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Thursday, December 4, 2014

Gross versus Net Defect Rates

Question
We have developed Net Defect Rate Targets, but we do not see the need to set targets for Gross Defect Rates. Is this acceptable?

Answer
No, it is not acceptable for several reasons. First of all, Fannie Mae requires lenders to set targets for both Gross and Net Defect Rates and then to track their performance with respect to meeting these target levels each month through their Post-Closing Quality Control Program.

More importantly, lenders need to track and monitor their Gross Defect Rates, because this percentage measures the efficiency or inefficiency of their loan origination process. In other words, how good of a job are they doing at originating, underwriting and closing mortgage loans? With today’s mortgage origination environment and ever shrinking profit margins, it is imperative that lenders have an efficient and cost effective process of producing viable mortgage loans. 

Gross Defect Rates are an excellent way of measuring and monitoring, over time, how good the production operation is performing, as this metric indicates the condition of the loan file documentation as received by the lender’s quality control department, directly from the production operation. 

Net Defect Rates, on the other hand, indicate the condition of the loan file documentation of the sample of loans after findings or errors have been fixed, remedied or explained away. Keep in mind that defect rates are calculated from the errors or findings found in the sample of loans, not the lender’s total book of business for the audit period.

If a lender has a high Gross Defect Rate but a low Net Defect Rate, that indicates it is good at fixing findings in the loans being sampled, but it is failing to realize that a high Gross Defect Rate in the sample indicates a high error rate in the total loans originated – assuming that the sampling method resulted in the sample being statistically representative of the total population. High error rates in a lender’s total book of business is costly and could increase the probability that loans will be originated that end up as ineligible for sale to investors.

Many lenders will concentrate on their Net Defect Rates in order to get an excellent Final Quality Control Audit Report to show their senior management, board of directors, and investors; but, these lenders are missing an important element of quality control, which is evaluating the cost effectiveness of their production operation.

I urge you to set targets and track your Gross Defect Rates, in addition to your Net Defect Rates.

Bruce Culp
Director/Quality Control & Loan Analytics
Lenders Compliance Group