PERSON OF THE WEEK: Phil McCall is chief operating officer at ACES Risk Management Corp. (ARMCO), where he serves as an expert in quality control (QC), loan origination, underwriting, mortgage fraud, loss and litigation. MortgageOrb recently interviewed McCall to learn more about the potential impact of the Federal Housing Administration's (FHA) new loan defect taxonomy, which seeks to streamline the taxonomy that's in place now.
Q: The FHA recently announced its new loan defect taxonomy, which came well after similar announcements by other agencies. Why did it take the FHA so long to create its own taxonomy?
McCall: Not being privy to the FHA's inner workings, I only know it has been working on this for quite a while and can only speculate on the possible difficulties it encountered in making this type of change. The FHA has been using its existing system of 99 set defect codes for decades. The proposed taxonomy requires that all defects be classified into nine distinct categories, and each category comprises between 15 and 40 reason codes. In addition, the lender must indicate one of four severity levels for each defect. Thus, the proposed taxonomy is far more complex than its predecessor, and the ripple effects of making a change of this magnitude within any organization can run very deep.
Q: There are significant differences between the FHA's taxonomy and Fannie Mae's. What challenges will these differences pose for lenders?
McCall: There are going to be several challenges lenders must address in order to provide both the FHA and Fannie Mae with the information they require in the correct format. At a very basic level, the FHA and Fannie Mae have different definitions for many of their individual defect categories, along with a diverging approach on how they define the severity of those defects. As such, these disparate severity levels do not easily align for standardized recording and will make recording loan defects a real challenge for many lenders.
For example, Fannie Mae has outlined two severity levels within its taxonomy: a critical defect, which makes the loan ineligible for sale to Fannie Mae, and a non-critical defect. Fannie Mae doesn't care if the lender breaks up its non-critical defects into more defined hierarchies (e.g., minor, moderate, etc.). It simply wants to know, in black-and-white terms, if the defect causes the loan to be ineligible for sale. That makes reporting a much simpler process.
The FHA, on the other hand, has outlined four tiers of severity levels to be associated with each defect. In my opinion, these tiers do not provide the clarity of Fannie Mae's severity levels. That lack of clarity leaves room for interpretation and subjectivity, which could ultimately lead to potential inconsistencies in application. I would have preferred to see the FHA take an approach similar to Fannie Mae's and have the severity levels be primarily concerned with whether the loan meets the eligibility requirements for the FHA insurance.
Q: What challenges do lenders currently face in codifying loan defects, and how will the FHA's new taxonomy help address some of those challenges?
McCall: Codifying loan defects has almost always been a process that varies from lender to lender. Though each process may share similarities, every lender takes on its own little nuances.
When Fannie Mae announced its defect taxonomy, this, for the first time, provided lenders with a model that would allow for standardization of loan defect categorization. Fannie Mae does not require its sellers to utilize this taxonomy; however, it does provide transparency for the process by which Fannie Mae will assess defects in its loan reviews. On the surface, it appears to me that the FHA is attempting to provide the same type of standardization, and as such, the FHA most likely will not make use of its taxonomy mandatory. The net positive here is that this creates a more standardized process for the FHA's assessment of loan defects.
Q: Why not go ahead and set an ‘effective date’ when announcing the new taxonomy? Is this designed to allow lenders to get familiar with the new taxonomy before being required to use it?
McCall: By not setting an effective date in its initial announcement, I suspect the FHA is leaving the door open for possible minor changes or tweaks to this taxonomy. In reviewing the documentation the FHA has provided to date, you can see that it spent a tremendous amount of time in developing this taxonomy, and I believe its intention is to begin using this taxonomy as part of its internal review process in conjunction with the release of the new FHA manual, which is scheduled to come out in mid-September. It's also likely that this omission was intended to allow lenders to get familiar with the new taxonomy before taking any further steps toward finalization.
Q: How can lenders use this new taxonomy in conjunction with other classification guidelines to address overall loan defects?
McCall: I see lenders facing some potential struggles with utilizing the new FHA taxonomy in conjunction with their existing taxonomy and Fannie Mae's taxonomy. Lenders may very well need to report their defects utilizing two unique taxonomies based upon the investor agency to which they are reporting.
As an overall QC process, Fannie Mae requires lenders to report QC findings on their entire book of business – not just the loans to be sold to Fannie Mae – which will include FHA loans. Therefore, if you're recording your FHA loans to an overall book of business to Fannie Mae, you're going to need to use Fannie Mae's taxonomy and classification of defects. However, the FHA is only interested in a lender's FHA book of business, so it's possible that lenders could have a dual rating system for every loan defect to provide accurate classification and recording to the investor.
Q: How does this new defect classification system fit into a lender's overall QC program?
McCall: Most lenders are very proficient at the review and identification of defects that are associated with the manufacturing process of a mortgage loan. However, I foresee struggles regarding the associations of these defects with multiple naming convections. Lenders are going to need to review their internal QC systems and figure out how this defect classification process is going to work within their systems or with third-party providers, if they happen to be utilizing a third party for QC. I think most lenders have the appropriate personnel and/or service providers to conduct their audits. It's all going to come back to the ability of the systems they currently utilize to be able to adopt this type of requirement.
Q: What adjustments should lenders make to prepare for the new taxonomy?
McCall: I think the time is right for lenders to take a step back and access their current technology for conducting QC audits. The FHA isn't going to be the last agency to announce a specific taxonomy associated with loan defects, so in the not-too-distant future, it wouldn't surprise me that a lender's QC system is going to need to support four, five, six taxonomies or maybe more. All of those taxonomies will be unique to the agencies that you're reporting your QC findings. The challenge then becomes how to develop a comprehensive mapping scheme to allow for different investors that want basically the same information reported to them using their own terminology. This isn't something that's going to be easily achieved using legacy systems or via spreadsheet.
Lenders will need to seek a QC audit platform that not only allows, but also supports the use of multiple defect codes, categories and severity levels, etc., and then provides standardization for the recording process of this functionality. Furthermore, their system is going to need to provide advanced analytics so that lenders can drill down into their defects not only to classify them properly, but also to identify the root cause of the defect, cure the defect and implement corrective action to prevent further defects from reoccurring.
One solution that can help lenders in this area is the ability to benchmark their QC results against that of the entire industry. This is an effort we've been championing since last year with ACES Analytics, and we think the FHA's new taxonomy is only going to intensify the desire for lenders to access this type of information.