By George W. Mantor
RISMEDIA, July 13, 2010—Street level appraisers have been getting a lot of heat for their role in the rise and collapse of real estate values and most of it is unfair. Without exception, every appraiser I have ever met was professional, direct, and considered the facts when arriving at his or her opinion of value.
That isn’t to say that there aren’t dishonest appraisers. I’m certain that just like any occupation, the percentage of bad apples probably mirrors the population in general.
And, there is no question that there is pressure, both subtle and not so subtle, to hit the “right number.” Opportunities certainly exist for appraisers to profit from either inflating or deflating values. But, blaming them or suggesting that they were responsible for the crash, fails to acknowledge the parties who had the most to gain from inflating values—like Wall Street.
Much of the misunderstanding emanates from an inaccurate view of the residential appraisal and its role in financing. The appraisal is not undertaken to determine the value of the property so much as to satisfy the underwriter that the risk is acceptable.
People are often shocked to discover that the appraiser already knows the contract price. But, the appraiser’s purpose is simply to verify that on the day in question, comparable properties were selling for similar prices.
It is but one piece of the financial intermediaries’ efforts at controlling risk. If the ability to collect on credit default swaps was contingent on a certain percentage of loans failing within a particular pool, then controlling risk is vital.
The appraisal is also part of the documentation used to support the quality of loans in a securitized pool. The financial intermediary wants the investor to believe that the value of the security is sufficient to justify the risk.
Comparable properties or “comps” are the meat and potatoes of the vast majority of residential appraisals.
There are other types of appraisal methods employed by lenders depending on either the uniqueness or complexity of the property being offered as security. But, for most residential lending purposes, underwriters rely on the comparable property method.
Most of the housing stock of the last fifty years has been tract development, both vertical and horizontal, offering only a few variations among thousands of homes.
Large areas of homogeneous housing make valuing homes fairly simple. They are a commodity. If they are clustered together, one can quickly see what a buyer in that area has to choose from.
That’s it. No complex algorithms or cryptic equations, just the principle of substitution. And that can change overnight if certain events occur.
Anything that brings more homes to market than the natural pace of activity can absorb will drive down the prices that buyers will negotiate.
One of the remarkable things about the period from 2004 to 2007 was the buyer’s willingness to pay more and more, and doing so because they believed that the replacement cost, i.e. the price of new construction was rising dramatically.
It is no mystery why the states that had the greatest amount of large scale new home construction also had the fastest appreciation rate despite the fact that you would think that all that over-building would keep prices flat or drive them down—but, no.
But, Wall Street had even more to gain than builders. Inflated values were a solution to a lack of borrowers. Demand was so great for the pools that they had to find a way to expand the market, and trigger the defaults.
They keep getting away with saying they didn’t know this would happen, and I keep saying that every consequence of this financial debacle was not only known to them, it was planned for, lobbied for, implemented by them in contravention of so many laws and regulations that run the gamut from local, city, county, state and federal that it suggests that there is literally nothing they would not do to make a buck.
They absolutely knew the consequences and got rich from them.
Remember, risk analysis is what they do. They are researchers, social scientists, accountants and lawyers.
They analyze risk and, as part of their business model, they are always keenly aware of value trends. They knew that one of the factors that would influence defaults would be a steep drop in values that would prevent the refis they promised and contribute to defaults across all pools of loans.
You may wonder, what difference does it make if they knew or didn’t know the consequences? It’s an element of proving fraud.
A misrepresentation is fraudulent if the maker (a) knows or believes that the matter is not as he represents it to be, (b) does not have the confidence in the accuracy of his representation that he states or implies, or (c) knows that he does not have the basis for his representation that he states or implies.
We keep forgetting the tool in all of this was information. The financial intermediaries had it and they studied it, and their denials that they knew this would happen fail in the face of their own research.
I found an interesting piece of that research, a little 20 page document called innocuously enough, “Global Economic Paper No. 177.”
It is produced by none other than Goldman Sachs Research Staff and its subject is Home Prices and Credit Losses.
“Regarding mortgage credit performance, feeding the predictions from the home price sales model into the mortgage loss model…”
Did you get that? They actually have pricing and default models. They know exactly what a home is really worth and they don’t even need an appraiser.
They knew exactly what circumstances were contributing factors to default.
They knew that the inclusion of certain terms in mortgage loan documents would cause foreclosure rates, which historically ran around 1% annually, to skyrocket to over 10%. Currently, as of mid-July 2010, nearly 13% of home loans are in default.
As a result, about a quarter of American homeowners have negative equity in their homes. Had the values been real, they would have held.
They knew that there were not nearly enough borrowers to place into loan pools to satisfy the demand.
They knew that wages had stagnated and affordability was becoming prohibitive to further lending.
The key to it all—inflated appraisals.
George Mantor is a nationally respected authority on all areas of real estate and is frequently quoted in a wide range of publications. He is an oft invited guest of Fox Business Network and for many years, he was the host of “Keepin’ It Real…Real talk about the real thing, real estate” on KCEO radio.His articles have also recently appeared in Real Estate Finance, The Real Estate Professional, National Real Estate Investor, Broker Agent News, and Realty Times. His blog is http://www.realtown.com/gwmantor/blog.