Will Better Days Bring Bigger Risks? Sponsored Content from First American

By Paul W. Harris, GM, Mortgage Analytics, First American Data & Analytics

Even before the Federal Reserve cut rates by 50 basis points, sentiment among our lender clients had shifted noticeably. They were more optimistic and, for the first time in two and a half years, focused once again on capacity and not just cost reduction.

For many, the turning point started earlier in the year when cash-out refinances began to steadily increase, mostly due to debt consolidation. With the market anticipating additional rate cuts, it is reasonable to expect that declining mortgage rates will soon make rate and term refinances attractive to homeowners who purchased in the last two years. Lower rates may also encourage more buyers to move off the sidelines, and more sellers to list their homes, improving the inventory situation.

Will this create a mini boom for our industry? Some very large lenders have been quietly adding headcount to handle higher volumes, and others have been publicly discussing their investments in AI to help them gain market share when the market improves.

At First American, our economists have been encouraged by recent directions in home sales and inventory. However, they have cautioned that affordability challenges and the rate lock-in effect created by the ultra-low-rate mortgages originated in 2020 and 2021 remain headwinds to the housing market.

No one can predict how much volume may increase. If past experience is any indicator, it is fair to assume that higher volumes, scaling organizations and changing market conditions will not only bring opportunity, but also a potential increase in manufacturing errors, borrower misrepresentation and fraud risk.

Early warning signs?

The same week as the Fed’s announcement, ACES Quality Management released their report on critical loan defects for the first quarter of 2024 and, for the first time in five quarters, errors and defects were on the rise and the share of defects in refinances had doubled. Another concerning trend: insurance defects, which usually don’t register at all, accounted for more than 8 percent of all errors.

Was the first quarter increase in errors and defects a fluke? Or are lenders taking on more risk as they help debt-ladened homeowners consolidate their high-interest credit cards, auto and student loans into more affordable cash-out refinances?

Rate and term refinances, which have been scarce over the last two years as the Fed raised rates 11 times, generally are considered less risky in terms of fraud, since there are fewer participants in the transaction. Estimates indicate there are roughly 4 million homeowners who purchased a home with a mortgage in the last two years who may soon be in the money. Depending on how quickly these homeowners pull the trigger on refinancing, there could be a strong, short-term surge in demand.

Protecting Against Fraud Risk as Volumes Rise

Lenders’ underwriting and processing teams may face a surge in demand that could increase the likelihood of simple errors and possibly decrease loan quality.

The good news is that we are seeing lenders re-hiring former employees who had been reluctantly let go during the last downturn. This should mean that they will experience less of a learning curve returning to their old positions and will most likely understand the technology, workflow and processes that the lenders have in place to reduce risk. Contrast this with the hiring boom that took place in 2020 and 2021 that led to a significant drop in loan quality and a large, expensive “hangover” of buyback demands.

While we are not hearing about an upswing in fraud-for-profit schemes, a re-energized purchase market may bring with it the risk of more fraud for housing, given current market conditions. For example, home prices are still at or near all-time highs, wage growth is slowing, and consumers are carrying record levels of debt. All of which means that qualifying for a mortgage, even at lower rates, will be challenging for many would-be buyers. In her recent blog post, for example, First American economist Odeta Kushi noted: “Even if rates dip below 6 percent, fewer than 30 percent of renters nationally could afford the median priced homes.”

This creates a ripe environment for misrepresentation in categories like income and employment. In fact, we are already beginning to see this in the marketplace and in our FraudGuard alert findings.

If (and when) the purchase market begins to heat-up, lenders can expect to see more fraud for housing, including falsifying income, undisclosed debt, and investors posing as occupants. All of which can result in expensive buyback demands. In the past year, for example, First American Data & Analytics has added new modules to its FraudGuard® suite designed to monitor undisclosed debt throughout the origination process and to help servicers identify investors that qualified as “owner-occupants.”

To reduce the risk of manual errors, our company has automated these services at specific milestones in the origination process and has seamlessly integrated this automation with a leading LOS provider.

New Types Fraud Risk to Consider

In many parts of the country, including some of the largest housing markets, soaring homeowners’ insurance costs are not only adding to the affordability challenge, but creating new fraud risk for lenders. A growing number of lenders are now advising buyers to secure insurance earlier in the origination process to avoid delays and last-minute surprises that could unfavorably tip debt-to-income ratios.

This has also spawned a new “cottage industry” on the dark web: fake insurance documents. To combat these fraudsters, lenders may need to rethink how they validate proof of insurance. For example, “Is a phone call enough? What kind of documents should be reviewed? How can those documents be verified?” As we move into the final quarter of 2024, the outlook for the mortgage industry is definitely brighter with lenders talking about growth, the value of both new and proven technologies, and a potentially better year ahead. But, as we have seen in the past, opportunity is often accompanied by risk. With the anticipated increase in volumes, maintaining loan quality remains crucial, even as attention shifts back to capacity.

(Sponsored content includes material submitted independently of the Mortgage Bankers Association and MBA NewsLink and does not connote an MBA endorsement of a specific company, product or service. For more information about sponsored content opportunities, contact Bill Farmakis at bill@jlfarmakis.com or 203/834-8832.)