Opposing Forces Keeping Rate of Application Defects in Check


After rising for the previous nine months, the frequency of defects, fraudulence and misrepresentation in the information submitted in mortgage loan applications was flat in March compared with February, according to First American’s Loan Application Defect Index.

Lower mortgage rates in February and March resulted in a slight rebound in refinance share, which, in turn, helped reduce the occurrence of defects driven by increasing purchase share.

In general, application defects increase as purchase share rises, because purchase loans include information which is being submitted by borrowers for the first time.

However, the decrease in defects spurred by lower rates and increased refinance share was offset by an increase in defects resulting from a strengthening seller’s market.

As the real estate market moves toward a sellers market, the prevalence of fraud and misrepresentation typically increases, due to sellers exaggerating or misrepresenting property condition.

“Loan application defect risk for purchase transactions continued its upward trend in March, increasing 1.0 percent month-over-month,” says Mark Fleming, chief economist for First American, in a statement. “Defect risk for purchase transactions has risen for seven consecutive months, however, the pace of growth slowed to its lowest point over that time span.”

“Overall, the frequency of defects, fraudulence and misrepresentation in the information submitted in mortgage loan applications remained the same compared to the previous month, ending the trend of increasing risk that started in July 2018. But, what could be driving this change?” Fleming adds. “Nationally, defect risk continued to surge in early 2019 and in February reached its highest point since 2013. Suddenly in March, the acceleration stopped.”

As Fleming explains, mortgage rates steadily increased during the second half of 2018, reaching a high of 4.9% in November, before reversing course in December.

“Mortgage rates have been declining ever since, reaching 4.27 percent in March, 0.17 percentage points lower than one year ago,” Fleming says. “As mortgage rates fall, the incentive to refinance increases. In the first quarter of 2019, the share of refinance mortgage transactions increased to 32 percent of the overall mortgage market, a five percent increase over the prior quarter.

“While loan application defects can happen on either purchase or refinance transactions, there is a lower propensity for fraud and misrepresentation with refinance transactions,” Fleming continues. “So, as the share of lower-risk refinance transactions increases, overall fraud risk tends to decline.”

The recent decrease in mortgage rates has also helped shift the housing market to a seller’s market, which, in turn, has driven up the rate of misrepresentation in applications.

“While declining mortgage rates spurred refinance activity, they’ve also encouraged potential home buyers to return to the market,” Fleming says. “In the first quarter of 2019, declining mortgage rates, ongoing household income growth and moderating unadjusted home prices boosted affordability.

“Yet, the increased demand for housing is occurring in a supply-constrained market, resulting in another sellers’ market this spring,” he adds. “In these competitive conditions, there is more motivation to misrepresent information on a loan application to qualify for the bigger mortgage necessary to win the bidding war for a home. In fact, employment misrepresentation increased 2.9 percent compared with the previous month.”

Although the rate of defects in March was flat compared with February, it was up 15.9% compared with March 2018.

However, to keep things in perspective, the rate of defects was still down 6.8% from the high point of risk in October 2013.

The rate of defects in refinance transactions was flat compared with February but was up 22.9% compared with March 2018.

The rate of defects for purchase transactions increased 1.0% compared with the previous month and was up 12.4% compared with a year earlier.

“The tug-of-war between the hot sellers’ market and the mix of refinance and purchase transactions will heavily influence the direction of fraud risk in the months ahead,” Fleming says.

States that saw the highest annual increase in defect frequency in March included Nebraska (+41.9%), New York (+41.3%), Iowa (+39.5%), West Virginia (+37.8%), and Maine (+36.2%).

There was only one state that saw a year-over-year decrease in defect frequency: Arkansas (-0.9%).

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