February 2018 Loan Application Defect Index

Will the Return of ARMs Lead to Surging Loan App Defect Risk?

"Today's ARM is not like those of the past. It is essentially the same as the 30-year, fixed-rate mortgage with one difference — rates adjust after an initial fixed period of usually five or seven years," says Chief Economist Mark Fleming.

The First American Loan Application Defect Index showed that in January 2018:

  • The frequency of defects, fraudulence and misrepresentation in the information submitted in mortgage loan applications remained the same compared with the previous month.
  • Compared to February 2017, the Defect Index increased by 9.2 percent.
  • The Defect Index is down 18.6 percent from the high point of risk in October 2013.
  • The Defect Index for refinance transactions remained unchanged compared to the previous month and is 13.1 percent higher than a year ago.
  • The Defect Index for purchase transactions decreased by 1.1 percent compared with the previous month and is up 7.1 percent compared with a year ago.

Mark Explains the Loan Application Defect Index

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States with the highest year-over-year increase in defect frequency:

  1. South Dakota (+28.2%)
  2. Wyoming (+20.5%)
  3. New Mexico (+19.4%)
  4. Oregon (+18.6%)
  5. Delaware (+18.5%)

There are three states with a year-over-year decrease in defect frequency:

  1. Louisiana (-9.8%)
  2. Connecticut (-5.6%)
  3. Minnesota (-5.0%)

Among the largest 50 Core Based Statistical Areas (CBSAs), the five markets with a year-over-year increase in defect frequency:

  1. Virginia Beach, VA (+24.3%)
  2. Oklahoma City (+22.7%)
  3. Portland, OR (+21.2%)
  4. Los Angeles (+20.0%)
  5. Cleveland (+18.8%)

Among the largest 50 Core Based Statistical Areas (CBSAs), there are three markets with a year-over-year decrease in defect frequency.

  1. Minneapolis (-7.5%)
  2. Austin, TX (-4.9%)
  3. Raleigh, NC (-4.8%)
  4. Hartford, CT (-1.5%)
  5. Pittsburgh (-1.5%)

"Today's ARM is not like those of the past. It is essentially the same as the 30-year, fixed-rate mortgage with one difference — rates adjust after an initial fixed period of usually five or seven years," said Mark Fleming, chief economist at First American.

Will the Return of ARMs Lead to Surging Loan App Defect Risk?

It's been a long time coming — a rising rate environment. The 30-year, fixed-rate mortgage has been below 4.5 percent since late 2013 and is now finally moving consistently higher. According to the consensus of economic forecasts, it is likely to approach 5 percent by the end of this year. This matters for defect, fraud and misrepresentation risk as rising mortgage rates reduce the benefit of refinancing and increase the share of purchase loan transactions in the market. As we have noted before, purchase loan transactions are riskier than refinance transactions.

But, there is another reason why a rising rate environment matters for defect, fraud and misrepresentation risk. The allure of the adjustable-rate mortgage (ARM) increases. The current rate on a 30-year, fixed-rate mortgage is approximately 4.5 percent. Yet, there is another mortgage option — the ARM, which typically has a lower rate than the traditional 30-year, fixed-rate mortgage. Currently, ARMs are available at about 4 percent. As rates increase and borrowers seek to keep their monthly payment low, more borrowers are likely to choose the adjustable-rate option.

A Kinder, Gentler, Less Risky ARM

ARMs historically have had more defect, fraud and misrepresentation risk than the traditional 30-year, fixed rate mortgage. Interestingly, that has changed recently. Adjustable-rate mortgages, based on our defect, fraud and misrepresentation index, are modestly less risky.

At the height of the housing boom, adjustable-rate mortgages were all the rage, and many included additional elements that added risk, such as negative amortization, payment-option and interest-only options, and teaser rate ARMs. Today's ARM is not like those of the past. It is essentially the same as the 30-year, fixed-rate mortgage with one difference — rates adjust after an initial fixed period of usually five or seven years. Saving half a percent on the mortgage rate may be worthwhile for many consumers, especially if their expected tenure length in the house is not 30 years.

As mortgage rates continue to rise, the share of adjustable-rate mortgages is also likely to increase and, if current defect risk patterns hold, will offset some of the increased risk the market will bear as it shifts to purchase transactions.

ARM Rate Graph

Methodology

The First American Loan Application Defect Index estimates the level of defects detected in the information submitted in mortgage loan applications processed by the First American FraudGuard® system. The index is based on the frequency with which defect indicators are identified. The Defect Index moves higher as greater numbers of defect indicators are identified. An increase in the index indicates a rising level of loan application defects. The index, nationally and in all markets, is benchmarked to a value of 100 in January 2011. Therefore, all index values can be interpreted as the percentage change in defect frequency relative to the defect frequency identified nationally in January 2011.

About First American

First American Financial Corporation (NYSE: FAF) is a leading provider of title insurance, settlement services and risk solutions for real estate transactions that traces its heritage back to 1889. First American also provides title plant management services; title and other real property records and images; valuation products and services; home warranty products; property and casualty insurance; and banking, trust and wealth management services. With total revenue of $5.8 billion in 2017, the company offers its products and services directly and through its agents throughout the United States and abroad. In 2018, First American was named to the Fortune 100 Best Companies to Work For® list for the third consecutive year. More information about the company can be found at www.firstam.com.

Opinions, estimates, forecasts and other views contained in this page are those of First American's Chief Economist, do not necessarily represent the views of First American or its management, should not be construed as indicating First American's business prospects or expected results, and are subject to change without notice. Although the First American Economics team attempts to provide reliable, useful information, it does not guarantee that the information is accurate, current or suitable for any particular purpose. © 2018 by First American. Information from this page may be used with proper attribution.