To say that our mortgage system is unique would be an understatement. The American Dream of home ownership has become a reality for more people than anywhere on the globe. Lending money based on the securitization of loans backed by real estate has been the rock on which this phenomenon has been built.
Fundamental to this system is the fair, objective and unbiased valuation of the real estate that secures these loans and provides the confidence Americans have in the value of their home. For this reason, the industry has created and depended upon a profession that has been central to our mortgage economy – the independent fee appraiser.
This profession is wholly based on its separation from all others within the mortgage system. It cannot be tainted by self-interest or the desire of others to profit from a mortgage transaction. It is the cornerstone upon which the value of real estate is dependent. In fact, one of the key features of the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA), of 1989, was to make certain that trained and certified licensed professionals completed the valuation process.
Ever since FIRREA, legislators, bank regulators and consumers groups alike have weighed in on the issue of ensuring sound residential real estate valuations. On Oct. 27, 2003, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corp., the Office of Thrift Supervision, and the National Credit Union Administration, issued a Joint Statement that requires the separation between loan production, appraisal ordering, and the appraisal review function. Like FIRREA an important element of the guidelines are independent appraisals that support the value of the collateral and not just paper the file.
The reason for this independence is obvious; everyone, except the appraiser and borrower, benefits monetarily in fees and performance bonuses from a higher-priced home. As it is not uncommon today for a lender to be on both sides of the equation, making the loan and picking the appraiser, the federal regulations seek to separate the appraisers’ work from other aspects of the transaction. That is the idea, anyway, but not always the practice. In practice there are lenders that hire staff appraisers who are picked by and report to the lender’s loan officers. Certain lenders and title companies own or are part owners in appraisal companies. There are agents and brokers that refer appraisers to lenders who are referred to borrowers by the same agents and brokers. This is all perfectly legal under the Real Estate Settlement and Procedures Act, but flies in the face of FIRREA and gets in the way of independence.
In May 2005, following the Joint Statement, the regulators again issued guidelines, warning that financial institutions “may not fully be recognizing the risk inherent in their aggressive lending standards.” In June, on the heels of this “shot over the bow,” The National Community Reinvestment Coalition, a nationally recognized consumer group, released a report entitled “Predatory Appraisals: Stealing the American Dream.” As they determined in their study, “problematic appraisal practices exist as a serious impediment to responsible lending, impede fair housing and equal access to credit, and place the American Dream of home ownership and the safety and soundness of the mortgage marketplace at risk.”
Today, no one can accurately assess how many homes are overvalued in the U.S. housing market and for how much. There are those who argue that there is no such thing as appraisal inflation and therefore, no problem exists; if a buyer is willing to pay an asking price, then the price isn’t inflated. True enough. But when appraisal inflation becomes systemic to the loan process and when almost half of appraisers say they are pressured to inflate appraisals by others involved in the loan closing, then maybe it is time to change the way appraisals are ordered.
The increased use of creative mortgage products and slowly rising interest rates, combined with predictions of falling prices in the hot real estate markets, concerns Julie Williams, acting controller of the Currency. In a speech given in March 2005, Williams raised price declines as part of her warning about the growing credit risks stemming from aggressive retail lending. She said, in an article titled “Amid the Housing-Bubble Din, Something Different?” published in American Banker April 12, 2005, that some of the increasingly popular hybrid mortgage products “are often predicated on continued healthy price appreciation for residential properties. No one knows how these loans will perform if housing prices stabilize or fall or, worst yet, if the value of homes fall below what the borrower owes.”
As interest rates rise no one knows how many Americans will be strapped with too much debt and forced into default…no one knows the magnitude of the damage overvalued homes will have on the U.S. economy.
This is a time of transition for the mortgage marketplace. Economists agree that although there is no nationwide housing bubble there are “regionalized bubbles” where housing prices seem to have risen to unsustainable levels and price declines have been predicted over the next two years. The mismatch between income gains and higher real estate values in some cities is particularly striking. How can someone earning $70,000 a year afford a $500,000 home, they can’t over the long run.
Regulators have taken steps in the past several months that could exert strong influence on lenders and all vendors providing services to lenders. Due to the volume challenges of the past two-three years, for some time now lower price and fast turn time have been favored over accuracy concerns. It remains to be seen if the real estate market changes and increased delinquencies put lenders in a more cautious posture. The ascendancy of credit risk over production in overall lending management may actually be on the near horizon, where it should have been all along.
I applaud The National Community Reinvestment Coalitions recently released report, their veracity on the subject of predatory lending and for asking the hard questions. This issue is systemic industry-wide, as the entire process from the regulators to the lenders to the third-party interactions of the loan officers and the Realtors/builders is broken. It certainly will take a collaborative effort from the entire industry to unravel the pyramid of bad practices that have occurred over the past 10 years.
William C. Apgar is the former Federal Housing Administration Commissioner. He currently is senior scholar at Harvard University’s Joint Center for Housing Studies and lecturer in public policy at Harvard’s Kennedy School of Government.
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