Due mainly to rising purchase share and the impact from natural disasters, the frequency of defects in mortgage applications increased 7.4% in December compared with November and was up 4.8% compared with December 2017, according to First American’s Loan Application Defect Index.
The frequency of defects in refinance transactions increased by 8.2% compared with the previous month and was up 14.5% compared with a year earlier.
The frequency of defects in purchase transactions increased by 7.1% compared with November but was down 1.1% compared with December 2017.
It was the fourth monthly increase in the rate of defects for purchase applications.
That’s partly due to the increase in purchase share: Purchase loans now make up about 70% of all originations. However, purchase loans generally carry greater risk of defects, because borrower data is often being submitted and verified for the first time.
The increase in defects is also partly due to the increased risk of misrepresentation in property condition for properties in areas impacted by the recent wildfires and hurricanes.
“Our research indicates that natural disasters go hand-in-hand with loan application defect risk, as natural disasters create the opportunity for misrepresentation of collateral condition,” says Mark Fleming, chief economist for First American, in the report. “Unfortunately, this trend appears to be playing out in the aftermath of the tragic wildfires that struck California in late 2018. Before July, defect, fraud and misrepresentation risk was declining in California. Since July, California’s defect risk has steadily increased. In California, fraud risk was 14.5 percent higher than one year ago, and six percent higher than November.”
However, Fleming says this particular type of defect risk should soon be on the decline, as the impact from the disasters recedes.
“Data from the 2017 Thomas Fire in California shows that defect risk remained elevated for five months after the wildfire, before trending down again,” Fleming says. “If this historical trend continues, we expect defect risk in California to normalize moving forward. Therefore, while the rise in mortgage rates and the tragic natural disasters of 2018 elevated loan application defect risk, we have reason to believe that this will stabilize in 2019.”
It should be noted that although the occurrence of defects has been on the rise lately, it is down 14.7%, overall, from the high point of risk in October 2013.
Fleming points out that if mortgage rates keep rising, refinance share will continue to shrink and purchase share will grow, which, in turn, could continue to push up the risk of defects.
Interestingly, however, the increase in mortgage rates could also have the effect of lowering the risk of defects.
“Rising mortgage rates reduced the share of refinance transactions, leading to a greater share of higher-risk purchase transactions,” Fleming says. “But, as we look forward to 2019, rising rates may also play a role in reducing defect risk.”
“In a rising rate environment, the appeal of the adjustable-rate mortgage increases,” he says. “As mortgage rates increase and borrowers seek to keep their monthly payment low, more borrowers are likely to choose the adjustable-rate option. And adjustable-rate mortgages, based on our defect, fraud and misrepresentation index, have been modestly less risky throughout much of 2017 and 2018.”
“If mortgage rates continue to trend up into 2019, a corresponding increase in the share of ARMs could help offset the rise in risk from the increasing share of purchase transactions,” he says.
It’s important to bear in mind that the risk associated with natural disasters is unique to the impacted areas, whereas the risk associated with increasing mortgage rates and rising purchase share is a national phenomenon.
“The fourth quarter of 2018 saw loan application defect risk rise significantly,” Fleming says. “Nationally, overall defect risk reached its highest point in more than four years. In December, defect risk increased in every state compared with the previous month, and defect risk increased in 39 states year over year.”
States with the biggest year-over-year increases in defect frequency in December included Alaska (+32.9%), West Virginia (+31.5%), Maine (+26.1%), New York (+24.7%), and Hawaii (+21.1%).
Sates with the greatest year-over-year decreases in defect frequency included Vermont (-17.4%), Florida (-11.1%), Arizona (-8.2%), Arkansas (-7.6%) and Minnesota (-7.3%).