Appraisal and Evaluation Program

QUESTION 

Our state banking department requested that we update our independent appraisal policy. They want us to update the "Appraisal and Evaluation Program." And they want us to provide information about its independence. We bought the policy from a company that sells mortgage policies, but the examiner says the policy is "defective." 

We went back to the mortgage policy company, and they said there was nothing wrong with their policy. Obviously, there's something wrong if an examiner has a problem with it! We told the examiner that the mortgage manuals company is well known, but she didn't care and told us to update the policy. 

We don't know what to put into the policy to satisfy the examiner. We need some pointers. 

What is an appraisal and evaluation program? 

What is independence in relation to an appraisal and evaluation program? 

ANSWER 

The term "Appraisal and Evaluation Program" is found in variations throughout various regulatory frameworks. An institution's board of directors or its designated committee is responsible for adopting and reviewing policies and procedures that establish an effective real estate appraisal and evaluation program. 

We believe there are certain features of an appraisal and evaluation program. The program should: 

·       Provide for the independence of the persons ordering, performing, and reviewing appraisals or evaluations. 

·       Establish selection criteria and procedures to evaluate and monitor the ongoing performance of appraisers and persons who perform evaluations. 

·       Ensure that appraisals comply with the agencies' appraisal regulations and are consistent with supervisory guidance. 

·       Ensure that appraisals and evaluations contain sufficient information to support the credit decision. 

·       Maintain criteria for the content and appropriate use of evaluations consistent with safe and sound banking practices. 

·       Provide for prompt receipt and review of the appraisal or evaluation report to facilitate the credit decision. 

·       Develop criteria to assess whether an existing appraisal or evaluation may be used to support a subsequent transaction. 

·       Implement internal controls that promote compliance with these program standards, including those related to monitoring third party arrangements. 

·       Establish criteria for monitoring collateral values. 

·       Establish criteria for obtaining appraisals or evaluations for transactions that are not otherwise covered by the appraisal requirements of the appraisal regulations. 

Regarding the independence of the appraisal and evaluation program, for both appraisal and evaluation functions, an institution should maintain standards of independence as part of an effective collateral valuation program for all of its real estate lending activity. 

The collateral valuation program is an integral component of the credit underwriting process and, therefore, should be isolated from influence by the institution's loan production staff. We also recommend that an institution establish reporting lines independent of loan production for staff who administers the institution's collateral valuation program, including the ordering, reviewing, and acceptance of appraisals and evaluations. 

Appraisers must be independent of the loan production and collection processes and have no direct, indirect, or prospective interest, financial or otherwise, in the property or transaction.[i] These standards of independence also should apply to persons who perform evaluations. 

For a small or rural institution or branch, it may not always be possible or practical to separate the collateral valuation program from the loan production process. If absolute lines of independence cannot be achieved, an institution should be able to demonstrate clearly that it has prudent safeguards to isolate its collateral valuation program from influence or interference from the loan production process. In such cases, another loan officer, other officer, or company director may be the only person qualified to analyze the real estate collateral. However, to ensure their independence, such lending officials, officers, or directors must abstain from any vote or approval involving loans on which they ordered, performed, or reviewed the appraisal or evaluation.[ii] 

Communication between the institution's collateral valuation staff and an appraiser or person performing an evaluation is essential for exchanging appropriate information relative to the valuation assignment. An institution's policies and procedures should specify communication methods that ensure independence in the collateral valuation function. These policies and procedures should foster timely and appropriate communications regarding the assignment and establish a process for responding to questions from the appraiser or person performing an evaluation. 

We are often asked if an institution may exchange information with appraisers and persons who perform evaluations. The short answer is Yes, with restrictions; for example, you may provide a copy of the sales contract[iii] for a purchase transaction. However, an institution should not directly or indirectly coerce, influence, or otherwise encourage an appraiser or a person who performs an evaluation to misstate or misrepresent the property's value. 

Consistent with its policies and procedures, an institution also may request the appraiser or person who performs an evaluation to: 

·       Consider additional information about the subject property or comparable properties. 

·       Provide additional supporting information about the basis for a valuation. 

·       Correct factual errors in an appraisal. 

Furthermore, an institution's policies and procedures should ensure that it avoids inappropriate independence of the collateral valuation function, including: 

·       Communicating a predetermined, expected, or qualifying estimate of value, or a loan amount or target loan-to-value ratio to an appraiser or person performing an evaluation; 

·       Specifying a minimum value requirement for the property that is needed to approve the loan or as a condition of ordering the valuation; 

·       Conditioning a person's compensation on loan consummation; 

·       Failing to compensate a person because a property is not valued at a certain amount;[iv] 

·       Implying that current or future retention of a person's services depends on the amount at which the appraiser or person performing an evaluation values a property; and 

·       Excluding a person from consideration for future engagement because a property's reported market value does not meet a specified threshold. 

After obtaining an appraisal or evaluation, or as part of its business practice, a institution may find it necessary to obtain another appraisal or evaluation of a property. You would be expected to adhere to a policy of selecting the most credible appraisal or evaluation rather than the appraisal or evaluation that states the highest value. 

Further, an institution's reporting of a person suspected of non-compliance with the Uniform Standards of Professional Appraisal Practice (USPAP) and applicable federal or state laws or regulations or otherwise engaged in other unethical or unprofessional conduct to the appropriate authorities would not be viewed by governmental agencies as coercion or undue influence. Indeed, an institution should not use the threat of reporting a false allegation to influence or coerce an appraiser or a person who performs an evaluation.

Jonathan Foxx, Ph.D., MBA
Chairman & Managing Director 

Lenders Compliance Group

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[i] The Agencies’ appraisal regulations set forth specific appraiser independence requirements that exceed those set forth in the Uniform Standards of Professional Appraisal Practice (USPAP). Institutions also should be aware of separate requirements on conflicts of interest under Regulation Z (Truth in Lending Act), see 12 CFR 1026.42(d).

[ii] For instance, the NCUA has recognized that it may be necessary for credit union loan officers or other officials to participate in the appraisal or evaluation function although it may be sound business practice to ensure no single person has the sole authority to make credit decisions involving loans on which the person ordered or reviewed the appraisal or evaluation. 55 FR 5614, 5618 (February 16, 1990), 55 FR 30193, 30206 (July 25, 1990).

[iii] Refer to USPAP Standards Rule 1-5(a) and the Ethics Rule.

[iv] This provision does not preclude an institution from withholding compensation from an appraiser or person who provided an evaluation based on a breach of contract or substandard performance of services under a contractual provision.

Social Media Influencers

QUESTION 

A social media influencer approached our marketing department to provide an endorsement. The influencer wants to be paid an endorsement fee. The marketing department says this would be a good lead source for us. We asked our regulator about it, and they cautioned that this comes under the advertising regulations. 

I am concerned that we do not know much about the regulations or what we are getting ourselves into. We've been a mortgage lender in business for over twenty years. We are familiar with getting testimonials from customers but have no experience getting endorsements from influencers. 

And, to say the least, we want no trouble with our regulator about our marketing involved with an influencer. So, we need some guidance. We are hoping you can shed some light on this situation. 

What are some of the concerns and challenges regarding endorsements from social media influencers? 

ANSWER 

I must admit that I can't figure out all the buzz behind the popularity of social media influencers; indeed, there are celebrity influencers who promote products and services to millions of social media followers, even though they fail to mention they were paid for their promotions. I won't get into the obvious concern that getting paid undermines the authenticity of the endorsement. 

You don't mention the name of your regulator, but no matter. I will provide an answer based on the Federal Trade Commission (FTC) advertising requirements, since the FTC serves a critical role in regulating advertising to protect consumers from false, misleading, or deceptive claims. 

The FTC is essentially a consumer advocacy agency that, among other things, combats untruthful advertising through enforcement actions, regulatory guidance, and consumer education. I think a cursory overview of the FTC's approach to ensuring truth in advertising can offer some helpful advice with respect to social media endorsements and testimonials. 

FTC Oversight 

The FTC's oversight of advertising is derived primarily from its authority under the FTC Act to prevent "unfair or deceptive acts or practices."[i] The FTC's deception enforcement policy specifies several factors in analyzing whether an act or practice is deceptive: 

·       There must be a representation, omission, or practice that is likely to mislead consumers. The FTC examines the overall net impression made by the ad, not just isolated words or phrases.[ii] 

·       The act or practice must be evaluated from the perspective of a reasonable consumer. The test is whether it is likely to mislead reasonable consumers. If the representation or practice impacts or is directed primarily to a particular group, the FTC examines reasonableness from the perspective of that group.[iii] 

·       The representation, omission, or practice must be material. That is, it must be important to consumers' decisions or conduct regarding the product.[iv] 

·       The representation, omission, or practice is likely to mislead consumers acting reasonably under the circumstances.[v] The facts and circumstances dictate the evaluation. 

It is critical to note that the FTC does not need to show actual deceit or even that any consumers were actually misled. Rather, it must simply show that the conduct in question has a tendency or capacity to deceive consumers who act reasonably.[vi] 

Tangentially relevant to your question is the action taken by the FTC against operators of websites that purport to provide independent reviews of products and services. The FTC has alleged the defendants posted fake positive reviews to increase sales and false negative reviews to harm competitors.[vii] Consider this an example of how the FTC combats deception relating to online reviews and endorsements. 

In addition to its authority to prevent deception, the FTC can challenge unfair practices.[viii] Unfair practices involve conduct that substantially injures consumers, violates established public policy, or may be unethical or unscrupulous.[ix] 

Advertising Issues 

One of the FTC's best known advertising guides is entitled Guides Concerning the Use of Endorsements and Testimonials in Advertising ("Endorsement Guides").[x] In this guidance, the FTC proposed extensive updates to the Endorsement Guides to address changes in the marketplace, especially the rise of social media influencers.[xi] The guidance defines an endorsement as 

an advertising message consumers likely believe reflects someone's independent opinions or experiences with a product.[xii] 

I will expand on this definition shortly. 

The Endorsement Guides outline FTC's views on topics like when endorsements must disclose material connections and how advertisers should substantiate claims made through endorsements. They also offer numerous examples to illustrate practical implementation. For instance, one example explains that tagging a brand in a social media post can constitute an endorsement as part of a paid relationship.[xiii] 

Here's where you must be very cautious, for you are now at the point where competent handling of the relationship with the social media influencer is imperative to avoid considerable regulatory risk. In updating the Endorsement Guides, the FTC clarified principles like the need to substantiate both express and implied claims made through endorsements.[xiv] If you are unfamiliar with such claims, pause your efforts and get professional compliance assistance. 

As a matter of fact, new examples include posting fake reviews and threats against negative reviewers.[xv] So, you must be sure to be current with the task at hand. These and other revisions, proposed and actual, reflect the FTC's close monitoring of deceptive practices in connection with consumer reviews, influencer marketing, and, in particular, social media influencer endorsements. 

The combination of general guides and specific guidance articles should be constantly monitored because the FTC updates and expands its guidance as technology and marketing practices continue evolving. 

Educating the Social Media Influencer 

For what it's worth, the FTC has also tried educating social media influencers on following endorsement guidelines in recent years. For instance, in 2019, the FTC sent educational letters to prominent social media figures reminding them about disclosing brand relationships. While not enforcement actions, these letters served as warnings to comply with the advertising guidelines. But none of what the influencer does or does not do about compliance will protect you, notwithstanding the FTC's consumer and business education efforts continuing to evolve as platforms, technologies, and advertising techniques change. 

Minefields 

Let's consider some salient minefields involving endorsements. Although the Endorsement Guides do not themselves have the force of regulations, they certainly reflect the FTC's views regarding endorsements. 

Definition of Endorsement 

The following is the FTC's broad definition of an endorsement. It is 

"Any advertising message that consumers are likely to believe reflects the opinions, beliefs, findings, or experiences of a party other than the sponsoring advertiser."[xvi] 

This definition covers endorsements in both traditional and social media. It encompasses statements, images, tags, likes, reviews, and much more. But, really, any message in advertising which consumers likely perceive as representing someone's independent opinions or experiences with a product or service can be an endorsement. 

And what is a nuanced example of a fake endorsement? An example would be where paid negative reviews of a competitor are obviously not endorsements, but fake positive reviews used to promote one's own products and services clearly are fake endorsements.[xvii]

Liability for Deceptive Endorsements 

Both advertisers and endorsers can be liable for false or unsubstantiated claims made through endorsements.[xviii] The advertiser is responsible for claims made through their ads, whether by directly making statements or using paid endorsers. 

Even though endorsers may be liable for deceptive endorsements they make, advertisers may also be liable for failing to adequately monitor endorsers for compliance issues.[xix] I suggest you draft and ratify a policy that sets forth how you, as an advertiser, will guide, monitor, and take action to remedy endorser non-compliance, whether the social media influencer, the endorser, is paid or not paid.[xx] 

This principle applies even when advertisers merely disseminate existing endorsements, like sharing (which is retweeting or reposting) positive social media endorsements. As an advertiser, you should always confirm that endorsements reflect a social media influencer's honest views before rebroadcasting them.[xxi]

Substantiating Endorsement Claims 

The advertiser must substantiate claims made through endorsements.[xxii] As with any advertising claims, you must substantiate consumer endorsements, because such endorsements are not necessarily competent or reliable evidence or proof.[xxiii] 

In reviewing such endorsements, my firm has evaluated endorsements that are skewed. When that happens, we advise our clients they are obligated to ensure that representations of outcomes made by consumers should generally achieve the outcomes associated with using the advertised product or service.[xxiv] Our rule of thumb is, when endorsements reference exceptional results well beyond the norm, the ads should clearly and conspicuously disclose what consumers can expect to experience.

Disclosures 

As an advertiser, you must disclose any connections between social media influencers, and other endorsers, and your company that could affect how people evaluate the endorsements.[xxv] This includes monetary payments and the receipt of free products or services. Put otherwise, any connections likely to affect the weight consumers give endorsements should be disclosed when they are not reasonably expected.[xxvi] 

Social media influencers, for example, should disclose brand sponsorships and gifts. Consumers may give greater credence to reviews and opinions from people they perceive as unbiased. Thus, clear disclosure of connections allows consumers to consider endorsements in full context. 

Jonathan Foxx
Chairman & Managing Director 

Lenders Compliance Group

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[i] Section 5, FTC Act, 15 USC § 45. False or misleading advertising falls under the umbrella of deceptive practices the FTC can prohibit.

[ii] See Federal Trade Commission, FTC Policy Statement on Deception (1983), as appended to In re Cliffdale Assocs., Inc., 103 FTC 110, 174 (1984).

[iii] Idem

[iv] Op. cit. ii, at 182

[v] Op. cit. ii, at 175-76

[vi] FTC v. Algoma Lumber Co., 291 U.S. 67, 81 (1934)

[vii] Complaint, FTC v. 427K, Inc., No. 4:22-cv-01069-JSW (N.D. Cal. February 28, 2022)

[viii] Op, cit. i

[ix] Federal Trade Commission, FTC Policy Statement on Unfairness (1980), as appended to In re Int'l Harvester Co., 104 FTC 949, 1070 (1984).

[x] 16 CFR § 255, Originally issued in 1980, 45 Fed. Reg. 3870 (January 18, 1980)

[xi] 87 FR, 44288 (July 26, 2022)

[xii] 16 CFR § 255.0(b)

[xiii] 16 CFR § 255.0(g)(5)(ii)

[xiv] 87 FR 44311 (July 26, 2022)

[xv] Idem

[xvi] Op. cit. xii

[xvii] 16 CFR § 255.0(g)(12)

[xviii] Idem

[xix] Op. cit. xvii

[xx] 16 CFR § 255.1(d)(3)

[xxi] 16 CFR § 255.2(a) & (b)

[xxii] 16 CCFR § 255.2(a)

[xxiii] Idem, Example 5

[xxiv] 16 CFR § 255.2(b)

[xxv] 16 CFR § 255.5

[xxvi] 16 CFR § 255.5(a)

Timeframe to Litigate in Right of Rescission

QUESTION 

In January, you answered a question about the three-year expiration on the Right of Rescission. The questioner said that they were being sued even after the expiration period had expired because, they claimed, there was a material violation of TILA, so the right to rescind should be allowed. 

As our company’s General Counsel and Compliance Officer, I was particularly interested in your answer because it explored several factually important aspects posed by the question. Your answer led to us improving our procedures relating to rescission reviews. 

I believe the right of rescission is not open forever to the consumer to file a suit to enforce rescission. But I can’t find any provision(s) in TILA that supports my view. I hope you will provide some guidance about the time of such litigation. 

Does TILA state a timeframe to initiate a lawsuit to enforce rescission? 

ANSWER 

The FAQ article you refer to is Right of Rescission after Three-Year Expiration, published on January 5, 2023. The question was: 

"May a borrower assert the right of rescission by way of recoupment even after the lapse of the three-year period, assuming a material TILA violation by the creditor, if the borrower did not previously assert that right?" 

My answer used, in part, a decision by a federal district court in California regarding how much time is allowed for filing a rescission action after TILA’s 3-year limitation period expires;[i] that is, when a borrower has exercised the right to cancel but hasn’t yet initiated litigation when the 3-year period expires. 

Your question asks, in effect, about when a cause of action for rescission arises. 

A consumer cannot wait indefinitely before filing a suit to enforce rescission. TILA does not answer how long the consumer may wait, so a court facing the issue will borrow the most closely analogous state or federal limitations period.

After that time period, a lender can at least be assured that the consumer cannot file a timely offensive court action. However, the consumer might be able to raise the fact of rescission as a defense to an action filed by the lender. TILA specifies that its rescission provisions do not affect a consumer’s right of rescission in recoupment under state law.[ii] 

A case, Shetty v Block, was recently decided by the U.S. Court of Appeals for the 9th Circuit, affirming a California federal district court decision.[iii] I think this decision offers some valuable insights in answer to your question. 

Here’s a brief outline. 

·       In December 2005, Zaharescu contacted New Haven Financial to inquire about a loan to purchase a home. 

·       New Haven offered her a loan for 50 percent of the purchase price. 

·       On December 29, 2005, New Haven sent Zaharescu loan documents, which she signed. She received only blank copies of the documents she signed. 

·       After signing, she received phone calls from New Haven requesting more documentation. Fearing that the New Haven loan would not close in time to purchase the property, Zaharescu obtained a loan from Liberty instead, which closed on January 20, 2006. 

·       On January 31, 2006. New Haven sent Zaharescu a check for $77,786 and a closing statement reflecting a closing date of January 27. 

·       When Zaharescu contacted New Haven to say she had received a loan from someone else and no longer needed the New Haven loan, she was told the loan could not be canceled and that she should use the money to make monthly payments on the loan. 

·       In February 2008, Zaharescu defaulted on the New Haven loan. 

·       On or about July 7, 2008, she sent a demand for rescission under TILA. 

·       New Haven provided a copy of the loan file, which showed altered documents and different terms from those Zaharescu had originally signed. 

·       On September 25, 2008, Zaharescu recorded a notice of rescission and mailed copies to New Haven. 

·       On July 18, 2021, nearly thirteen years later, Zaharescu sued for rescission under TILA, among other remedies. 

Ø  The district court dismissed the complaint as time-barred. 

Ø  The 9th Circuit affirmed. When a lender fails to act on a borrower’s notice of rescission, courts in the 9th Circuit look to state law to determine the statute of limitations for a borrower’s suit to enforce the rescission. The state statute of limitations for a breach of contract applied in this situation, which, in California, was 4 years. 

The statute of limitations for enforcement of rescission began to run at the latest 20 days after Zaharescu recorded her notice of rescission on September 25, 2008 – twenty (20) days because that was TILA’s deadline for the lender to return any money or property given to anyone in connection with the loan and take any action necessary to reflect the termination of the security interest. Note this occurred about 13 years before the filing of the complaint, well outside the 4-year statute of limitations. 

Lenders have argued that the rescission procedures are unfair and that allowing consumers to unilaterally rescind by sending notice empowers them to void security interests even when the consumer has received all required disclosures. But this argument ignores the fact that only valid notices result in rescission. 

As a practical matter, a lender may find itself caught between a rock and a hard place. 

When a court looks back at the receipt of a rescission notice, it can look at the documents, circumstances, testimony, and arguments, and decide whether the rescission notice was valid or invalid. In contrast, a lender must look forward. A lender often cannot know in advance whether the rescission notice is valid and cannot know for sure what a court might someday decide. 

When a lender receives a rescission notice, a lender wants to know its effect immediately. A lender must quickly (within 20 calendar days) decide how to respond. Sometimes, a lender can tell by looking at the documents that a mistake was made, and the consumer is correct – a material disclosure violation occurred, giving the consumer a right to rescind. Sometimes, a lender is almost certain it did everything correctly. Other times, the answer is unclear and won’t be clear until a court, maybe an appellate court, maybe even the Supreme Court, has reviewed it. 

Accordingly, a lender might prefer to operate under a default mode that assumes a notice of rescission is valid. As a practical matter, to ensure regulatory compliance, it may need to handle all rescission notices as valid. Heading straight to court offers no help; the likelihood of getting the issue resolved by a court within 20 calendar days is nil. 

Regulation Z[iv] sums it up: 

“Any security interest giving rise to the right of rescission becomes void when the consumer exercises the right of rescission. The security interest is automatically negated regardless of its status and whether or not it was recorded or perfected. Under § 1026.23(d)(2), however, the creditor must take any action necessary to reflect the fact that the security interest no longer exists.”[v] 

Jonathan Foxx, Ph.D., MBA
Chairman & Managing Director 

Lenders Compliance Group

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[i] Plong v. Fisher, 2022 U.S. Dist., C.D. Cal. June 27, 2022

[ii] TILA § 125(i)(3)

[iii] Shetty v. Block, 2022 U.S. Dist. (C.D. Cal. Jan 27, 2022), aff’d, 2023 U.S. App. (9th Cir. Aug. 22, 2023)

[iv] Comment 23(d)(1)-1

[v] “Within 20 calendar days after receipt of a notice of rescission, the creditor shall return any money or property that has been given to anyone in connection with the transaction and shall take any action necessary to reflect the termination of the security interest.” § 1026.23(d)(2)

Quality Control Challenges – Defect Rates and Trendlines

QUESTION 

During a MORA review, Fannie determined that several areas were problematic. We thought we were mostly ready until we got the MORA results. Fannie required us to revise a list of issues. 

It was too late for us to use your Fannie Tune-up. So we mustered through as best as we could. One area that the MORA team criticized us for was that we did not establish a "methodology for identifying, categorizing, and measuring defects and trends against an established target defect rate." 

They found our Quality Control Plan was defective, and we could not show that we followed a methodology to uncover defects and trends. Our QC Manager discussed this with our QC auditor, but they became defensive. They did not want to update their Quality Control Plan or provide their procedures for Fannie to evaluate. So, on top of everything else, we need to get another QC auditor. 

We need your help in understanding some basics about defects and trendlines. 

What methodology is used for "identifying, categorizing, and measuring defects and trends against an established target defect rate?" 

ANSWER 

It's unfortunate that you did not contact us soon enough for the Fannie Tune-up. It takes 60 days to complete, and it is inexpensive. Most clients use the Fannie Tune-up to comply with Fannie guidelines and stay ready or get ready for a Mortgage Origination Risk Assessment (MORA) visit. 

_____________________________________________ 

Anyone interested in the Fannie Tune-up can request information here. 

_____________________________________________ 

I thought it would be a good idea for you to get some feedback from Brandy George, the Executive Director of LCG Quality Control. 

There are few professionals in mortgage banking with Brandy's credentials and depth of experience. Her group audits small and large loan production into the thousands of units. Importantly, Brandy works hands-on with clients to ensure their quality control meets Fannie's guidelines. So, I asked her to join me in answering your question. 

_____________________________________________

 Brandy also offers a free Quality Control Plan (terms apply)

that meets GSE and regulatory scrutiny. 

If anyone wants to talk to Brandy about their Quality Control needs,

you can contact her here. 

_____________________________________________ 

I asked Brandy to give a brief but useful answer to your question. The following outline is reflective of my notes from my conversation with her. 

Brandy confirmed that a financial institution must have a set of policies and procedures documented in its Quality Control Plan, establishing a target defect rate and the methodology for "identifying, categorizing, and measuring defects and trends" against that rate. 

According to Brandy, 

the target defect rate is the final net defect rate your firm has established as an acceptable percentage rate of open defects in any given audit period and the year-to-date percentage rate of open defects. 

That led to our discussion about calculating the defect rate. I like Brandy's response: 

Calculating and tracking the actual defect rate against your target defect rate is how you assess your credit and financial risk performance and measure progress in meeting your quality control goals. Managing gross and net defect rates is critical to understanding the financial exposure revealed during the QC process. 

The gross defect rate is calculated by dividing the number of all defects noted by the number of loans reviewed in the audit period, and the final net defect rate is calculated by dividing the number of open defects by the number of loans reviewed in the audit period. 

To provide a granular description that brings in threat levels, having a target defect rate is required for the top severity level – which, by the way, is ineligible for delivery to Fannie Mae – and enables the lender to regularly evaluate and measure progress in meeting its loan quality standards. 

The lender must define lower severity levels as appropriate for its organization, and different target defect rates may be established for different severity levels (if applicable). Note that the target defect rate is a Fannie Mae requirement!

With respect to calculating the target defect rate, I would like to add my observation to Brandy's guidance. Calculating a defect rate is how you measure against your target defect rate. Some lenders use only a gross or a net calculation when determining their monthly defect rate, while others use both. 

• The gross defect rate is the defect rate based on the initial findings prior to any rebuttal activity. 

• The net defect rate is the defect rate based on the final findings after the rebuttal activity. 

Understanding the root cause of the issues resolved during the rebuttal process may provide insight into how the defects can be prevented. 

Concerning the severity level, if a loan has both the highest-severity level defect and a lower-severity level defect, Fannie directs that the lender should only count the loan once – in the highest-severity category – in a defect rate calculation. Calculations should be done for your two most severe defect types (i.e., Significant and Moderate). 

My conversation with Brandy concluded with discussing the methodology for identifying defects and trendlines. Her insight here is helpful. She said: 

The methodology for identifying defects and trends lies within the audit process. How loan defects are identified and categorized leads to the final reporting results. Meaning, exceptions and defects need to be categorized in such a way that puts the defects in risk rating categories, such as Minor, Moderate, and Significant, compliance and regulatory, or by area of responsibility, such as Loan Officer, Processor, Underwriter, or Closer.  

Categorizing into risk rating categories is essential to the mission of the quality control project. Once initial (gross) defects are cured, it is important to determine root causes, analyze issues, and reconcile the difference between your gross and net defects and action plan accordingly. Be sure to analyze the cause between the gross and net defect rates! The goal is to identify and remediate the issues to narrow the gap between gross and net defect rates. 

A final word about targets and defect rates. An effective way to establish loan quality targets is to model the financial exposure created at a certain defect level. The concept of "zero defects" generally will be considered challenging to achieve. And, in any event, Fannie Mae does not evaluate lenders by a zero-defect-rate standard. 

Fannie Mae expects lenders to set defect rate targets as reasonably low as possible based on a formal cost-benefit analysis of meeting that target. The MORA team expects lenders to demonstrate to Fannie how they manage loan quality to meet their established target. 

_____________________________________________ 

Brandy also offers a free Quality Control Plan (terms apply)

that meets GSE and regulatory scrutiny. 

If anyone wants to talk to Brandy about their Quality Control needs,

you can contact her here. 

_____________________________________________ 

Jonathan Foxx, Ph.D., MBA
Chairman & Managing Director 

Lenders Compliance Group