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Should Lenders Have Zero-Defect-Rate Targets for Loan Production Quality?

By Steve Spies, Fannie Mae

Quality in the loan manufacturing process is critical, and Fannie Mae requires our customers to implement strategies to minimize defects. This has raised some interesting questions: Should lenders have a target of zero eligibility defects in loan production? Is it achievable? And does Fannie Mae expect it?

We always aspire to no eligibility defects, and encourage our lenders to produce defect-free loans, but we do not evaluate lenders by a zero-defect-rate standard.

Lenders Must Set and Manage to Their Own Standards

Fannie Mae requires lenders to set and manage to their own target defect rates to help them originate high-quality loans. The lender also must define at least two severity levels for defects, with the highest level representing breaches of eligibility for loan delivery to Fannie Mae. Lower severity levels may define defects that also should be addressed in the lender’s process, but that do not, in Fannie Mae’s opinion, make the loans ineligible for delivery to Fannie Mae.

Each lender must establish its own set of standards for loan quality that define its credit culture and aid in the development of appropriate controls. We expect lenders to set defect rate targets as low as reasonably possible based on a formal cost-benefit analysis of meeting that target. Then we expect them to demonstrate to us how they are managing loan quality to meet their established target.

Guiding Principles and Key Requirements

Fannie Mae’s updated requirements for lender quality control (QC) (see Announcement SEL-2013-05), which must be implemented by January 2014, require the lender to have an “effective” QC program. An effective program defines the lender’s individualized loan quality standards and establishes processes designed to achieve them throughout the lender’s entire origination book of business, including identifying deficiencies and implementing plans to quickly remediate those deficiencies.

Lenders delivering mortgage loans to Fannie Mae are responsible for understanding and complying with our QC requirements as detailed in the Selling Guide, but a good starting point is to understand Fannie Mae’s guiding principles and some key requirements for lender QC (these are highlights, not an exhaustive list; refer to the Selling Guide for all requirements):

  • Set target defect rate and severity levels. Although long recommended, Fannie Mae’s updated requirements include that each lender must establish target defect rates and severity levels (highest severity level to indicate loans ineligible for delivery to Fannie Mae). These requirements are intended to help lenders mitigate risk – generally, the lower the lender’s eligibility defect rate, the less its repurchase risk exposure will be.
  • Identify and remediate. The lender must have a structure to identify and remediate defects.
  • The buck stops with senior management. The lender’s QC program must include reporting results of QC reviews to senior management, who must ensure that actions are implemented to address and remediate defects discovered in the lender’s review process, if appropriate. The strength of a lender’s corporate governance of QC is one component Fannie Mae evaluates during Mortgage Origination Risk Assessment (MORA) reviews.
  • Staff the QC function appropriately. Lenders must establish minimum requirements for the skill set and expertise of staff performing QC file reviews.
  • Manage vendors. Lenders that elect to use a QC vendor are responsible for appropriate oversight of the vendor’s work. New requirements: The lender must ensure the QC vendor conducts its reviews in accordance with the lender’s QC plan, and must review at least 10% of loans reviewed by vendors; review must be conducted by the lender, not contracted out.

Key Performance Indicators

Lenders’ senior management should be aware of key QC performance indicators for their organization, such as:

  • Target defect rate and why it is what it is. The target rate should reflect the organization’s risk appetite and have full senior management buy-in.
  • Actual defect rate. A gross defect rate is standard; adding a net rate is optional.
  • Defect rate for each severity level. The highest severity level must reflect eligibility violations, which generally mean a potential repurchase.
  • Action/remediation plan with dates and prioritization. What is being done to address defects, what are the planned actions meant to accomplish, and when are results expected to be seen?

Post-delivery Clarity, Certainty, and Transparency 

A lender that focuses on having an effective QC program is on the right road to minimizing serious loan defects, but the real test is whether a lender’s loans delivered to Fannie Mae meet our eligibility requirements.

This year Fannie Mae implemented a new process to review loans soon after we acquire them to attempt to confirm that the loans were originated in accordance with applicable underwriting and eligibility requirements. Fannie Mae will notify lenders when we have identified concerns that might trigger a request for a loan file review or a data change. This approach supports the updated representation and warranty framework, and provides lenders more clarity, certainty, and transparency regarding their obligations after delivering a loan to Fannie Mae.

We also are committed to providing both loan-level and lender-level feedback to help lenders identify and address any potential issues in their business processes. New loan quality reports are being made available to our lenders monthly starting in December 2013 to provide a detailed view into loan defects we identify in the lender’s deliveries to us. By using Fannie Mae-provided feedback in conjunction with an effective QC program and diligent senior management engagement, lenders will be well-positioned to produce high-quality loans with minimal defects and reduced risk exposure.


Steve Spies is Fannie Mae’s Vice President of Loan Quality and Lender Assessment. His role includes developing, implementing, and monitoring loan quality standards, evaluating the quality of loan deliveries, as well as oversight for lender quality control effectiveness. In addition, he leads Fannie Mae’s Mortgage Origination Risk Assessment team (MORA) that conducts operational compliance reviews of a lender’s origination controls. He also leads Fannie Mae’s new Data Validation Center.

Steve is a Certified Mortgage Banker (CMB) and past President of the Fort Worth Mortgage Bankers Association. He is a graduate of the MBA’s School of Mortgage Banking. He holds a JD from SMU’s Dedman School of Law, and an MBA from the University of Texas.

Parts of this article were previously published by Fannie Mae as an FM Commentary.

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