Monday, March 01, 2010

Local Knowledge and Intervention: Real Life Example

My professional life revolves around real estate. And although I am dually licensed as an agent and as a real estate appraiser my appraisal business accounts for 80-90% of my income and for all intensive purposes I consider myself a real estate appraiser. The real estate appraiser is purported to be the local market expert for real estate in his area. Even more so then the real estate agents the appraiser studies trends, news, data and keeps up to date with what is going on in their local real estate market. They are supposed to be an impartial entity that has no direct interest in any given transaction. It is their local knowledge that is supposed to contribute heavily to their expertise requiring them to be geographically competent in the areas they are appraising and familiar with the markets that service the property types they are appraising.

In the real estate purchasing process there are several professionals involved in the process. For this post there are three that we’re going to focus on, the buyer, their lender and/or loan originator and the real estate appraiser. The appraiser is hired as a third party unbiased professional to provide an opinion of value of the home to help assure the lender that the home which is the collateral for the loan is worth a certain amount in respect to the loan. The key here is the third party unbiased opinion of value the appraiser provides. Their impartiality and being free of influence is the key to the profession and their involvement. Until recently the appraiser was hired by the broker who originated the loan directly with that contact. In this manner the appraiser was able to build a working relationship with their clients and compete for their business. Now as I mentioned this was until recently. Thanks to a lawsuit from the Attorney General of New York regarding Fannie Mae’s appraisal quality assurance guidelines, a trend which was initially agreed upon by Fannie Mae (the largest purchaser of mortgages on the secondary market) has been forcefully adopted by the majority of the industry and is now being taken fully into the system through FHA loans. This trend is that appraisals have to be ordered with no contact from the mortgage originator to the appraiser, meaning that the originator has no contact, knowledge, choice in or otherwise influence on the appraiser that is going to be utilized. This comes from the fact that prior to these regulations forms of collusion existed in the marketplace between some appraisers and some loan originators. The concept is by removing the contact between appraiser’s and originators collusion on values and appraiser pressure to omit and overlook negative factors of a home will be eliminated. And this is all well and good but it comes with a tradeoff. It assumes to negate risk on the part of the lenders through regulation (which is another discussion for another post – think... no bail out, let them fail and they’ll wise up. Moral hazards anyone?).

So what has happened as an offspring of this is the rise of AMCs (Appraisal Management Companies). These are third parties that the loan originators order appraisals from. These AMCs and have a roster of appraiser’s from across the country. The benefits are negligible but do include the desired erection of a barrier of communication between the loan originators and the appraisers. This has, definitely reduced the influence and pressures on the appraisers. I can testify to that from firsthand knowledge and it is the surface reason for this legislation. However the true intention of the legislation is to provide more accurate and honest appraisal products. That is where the failure of the industry standard which was born out of government force or threat of force comes in. AMCs are little more than order shuffling and processing companies who hire appraisers with minimal vetting. There incentives and business volume are almost exclusively based on turn time of the appraisal product and competitive pricing which in and of itself is not an issue if that is what the market demands. However at least initially the lack of vetting has changed the structure of the product received by the lender and has been a serious dampener on competition for appraisers. How good an appraiser is how knowledgeable they are and how it contributes to the accuracy range of their valuation have now become non-competing factors. The market showed that until the new regulations were introduced these were important to lenders (this was derived from the fact that these are what lenders were rostering appraisers for during the free market competition era of appraisers). Now several appraisers have left the industry due to regulation after years of being in the same business losing most of their clients overnight. Furthermore appraisers with a smaller skill set and less experience are being employed as they will often compete on price and speed while producing a product of what has in the past been lower quality. If this was a result of a shift in the industry based on a calculated trade off of accuracy vs. time and speed on the part of the clients and appraisers then that would be fine, and in the future the market will most likely adjust to accommodate that. However this has arisen from intervention politics and is resulting in a government failure of policy trumping local knowledge. So this legislation has ‘solved’ a surface issue and in doing so created a new face for the same core problem and most likely in a proportion of risk that the market would not normally produce. They have forced a regulation that squashes the benefits of local knowledge and market competition and created the growth of something else.


Larry Eubanks said...


I not sure I understand the idea of collusion in your post. If I buy a used car from you, I don't think you and I can collude about anything. You and I agree to terms of exchange. The person who will be loaning money to the home buyer wants an estimate of the value of the home. It seems to me the person making the loan wants to be able to pick out an appraiser that is trustworthy in providing the kind of estimate wanted to assess the loan application. I don't see how collusion comes in to the relationship between the appraiser and the person loaning the money. It looks like you are merely exchanging your appraisal services for money. I can see the issue as one of incentives, and also local knowledge which the loan originator is likely to value, I just don't see the collusion idea.

mdehn said...

I know nothing about the real estate business, but doesn't the appraisal of the house that a buyer wants to purchase weigh into the factors of the ability of that said buyer to pay back the loan? Essentially, when someone takes out a mortgage, the lender is able to take the house back if the buyer isn't able to pay. But what I think Doug is referring to is the fact that the incentives for the lender is high if they lend a lot of mortgages, so the appraiser may collude with the lender in order to lower the value of the house and make the mortgage easier to get, thus being beneficial to the lender. Am I on the right track? I think I confused myself.

Douglas Loeper said...

Sorry I should have given more background in terms of the collusion issue for it to make sense. The issue of collusion comes into play with who orignates the loan and how they are paid. With 'Mortgage Brokers' they originate the loan and then basically sell the loan or the loan package to a lender. They were paid a commission upon the successful issuance of a loan. They are independant contractors as well as do not work for any one bank. However after this initial sale of the loan package (which is reviewed in depth by an underwriter) they have no direct connection to the loan. For a loan to become approved several qualifications have to be met, the major ones include income, credit and the value of the property that is collateral for the loan amount. Loan amounts are based on the appraised value of the home so if the appraised value isn't enough to get the loan amount needed and the buyer or in the case of a refinance the homeowner doesn't have enough to cover the short fall in either equity or cash the loan doesn't get closed and the mortgage broker doesn't get paid.

Now it IS in the best interest of the person lending the money to have an honest, fair and unbiased appraiser make the valuation of the home. However the person lending the money is not always the same person hiring the appraiser and when the mortgages are then resold on the secondary market there is even more distance put between the appraiser and the person now holding the note on the loan.

And 'poof' this opens the door for collusion. The mortgage broker puts together a loan for a homeowner, for the 'loan to work' the home needs to be worth at least $100,000 dollars. The appraiser gives their opinion of value and it is only $98,000. The mortgage broker then promises the appraiser that he'll continue to give him business if he can just 'nudge' the figure up to $100k (the appraiser has some latitude to the value conclusion as usually it comes from a range of values but that is a whole other discussion). The appraiser wanting future business and not seeing the harm in changing the value just a couple of thousand modifies his appraisal, the deal is finalized and sold, the mortgage broker gets paid, the loan gets done, the homeowner now has a loan higher then he was supposed to and the lending institution now has an undercollateralized loan. Now take those numbers to bigger margins and repeat it many times and you have a significant issue within the appraisal and lending community that the regulation was intended to fix. Mostly resulting from a misalignment of incentives and a poorly devised loan system.

Larry Eubanks said...

Okay Doug I'm looking at the last paragraph in your comment and explanation. I suspect something is still missing. I suspect that something is government regulations.

I don't think if this were an unregulated market people would want to make loans, or buy loans from brokers, that were "bad" or overly risky. Well, unless of course, there was a sufficient risk premium priced into such transactions.

So, the incentive for the broker to distort the appraisal information I can see, but I think this would be "weeded" out by a truly free market. The person buying the loan from the broker would want to be able to gain their own independent evaluation of the value of the property before purchasing the loan from the broker. At least this is the way it seems to me.

What I suspect in terms of government intervention is a couple of things. There are regulations that may provide an assurance to the buyer from the broker that the appraisal is accurate, and/or government policy is such that the buyer acts with moral hazard because of a belief, maybe even assurance, that purchased bad loans from brokers would be covered. I think this moral hazard part was common over the last decade or so because the Fannies were government backed.

How does this all sound?