You’ve got to try harder

In the aftermath of the subprime meltdown, fingers are being pointed every which way, among them at the appraisal community, which led to a systemic change brought about by new York’s aggressive Attorney General, Andrew Cuomo, who pressured the GSEs into an agreement about which I recently posted:

[The Home Valuation Code of Conduct (HVCC), which applies to mortgages placed via Fannie Mae and Freddie Mac, bars loan officers, mortgage brokers or real-estate agents from any role in selecting appraisers.]

This has encouraged lenders to outsource the selection to appraisal-management companies, or AMCs, which take a sizable cut of the appraisal fee.

This is value-chain re-engineering. If the link between commissioner and appraiser is too cozy, then it’s necessary to add a link. Adding a link adds costs. The first-order systemic response is simple:

As a result, appraisers are under pressure to “do it faster, do it cheaper,” said Bill Garber, a spokesman for the Appraisal Institute, a trade group.

It takes all the cycle-time shrinking you can do just to stay ahead of the workload

Faster, cheaper leads to an easy second prediction:

With costs cut, we have the second-order reaction – adverse selection by quality. Premium providers are pushed out of the business.

Now, to judge by this Banker & Tradesman article, that prediction is already coming true:

Mortgage brokers and appraisers predicted headaches and worse with the advent of the new appraisal rules that hit the mortgage business on May 1, and now they say that’s just what they’ve found – with a few extra aggravations thrown in.

As if you haven’t got enough to worry about

Appraisers say it’s just as they feared:

Under the new Home Valuation Code of Conduct:

[1] They’re making less for each job

[2] Consumers are paying more

[3] For an inferior appraisal.

Outcome 1 was self-evident; outcome 2 was the inevitable corollary.

Appraisers are also complaining appraisal management companies take a chunk out of their fees as payment for arranging the assignment.

What about the third, inferior quality? Two weeks ago I extracted this risible quote:

Funny, by George

Jeff Schurman, executive director of the Title/Appraisal Vendor Management Association, said AMCs typically take about 40% of the fees and appraisers get the rest.

Two-fifths isn’t exorbitant, but it’s not minuscule either.

Mr. Schurman said he has seen no evidence that AMCs’ practices lead to lower quality.

At that I laughed out loud. “The head of an association that takes 40% of another’s fees said he has seen no evidence that cutting what’s paid for actual work leads to lower quality.”

A four-year-old child could make it out!
Quick, get me a four-year-old child, I can’t make head or tail of it

More significant for consumers are these disruptions in the value chain:

Don’t break the value chain; use the Force

Meanwhile, brokers can’t easily make good on locked-in interest rates because new rules gum up the application process, said David Black, president of First New England Mortgage in Newton.

Also, brokers now often struggle to transfer appraisals between lenders, leaving them unable to easily transfer the application to a more favorable lender.

“We could keep banks honest,” he said. “If we can’t get our job done, we’ll disappear.”

This argument is intriguing. Mortgage brokers can shop for different lenders, and if they can take a single appraisal to multiple lenders, they can get better apples-to-apples price comparison.

When mortgage brokers ordered the appraisals, they could take those numbers to a variety of lenders, ideally shopping around for the best terms on behalf of the borrower.

This leaves unanswered the challenging question of who the mortgage broker actually works for, about which readers may be forgiven for being skeptical.

The National Association of Mortgage Brokers, which tried to prevent the rules from taking effect, is now urging brokers to direct their uproar toward The Federal Housing Finance Agency and other organizations.

No namby-pamby lobbyists these!

NAMB has also succeeded in persuading two representatives to introduce HR 3044, legislation proposing an 18-month moratorium on HVCC.

But that fight truly began last year, when FHFA announced that Fannie Mae and Freddie Mac would not back mortgages in which brokers had contact with appraisers, and issued the new code to prevent that.

As I posted previously, contact between an interested and a disinterested party isn’t necessarily improper; it may be the lifeblood of accuracy.

Avoid impermissible contact, okay?

At my for-profit company, we do valuations of complex structured interests. After making our initial data request, which includes a comprehensive checklist of information we think relevant, we also invite our customers to provide any information they think worthwhile for us to know. Unless the circumstances are unusual, we also give our customers a chance to look at and comment upon our draft, and to provide additional evidence. This creates an intellectual argumentation, where the client is advocate for its view of the right value, and we are judge and jury of what we think is the right value.

Such contact also allows influence to be brought to bear:

Make up your own mind

Previously, brokers order the appraisal before submitting the loan application to the lender – and often, critics say, those brokers would pressure appraisers to come back with higher valuations.

Get it?

Naturally that pressure will be applied, and the expert has to be intellectually and morally tough:

For this tension to yield improved (more accurate, more thoughtful) results, we as valuation experts have to be strong enough to repel improper suggestions and to resist flimsy or unsubstantiated argumentation.

Evidently, many appraisers were suspected of being weaklings.

And proud of it!

Now the appraisal comes through the lender, and critics say if consumers want to shop around, they’ll have to order a new appraisal for each lender they try out.

Ironically, the cozy relationship of in-house commissioned appraisals – being proposed as a reform – is among the sins of which Countrywide’s Angelo Mozilo was accused.

“There’s a real competitive issue here,’ said Stephen Sousa, executive vice president of the Massachusetts Board of Real Estate Appraisers.

Hoping to put your financial house in order

The lender who ordered the first appraisal has to certify it in order to pass it along to another lender, Sousa said, and it’s doubtful lenders will want to shoulder the liability – with no potential reward – that comes with certifying an appraisal for a loan they’re not going to make.

Absolutely right. Why should I take a risk that helps you make money I’m not going to?

“On top of that, other lenders don’t want to accept the other guy’s appraisal anyway, and will request another – at hundreds of dollars of cost to the consumer.”

“That was one competitive advantage [for brokers]: We could take the loan to a new lender,” Black said. “Now we can’t do that.”

A valid point.

Another in the list of complaints: The new code prevents brokers from successfully locking in borrowers at lower rates, says Richard Shapiro, principal of Asset Mortgage Group in Natick.

Because the appraisal is completely out of the mortgage brokers’ hands and another layer of management is inserted in the process, everything just takes longer and 30-day lock-ins are likely to expire before the application is complete.

This, by contrast, strikes me as simply growing pains. Give the system time and it’ll get faster.

Longer lock-ins are possible, but are more expensive to the consumer.

Any growing value chain is inherently less efficient until it achieves stabilization and scale.

Many appraisers were upset that their work was being shuttled through appraisal management companies because the new system broke professional ties they’d established with brokers, who would refer them to jobs in their area. Now management companies just cast around for whoever will do the job cheaply and quickly, they say.

What’s quality worth? Does it compensate for cozy relationships?

We’re not cozy, it just looks that way

Sousa said his organization sent out a survey on the new code that – so far – has 55% of appraisers saying the number of assignments they’ve received has declined, and 39% said their assignments have decreased more than 10% since HVCC kicked in on May 1.

Foolish statistic; all appraisals are probably down.

What is the future of these regulations? The HVCC is a set of guidelines laid out by Fannie and Freddie, not legislation; David Bunton, president of Appraisal Institute, speculates the HVCC is merely “placeholder” rules that will be swept away in the spate of new regulations coming out of Washington.

We saw above that the NAMB got legislation introduced requesting an 18-month delay – but that’s a long, long way from it becoming law.

Others aren’t as optimistic.

“The longer it’s in place, the more it becomes entrenched,” Sousa said.

Think you can shoot down that legislation, boys?

He’s right; HVCC is here to stay.

Lenders are spending time and money to engineer the new processes, and would kick up a fuss if someone suggested change. Chris Kelley, sales manager at First New England Mortgage, noted that the mortgage brokers’ Washington lobby can’t match the powerful banking machine in place.

And with all due quivering respect to the mighty banking machine versus the plucky mortgage broker machine, the case for repealing HVCC is far from proven. Certainly the value-chain problems cited above are relevant, but they sound transitional, and by the time Congress gets around to considering whether to suspend the HVCC, the system will probably be operating more efficiently.

Still, the brokers keep hoping:

Shapiro theorized that they’d need a politician or well-connected lobbyist to get fired up on their behalf: “I’m just hoping that the right big shot gets their loan all screwed up because of this and says, ‘Why are we even doing it?’”

It’s more fun than being depressed

E-mail: lschreier@thewarrengroup.com

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In yesterday’s exploration of the changing appraisal world, using an interesting Wall Street Journal article, we’d identified the intrinsic challenge of appraisal – having to simulate a forward-looking market by using exclusively backward-looking evidence from past sales. Called upon to appraise a pending sale, the appraiser is in a really weird position:

• She has to simulate actions of hypothetical people buying and selling a property
• Somehow overlooking that there are, in fact, actual people who are buying and selling that same property.

“What you are doing is irrelevant,” says the appraiser. “I have to figure out what rational people would do.”

Who are you going to believe, your lying eyes or me?

In light of this, what’s a borrower to do? A Journal inset offers helpful advice:

How to Appeal a Flawed Home Appraisal

In today’s turbulent real estate market, appraisals can easily kill a home sale or an application for refinancing. So what can you do if you believe you got a bum appraisal?

Lenders generally say they are open to appeals from homeowners who believe the appraiser got it wrong.

The appraiser got it wrong?

They should be. Lenders don’t make money rejecting loans; nor do they make money making loans that will default. And in these times, lenders will be hypersensitive to charges of consumer insensitivity. That doesn’t mean, however, that you can appeal emotionally:

You’ll need to provide evidence. Read the appraisal report carefully and check for errors. Did the appraiser miss one of your bathrooms?

Did you miss this amenity?

Miscalculate the square footage? Fail to note your two-car garage?

At my for-profit company, we do valuations of complex structured interests. After making our initial data request, which includes a comprehensive checklist of information we think relevant, we also invite our customers to provide any information they think worthwhile for us to know. Unless the circumstances are unusual, we also give our customers a chance to look at and comment upon our draft, and to provide additional evidence. This creates an intellectual argumentation, where the client is advocate for its view of the right value, and we are judge and jury of what we think is the right value. For this tension to yield improved (more accurate, more thoughtful) results, we as valuation experts have to be strong enough to repel improper suggestions and to resist flimsy or unsubstantiated argumentation.

More important, take a close look at the recently sold houses listed as “comparable” to your home. How comparable are they? Is one in an inferior school district or adjacent to an adult-video store?

Adult video store? So 1995, dude!

Undermining neighborhoods since 1995?

Try downtown erotic lingerie shop.

Ask a friendly real-estate agent [Like the selling broker – Ed.] to check if there are any better “comps” that you could provide. But don’t cheat:

They just sell short

Use only homes that you can justify as being similar in quality and location to yours, and use all of those, not just the ones that sold for the highest prices.

The principle here is ‘minimizing differences.’ Just as no two snowflakes or people are alike, no town houses are identical. (Condos are closer; stacked in high-rises, they can be almost identical.) Appraisers work on the principle of additive differences – that each element of difference is a plus or minus, much like the price of a car goes up or down as you add satellite radio, leather seats, and other accessories.

There is no guarantee that the lender will budge, of course, but it’s worth a try, especially if you see signs that your appraisal was seriously flawed.

By far the most common flaw in appraisals is omission brought on by time pressure or price cutting. At my for-profit company, we’re seldom the cheapest valuation expert for any given assignment, but we pride ourselves on being the most sophisticated, thorough, and evidence-based.

It pays to be a choosy mother

Do we get chosen? Depends on what the client cares about. And for that matter, it depends on who’s doing the hiring – which, as we discover back in the first Wall Street Journal article, has recently changed.

[The Home Valuation Code of Conduct, which applies to mortgages placed via Fannie Mae and Freddie Mac, bars loan officers, mortgage brokers or real-estate agents from any role in selecting appraisers.]

This has encouraged lenders to outsource the selection to appraisal-management companies, or AMCs, which take a sizable cut of the appraisal fee.

This is value-chain re-engineering. If the link between commissioner and appraiser is too cozy, then it’s necessary to add a link. Adding a link adds costs. The first-order systemic response is simple:

As a result, appraisers are under pressure to “do it faster, do it cheaper,” said Bill Garber, a spokesman for the Appraisal Institute, a trade group.

With costs cost, we have the second-order reaction – adverse selection by quality. Premium providers are pushed out of the business.

Debbie Huber, a Las Vegas appraiser for 20 years, said she has turned down requests from AMCs that offer to pay 50% to 70% of her standard fee and require that the work be completed in as little as 48 hours.

I don’t mind the speed requirement – a single-family appraisal can be done in that interval – but normally, drop-everything-do-it-now speed commands a premium, not a discount. If you need a discount, offer more time.

Pick any two?

If you choose solely on lowest-price bid, you can get lowest quality product.

Some appraisers said AMCs settle for appraisers who have little experience or live far from the homes they evaluate. John Simms of Peoria, Ariz., said he often gets assignments more than 100 miles away in neighborhoods he doesn’t know well.

Market knowledge includes a holographic element. Everything you know can potentially bear on everything else you know, particulary when it comes to neighborhood locations, which include factors both visible (comparables, daily use) and invisible (reputation, evening and night use). Do it too fast and quality declines.

The upshot, appraisers said, is less accuracy and certainty about a property’s actual value.

We saw in Part 1 that all appraisals have inherent uncertainty. Reducing the band of uncertainty should e the goal. Slapdash appraising increases the band of uncertainty, but that may be very hard to perceive without a review more thorough than the original appraisal.

Remember, buyers and sellers make the market; appraisers estimate the market. Appraisers simulate what buyers and sellers do. And there’s another wrinkle which might seem to undo the independence – or at least, throw it a curveball.

Independent?

The code also permits lenders to own stakes in AMCs. That means lenders can profit from a service they require borrowers to buy — and that protects the lenders themselves.

Now, this is one of the many sins of which Angelo Mozilo has been accused. Among the least of them, to be sure, but still!

Appraisal-management companies said they need a big cut of fees to cover their costs and ensure quality.

‘Cover their costs,’ dear reader, includes ‘pay our salaries and make our profits,’ so it’s a classic meaningless phrase. Ensuring quality depends on two things: initial qualification of the stable of appraisers, and pre-submission review of the draft appraisal.

When you need the horses, make sure they’re all qualified

Jeff Schurman, executive director of the Title/Appraisal Vendor Management Association, said AMCs typically take about 40% of the fees and appraisers get the rest.

Two-fifths isn’t exorbitant, but it’s not minuscule either.

Mr. Schurman said he has seen no evidence that AMCs’ practices lead to lower quality.

At that I laughed out loud. “The head of an association that takes 40% of another’s fees said he has seen no evidence that cutting what’s paid for actual work leads to lower quality.”

A four-year-old child could make it out!

Quick, get me a four-year-old child, I can’t make head or tail of it

While the new code is likely to prevent some abuses, it also removes flexibility. For instance, loan officers or mortgage brokers used to be allowed to discuss specific home values with appraisers, who sometimes would advise against ordering an appraisal if it seemed unlikely to be high enough to warrant a loan. That would save borrowers money.

Conversation is information. It is also influence. The challenge is balancing the two.

The new regime also results in higher costs in at least some cases. Mitch Ohlbaum, a Los Angeles mortgage broker, said one client was recently charged $500 for an appraisal that would have cost about $300 before the code took effect.

Here’s the third-order outcome of the change in appraisal rules. We’ll stabilize with higher appraisal fees as the market will price back in the cost of the intermediaries who do the choosing.

Will raising the price of appraisal raise the price of housing?

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All we know is what’s behind us

Our brains reinterpret this flurry of pass information into a seamless present, which works beautifully except when reporting cycles are misaligned, as in the flash of lightning preceding the clap of thunder, or the roar of a jet causing us to look to see it, not where it is now, but where it was when it made the boom that is only now reaching us across a gap of miles.

We hear it on the right, see it on the left

That same perception dislocation applies to markets. Buyers dream of the future (pessimists never win auctions). Markets exist in the present (the tumbling chaos of individual events). Transaction reports bring us news of the past. Every sale recorded today was agreed some weeks or months or even years before. When appraisers, whose canon of ethics and professional standards require them to have evidence for their conclusions, are seeking to find values for assets whose prices are in disequilibrium, they’re always projecting against a subset of the past – driving, as I like to put it, solely through the rear-view mirror, hoping that the road ahead will be a continuation of the straight-aways and curves just experienced.

The market is going up, but we see it in the past, going down?

Which it never is, as illustrated by this Wall Street Journal article:

Appraisals Roil Real Estate Deals

Conservative Approach to Home Pricing Makes It Harder to Refinance or Sell

By JAMES R. HAGERTY and RUTH SIMON

Appraisals are becoming one of the biggest obstacles for Americans trying to sell their homes, refinance their mortgages or tap into home-equity credit lines.

If you’re aiming out of the rear-view mirror, you’re more or less condemned to overshoot or undershoot; it would be the fluke of flukes to hit the target.

Appraising itself is more difficult with home prices fluctuating rapidly and transactions few and far between in some markets; sale prices from a few months back may no longer reliably indicate the value of nearby homes.

Good appraisers, more than most, are keenly aware that though their customers demand to-the-dollar precision, their valuations (which are always quite correctly called ‘estimates of value’) involve ineradicable uncertainty.

“If history is no longer valid, then it is very difficult to get good and accurate values,” said Mark Rattermann, an appraisal trainer in Indianapolis.

Bad enough we have uncertainty, what if truth is over there?

That too is a tension, because the commissioning customer wants accuracy, and will lean on the appraiser to give that accuracy, preferably in the commissioner’s favor:

During the housing boom, appraisers often complained of pressure from lenders to inflate home-value estimates to justify dubious mortgage lending.

The effect of lagging sales information, coupled with the natural human propensity to find patterns out of chaos (an evolutionary comparative advantage for humanity, by the way, which is why it’s so strongly wired into us; if you’re always puzzling out the world’s logic, you’re always learning and will beat species that don’t), means that appraisers develop a narrative of their markets. This one is rising, that one is falling. This one is turning the corner, that one is showing weakness. Anecdotal confirmation also plays its part. Ha ha, says the originator to the appraiser, that property you thought wasn’t worth more than $325,000? The buyer just flipped it for $390,000. The desire not to be shown up, coupled with the market’s decade of nothing but rises, gradually beat down the appraisers’ caution.

From the Wall Street Journal

When the data’s fragmentary, can we tell where the market is going?

Now, some people in the mortgage business — and some borrowers — say the pendulum has swung too far the other way.

Two years ago, the appraiser would be harangued by an originator table-pounding for a loan approval. Now it’s the Chief Risk Officer, or the TARP ambassador, wanting the appraiser to prove the property’s worth at least the appraised amount.

Taking their cues from lenders, appraisers are avoiding any estimate that could be deemed excessive. “I don’t want to stick my neck out,” said Mr. Rooney, the Phoenix appraiser.

The apparent reversals can be astonishing.

Patti Sanders, an aerospace engineer in Oakdale, Calif., knew prices were down sharply but said she was “flabbergasted” recently when her 3,100-square-foot Victorian home was appraised at $250,000, compared with $635,000 assayed two years earlier.

$250 or $635? You decide!
The Sanders home in Oakdale, Calif., which has been appraised
for much less than the owner feels it is worth.

Why does a homeowner care about the notional value of a home? It’s the same home before and after, isn’t it?

What differences does the appraised value make if you’re not moving?

Appraisal ties to financing, and that ties directly to consumer cost of capital, and consumer availability of capital:

The new estimate prompted a lender to reject her application for a refinancing that would have lowered her mortgage payments about $400 a month.

Now this is a highly perverse outcome. Ms. Sanders want to refinance (presumably at a lower price) with the result that next month she will need to pay $400 less than she pays this month. It is therefore indisputable that the new loan will be safer than the existing loan – yet the appraisal condition is acting as a barrier to that self-evidently wise move.

Lenders burned by huge losses from defaults now are pressing appraisers to be more conservative.

But, says the attentive reader, the current loan might be over-extended? Why should the new lender bail out the old? Correct, replies the blogger, and therefore if Ms. Sanders cannot get a sympathetic hearing from this lender, she ought to go back to her current lender.

I can’t refinance and cut my payments even though I’m more able to pay the new loan? Say what?

[Once upon a time, HUD had a multifamily refinancing insurance known as Section 223(a)(7), which existed solely to enable a borrower to swap a new, lower-payment FHA-insured loan for the current, higher-payment FHA-insured loan. I can remember running into some situations, where despite the evident logic of swapping a current risk for a lower future risk, a HUD field office's mortgage credit department rejected the (a)(7) refinancing because of an inadequate appraisal. Fortunately, appeals up one or two levels within HUD produced a reversal and led to the right outcome. - Ed.]

Refinancing is a mild kind of appraisal-uncertainty problem; the severe problem comes, of course, on sales.

Chris Rubis, a real-estate agent in Fairfield County, Conn., said one client recently accepted an offer of about $750,000 on a four-bedroom, four-bathroom home. But the appraisal, which was done by someone outside the local area, came in last week at $700,000. That might require the buyer to come up with more cash for a down payment.

Let’s consider what could happen here, starting with the mechanical.

A typical single-family loan is the least of three numbers:

1. Coverage-capped. A percentage of the borrower’s income.

2. Price-capped. A percentage of the sale price.

3. Value-capped. A stipulated Loan-to-value (LTV) ratio.

This being a typical single-family, the lender’s is probably at 80% LTV. At an appraised value of $750,000, the loan will be capped at $600,000; at $700,000 appraised, the loan will be $560,000 –- $40,000 less.

So now we have three possible outcomes:

1. Seller takes $50,000 lower price.

2. Buyer comes up with $190,000 of down payment, $40,000 more than originally anticipated.

3. A new or revised appraisal miraculously rediscovers the original $750,000 price, and the sale proceeds as negotiated.

Which do you think the seller and buyer are rooting for?

We’re rooting for the appraisers’ home team

Observe the importance of hard equity:

“It’s opened a whole new door for negotiation,” Mr. Rubis said.

Equity is hard when it can be contributed, as cash, by a buyer into a property. When the buyer has already put in the cash, equity becomes an intangible – the money I could realize (conditional verb) if I were to finance or sell (even more conditional verb).

Credit lines are also vulnerable. J.P. Morgan Chase & Co. recently froze one customer’s home-equity line of credit because, the bank said, his Manhattan apartment — a 2,650-square-foot three-bedroom, two-bedroom duplex with a terrace appraised at $1.475 million in 2005 — was worth just $600,000. Chase told the borrower, who asked not to be identified, that the lower credit line would remain in effect until a new appraisal could demonstrate the value was much higher than $600,000.

Not unreasonable at all. If you’re going spendthrift on the inheritance, to finance your wastrel lifestyle, we’d best be certain you have an inheritance to waste!

The borrower then paid for a new appraisal that pegged the property at $1.8 million.

Fragmentary glimpses of the highway, easily to make false linear interpolations.

“To protect borrowers and the bank, we use an automated appraisal system on our portfolio,” a Chase spokesman said. “The system has proven effective.”

Automated single-family appraisal eliminates bias, increases speed, and lowers transaction costs.

This sort of overvaluation has come up before,
And it has always been due To human error

Think of Zillow, an endless source of financial voyeurism to those who wish to use it that way. If markets are rational – which they are in the long run, if not the short, because they represent the accumulated decisions of thousands and millions of people acting independently and rationally by their own lights – then the price of my house ought to correlate somehow with the price of my neighbor’s.

“However, we encourage customers who think that the valuation is too low to order an appraisal and we will reimburse them … if it supports their claim.”

A good principle, and a good position by Chase. Appraisers are creatures of information.

In some cases, lenders are requiring that appraisals be based on sales closed within the past three months rather than the prior six-month norm, appraisers said. Some lenders are also asking for comparisons with at least one sale in the past 30 days.

They work with partial data. Give them more data, better data, and they will change their minds.

Chase will restore this borrower’s full credit line, he added.

Absolutely.

The situation became more complicated on May 1 when the appraisal industry adopted the Home Valuation Code of Conduct. These new rules apply to mortgages that will be owned or guaranteed by government-backed mortgage companies Fannie Mae and Freddie Mac, which recently have accounted for about two-thirds of all new home loans.

In other words, ‘effectively controlling the debt markets.’

Financial wizardry gives us control

Fannie and Freddie agreed to the code last year after New York Attorney General Andrew Cuomo accused them of failing to ensure that appraisers were shielded from pressure to inflate their estimates.

Give Mr. Cuomo his due; without actually having the standing to bring the claims he brought, he nevertheless identified a weak link in the appraisal chain, and used the bully pulpit to change the system.

The code bars loan officers, mortgage brokers or real-estate agents from any role in selecting appraisers.

Sounds good, doesn’t it?

It always sounds good in the drawings

[Continued tomorrow in Part 2.]

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