On January 7, 2025, the Federal Housing Administration (FHA) officially revised its Defect Taxonomy (Final Defect Taxonomy) with the publication of Mortgagee Letter (ML) 2025-01 and the related attachment detailing those changes. The changes are effective as of January 15, 2025, and will be implemented in Appendix 8.0 of FHA Handbook 4000.1 at a later date.
FHA first proposed revising the Defect Taxonomy on October 28, 2021, with the publication of FHA INFO 2021-92. Since then, FHA announced a new proposed version of the Defect Taxonomy with the publication of FHA INFO 2024-25 on July 10, 2024 (Proposed Defect Taxonomy). As we reported at the time, the proposed revisions to the Defect Taxonomy were broad and, most notably, created a new section specific to loan servicing defects. The Proposed Defect Taxonomy did not suggest revisions to the Underwriting Loan Review section of the Defect Taxonomy, but it did propose revisions to the generally applicable introduction of the Defect Taxonomy, as well as the creation of an entirely new Servicing Loan Review section. The Final Defect Taxonomy generally aligns with the Proposed Defect Taxonomy from July 10, 2024. However, based on its own internal review and/or industry feedback, FHA has made some notable revisions to the Final Defect Taxonomy that will likely impact how the U.S. Department of Housing and Urban Development (HUD) applies it in practice.
Examples/Explanation of What Constitutes a Tier 2 or Tier 3 Finding
The Defect Taxonomy has general definitions of what constitutes either a Tier 1 or Tier 4 defect. Both relate to Findings of fraud or materially misrepresented information, but a Tier 1 defect is a Finding that the “Mortgagee knew or should have known” about and a Tier 4 defect is a Finding that the “Mortgagee did not know and could not have known” about. Unlike the clearly stated definition of a Tier 1 or Tier 4 defect, the Defect Taxonomy uses specific examples of Mortgagee conduct to define a Tier 2 or Tier 3 defect as something that falls between a Tier 1 or Tier 4 defect. These examples are included in multiple parts of the Defect Taxonomy, including the introduction, the Underwriting Loan Review section, and the Servicing Loan Review section. The recent revisions only impact the introduction and Servicing Loan Review sections.
The edits to the introduction section of the Final Defect Taxonomy are generally clarifying edits. However, FHA made a more substantive change to the examples given in defining a Tier 3 defect. Specifically, the Final Defect Taxonomy now states that a Tier 3 defect includes a Finding “of noncompliance remedied by the Mortgagee prior to review by the FHA.” This example is not included in the Proposed Defect Taxonomy. The addition is helpful in drawing a line between a Tier 3 and Tier 2 defect, because the Final Defect Taxonomy defines a Tier 2 servicing defect as a Finding that requires “mitigating documentation, corrective servicing action, and/or financial remediation.” As a result, it appears FHA recognizes that a self-mitigated defect merits a lower tier rating for purposes of the Defect Taxonomy.
For the Servicing Loan Review section, FHA made numerous revisions to the examples provided for what constitutes a Tier 2 or Tier 3 defect under each specific defect area. The revisions generally reflect a more specific or clear example of a Tier 2 or Tier 3 defect, so these revisions do not present a significant departure from the Proposed Default Taxonomy. However, it would be beneficial for all servicers or impacted parties to review the new examples of Tier 2 and Tier 3 defects under the Final Defect Taxonomy.
Remedies for Tier 2 Findings
Like the revisions to the examples of a Tier 2 or Tier 3 defect, the Final Defect Taxonomy outlines different potential remedies for a Tier 2 defect compared to the remedies outlined in the Proposed Defect Taxonomy. Some of these revisions may be impactful for Mortgagees. For example, in the context of a Loss Mitigation Processing defect, the Proposed Defect Taxonomy stated that FHA would accept a one-year or five-year indemnification if the borrower did not accept the terms of the appropriate loss mitigation option. But now, the Final Defect Taxonomy states that “FHA will accept indemnification (1-Year or 5-Year) only when the Servicer provides documentation of a good faith effort to complete” the loss mitigation option. Similar revisions were incorporated in the context of Home Disposition defects and Home Retention defects. It is unclear what constitutes “a good faith effort,” but at the very least, this revision will potentially impose a new reporting obligation on impacted servicers.
Rebuttal of a Finding or Severity Determination
The introduction section of both the Final and Proposed Defect Taxonomies state that a Mortgagee may provide supporting documentation through the Loan Review System (LRS) to rebut any Finding or severity determination under the Defect Taxonomy. However, the Final Defect Taxonomy also specifies that “Rebuttals are based on information available to FHA prior to the initial Finding.” This seemingly small addition appears to meaningfully limit the scope of the information a Mortgagee can use to rebut HUD’s determinations pursuant to the Defect Taxonomy. As a result, this limitation on the rebuttal process could be a future cause of Mortgagee concern.
Takeaways
Going forward, Mortgagees and other impacted parties likely should review the Final Defect Taxonomy to develop a better idea of what FHA and HUD view as a Tier 1, Tier 2, Tier 3, or Tier 4 defect. It would also likely be beneficial for Mortgagees to implement this information in their policies and procedures, such as internal audit and quality control, to try to preempt potential origination or servicing defects. Other factors to consider include: (1) identifying defects that could be self-mitigated and therefore characterized as a Tier 3 defect; (2) documenting good faith efforts to complete loss mitigation; and (3) reviewing the information submitted in the LRS to ensure that it is detailed enough to support a potential rebuttal to a Finding or severity determination pursuant to the Defect Taxonomy.
The impact of the Final Defect Taxonomy will become clearer as HUD interprets and implements it in the near future.