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The Appraisal: One Source of Our Economic Woes

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Out of all the cacophony caused by the current meltdown of this country's financial industry, one of the sources in the grass roots mechanics of how all this housing mess came about has been largely ignored: The appraisal.

In the past, until a few years ago, FHA maintained a list of approved appraisers who were given assignments by FHA, not the lender. While there is no sure thing, this system made it more likely that the appraiser would be impartial, that she or he would be an advocate for the property – not the lender, the buyer or seller, or even the realtor, if one was a participant. This system allowed the appraiser to maintain an arm's length relationship with others involved in the transaction.

Under pressure from the banking/lending industry, plus the efforts in Washington to downsize government, FHA abandoned that system in favor of allowing each lender to choose its own appraiser. While HUD still requires that those performing appraisals for FHA-insured mortgage loans be approved via application and testing, the arm's length situation that formerly prevailed is no more.

Also, until a few years ago many banks and other mortgage lenders employed one or more staff appraisers, who valued properties being secured by that institution for conventional or insured conventional loans. A few lenders still maintain appraisers on staff, but the obvious appearance of a possible conflict of interest finally made the maintenance of them untenable for most lenders.  On the surface, this seemed  to be a good thing – not for staff appraisers of course, but for the lending industry as a whole – in that it would promulgate that arm's length relationship.

That, however, has not been the case. Pretty much across the board, lenders maintain a list of approved appraisers who are not employees, but who are, in effect, fee paid contractors. The same pressures remain; in order to remain on that approved list, each appraiser must play ball, as it were.

Of course, it has become more complicated than that. Three major factors have developed over the past 15 to 20 years:

First, the advent of so called "mortgage brokers." By and large, over time, these people became the real bottom feeders. Most of their clientele were people who could not obtain approval from any of the more mainstream lenders. If purchasing a home, many of these wannabe mortgagors came into the game often with little cash, questionable income, spotty employment records and weak credit scores. If refinancing existing loans, many brought to the table some or all of the above, plus the added problem of attempting to borrow against a property having little or no equity. More often than not, these were the people on behalf of whom mortgage brokers were attempting to obtain approval. Note that a mortgage broker makes nothing unless the loan is closed.

Herein lay the problem for the appraiser. Especially with refinances and home equity type loans, the pressure came loud and clear from brokers that a certain figure must be met in the appraisal for the deal to work. Failure to comply meant that the broker would simply make a phone call or two until he or she found an appraiser who would get the value up where it needed to be.

Second: The advent of computer generated Automated Valuation Models, or AVMs.

AVMs are created via large data bases maintained by companies which gather real estate sales data, much like locally maintained multiple listing services (MLS), but on a regional or national level. These AVMs use this accumulated data to determine the value of individual properties via computer generated models. Many lenders have adopted their use in lieu of standard appraisals. In some instances, an AVM valuation may be backed up by a so called "desk top" or "drive by" appraisal performed by either appraisers or real estate brokers. Neither the desk top nor the drive by report involves an actual "feet on the ground inspection of the property.

AVMs tend to work best where there is an ample amount of data – say for a 1200 square foot, three bedroom, two bath, brick veneer ranch home built on a crawl with a 2 car attached garage located in a subdivision of hundreds of other 1200 square foot, three bedroom, 2 bath, brick ranches having large numbers of recent sales. However, their dependability wanes dramatically in areas where there is less homogeneity. Also, the data compiled by these AVMs is often spotty at best; and at times, wholly inaccurate – far less complete and accurate than data typically found in traditional MLS data systems.

The appraisal has long been considered by lenders, realtors, and even sellers and buyers, as a fly in the ointment. An appraisal that fails to meet the sales price or whatever the minimum value estimate necessary to attain the prescribed loan-to-value ratio is, will kill the deal. Lenders have done everything possible to remove the appraisal – and consequently the appraiser – from the equation. The excuse usually raised is the cost factor. This argument is bogus in that the cost of the average appraisal in today's market is somewhere between $275 and $350, or so. (The cost for larger, more complex properties may be higher, but such properties are generally outside the norm.) That cost  pales when measured against the average total costs of closing a mortgage loan. The real reason is control. The lender generally has less control over an independent appraiser. A bad or low appraisal, as noted, will either kill a deal outright, or at best, cause a delay while another appraisal is sought, in the hope that the first appraiser, perhaps with a little nudging, will "see the light."

The marriage between computer geeks and the lending industry has brought about the development and use of AVMs in the effort to obviate the need for on-the-ground appraisals. However, as noted, these models are often based on inaccurate data. It is also much easier for anyone generating these reports to selectively piece together data which supports whatever value the lender is seeking, owing to less oversight. Keep in mind that in these instances, no one ever so much as lays eyes on the property in question. By comparison, a full blown Fannie Mae appraisal is a fairly detailed and painstakingly developed report, often consisting of 20 to 30 pages (sometimes more), which must meet a number of specific guidelines set forth by Fannie or Freddie and/or HUD and/or the VA. Detailed explanations must be included in the event any aspect of the report does not follow the aforementioned guidelines.

Third: The emergence of appraisal management companies (AMCs). These are generally regional or national companies which act as a sort of clearing house or middle man for lenders to obtain appraisals and in some instances various aspects of loan processing, including credit checks, verification of borrower information, title work/insurance and even closings. In their middleman capacity, AMCs take requests for these services and then assign them to appraisers, title companies, etc., who have applied to and been approved by the AMCs.

As little as most appraisers like it – because this necessitates fee sharing – this arrangement does once again create an arm's length situation between the lender and the appraiser. At this juncture, I am not sure just what percentage of current residential mortgage appraisals are being handled through AMCs, but the number has been steadily rising over the past two decades or so.

As with the S&L debacle in the early 90s, there are certainly some appraisers who have been culpable in creating the current financial mess by succumbing to pressures and inflating values. On paper a skilled appraiser can make pretty much any property appear to be worth whatever figure a lender or broker stipulates.

In defense of appraisers though, it is  a tough, competitive industry for them, just like most everything else. An appraiser's livelihood usually depends wholly on the favor of loan originators or loan processors, AMCs and, yes, mortgage brokers. Their loyalty to appraisers only goes as deep as the success of recent loans. "What have you done for us lately?" Happily, most appraisers operate above those pressures, but it is precarious at best. Appraisers have to eat like everybody else.

While I certainly don't contend that what is happening in Washington even as I type, is solely or even primarily due to bad appraisals, bad appraisers, or even to the evil mortgage brokers and AVMs, nevertheless, they are and have been players in all this. A return to more traditional lending and valuation procedures could go a long way toward a more equitable and transparent lending process.

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About Baritone

  • Doug Hunter

    The article is spot on. What I still fail to understand is what made the big banks actually front the money for this garbage (and in turn the ultimate investor/fund). Did they think they could ditch the trash skimming a fee off the top and walk away scott free? What about the final owner, what made them buy up these obviously unstable mortgages?

    As am amateur investor I could see these things were being overvalued and overleveraged years before this ‘crisis’, smaller banks that lend their own money wouldn’t touch these buyers or these properties at the prices being paid. I remember several conversation with bank officers over the last few years discussing who was footing the bill for these foreclosures and overleveraged properties (i knew it was the government/HUD taking the hit on many of them but had no idea private money was being spent so stupidly).

    If amateur investors and small banks could figure it out there’s no question the big guys and institutional investors knew exactly what was going on. I have no doubt what will happen though, they’ll simply claim ignorance and incompetence, collect their fat bailout, and ride off into the sunset secure in their golden parachutes.

  • http://www.indyboomer46.blogspot.com Baritone

    Doug,

    I believe that deregulation played a role. It opened up the markets to a broader spectrum of lenders increasing competition to a fever pitch. For whatever reason, lenders of all stripes have been falling all over themselves to make these loans. There doesn’t seem to be much logic involved. Dave Nalle has claimed that lenders were pressured to make mortgage loans available to a broader spectrum of the populace, necessitating the lowering of the bar regarding qualifications. That may be, but I find it difficult to believe that anyone, including any arm of the federal government could successfully muscle the banking industry into doing anything they didn’t want to do.

    Also, there are a great deal fewer “local” lending institutions any longer. Local and regional banks, S&Ls and mortgage companies are pretty much a thing of the past. The small lenders have either been absorbed by bigger entities or just disappeared altogether, unable to compete with the big boys.

    Indianapolis used to have 3 major banks and a handful of smaller lending institutions all locally owned and managed. Now there are none. Indy now has 2 major banks – Chase and National City, plus a plethora of relatively smaller players – Fifth/Third, Regions, Citizens, etc., none of which are locally managed or owned.

    Most of these institutions handle their loan processing at some central location other than here in Indy. Often, no one local has any direct contact with borrowers – the entire transaction is handled either by phone and/or over the internet.

    As I noted in the article, the elimination of full appraisals requiring complete interior and exterior inspections is just one aspect that brought us to this pass. “No doc” loans became the basic tool of sub-prime lending requiring little or no verification of a borrower’s employment, income, cash on hand, etc. In many cases loan originators and mortgage brokers encouraged borrowers to “make the figures work” on paper thereby emboldening them to inflate income figures and over-state their employment records, etc. with at least some reassurance that no one would verify or challenge them. All too often that proved to be the case.

    B

  • chuck lyons

    I am still amazed that the majority of the problems with this financial debacle are still attributed to the poor soul who had ‘spotty credit’, and so on.
    In reality, the mortage problem is just a part of the problem. Low cost credit cards, commerical properties all contribute.
    Its too easy to berate some poor schmuck who tired to do better for themselves by buying a house that was sure to go up.
    Its really the same philosophy as buying stock on options; 401k to prepare for retirement, etc. You plan for it to go up. And then it doesnt, and then you retire to poverty..
    Lets worry more about the Steel company who reneges on your pension, the finance company that goes belly up, the CEO that walks away with big bucks, and the homeowner decides to gamble in hopes of being able to provide for them selves.
    Sorry, ain’t buyin’ it here….

  • Pablo

    Your comment Chuck:

    “I am still amazed that the majority of the problems with this financial debacle are still attributed to the poor soul who had ‘spotty credit’, and so on.”

    Kinda reminds me of how the Bush administration claimed that those that were doing the torturing at Abu Gharab were simply misguided youth, as opposed to what was really going on, orders from the top!

  • http://www.OurAppraisal.com Brian J. Davis

    Terry – I went looking for a way to contact you directly and couldn’t find an email link… so I’m doing so here.

    Excellent article – fair and balanced.

    I’m the owner of a real estate appraisers blog and would like to get your permission to re-print your article there with full credit to you.

    You can find my contact information there or at my URL.

    THANKS

    Brian J. Davis

  • http://www.associatedcontent.com/user/39420/joanne_huspek.html Joanne Huspek

    I’ve known this for at least six years, when the bank during a refinance claimed that our house was worth $100K more than we thought it was. We were right. When we sold it, it was exactly $100K less than we originally listed it for.

    Another example: last October, we bought a commercial business in Detroit. As collateral, we put up our commercial property in Royal Oak. At the time, the bank (who of course wanted the deal to go through) came up with an appraisal on the Royal Oak building that far exceeded the loan amount ($600K). It was such a ridiculous appraisal, we were literally laughing out loud during the closing.

    Last spring, my husband had a listing agent come through, and he told us we could MAYBE get $200K, which is what I thought the place was worth.

    While the banks and appraisers have a hand in inflating property value, a savvy, level-headed homeowner should know better. Take the stars (and dollar signs) out of your eyes!

  • http://www.indyboomer46.blogspot.com Baritone

    Brian,

    I will get back to you a bit later today. I actually have an appraisal to do, believe it or not.

    Chuck and Pablo,

    I will also respond to you guys as well this PM.
    I happen to agree with you on the issue of placing the blame on the shoulders of the borrowers.

    B

  • http://www.indyboomer46.blogspot.com Baritone

    Chuck and Pablo,

    I know it seems that I was laying blame on homeowners above but that was not my intent. I think that there is certainly culpability amongst some of the sub-prime borrowers, but there is certainly plenty of blame to be spread around to pretty much all involved.

    Greed is one of the recurring factors cited. For most of the homeowners caught up in this mess, I don’t feel that greed was at issue. These people simply wanted to own a home – the so called “American Dream.” That many were gullible and naive is troubling, but that doesn’t make them greedy. Clav and others have stated that these people should have sought council from an attorney, or someone with adequate expertise to explain the details regarding the procedure and the meaning of all the fine print. The fact is that damn few people do that.

    For people who are scraping together the earnest money deposit, the down payment (if any,) and the closing costs, spending even a few hundred dollars for legal advice is probably too much of a stretch.

    Most borrowers tend to depend on realtors and others they encounter in the lending process to be honest and to properly explain things to them. Again, that my be naive, but most believe that is in particular the job of the realtor. However, unless a purchaser specifically hires a realtor to act as their representative, the realtor’s first fiduciary obligation is normally to the seller – the person who contracted with the realtor to market their property.

    There is obviously a lot more to be said on this issue. Predatory brokers and lenders prey upon eager but uninformed wanna be homeowners. It’s the American way.

    B

  • bliffle

    Good article, Baritone.

    Individual buyers and sellers are largely captives of the systems that write the contracts and offers that are presented to individuals. And they are also captives of the intricate fee systems that build up all the commissions.

    In the end, homeowners are trying to improve their lives and the lives of their families, and this honest desire is warped into something dreadful by people who are simply better organized and have more power.

  • Baronius

    Informative and well-written. Great work, Baritone.

  • http://www.indyboomer46.blogspot.com Baritone

    Thanks Blif & Bar.

    B

  • bliffle

    It’s wrong to think that all the mortgage defaulters are lost souls. Last night I talked with two friends (while repairing their !@@$##% Vista systems!) They’re both defaulting on loans for the simple reason that it’s a better investment strategy. I.e., with the property $50k below loan amount, and negative cash flow of $2000/mo., if it takes 5 years to recover that will be a further investment of about $120k! It’s not worth it. By getting out they can sit on the sidelines with cash (that they took out when they refied to a big loan on an over-appraised property) and wait for something to develop.

    “What about their credit rating?” you may protest. They don’t care because they customarily buy property with 20-25% down which obviates credit checks and income verification.

    Only upward-struggling schmucks need care about credit ratings.

    So the elaborate rationale people have constructed about low-class characters over-buying to speculate is not a good model.

    In this investment environment ANYONE may find it advantageous to forfeit.

  • Clavos

    You’re right, Bliffle, and thousands are doing just that.

    An elderly cousin of mine died a few months ago, leaving a house which he had purchased about a year before. His kids (who are his heirs), looked into the status of his loan and discovered he was upside down in it, so they simply walked away. In their case, they didn’t even damage their credit ratings; it wasn’t their loan.

    A LOT of defaulters here in Florida were condo flippers, NOT poor schmucks. No sympathy for them.

    The pols, of course, are playing it for all it’s worth, implying every foreclosure belonged to an elderly couple on SS.

  • http://www.indyboomer46.blogspot.com Baritone

    Blif,

    “What about their credit rating?” you may protest. They don’t care because they customarily buy property with 20-25% down which obviates credit checks and income verification.”

    That scenario seems dubious to me. Paying 20-25% down is simply that necessary to obtain a normal conventional (non-insured) mortgage. While I haven’t been involved in home sales for several years, I was not aware that a 20% down payment would render credit checks and the rest unnecessary. If that is the case, that is a big reason why lenders are in serious trouble.

    That would mean that someone purchasing a home for say $500000. and putting $100000 down would obtain a $400000 loan with no credit check, employment or income verification? I don’t know. That sounds hinky.

    Otherwise, I understand what both you and Clav are saying. However, I doubt that most of the people who are facing the loss of their homes had any such thing in mind at the outset. As you indicate, though, this has obviously occured to some, and it actually makes financial sense, and you can’t really blame people for that. They are simply looking out for their best interests.

    But that never occured to many people, or for any number of reasons they could not take such a step. It’s just unfair to stamp these people as being greedy or low lifes. There are about as many scenarios as there are people who have or are likely to lose their homes.

    To lay heavy blame on borrowers tends to relieve predatory lenders of their share of responsibility.

    B

  • Cannonshop

    The pols, of course, are playing it for all it’s worth, implying every foreclosure belonged to an elderly couple on SS.

    Yup, because the Boomers are hitting that age-bracket, but the really screwed ones are mostly from the last two generations of poorly-educated kids just starting out, who have grown up in a Credit Economy watching their parents live beyond their means and thinking ’tis normal.

  • bliffle

    Baritone,

    I think you live in Indiana, a bucolic state which has not yet been blessed by the hysterical advantages of California and Florida, like Clavos and me.

    I can assure you that a 20% down would buy you any middle-class or upper-middle house around here without income or credit check. My wife bought her house that way in 1999, with no credit rating and a down brought from Europe and a miserable little income in the school system. I don’t even think she was a US citizen yet at that point. I myself bought 3 such houses the same way. On two of those I turned around and borrowed half the down back on a second with no checks. I did that because I was worried about The Collapse and wanted to shift my liability to others.

    Cash is king.

    In California we have had a peculiar situation WRT landlords and renters: landlords have MOSTLY been renting houses out at a loss, negative cash flow every month, looking forward to picking up the equity appreciation upon eventual sale, or refi. But that’s finished, now. Now some renters find that their landlord has walked away from a property leaving the tenant stranded.

    I’m very distrustful of pundits and politicians who claim that subprime loans and over-ambitious borrowers are at the root of this problem. It’s not what I see, and doesn’t fit what I see here. We didn’t see 2 million foreclosures because of bad loans. There’s a systemic problem, and I think it’s the crash of the many-years stoking of house prices, and I think that’s the result of mistaken Fed policies attempting to control inflation.

  • http://www.indyboomer46.blogspot.com Baritone

    Blif,

    Then again, I’d say that is a source of the problem. The bar for so called “no doc” loans kept getting lowered until about anyone with a pulse could by a home – often a very nice home – borrowing most or all of the sales price (sometimes even up to 125% of the value) with little or no documentation. That is a far different world than the one I came into as a realtor and later an appraiser back in the early 1980s.

    Back then, you couldn’t buy a yoyo without a solid work history, good credit and money in the bank. Seems like a viable system to me. But what do I know?

    I agree that there are many causes to the economic cluster fuck we now find ourselves in. At the root of it, though, was and is the relaxing of qualifications, little or no attempts at data verification and predatory lending practices across the board. Lowered interest rates, among other factors, just exacerbated the problem.

    The house of cards created by making large numbers of adjustable rate loans starting out, say at 3.5% but subsequently escalating to perhaps 6% or 8% or more in a few short years, were made with the expectation that home values would continue to inflate and that borrower income would increase in kind. That was essentially the bill of goods.

    The initial low payments wrongly made it seem to borrowers that they could afford more home than they had initially believed. But in many instances, incomes did not rise, at least not at the rate necessary to cover the ballooning mortgage payments. Problems in other areas of the economy caused large numbers of job losses. The relative trickle of foreclosures swiftly became a torrent further causing values to at first flatten and eventually to take a dive.

    Meanwhile, various lenders and investment groups around the world were cajoled by the likes of Fannie and Freddie to buy big chunks of what was soon to become bad paper. That this practice continued even after it was apparent that these loan packages were likely not a viable investment places the onus on the mucky mucks at Fannie and Freddie and other investment arms for what may well have amounted to fraud or something damn close to it.

    B

  • http://www.indyboomer46.blogspot.com Baritone

    er… buy a home

    B

  • bliffle

    As long as I can remember, the advice to home buyers has been “buy the most home you can qualify for”.

    I remember 1965 when I was a humble engineer at IBM, struggling to qualify for a $25k house in Menlo Park on my $10k salary (when 2.5 was the MAX purchase allowed by banks, and 2.0 was better, but there were no 20k houses!) I was astounded to discover that the guy who drove the “Roach Coach”, i.e., the converted truck bearing hot tortillas that rolled into the parking lot every day around noon playing “La Cucaracha”, was paying for a $40k house! I was floored! But he explained: no IBM pension plan, he had parlayed progressively bigger houses into a house that would provide for a pleasant retirement on the beach in Manzanilla.

    It’s The American Way!

    It’s the American Dream!

    It’s always worked before!

    But “the market discounts everything” as investors say. So the market started inching up the buy ratio, until now an engineer at IBM making 100k cannot find a 250k house, let alone 200k, so he puts together a deal to buy a 700k house (at a 7.0 ratio!) however he has to, even borrowing 70k from his employer as a signing sweetener. Sorry, he can’t buy my old house in Menlo Park because it was at 1.2m the last time I drove by it, 12 times his income.

    This bubble was bound to burst at some point, and so it has.

    But how did it come about?

    Two reasons: in 1974 the FHA changed their qualification policy to include BOTH salaries in a 2 income family instead of just the largest salary. This resulted in a quick escalation of prices. It also increased the risk of home purchase to a family.

    Second, the Federal Reserve took as it’s holy task to control inflation. Thus the federal government was excused from loathsome tasks like balancing the budget, because the Fed would trick around with interest rates and bookkeeping stunts to make it all look good. As long as the economy kept growing. This was enabled by Nixon taking us off the Gold standard (which would have been a good thing if we had elected responsible leaders, but noooooo).

    It was a huge Ponzi scheme: subsequent buyers would be even MORE foolish and pay even higher prices. So everyone thought.

    But you couldn’t do as your sense said and stand aside. As Canada Bill Jones said famously to George de Vol (cf, “Twenty Years a Gambler on the Mississippi”, de Vols autobiography) while de Vol was dragging him out of a brace card game in Kansas City: “But It’s the only game in town!”

    And so it was. The only game in town. The buyer had to figure out how to beat the system, not how to reform it’s morals.

    So that’s how we got where we are. Any questions, class?

  • Cannonshop

    The solution Washington ignored When they started “Reforming” the housing market to create affordable housing.

  • bliffle

    Quite a different take from the usual “bash the stupid greedy homebuyers” routine was offered by, of all people, Ira Glass of “This American Life”. He actually talked to people involved from top to bottom, interviewed them and put together about a 15 minute audio report. It played today on NPR and you can find it someplace on the TAL website.

    It goes something like this:

    -in 2000 the IMF measured the entire savings of the world at about $36trillion. By 2006 that had grown to $70trillion because of all the 3rd world countries accumulating money as new manufacturing centers.

    -these new mfg countries had to find ways to invest the savings. China had huge warehouses full of smart people investigating foreign investments and figuring out how to make good returns.

    -they started buying smalltime USA Home Loan Aggregations because they could get 5-6% instead of 1%. Some of these were aggregated by small stripmall Loan Brokers acting as aggregators.

    -these loan aggregations were very good, high return and low risk. So the demand from these (largely) foreign investors drove the market for ‘securitized’ USA home loans. Growth went crazy.

    -then the loan brokers discovered they could take shortcuts qualifying applicants. And, of course, they had to recruit salesmen, etc., from bars, etc.

    -some of the shortcuts were astonishing. They’d tell a buyer to say on his application that he was a “Computer Engineer”, for example and his income was 100k. They wouldn’t check his employment, they’d just have a CPA state that 100k was right for a “Computer Engineer”. PRESTO!

    -many other scams.

    -they even floated loans to dead people.

    The interesting thing is that the market was driven by demand, i.e., investors who had a desperate need to invest money in something.

    This coheres with my experience, since I was active in the loan market at the time, and I was constantly getting calls from “Loan Brokers” trying to talk me into these crazy things. Some were almost demanding that I take their loans. They cut points and commissions down to nothing.

    So it wasn’t those irresponsible peasants trying to greedily buy houses they couldn’t afford. In fact, that argument never made sense because how could they force loan brokers to offer them such loans?

    You can learn a lot from NPR. You remember radio, don’t you? It’s TV for grownups.

  • http://biggesttent.blogspot.com/ Silas Kain

    This article is right on the mark. I hope the next Administration will have the fortitude to perform an in depth investigation into this whole mess and start mass prosecutions. Enough is enough. We’ve been held at bay by a handful of Wall Street fat cats who bought and paid for the members of Congress. For two years I have been trying to get people to wake up and realize that nothing in Washington will change until the lobbyists are either thrown out of Washington or sentenced to hard labor cleaning toilets in Harlem. Folks, don’t put your faith in Barack Obama or John McCain. They’re stuck in the quagmire until we send a clear message to the Rotunda that business as usual is off the table. Every member of Congress who is running for reelection and has received money from Wall Street, Fannie Mae or Freddie Mac should be thrown out of office, period. Until we accomplish this mission, nothing will change.

  • Lisa Solod Warren

    I do, indeed. I lisen to NPR all the time.

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