Defect Risk at ‘Turning Point?’

Frequency of defects, fraudulence and misrepresentation in the information submitted in mortgage loan applications were unchanged in July after seven consecutive monthly increases, said First American Financial Corp., Santa Ana, Calif., suggesting such defects could be at a “turning point.”

The company’s monthly Loan Defect Risk Index rose by 20 percent from a year ago, however, although it noted the index is down by 17.6 percent from the high-water mark in October 2013. The Defect Index for refinance transactions increased by 1.4 percent month-over-month and is 20.3 percent higher than a year ago; the Defect Index for purchase transactions remained the same compared to last month and is up 15.2 percent from a year ago.

Rising rates may reduce overall mortgage affordability and incent borrowers to consider adjustable-rate mortgages, but the product shift isn’t likely to impact defect, fraud and misrepresentation risk, said Chief Economist Mark Fleming.

“No change compared to last month is welcome news,” Fleming said. “In particular, purchase transactions, which are inherently more at risk of defects, fraud and misrepresentation, showed no increase compared to a month ago. One month doesn’t establish a trend, so it will be important to see if we’ve reached a turning point in the long-run trend of increasing defect risk.”

The Index estimates the frequency of defects, fraudulence and misrepresentation in the information submitted in mortgage loan applications.

Fleming said higher mortgage interest rates could push more borrowers consider adjustable-rate mortgages with lower rates instead of more traditional fixed-rate mortgages to maintain purchasing power. “An adjustable-rate mortgage can be a good alternative to a fixed-rate mortgage in a rising rate environment, but they have historically had more fraud and misrepresentation risk,” he said. “Yet, this year the risk gap has closed. Rates may rise and adjustable-rate mortgages may be more attractive, but the Fed’s actions won’t impact loan defect risk.”

The report said states with the greatest year-over-year increase in defect frequency are South Dakota (+68.5 percent), North Dakota (+54.5 percent), Wyoming (+50.8 percent), North Carolina (+39.4 percent) and Iowa (+33.9 percent). No state saw a year-over-year decrease in defect frequency.

Among largest metros, markets with the greatest year-over-year increase in defect frequency are Raleigh, N.C. (+54.0 percent); New Orleans (+34.7 percent); Charlotte, N.C. (+28.6 percent); Buffalo, N.Y. (+27.6 percent); and Tampa, Fla. (+25.3 percent). Only Houston (-1.1 percent) saw a year-over-year decrease in defect frequency.