What the appraisal crisis really means.
You may have heard that the real estate industry isn't happy with the new Home Valuation Code of Conduct (HVCC) forced on Fannie Mae and Freddie Mac, the two biggest players in mortgage securitization, by New York Attorney General Andrew Cuomo.
The Home Valuation Code of Conduct is a major revision of the appraisal expediting process, intended to eliminate pressure on appraisers to rubber-stamp whatever price is written on the purchase contract. The real estate industry claims that the HVCC, while well-intentioned, has led to an epidemic of poorly researched low-ball appraisals, done by under-paid inexperienced out-of-area appraisers unfamiliar with local markets, that derail legitimate transactions while costing buyers hundreds of dollars for worthless reports. It also accuses the HVCC of delaying transaction closings because over-extended appraisers are taking far longer to get their reports to lenders.
On the other side of the debate is an unofficial consortium of an unknown number of appraisers and an entire army of armchair real estate experts who say, "It's about time appraisers were allowed to inject sanity into the marketplace. Let them do their job!" Not that the armchair experts seem to understand what that job really is.
I'll hit the highlights of the Home Valuation Code of Conduct in a moment, but first I want to give you four real-life examples of what it's done to complicate and hinder the already complicated and hindered process of selling a home in 2009.
In the first example, an appraiser calls a local agent about a listing he sold last November in the County area of Menlo Park. The appraiser demands, "Why did your listing sell so cheap?" Agent, who knows his listing sold for top dollar, retorts, "Why do you want to know?" It turns out that the appraiser, who works out of Sacramento, has been hired to appraise a home in Central Menlo Park, a neighborhood adjacent to the County area, and is using recent sales near that Central Menlo home to do her appraisal. And this County sale is only about a mile from the Central Menlo home she's appraising.
Only a mile away? That must make the County sale a great comp, right? Wrong. Because about the only two things the County area and Central Menlo Park have in common are their mailing address and latitude. The typical County home is a small minimalist bungalow, on a small lot, in an area that could either be described as "quaint" or "scruffy" (I've heard both), depending on how you feel about a neighborhood that can get a little funky. In 2008 the average sales price in the County area was $1,995,837, high for a "scruffy" neighborhood unless you know that half the 34 sales were new or newer homes. The more typical bungalow, like that November sale, sells for maybe $1.2M.
The typical Central Menlo home, on the other hand, is a spacious rancher, pricey when new in 1952 and a whole lot pricier today, on a large quarter-acre lot, in a manicured neighborhood that has always been described as "upscale". In 2008 the average sales price in Central Menlo was $2,441,953, with only 7 of 40 sales new or newer construction. The typical rancher sells for about $2M.
Different housing stock, different lot sizes, different ambience, even different school districts. Virtually everything that matters in valuing a house is drastically different in these two areas. But on paper the County area and Central Menlo look alike to the outsider because they're next to each other, their homes are typically 50 to 60 years old and they share a Menlo Park mailing address—except that even the mailing address is deceptive, because the County area is unincorporated and not really part of Menlo Park.
So some appraiser three hours away peers at her map, sees two houses about a mile apart, about the same age and apparently both located in a town called Menlo Park. A town called Menlo Park that she's probably never seen. And her map and erroneous assumption make her an expert on Menlo Park home values. So expert on Menlo Park home values, in fact, that her say-so can derail a Menlo Park real estate transaction. And if she's using County sales as comps for a Central Menlo house, she will derail that transaction.
Ever heard of the Law of Unintended Consequences?
The next story also involves a Sacramento appraiser, in this case called in to do an appraisal for a Redwood City pending sale. Redwood City is a little closer to Sacramento, so in all fairness we can't say that this appraiser is three hours away. No, he's only two hours and fifty-five minutes away. Which doesn't stop him from driving all the way to Redwood City to do a $500 appraisal—and as we'll see in a moment, his share of that fee may be as little as half. Which suggests that there's at least one appraiser willing to work for minimum wage. Appraiser then calls the listing agent and frantically asks him what his other pending sale down the street sold for. Listing agent tells him, appraiser says "whew!", everyone not the appraiser keeps their fingers crossed and, somehow, the home appraises at not less than the purchase price and the transaction closes. By the skin of its teeth. But it wasn't even that simple. Because everyone had to wait four long days while the appraiser figured out how to upload his appraisal to the lender.
"Who has driven 50 miles to an appraisal?" asks Mark Johnson, the chief operating officer of LSI, a large AMC. "I can't find him." Hey Mark, I've got two for your collection right here.
The third story involves, no, not a Sacramento appraiser, but a Sacramento house that's in contract. The appraiser selected to appraise the Sacramento house isn't from the Sacramento area (maybe he's from Redwood City?). His appraisal comes in 11.25 percent under what the buyers offered. End of discussion, end of transaction, and one home that won't be selling anytime soon.
The last story I'll tell has no denouement, happy or unhappy, at least not yet, because the buyers' agent has been trying for two weeks to get the appraiser to return her calls. "When are you doing the appraisal? I have a two-week financing contingency that's almost up, and my buyers won't release it unless they know the home appraises. Plus my buyers have given notice where they rent, and if the home doesn't appraise, they won't have a place to live." Two weeks of this, and until the HVCC it usually took just a few days to get an appraiser out to a home. Finally, today, the agent hears from the appraiser. "I can do it Thursday." "But the contingency expires Wednesday." "Sorry, we're really backed up these days."
Not the sort of scenarios that would give buyers and sellers confidence in the home-selling process, a process that, as you may have heard, badly needs a shot of confidence. And meanwhile, the world economy teeters on the brink because of lack of confidence in the U.S. housing market. So there's no rush. No, we've got plenty of time—months, years—to work out the bugs in the HVCC.
The only people who could possibly be satisfied with this state of affairs are the ones who think that all home buyers should be punished for having the temerity to buy homes—and who have nothing to lose to a bad economy.
As for the claim that appraisals are coming in low simply because "distressed properties"—foreclosures and short sales—are dragging down the price of every home, three of the four examples above come from neighborhoods in which an appraiser couldn't (or at least shouldn't) find distressed properties to use as comps. And in neighborhoods where they are a factor, I can tell you from seeing hundreds if not gazillions of bank-owned homes over the past year-and-a-half that virtually all of them are hammered, partly but not entirely because the former owners don't care how they leave them. It also seems as if most of the homeowners who ended up getting in over their heads either gravitated to, or were able to afford only, the worst homes in the neighborhood, something I've seen so often that I've given up thinking it's a fluke. Either that, or these homes were really lived in during the year or two the defaulting homeowners owned them. In addition, banks compound the problem by spending little or nothing to present these homes so that buyers might find them attractive (which, admittedly, hasn't stopped them from selling like hotcakes lately). Add it all up and bank-owned homes are great comps for other bank-owned homes, but not if they're not.
The other contention often raised in defense of the HVCC is that agents just can't wrap their minds around the idea that prices are still declining. This ignores the fact that multiple offers on well-priced bank-owned homes indicate too much demand for too few homes, which in any circumstances other than bust hysteria would make a strong case for rising prices at the low end. It's as if these people are saying, "Wait a minute! We don't think home prices should recover just yet!"
So what is this Home Valuation Code of Conduct, and how did it come to pass?
According to a Fannie Mae press release, the HVCC is designed "to help enhance the integrity of the home appraisal process in the mortgage finance industry". Translation: Consumer advocates and some appraisers had been complaining that during the boom appraisers were forced to inflate home prices because of pressure from lenders, agents and (ironically) consumers to come up with appraisals that ratified whatever the buyers offered. Of course, booms are never this easy to explain away—note that the very consumers the HVCC is ostensibly designed to protect were often the ones pressuring appraisers. No, booms are very much a team effort (as are busts) and only politicians and regulators could ever claim with a straight face that one quick fix could defang market cycles.
No, the problem is far more complex and more irritatingly complex than the pols, bureaucrats and other outsiders would prefer to believe. During the boom, everyone involved—appraisers, buyers, sellers, agents, loan agents—faced this problem: in rising markets, yesterday's closed sales won't justify today's higher prices. So what to do? Repeal market cycles? Pass a law that says home prices can go up only X percent each year? Or let appraisers use whatever market knowledge and judgment they have to keep from getting in the way of normal price increases? And when do price increases cross the line from "normal" to "bubble"? And who gets to draw that line? Appraisers? Regulators? Buyers? The first two are thin reeds, the third prone to swinging between excessive optimism and excessive pessimism.
Yes, a situation like this calls for a well-reasoned, nuanced solution, if in fact there's any real solution to corporate greed and human nature. And in the heat of the moment, with heads to hunt, careers to advance and an angry populace clamoring for someone to do something—anything—reason and nuance get run over by headlines and expedience.
So by November 2007 New York Attorney General Andrew Cuomo (Governor Cuomo? President Cuomo?) had waded into the fray with an investigation of "widespread collusion" between lenders and appraisers. However, Cuomo's "investigation" appears to have consisted entirely of issuing subpoenas for the records of Fannie Mae and Freddie Mac, who together currently account for about two-thirds of home loans. Rather than let Cuomo have a field day tramping through their books—and see how precarious their financial position was?—Fannie and Freddie capitulated to a set of restrictions on appraisal origination, written by Cuomo's office, that went into effect May 1, 2009. And while the HVCC applies only to appraisals for loans Fannie and Freddie purchase, FHA loans may be next, and since Fannie and Freddie guidelines carry so much weight within the mortgage industry it may only be a matter of time before the HVCC affects appraisals for all home loans.
So what are these restrictions? Fannie's Home Valuation Code of Conduct FAQs is eight pages of mostly arcania, so I'll give you the highlight: "loan production staff" can no longer speak directly to appraisers. "Loan production staff" consists of "those responsible for generating loan volume or approving loans, as well as their subordinates. This would include an employee whose compensation is based on loan volume or the closing of a loan transaction". A Princeton Capital handout to its loan agents amplifies this: "loan originators, REALTORS® and other interested 3rd parties cannot have any part in selecting the appraiser...loan originators cannot have direct contact with the appraiser until such time as the report is complete." To enhance the appearance of hands-off impartiality, many lenders have started using "appraisal management companies" (AMCs) to initiate and follow up on appraisals. But since these lenders often have an ownership interest in the AMCs they use, the potential if not actual conflict of interest the HVCC was intended to eliminate still exists.
Now here's where the Law of Unintended Consequences comes in. Appraisal management companies are another link in the appraisal chain and, in real life, as opposed to political and regulatory life, links don't come free. In real life, links are people and capital equipment that someone has to pay for. So now someone has to pay the employee whose sole job is to order and follow up on appraisals. Someone's also got to pay the rent for the office space she sits in. Someone's got to pay for the desk she sits at, the phone line she uses to talk to appraisers, the copier she copies on, the fax machine she faxes with, the office supplies she burns through, the coffee-maker in the break room, her support staff (and their desks, phone lines etc.) and the cleaning crew that comes in at night. And that someone isn't going to be the lenders, not if the lenders can help it.
How about the consumer? Sure, the consumer will pay, but mostly indirectly, or otherwise there'd be even more flack directed at lenders. So who else's hide can these extra costs come out of? How about the appraisers themselves? Sure, think the lenders' best minds, there must be plenty of desperate appraisers these days, now that home sales are down. Desperate appraisers who'll take what we pay them, just to have a steady income stream. Or maybe it'll be more like an income trickle, because we'll pay them as little as half what appraisers are usually paid. But we'll sweeten the deal by giving them all the work they can handle and then some, much of it in far-away places they've never heard of.
Now, what kind of appraiser might be desperate enough to work harder and drive longer for less money? Maybe a newer, less-experienced appraiser who hasn't been around long enough, and demonstrated enough competence, to establish what until May 1 were all-important business relationships with lenders and mortgage brokers?
No one familiar with the latest in affinity relationship thinking will be too surprised that the AMCs are taking their pound of flesh out of the appraisers, the lowest end of the food chain. AMCs are no different than the corporate and third-party relocation departments who've eliminated their cost to employers by squeezing agents, the lowest end of that food chain, for all they're worth.
And no one familiar with the fate of unworkable but politically expedient quick fixes will be surprised that Cuomo's HVCC is under fire from powerful special-interest groups including the National Association of Realtors, the National Association of Home Builders, the National Association of Mortgage Brokers and established appraisers protesting the AMCs' disruption of existing relationships and wholesale fee discounting. Even the Mortgage Bankers Association has expressed "concern". The only surprise is that it's taken months, not the usual years, for this particular unworkable but politically expedient quick fix to show itself for what it is.
Which is a shame, because lost in all the hoopla and finger-pointing is the fact that there really is a problem, although as usual it's not the problem most people think. No one can blame appraisers for adapting to the peculiar realities of their profession, and after several years of hearing appraisers assure us they'd be the last honest men and women in real estate if only they were left alone, I'm prepared to believe that they're pressured to "make the price" in boom markets. And it's rapidly become apparent that in busts appraisers are either pressured, or pressure themselves, to give conservative valuations. "I don't want to stick my neck out", says a Phoenix appraiser quoted in a June 9 Wall Street Journal article.
Add to this the fact that very few people understand that the appraiser's client is the lender, not the borrower—that the borrower simply pays $500 to the appraiser to safeguard the lender's, not the borrower's, let alone society's, interests—and you're guaranteed even more popular confusion about what the appraiser's real role is and could ever be.
So, given the:
it's beyond my comprehension why anyone thinks this system could ever work. No, I take that back. The system does work—for the lenders who still run it, despite all the lipstick and powder that they and Cuomo have applied to it. Which should please anyone who thinks that the lenders' interests are society's interests.
No one should be surprised that an agreement a cynic would say was crafted solely to, on the one hand, advance the career of an ambitious politician and, on the other, save the careers of a few people at Freddie Mac and Fannie Mae (and unsuccessfully at that) would be deeply flawed. Nor should anyone be surprised that the lenders affected figured out how to make a quick buck off it. Nor should anyone be surprised that in this latest morality play, pitting sleazy real estate industry against crusading attorney general, the hero isn't necessarily the guy wearing the white hat.
What's the solution? Zillow. Yes, Zillow, the outfit that uses 100 comps, 99 of them bad, and knows less about your neighborhood real estate market than you do. Because that's where the HVCC's unintended consequences seem to be taking us. And Zillow doesn't charge you $500. Nor is it likely to point fingers when the chickens come home to roost.