On June 17, 2024, FHA announced in draft Mortgage Letter 2024-12 a proposed 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. Comments on the proposed revision are due June 24, 2024.

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. Currently, 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 proposes to modify the Defect Taxonomy to provide 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.

If the proposed revision is adopted, 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.

Parties seeking to comment on the proposal may do so by completing a Feedback Response Worksheet that is available here. The completed Worksheet may be submitted to a HUD email address, which also is available here.