The Federal Housing Administration (FHA) recently finalized in Mortgage Letter 2024-14, dated July 10, 2024, a revision to its Defect Taxonomy to clarify that fraud or material misrepresentation involving a sponsored Third-Party Originator (TPO) is a Tier 1 severity defect in connection with loans insured under the Title II program. Previously, we reported on the proposed clarification, in connection with which FHA provided an entire one week comment period. The clarification made by the Mortgage Letter became effective upon issuance.

FHA’s Defect Taxonomy is set forth in Appendix 8 to HUD Handbook 4000.1. There are four Tiers of defects that FHA may assign to a finding with regard to an FHA insured loan, with Tier 1 being the most severe and being deemed unacceptable and requiring a lender response. The Defect Taxonomy provides that findings of fraud or materially misrepresented information can fall into one of two severity tiers:

• Tier 1 (indicating that the Mortgagee knew or should have known), or
• Tier 4 (indicating that the Mortgagee did not know and could not have known).

The Defect Taxonomy further states that FHA determines if the Mortgagee knew or should have known based on whether:

• An employee of the Mortgagee was involved, and/or
• Red flags in the loan file that should have been questioned by the underwriting Mortgagee.

FHA explains its rationale for the change in the Mortgagee Letter:

“Mortgagees are responsible for the actions of their sponsored TPOs under 24 CFR § 202.8(a)(3) and Handbook 4000.1 Section I.A.5.a.v. To better align the Defect Taxonomy with these existing requirements and mitigate risk to the MMIF, FHA is updating the Defect Taxonomy to include fraud or material misrepresentation involving a sponsored TPO as one of the “knew or should have known” conditions used by FHA to determine whether a Tier 1 severity classification is appropriate.”

With the clarification, the Defect Taxonomy now provides that FHA determines if the Mortgagee knew or should have known based on whether:

• an employee of the Mortgagee or sponsored Third-Party Originator was involved and/or
• red flags in the loan file should have been questioned by the underwriting Mortgagee.

Based on the clarification, FHA will seek life-of-loan indemnification from Mortgagees when there is evidence of fraud or material misrepresentation involving a sponsored TPO, regardless of whether FHA identifies specific red flags that should have been questioned at underwriting.

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