Editor’s note: This is the second of a three-part series.
The first article of this series described an epidemic of late-stage mortgage loan rejections. These rejections are very costly to consumers because they occur after the payment of an appraisal fee, and in some cases after payment of a nonrefundable fee to the lender.
A major factor underlying the increase in late-stage rejections is a decline in the quality of appraisals, which is the subject of this article.
Why appraisal quality has declined: market factors
Part of the decline in appraisal quality has been the result of market factors beyond anyone’s control.
Home-price weakness: During the go-go years before 2007, home prices generally increased. Both appraisers and underwriters implicitly assumed price increases would continue, which imparted an upward bias to appraisals.
The price declines following the financial crisis have flipped attitudes in the opposite direction. Underwriters want some built-in protection against additional price declines, and appraisers tend to err on the downside.
Fewer reliable "comps": A major factor underlying the decline in appraisal quality has been the reduced number of reliable prices for appraisers to consult. Appraisals are largely based on "comps": recent sale prices of comparable houses in the same market area.
As comps become scarcer, appraisers are forced to search for comps at further distances from the subject property, which means that the comps have less relevance. Fewer comps and less relevant comps results in lower-quality appraisals.
In addition, an abnormally large proportion of transactions today consist of foreclosure sales and short sales, often to investors. The prices of these deals are often below true value because of pressures to sell fast. Including such transactions in comps adds to the downward bias in appraisals associated with overall price weakness.
Why appraisal quality has declined: the Home Valuation Code of Conduct (HVCC)
The upward bias in appraisals during the go-go years before the crisis led regulators to issue HVCC. The goal was to insulate the appraisal process from influence by any of the parties with an interest in the outcome — especially lenders. Under HVCC, lenders must obtain appraisals in some manner that prevents them from exercising any influence on the outcome.
The great majority of lenders comply with HVCC by ordering appraisals through appraisal management companies (AMCs), which intermediate between the lender and the appraiser. The AMC selects and pays the appraiser, and passes the appraisal to the lender, who has no direct contact with the appraiser.
HVCC provided an enormous boost to AMCs, and their numbers have proliferated. Based on incomplete lists I have seen, there currently are 150-200 AMCs, perhaps more.
HVCC became effective May 1, 2009, or squarely in the middle of the worst housing market since the 1930s. With house prices declining, the upward bias in appraisals that had prevailed during the bubble had morphed into a downward bias. HVCC aggravates the bias by reducing the quality of appraisals.
Reduced compensation to appraisers: While appraisal fees paid by borrowers are much the same today as they were before the financial crisis, the fees received by appraisers are lower because AMCs first take their cut. When a lender selected the appraiser and the borrower paid a $400 appraisal fee, the appraiser received the $400. With an AMC in the picture, the appraiser might get as little as $200. Reduced compensation reduces appraisal quality.
More travel time: When lenders selected appraisers, they invariably chose locals who knew the market. With AMCs making the selection, appraisers sometimes are sent to more distant areas with which they are unfamiliar. The combination of increased travel time and limited knowledge of the local market further reduces the quality of appraisals.
Mortgage lenders as AMCs: Mortgage lenders are adept at converting regulations designed to curb their influence into a source of profit. Since AMCs were profiting from the business directed to them by lenders, why not get a piece of those profits by partnering with them — or better yet, by establishing their own AMC? All the major mortgage lenders now have their own AMCs, and an increasing number of second-tier lenders have them as well.
A lender can’t be paid by an AMC for the referral of business, because referral fees are illegal. But if the lender owns the firm to which business is referred, in whole or in part, it becomes an "affiliated business relationship" (ABA), and payments to the lender are legal. Because it is costly to establish ABAs that are legally compliant, it makes business sense only for the larger lenders.
I surmise that lenders who own or have a financial interest in AMCs have higher late-stage loan rejection rates than lenders who don’t. A lender who directs all of its appraisals to its own AMC will have lower-quality appraisals. None of the four largest mortgage lenders have responded to my request to interview them on this topic.
Next week: What can be done?
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
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