Falling Rates Drive Jump in Loan Defect Risk
First American Financial Corp., Santa Ana, Calif., released its Loan Application Defect Index for January, showing frequency of defects, fraudulence and misrepresentation in the information submitted in mortgage loan applications increased by 4.6 percent compared December, the fifth consecutive monthly increase.
From a year ago, the Defect Index increased by 9.6 percent. However, the Defect Index is down nearly 11 percent from the high point of risk in October 2013. The Defect Index for refinance transactions increased by 5.1 percent compared December and is up 20.3 percent from a year ago. The Defect Index for purchase transactions increased by 5.6 percent compared to Dece3mber and rose by 3.3 percent from a year ago.
“While overall fraud risk has been on the rise since July 2018 due partially to the impact of natural disasters, the last two months have experienced an acceleration in fraud risk,” said First American Chief Economist Mark Fleming. “Surprisingly, mortgage rates declined in December and continued falling into January, reaching their lowest levels since April 2018. Prospective home buyers and existing homeowners reacted to the lower rates, resulting in a mini-boom in mortgage applications, both purchase and refinance,”
Fleming noted the Defect Index has historically illustrated a distinct difference in risk between refinance and purchase loan transactions. “Refinance loan transactions have always been less risky than purchase transactions,” he said. “The relationship has often shown that as mortgage rates rise, so does overall defect, fraud and misrepresentation risk. As mortgage rates rise, fewer people refinance, so the share of less risky refinance loan transactions decreases and the share of more risky purchase transactions increases. This dynamic played out throughout most of 2018, as rates were rising. However, the forces driving the acceleration in fraud risk over the last two months are a little less clear because the recent decline in mortgage rates prompted a surge in both purchase and refinance mortgage applications.”
Fleming added although the overall rise in purchase and refinance applications, coupled with strong first-time home buyer demand and tight inventory, bodes well for an early spring home-buying season, it could also contribute to further increases in defect risk.
“Historically, purchase transactions tend to be more at risk of defects, fraud and misrepresentation, and the pressures resulting from rising demand and a strong sellers’ market compounds that risk,” Fleming said. “When home values are rising and the housing market is competitive, more buyers want to enter in the market. As a result, misrepresentation and fraud are more likely on a loan application.
The report said states with the greatest year-over-year increase in defect frequency were West Virginia (+37.5 percent), Maine (+35.8 percent), New York (+35.5 percent), Nebraska (+33.3 percent) and Alaska (+30.7 percent). States with the greatest year-over-year decrease in defect frequency were Vermont (-12.8 percent), Florida (-5.1 percent), Arkansas (-3.7 percent), Arizona (-3.6 percent) and Ohio (-1.3 percent).
Among largest metros, markets with the greatest year-over-year increase in defect frequency were Richmond, Va. (+33.8 percent), Pittsburgh (+29.2 percent), Buffalo, N.Y. (+26.5 percent), San Jose, Calif. (+26.5 percent) and Hartford, Conn. (+25.4 percent). Markets with the largest year-over-year decrease in defect frequency were Jacksonville, Fla. (-13.3 percent), Houston (-11.5 percent), Orlando, Fla. (-7.3 percent), Tampa, Fla. (-5.3 percent) and Miami (-4.8 percent).
