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. 

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

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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. 

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 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. 

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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

A New Quality Control Program

QUESTION 

We are a lender in the southwest. I am the VP of mortgage lending. Our loans are only conventional on 1-4 single family residential property. Our primary investor is Fannie Mae. We do not originate government loans or investor loans. 

Recently, we ended the relationship with our quality control auditor. So, we're now looking around to replace them. We went to a conference where several lenders highly recommended your firm. So, our compliance manager will be contacting you soon. 

Now, we're updating our quality control plan. We need to start over with a new quality control plan. We need guidance about the areas we should outline in the QC plan. I realize this is a big subject, so maybe you can provide an overview of the basic elements. 

What are the basic requirements of a QC Plan? 

ANSWER 

There are essentially six parts to a basic Quality Control Plan ("Plan" or "Program"). More about that shortly. Depending on the company's size, risk profile, complexity, loan products, and investor conduits, to name a few factors, the Plan's purpose is central to controlling a mortgage lender's originating environment. 

Thank you for contacting us to handle your quality control auditing. We can accommodate any production size and audit virtually all loan products. We have an entire group devoted to quality control, headed by an Executive Director, and staffed with an accomplished audit staff. 

Please contact us here. We'll see that you speak directly with our audit management team. 

I would add that it is critical to ensure that the Plan and the QC auditing are aligned. When regulators and investors review your QC reports, they want to see that you are implementing the requirements of your specific Program. When LCG conducts QC, we can provide a Plan that properly reflects your auditing needs. Be sure to discuss the Plan requirements when you speak to us. 

You should consider establishing a baseline review of your quality control compliance. To effectuate this assessment, many company's use our QC Tune-up. This mini-audit provides substantive evaluation of your quality control function and provides a risk rating. It's cost-effective, hands-on, and quick. If interested, contact us here for information about the QC Tune-up.

Because you originate only conventional loans and your primary investor is Fannie Mae (“Fannie”), my response will address the QC requirements for conventional generally and Fannie in particular.[i]

Your QC Plan must define your lending standards for loan quality, establish processes designed to achieve those standards and mitigate risks associated with the loan origination processes. In that regard, Fannie requires the lender to develop and implement a QC program that provides a structure for identifying the deficiencies in the loan manufacturing process and implementing plans to remediate those deficiencies and underlying issues quickly. 

Six Parts of a Quality Control Program 

I mentioned above that there are six parts to a basic Quality Control Plan. I am going to provide a brief description of each part. I urge you to contact us if you want a more detailed discussion. 

The six parts of a QC Program are: 

1.     Overview; 

2.     Contents; 

3.     Standards and Measures; 

4.     File Reviews; and 

5.     Reporting and Remediation. 

Overview 

Put simply, the Program must include a documented QC Plan that outlines requirements for validating that loans are originated under its established policies and procedures. 

The Overview must provide guidelines to ensure that: 

·     the loans comply with applicable federal, state, and local laws and regulations; 

·     the loans comply with investors' guidelines, such as Fannie Mae's Selling Guide, all related contractual terms and agreements, and are in all respects eligible for delivery to Fannie; and 

·     the Plan must guard against fraud, negligence, errors, and omissions by officers, employees, contractors (whether or not involved in the origination of the mortgage loans), brokers, borrowers, marketing partners, and others involved in the mortgage process. 

Contents 

The Plan must include documented QC procedures that establish standards for quality and incorporate systems and processes for achieving those standards. At a minimum, the Plan must contain the following categories.

 

·     Quality standards and measures, including:

 

o   a general overview and description of the QC philosophy;

 

o   the plan objectives;

 

o   specific risks to be measured, monitored, and managed; and

 

o   the methods used to ensure the Program is an independent and unbiased function, including program governance (targets, sampling) and transaction execution.

 

·     Procedures involving detailed operating and reporting methods for all employees affected by the QC process.

 

·     QC file review process: a process for performing prefunding and post-closing QC file reviews, including, at a minimum, a method for

 

o   confirming compliance with the investors’ guidelines, all related contractual terms and agreements, and that the loans are in all respects eligible for delivery to Fannie; and

 

o   confirming compliance with applicable federal, state, and local laws and regulations.

 

·     Sample selection process: the procedures and metrics for identifying a representative sample of loans for QC file reviews using both random and discretionary selection methodologies, as applicable, that include loans

 

o   originated through each applicable production channel (for example, retail, correspondent, and third-party originators);

 

o   originated under all mortgage products (for instance, fixed, ARM, and special or niche programs); and

 

o   originated using all underwriting methods (manual and AUS).

 

·     Reporting: written procedures for reporting the results of the QC file reviews, including the method of monthly reporting of review findings, including

 

o   the method of monthly reporting of review findings;

 

o   identifying critical components included in the reports;

 

o   distributing summary-level findings to senior management;

 

o   distributing loan-level findings to the business unit(s), specifically to parties within the business unit(s) responsible for resolution;

 

o   requiring a timely response to and resolution – or resolution plan – of findings identified in the QC review process; and

 

o   maintaining accurate and detailed records of the QC reviews’ results.

 

·     Vendor review: a process for reviewing the QC work performed by the third-party auditors.

 

·     File retention: procedures for maintaining for three years records of the QC findings and reports, loan files reviewed, and all related documentation, including chronicling the location of such records.

 

·     Audit: an audit process to ensure that the lender’s QC processes and procedures are followed by the QC staff and that its assessments and conclusions are recorded and consistently applied. 

Quality Standards and Measures 

This is a somewhat complicated area, often leading to confusion. So, I will offer a high-level description. A lender is responsible for the development and maintenance of standards for loan quality and the establishment of processes designed to achieve those standards. 

To evaluate and measure loan quality standards effectively, the lender must establish a methodology for identifying, categorizing, and measuring defects and trends against an established target defect rate. 

At a minimum, the lender must identify any loans with a defect; specifically, these are loans not in compliance with investor guidelines or other related contractual terms and agreements. A methodology must be established by which all loans with identified defects can be categorized based on the severity of the defect. The lender must define the severity levels appropriate to its organization and reporting needs; however, the highest severity level must be assigned to those loans with defects resulting in the loan not being eligible as delivered to Fannie. 

The lender must also establish target defect rates for its organization, reflecting its quality standards and goals. Establishing a target defect rate is based on a lender’s post-closing random QC sample. It enables the lender to regularly evaluate and measure progress in meeting loan quality standards. 

Different target defect rates may be established for different severity levels; however, at a minimum, a target defect rate must be established for the lender’s highest level of severity. 

Here’s an suggestion: a target defect rate that is as reasonably low as possible should be established. Once the targets are set, performance against the targets must be measured at least quarterly and reported to management. It is also essential that the target defect rate(s) be evaluated and, if necessary, reset at least annually. The lender must document the rationale for establishing the target rate(s). During a Fannie review, consideration may be given to how the lender’s chosen target defect rate affects the investor’s risk. Sometimes, this leads to the investor requiring a more realistic target.

Fidelity Bond and Errors & Omissions Insurance – Fannie Mae Requirements

QUESTION

We are a mortgage lender in the northeast. We've been a Fannie Mae Seller/Servicer for many years. Our recent MORA audit found some problems handling our Fidelity Bond and Errors and Omissions Insurance. For example, we don't have a process to notify Fannie about losses that exceed $250,000. 

Another procedure issue is we do not have a process to evaluate the insurance regularly. We were criticized for not having sufficient documentation to ensure that all insurance requirements are maintained. 

MORA found several issues with the insurance itself, such as the deductible not meeting Fannie's requirements and the coverage not meeting Fannie's guidelines. 

We now have a few days to correct these findings and convince MORA that this situation is fixed. However, we want to be sure we're on track to give them what they want. So, we're coming to you for some basic guidance on the requirements. 

What should we expect a MORA review to examine with regard to the documentation needed for a MORA review of the Fidelity Bond and Error and Omissions insurance? 

ANSWER

You have mentioned several common findings involving Fidelity Bond and Error and Omissions insurance. Fannie Mae's Mortgage Origination Risk Assessment,[i] known by its acronym "MORA," is an audit team that conducts reviews, usually on-site, which is tasked with assessing the operational capabilities, governance, and compliance with Fannie Mae's Selling Guide ("Guide") requirements. 

In addition to the findings you mention, there are other results, such as the insurance not including appropriate provisions to protect Fannie's interests, as outlined in the Guide. 

A Fannie Seller/Servicer must always be prepared for a MORA audit, which means that the Seller/Servicer must continually monitor and document its compliance with Fannie guidelines. 

We are keenly aware of the requirements reviewed in a MORA audit. Many companies use our Fannie Tune-up® as a tool to prepare for the audit and ensure that they comply with many Fannie guidelines. If interested, you can request information HERE about the Fannie Tune-up®. 

As a Seller/Servicer, you must have a blanket Fidelity Bond and Error and Omissions insurance policy in effect at all times in an amount sufficient to meet Fannie's minimum coverage requirements, maximum deductible requirements, and provision requirements.[ii] 

A fidelity bond is a form of insurance protection that covers policyholders for losses they incur due to fraudulent acts by specified individuals. Errors and omissions insurance is a type of professional liability insurance that protects companies, their workers, and other professionals against claims of inadequate work or negligent actions.

You mentioned that MORA found that your fidelity bond coverage did not meet Fannie's guidelines. Although you requested information specifically about documentation needed for a MORA review of the insurance, I will caution you to be sure that your fidelity bond coverage is equal to a percentage of the greater of your annual total Unpaid Principal Balance ("UPB") of single-family and multifamily annual mortgage loan originations or the highest monthly total UPB of single-family and multifamily servicing of mortgage loans that you own, including mortgage loans owned by you and serviced by others. Coverage must be determined using Fannie's precise formulas.[iii] With certain limitations, errors and omissions coverage must equal the amount of your fidelity bond coverage.[iv] 

Given the foregoing, at minimum you should have: 

·      a process to monitor that coverage is consistent with Fannie requirements and to note that the maximum UPB definitions are based on an annual basis, not just a point in time; 

·      a process to validate that deductibles are consistent with Fannie requirements; 

·      a process to validate annually that coverage includes required provisions; and 

·      a designated individual who maintains evidence of the fidelity bond and errors and omissions coverages. 

Now, onto your question about the documentation expectations! 

You should be able to provide at least nine types of documentation to MORA. Any defects in these categories may lead to an adverse finding on a MORA audit. I will outline them, though please understand that I must be brief, respecting the article's length and the complexity of the subject.[v] 

Documentation Required by Fannie Mae: Fidelity Bond and Errors and Omissions Insurance[vi] 

1)    Provide the total UPB of single-family and multifamily annual mortgage loan originations (this should not be exclusive to the Fannie servicing portfolio held by your institution and should include the entire serviced portfolio). 

2)    Provide the highest monthly total UPB of single-family and multifamily servicing of mortgage loans that the seller owns, including mortgage loans owned by the seller and serviced by others. 

3)    Indicate if multifamily mortgage loans are serviced in addition to servicing single-family mortgage loans. 

4)    Indicate if there have been any occurrences within the past 12 months of a single fidelity bond or errors and omissions policy loss that is mortgage-related and the amount exceeds the lesser of $250,000 or the policy's deductible. If yes, you should describe in detail the nature of the claims and if they were mortgage-related. 

5)    Describe the process in place to notify Fannie Mae of a fidelity bond or errors and omissions policy loss that is mortgage-related within 30 days of discovery. 

6)    Describe the coverage review process, such as how often coverage is evaluated, how adequate coverage is determined, and who within your organization performs this task. 

7)    Fidelity bond policy has the following:

a.   The insurer's name on the insurance certificate;

b.   The policy and/or bond number;

c.   The named insured;

d.   The type and amount of coverage (should specify whether the insurer's liability limits are an aggregate loss or per-mortgage basis);

e.   The effective date of the insurance coverage;

f.    The expiration date of the insurance coverage; and

g.   The deductible amount of the insurance coverage. 

8)    Errors and omissions policy has the following:

a.   The insurer's name on the insurance certificate;

b.   The policy and/or bond number;

c.   The named insured;

d.   The type and amount of coverage (should specify whether the insurer's liability limits are an aggregate loss or per-mortgage basis);

e.   The effective date of the insurance coverage;

f.    The expiration date of the insurance coverage; and

g.   The deductible amount of the insurance coverage. 

9)    Contains evidence of the following provisions for both the fidelity bond and errors and omissions policy:

a.   Fannie is named as a "loss payee" on drafts the insurer issues to pay for covered losses incurred by Fannie;

b.   Fannie has the right to file a claim directly with the insurer if the lender fails to file a claim for a covered loss incurred by Fannie Mae (if available);

c.   Fannie will be notified at least 30 days before the insurer cancels, reduces, declines to renew, or imposes a restrictive modification to the lender's coverage for any reason other than partial or full exhaustion of the insurer's limit of liability under the policy; and

d.   Fannie will be notified within 10 days after the insurer receives a lender's request to cancel or reduce any coverage. 

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

Lenders Compliance Group

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[i] A Fannie team may also audit for compliance with Servicer Total Achievement and Rewards (STAR) requirements
[ii] Fidelity Bond and Errors and Omissions Coverage, Selling Guide, A3-5-01, Fannie Mae, July 25, 2017
[iii] Fidelity Bond Policy Requirements, Selling Guide, A3-5-02, Fannie Mae, July 25, 2017
[iv] Errors and Omissions Policy Requirements, Selling Guide, A3-5-03, Fannie Mae. July 25, 2017
[v] Seller/Servicer Risk Self-Assessment, Fidelity Bond and Errors and Omissions Insurance, Fannie Mae, 2020
[vi] See also Fidelity Bond and Errors and Omissions Coverage Provisions, Selling Guide, A3-5-01 Fannie Mae, July 25, 2017