In a June 18, 2015 News Release, HUD/FHA announced that it has further refined its risk management processes and has created a new “Defect Taxonomy”. The framework for this revised taxonomy centers on three core concepts:
- Identifying a defect
- Capturing sources and causes of a defect
- Assessing severity of a defect
Just what does this mean for mortgage lenders? Currently, FHA staff process Post-Endorsement Technical Reviews (PETRs) on a certain percentage of insured loans for each lender as well as review closed loans during an on-site monitoring review.
After completion of these reviews, an overall rating is assigned to each case by FHA staff. These ratings are:
- Conforming (no substantive defects observed),
- Deficient (minor underwriting errors found but they do not impact the insurability of the loan) and
- Unacceptable (the defects uncovered pose a substantial risk to HUD as the mortgage insurer).
Deficiency letters are generated on all cases rated as Unacceptable and the lender will be given 30-45 days to provide a response to mitigate each deficiency cited. If a lender fails to respond or provides an insufficient response – an Indemnification Agreement will be proposed.
There are no less than 99 different codes that are currently being used by FHA staff to describe the various appraisal and credit review deficiencies found on a post-closing technical review. Lenders can say that they have 99 (potential) problems and an Indemnification may be one!
The revised Defect Taxonomy will establish the following 9 defect categories:
- borrower income
- borrower credit/liabilities
- loan to value & maximum mortgage amount
- borrower assets
- property eligibility
- property appraisal
- borrower eligibility
- mortgage eligibility
- lender operations.
Under the new Taxonomy, FHA will use four Tiers (Tier 1 being the most severe and Tier 4 being minor deficiencies) to communicate the severity of a defect. This will replace the present rating system of Conforming, Deficient and Unacceptable. As a result, for each of the 9 defect categories listed above – a rating of Tier 1, 2, 3 or 4 will be ascribed by a Reviewer when a deficiency is noted (Note: for the two property related defect categories there is no Tier 3 rating).
The bottom line will be that more substantive reports will be produced and will help lenders drill down and identify specific problem areas that they can provide training and take corrective actions – thereby reducing their defect rates in the future.
What is disappointing, however, is that HUD did not take this opportunity to also revise its procedures for requesting Indemnification Agreements from lenders. Many times such requests are viewed as though they are punitive measures and the judgment used by the DE underwriter when approving a borrower is discounted.
Despite this revised Taxonomy, there is still a lot of judgment calls made by the DE underwriter in their review of the acceptability of the property and the creditworthiness of the borrower(s). If their thought process and decision making are well documented, HUD should consider the establishment of an impartial panel or Division in making the decision to rescind any proposed Indemnification Agreement request.
Finally, it should be noted that HUD has not yet set an effective date for implementation of this new Defect Taxonomy.