Commentary: A Question of Value
For this week's editorial, I was thinking about how much press coverage 'exotics' get, both in terms of the lax (or at least, poorly understood) underwriting criteria and in terms of how borrowers with these sorts of loans quickly find themselves in deepening water. While justified to a certain extent, the problem of exotics is a drop in the bucket of a much larger, and ultimately more sinister problem: appraisals. How do you value property in an escalating market? How do you value property in a rapidly decelerating market? How do you know exactly when a local market shifts and adjust property values accordingly? Property valuation is an inexact science at best -- compare a set of comps, benchmark against varying AVMs (automated valuation models), and try to zero in on what the market value of a particular property is. Get it right, the borrower gets what they pay for -- and what they can afford. Get it wrong, and a borrower can be hamstrung by their own mortgage in even the slightest of downturns. A grey area When it comes to grey areas, the potential for fraud here is particularly rich. And it's been the dirty secret of real estate the past few years. With many appraisers caught flat-footed at the outset of the housing boom, and subsequently undervaluing properties, many began boosting property values to capture as much revenue as possible for everyone involved in a housing transaction -- the lender, the title company, the broker and, of course, themselves. Undervalue a property during the boom (in other words, leave money on the table) and a mortgage company might choose to never use you again. Other appraisers could be found who'd push the value to where it needed to be. So where does the desire to adjust values to market conditions cross the line into outright fraud? When does an appraiser inflate a value just to get business? I don't know for sure. But I do know that there are good number of borrowers across all credit classes who are now seeing their property values flatten out, even if they haven't moved into a full-blown descent. And these borrowers are finding out that they might have been put behind the eight ball when they first bought, because of a valuation that was too aggressive or just flat-out wrong. They're finding out that they can't sell, even if they want to. A value chain in peril For prime borrowers, that probably just means a few less lattes. But for subprime borrowers -- the credit class that led the charge into our historic housing boom -- the aggressive strategies used to push profits through the value chain are now putting them in peril. And in mass numbers, too, if the CRL is to be believed. I'm not getting into the criminal element here, those appraisers involved in straw-buyer schemes who inflated appraisals as part of an elaborate property flipping scheme. That's the fringe element. But what about those more mainstream appraisers who were just doing what they had to do to get and keep business? This isn't just a problem for borrowers. It's a problem for lenders, too, and not just when it comes to refinancings. When faced with a troubled borrower, loss mitigation departments will often assess available options, including something known as a 'short sale,' where a lender agrees to take less than the mortgage balance in exchange for the proceeds from sale of the property. If that mortgage is inflated because the original appraisal was upwardly biased, it's much less likely that borrower will have the short sale option available to them. And that's just for starters. As foreclosures increase and real estate markets stagnate, the number of speculators picking up properties at foreclosure auction drops, increasing a bank's inventory of property (called REO by most). Banks will base their sales price on the loss amount, looking to minimize their loss ratios. But if the mortgage was inflated, the bank's loss ratio will be inflated as well -- and few banks will easily drop their prices as a result, as any real estate agent who works in REO will tell you. The upshot is an increase in foreclosed inventory on the market, which serves to further destabilize those neighborhoods that are most vulnerable. A rosy ending? The point here isn't to paint gloom and doom, but to bring some attention to an area that I think is driving so many of the problems in our current housing market. And it's just the sort of thing that has large mortgage operations working overtime to figure out how they can best solve the problem, both for themselves and for their borrowers. How successful the mortgageÂ industry is in this particular endeavor could largely determine the depths to which the housing market will fall -- although only industry insidersÂ (and well-heeled HW readers, of course) will likely know about it.