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Good News on the Housing Front

March 3, 2008 – 8:43 pm

Fan and Fred reached a deal with the NY Attorney General to stop purchasing loans that don’t meet new standards for independent appraisals.

This is huge on a number of levels, not least of which is that it will help with price discovery in the current market. Home values are very much in doubt. Homeowners are in denial about their homes’ “worth.” According to a CNBC study released today, only 17% of homeowners believe their house will decline in value this year. Buyers know better. They’ll just wait until sellers acknowledge the obvious and start cutting asking prices.

To the extent that market participants may finally get accurate appraisals about house values, they may begin to return to the markets to buy and sell. A similar problem is happening in various credit markets, where values are in question causing markets to break down.

Better appraisals will by no means rescue the housing market, but they represent an important step in the right direction.

What’s the problem that needs solving. A good article from bankrate on the subject can be found here. But a quick example tells much of the tale:

Say a borrower owes $70,000 on a first mortgage and wants to take out a second one for $30,000 to consolidate debt. If the lender won’t lend at more than 95 percent loan-to-value and the property appraisal comes back at $100,000, the borrower is out of luck. The same holds true for the loan officer, who gets paid a commission based on the number of loans closed in a given time period.

But if the home value can be coaxed up to $105,300, the problem goes away. Originators know this, so some will try to talk appraisers into modifying their estimates. Experts say that isn’t too tough because those estimates rely to some degree on an appraiser’s subjective evaluation of property and market conditions.

If it’s the originator that pays the appraiser for appraisals, well then folks, you see how the whole process might get called into question. Despite the obvious conflicts of interest, the problem is “laughably” common. According to a recent Bloomberg article:

About three quarters of residential mortgage appraisals are arranged through brokers who only get paid if a loan closes, Miller said today in a phone interview. He called the practice “laughable” because it creates a financial incentive for mortgage brokers to push appraisers toward higher valuations. Higher appraisals also mean more homeowners qualify to refinance their homes and take cash out, he said.

The Bankrate article goes on to explain quite clearly how this crooked appraisal apparatus contributed to house price inflation:

“It starts with the originator trying to make the deal happen,” says Sandy Nickol, a regional president with Republic Bancorp Inc.’s mortgage company in Farmington Hills, Mich. “Sometimes you can’t close the deal unless you can get the customer a mortgage of ‘X.’ If they’re trying to pull cash out to pay off three credit cards and it doesn’t make sense to refinance today unless they can do that, the whole deal is going to hinge on an appraisal that’s high enough to do that.”
At first glance, the process might look harmless. After all, it helps borrowers get the loans they want. But in reality, overinflated appraisals trap consumers with too much debt and lock them out of the refinance market. They can also force people into default.

Say our sample borrower lost a job and needed to sell the property to move somewhere cheaper. Buyers aren’t likely to pay much more than the property’s actual $100,000 worth, even if some random appraisal pegs the value at $105,000. That means the borrower wouldn’t get enough money from the transaction to settle the two debts, considering the cost of the real estate agent commission and pre-closing repairs.

“It really becomes an issue where for whatever reason it’s necessary to sell the property,” Rogers says. “You’re left with a shortfall, a large shortfall.”

Fan’s and Fred’s huge market power will act like a cudgel, beating sense into the origination/appraisal process. That’s why this announcement is so significant. Non-conforming loan production has slowed significantly nationwide. To remain in business as a residential mortgage lender these days basically means you have to do business with Fan and Fred. So when the GSEs decree that…

No employee, director, officer, or agent of the lender, or any other third party acting as joint venture partner, independent contractor, appraisal management company, or partner on behalf of the lender, shall influence or attempt to influence the development, reporting, result, or review of an appraisal through coercion, extortion, collusion, compensation, instruction, inducement,intimidation, bribery…..

…you can bet originators are probably listening. Here’s hoping the enforcement mechanisms work.

It’s a shame that it took the threat of legal action from the NY Attorney General to get it done. Also a shame that the chief reason originators will be acting in response to this announcement is the immensity of Fannie’s and Freddie’s market power. That immensity is courtesy of the U.S. taxpayer.