking more time to close each loan transaction. Productivity, which measures the number of loan applications processed per month by an underwriter, is down significantly from the rate of underwriting present at the height of the housing boom.
    The Defect Index for refinance transactions declined 3.1 percent month-over-month, and is 10 percent lower than a year ago. The Defect Index for purchase transactions declined 2.4 percent month-over-month, and is down 11.4 percent compared to a year ago. Since defect risk for both purchase and refinance transactions peaked in late 2013, defect risk on refinance transactions continues to decline much more than defect risk for purchase transactions, declining 38.0 percent as compared to 22.1 percent for purchase transactions.
    "Better technology and standards in the loan application process combined with more time spent underwriting each loan application may be increasing the cost of loan production, but we continue to see clear benefits too," said Fleming. "While the costs of compliance are higher and reducing the profitability of mortgage lending, there is long-term financial benefit to increased loan quality. Fewer defects and less misrepresentation will reduce repurchase risk and expenses for underwriters in the future."
    Loan Application Mix Matters in Understanding Locational Differences
    Fleming said it is important to understand that the overall national as well as geographic trends that are observed in defect, misrepresentation and fraud risk are in part driven by the relative mix of loan purpose, occupancy type, property type and transaction type.
    “Based on a review of the proprietary data we use in the Defect Index, refinance loan transactions are 23.5 percent less risky than purchase loans,” he reported. “Owner-occupied loans are 30.1 percent less risky than investor loans. Single family properties are 11 percent less risky than condos and FHA loans are 15 percent less risky than conventional loans.”
    When rates begin to rise consistently higher, which is now less likely in 2016 given Britain's decision to exit the European Union, according to Fleming, there should be less refinance activity relative to purchase loan applications.
    “We expect this relative shift away from lower risk refinancing to higher risk purchase loans will put upward pressure on the overall risk indices,” he noted. “More generally, because the indices don't hold the ‘mix’ of refinance and purchase applications constant, the overall index measures the underlying risk trend, but also any change in the mix.”
    According to the report, every month, the loan application mix can change across a number of different categories. Also, the month-to-month change in the loan application mix in one location will be different than the change in another location. For example, Florida, and Miami in particular, is consistently ranked as a hot spot for loan defect, misrepresentation and fraud risk. But, it is also a market with a high concentration of loans for investor-owned condominiums, which involve higher risk loans. In other words, part of Miami's risk profile is driven by its unique mix of transactions.
    “While we have often stated that location matters, it is important to keep in mind that part of the locational variances in loan defect risk among markets is due to the unique mix of loan applications in each market," said Fleming. "We expect misrepresentation and fraud risk to move higher with more purchase, investor and condominium transactions. The loan application mix influences the Defect Index, even when compliance drives the overall trend down."
    The First American Loan Application Defect Index estimates the level of defects detected in the information submitted in mortgage loan applications processed by the First American FraudGuard® system. The index is based on the frequency with which defect indicators are identified. The Defect Index moves higher as greater numbers of defect indicators are identified. An increase in the index indicates a rising level of loan application defects. The index, nationally and in all markets, is benchmarked to a value of 100 in January 2011. Therefore, all index values can be interpreted as the percentage change in defect frequency relative to the defect frequency identified nationally in January 2011.