Loan quality takes a hit even as mortgage origination volume slows

The overall critical defect rate for mortgages increased in the first quarter of 2024, ending five consecutive quarters of decline. But the increase itself was relatively modest and the share of loans with defects now stands at 1.58%, according to a report released Thursday by ACES Quality Management.

The company’s Mortgage QC Industry Trends Report analyzes post-closing quality control data taken from its Quality Management & Control software platform. It contextualizes the information based on volume to reflect overall trends in originations. But a seasoning factor to the included data means that the report is not a “precise mirror” for the overall market, the company explained.

Critical defects rose 3.27% compared to the fourth quarter of 2023, the report stated. Income and employment data remained the leading category for defects, although performance in this area “improved tremendously” on a quarterly basis.

Two of the four major underwriting categories posted increases in defects, and credit defects “nearly doubled” from levels recorded in Q4 2023. But legal, regulatory and compliance defects saw a sharp increase, more than doubling their share as they were found in 16.22% of all loans. They accounted for the second-largest category of defects in Q1 2024, followed by loan documentation defects (14.41%).

Insurance defects are “usually negligible,” the report explained, and made up 8.11% of the total defect share in Q1 2024. The refinance review share also declined during the period, but the defect share in this area doubled, which indicates a “degradation in quality in this area,” the results explained.

Both the review and defect shares for the Federal Housing Administration (FHA) loan category declined in the first three months of the year. Lenders also recorded “substantial improvements” in the defect share for U.S. Department of Veterans Affairs loans, “despite significantly increasing review share over Q4.”

The defect share outpaced the review share for both conventional and non-agency loans in the first quarter, which the report attributed to “the surge in refinance defects.”

Nick Volpe, executive vice president for ACES Quality Management, said that some of the recorded changes in the new report were unexpected.

“Given origination levels in the first quarter of this year, the findings in this report showed greater changes than expected,” Volpe said in prepared remarks.

“Historically, defect rates decrease when there is a decline in origination levels; however, that was not the case for Q1. Mortgage lenders are no strangers to market adversity. While the market is shifting, we hope this report will serve as a reminder to reinforce quality control across the board.”

Lenders must continue to navigate the mortgage market with an emphasis on precision, according to company CEO Trevor Gauthier.

“Although the critical defect rate remains low by historical standards, the increase in a quarter with record-low origination volumes is concerning,” Gauthier said. “Notable rises across underwriting categories and unexpected insurance defects need closer scrutiny from lenders.

“Overall, the data clearly shows that lenders are under increasing pressure to maintain quality amid changing market dynamics. A proactive approach to quality control is crucial for mitigating risk and ensuring long-term stability.”