Nick Volpe: A Brief History of Defects; Q3 2020’s Loan Quality Performance Sets Stage for Areas of Concern in 2021

Nick Volpe is executive vice president of account management at ACES Quality Management. Reach him at nvolpe@acesquality.com.

“Those who cannot learn from history are doomed to repeat it.” – George Santayana.

This precept has a variety of appropriate applications, though none may be more relevant for mortgage lenders than in the area of critical defects. Given the necessary delay that must precede the analysis of post-closing data, it is easy to forget the significance of these findings. However, mistakes made in the past often do not remain so, especially when those mistakes go unaddressed. Thus, lenders have a great deal to learn from their post-closing quality control analyses, even more so given the market disruptions and macroeconomic impact of COVID-19.

A look at post-closing quality control data from the third quarter (Q3) of 2020 reveals the critical defect rose to 2.34% in Q3 2020, up 25% from Q2’s 1.88%. While multiple contemporaneous factors contributed to the significant spike in the overall critical defect rate, these results hold significant implications for lenders in 2021, particularly in light of industry origination forecasts for the year.

Residential mortgage lending volumes hit a 10+-year peak in Q3 2020, though this record will certainly be surpassed by Q4. While volume is a good problem to have, volume spikes tend to heavily impact quality, and the surge in volume over Q2 certainly contributed to the spike in defects. In addition, purchase transactions increased slightly over Q2 total, though refinances continued to make up the majority of transactions. History also tells us that defects tend to rise when purchase transactions dominate market share, as these transactions are far more complex than refinances and thus leave more room for error.

So what do these now historical trends have to do with the current market? The answer is “plenty.” According to the Mortgage Bankers Association’s March Mortgage Market Forecast, originations are expected to reach $3.184 trillion in 2021, with purchase transactions expected to comprise 52% of all transactions. While predictions for this year’s volume are less than 2020’s historic $3.828 trillion, it still represents quite an increase over what the industry saw in 2018 ($1.64 trillion) and 2019 ($2.173 trillion).

What’s more, purchase transactions only made up 37% of 2020’s total origination volume, which means lenders are expected to see only a 17% decrease in volume but a 41% increase in purchase volume. Thus, given the parallels between market conditions in Q3 2020 and the forecast for 2021 (i.e. high volumes and an increase in purchase transactions), it is not only reasonable but also prudent for lenders to be more vigilant than ever regarding loan defects.

The loan defect data from Q3 2020 can not only give lenders guidance as to what to look for, but also where to look. When examining defects trends according to Fannie Mae’s loan defect taxonomy, the categories that saw the biggest spikes were related to loan manufacturing, which includes Loan Documentation (+8.5%), Borrower/Mortgage Eligibility (+5%) and Appraisals (+3%). This indicates that many of the defects that contributed to Q3’s spike are within lenders’ control to fix, and by examining the root cause of these defects in Q3, lenders can determine if any of those factors still need to be addressed to prevent history from repeating itself in 2021.

Difficulties in finding talent, hiring and training throughout the pandemic certainly contributed to the increase in loan manufacturing defects in Q3. As volumes rose, competition intensified for employees, and many underwriters and processors changed employers for better salaries. With many lenders finding themselves understaffed to manage the business coming their way, it was inevitable that mistakes were made. With the slight decrease in overall expected volume for 2021, this may not be as much of a concern for those that were able to staff up. However, if lenders failed to address their capacity constraints in 2020, they may find themselves in a similar position in 2021.

The mid-quarter announcement of the adverse market fee and its September 2020 effective date also likely caused many lenders to push loans through their pipelines faster than they would have liked to get ahead of the implementation date. Lenders also originated 3.25 million residential mortgages in Q3 2020, up 17% from the prior quarter and 45% from the same quarter in 2019, according to Attom Data Solutions.

Given the combination of the rush of a high-volume environment and these new fees, many lenders didn’t have the time to react strategically, making it highly like that loan quality suffered as a result. While purely speculative, this potential “race to close” could also have contributed to the spike in manufacturing-related defects, and given the unlikelihood of another change of this magnitude being issued with such a tight timeline for compliance, this is likely a one-time issue versus something with which lenders should be concerned in 2021.

While it is easy to get discouraged looking at Q3’s data after nearly two years of good performance, context is important. During this quarter, lenders experienced the perfect storm of rising volumes, increases in purchase transactions and staffing shortages in what had already been a highly unusual and challenging year. As the industry looks ahead to 2021, it must do so with Q3 2020’s defect trends in mind to ensure the errors of the past do not repeat themselves in the coming year.

(Views expressed in this article do not necessarily reflect policy of the Mortgage Bankers Association, nor do they connote an MBA endorsement of a specific company, product or service. MBA NewsLink welcomes your submissions. Inquiries can be sent to Mike Sorohan, editor, at msorohan@mba.org; or Michael Tucker, editorial manager, at mtucker@mba.org.)