Loan Defects Rise for 4th Straight Month

First American Financial Corp., Santa Ana, Calif., said its Loan Application Defect Index rose in December, the fourth consecutive monthly increase, but remains below historical levels.

First American reported the frequency of defects, fraudulence and misrepresentation in information submitted in mortgage loan applications increased by 7.4 percent in December from November. From a year ago, the Defect Index increased by 4.8 percent, but is down by 14.7 percent from its high point of risk in October 2013.

The report said the Defect Index for refinance transactions increased by 8.2 percent from November and is up by 14.5 percent from a year ago. The Defect Index for purchase transactions increased by 7.1 percent from November but is down by 1.1 percent from a year ago.

First American Chief Economist Mark Fleming said while the rise in mortgage rates and the natural disasters of 2018 elevated loan application defect risk, trends point toward a stabilizing index in 2019.

Data from the 2017 Thomas Fire in California shows that defect risk remained elevated for five months after the wildfire, before trending down again,” Fleming said. “If this historical trend continues, we expect defect risk in California to normalize moving forward. Therefore, while the rise in mortgage rates and the tragic natural disasters of 2018 elevated loan application defect risk, we have reason to believe that this will stabilize in 2019.”

For now, however, the national overall defect risk reached its highest point in more than four years. In December, defect risk increased in every state compared with the previous month, and defect risk increased in 39 states year over year.

Two recent trends drove the late 2018 rise in defect risk, Fleming said. “In 2017, mortgage rates were consistently below 4 percent, but rates steadily increased throughout 2018, reaching a high of 4.8 percent in October 2018 before moderating slightly to 4.6 percent in December 2018. As mortgage rates rise, the incentive to refinance declines. The share of refinance mortgage transactions dropped to 27 percent of the overall mortgage market in the fourth quarter of 2018, 10 percent lower than the previous year. While loan application defects can happen on either purchase or refinance transactions, there is a greater propensity for fraud and misrepresentation with purchase transactions. We have seen this before, in 2013, as mortgage rates increased, so did overall defect, fraud and misrepresentation risk.”

Looking ahead, Fleming said rising mortgage rates should reduce the share of refinance transactions, leading to a greater share of higher-risk purchase transactions. “But, as we look forward to 2019, rising rates may also play a role in reducing defect risk, he said. “In a rising rate environment, the appeal of the adjustable-rate mortgage increases. As mortgage rates increase and borrowers seek to keep their monthly payment low, more borrowers are likely to choose the adjustable-rate option,” said Fleming. “Adjustable-rate mortgages, based on our defect, fraud and misrepresentation index, have been modestly less risky throughout much of 2017 and 2018. If mortgage rates continue to trend up into 2019, a corresponding increase in the share of ARMs could help offset the rise in risk from the increasing share of purchase transactions.

First American reported states with a year-over-year increase in defect frequency were Alaska (32.9 percent), West Virginia (31.5 percent), Maine (26.1 percent), New York (24.7 percent) and Hawaii (21.1 percent). States with the greatest year-over-year decrease in defect frequency were Vermont (-17.4 percent), Florida (-11.1 percent), Arizona (-8.2 percent), Arkansas (-7.6 percent) and Minnesota (-7.3 percent).

Among the largest metro areas, markets with the greatest year-over-year increase in defect frequency were San Diego (30.1 percent), Pittsburgh (24.6 percent), Richmond, Va. (23.2 percent), Detroit (21.3 percent), and Memphis, Tenn. (20.5 percent). Markets with the largest year-over-year decrease in defect frequency were Jacksonville, Fla. (-17.2 percent), Houston (-16.5 percent), Tampa, Fla. (-13.5 percent), Orlando, Fla. (-10.3 percent) and Minneapolis (-10.1 percent).