Defect Risk Expected to Stabilize in 2019, According to First American’s Loan Application Defect Index

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, says Chief Economist Mark Fleming


January 30, 2019, Santa Ana, Calif.

First American Financial Corporation (NYSE: FAF), a leading global provider of title insurance, settlement services and risk solutions for real estate transactions, today released the First American Loan Application Defect Index for December 2018, which estimates the frequency of defects, fraudulence and misrepresentation in the information submitted in mortgage loan applications. The Defect Index reflects estimated mortgage loan defect rates over time, by geography and loan type. It is available as an interactive tool that can be tailored to showcase trends by category, including amortization type, lien position, loan purpose, property and transaction types, and can provide state- and market-specific comparisons of mortgage loan defect levels. 

December 2018 Loan Application Defect Index

  • The frequency of defects, fraudulence and misrepresentation in the information submitted in mortgage loan applications increased by 7.4 percent compared with the previous month.

  • Compared to December 2017, the Defect Index increased by 4.8 percent.

  • The Defect Index is down 14.7 percent from the high point of risk in October 2013.

  • The Defect Index for refinance transactions increased by 8.2 percent compared with previous month and is up 14.5 percent compared with a year ago.

  • The Defect Index for purchase transactions increased by 7.1 percent compared with the previous month and is down 1.1 percent compared with a year ago.   

Chief Economist Analysis: What’s Behind the Late 2018 Surge in Loan App Defect Risk?

“In December 2018, the Loan Application Defect Index for purchase transactions continued its string of month-over-month increases, rising for the fourth month in a row. Despite the upswing, the Defect Index for purchase transactions still remains 1.1 percent below its level in December 2017,” said Mark Fleming, chief economist at First American. “The Defect Index for refinance transactions also increased 8.2 percent compared to the previous month and is 14.5 percent higher than a year ago. The overall Defect Index, which includes both purchase and refinance transactions, increased 7.4 percent compared with November, and increased 4.8 percent year over year.

“The fourth quarter of 2018 saw loan application defect risk rise significantly. 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. Two recent trends drove the late 2018 rise in defect risk,” said Fleming. 

Rising Share of Purchase Transactions

“In 2017, mortgage rates were consistently below 4 percent, but rates steadily increased throughout 2018, reaching a high of 4.8 percent in October 2018 before moderating slightly to 4.6 percent in December 2018. As mortgage rates rise, the incentive to refinance declines,” said Fleming. “The share of refinance mortgage transactions dropped to 27 percent of the overall mortgage market in the fourth quarter of 2018, 10 percent lower than the previous year. While loan application defects can happen on either purchase or refinance transactions, there is a greater propensity for fraud and misrepresentation with purchase transactions. We have seen this before, in 2013, as mortgage rates increased, so did overall defect, fraud and misrepresentation risk.” 

Impact of Natural Disasters

“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. Unfortunately, this trend appears to be playing out in the aftermath of the tragic wildfires that struck California in late 2018,” said Fleming. “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 6 percent higher than November.”

What to Expect in 2019

“Rising mortgage rates reduced the share of refinance transactions, leading to a greater share of higher-risk purchase transactions,” said Fleming. “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 (ARM) increases. As mortgage rates increase and borrowers seek to keep their monthly payment low, more borrowers are likely to choose the adjustable-rate option,” said Fleming. “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.

“Additionally, data from the 2017 Thomas Fire in California shows that defect risk remained elevated for five months after the wildfire, before trending down again. If this historical trend continues, we expect defect risk in California to normalize moving forward,” said Fleming. “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.” 

December 2018 State Highlights

  • The five states with a year-over-year increase in defect frequency are: Alaska (+32.9 percent), West Virginia (+31.5 percent), Maine (+26.1 percent), New York (+24.7 percent), and Hawaii (+21.1 percent).

  • The five states with the greatest year-over-year decrease in defect frequency are: Vermont (-17.4 percent), Florida (-11.1 percent), Arizona (-8.2 percent), Arkansas (-7.6 percent), and Minnesota (-7.3 percent). 

    December 2018 Local Market Highlights

  • Among the largest 50 Core Based Statistical Areas (CBSAs), the five markets with the greatest year-over-year increase in defect frequency are: San Diego (+30.1 percent), Pittsburgh (+24.6 percent), Richmond, Va. (+23.2 percent), Detroit (+21.3 percent), and Memphis, Tenn. (+20.5 percent).

  • Among the largest 50 Core Based Statistical Areas (CBSAs), the five markets with the largest year-over-year decrease in defect frequency are: Jacksonville, Fla. (-17.2 percent), Houston (-16.5 percent), Tampa, Fla. (-13.5 percent), Orlando, Fla. (-10.3 percent), and Minneapolis (-10.1 percent). 

    Next Release

    The next release of the First American Loan Application Defect Index will take place the week of February 25, 2019. 

    Methodology

    The methodology statement for the First American Loan Application Defect Index is available at http://www.firstam.com/economics/defect-index

    Disclaimer

    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. © 2019 by First American. Information from this page may be used with proper attribution. 

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; banking, trust and wealth management services; and other related products and 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

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