Reforming the Mortgage Banks

    

Home prices ballooned far out of proportion to economic reality between 2002-2007 in many U.S. metropolitan areas.  Among the leading causes for the real estate bubble was a widespread collapse in lending standards, the ubiquity of cheap money (low interest loans), and a systemic problem in the home value appraisal industry that must be addressed now.

Grossly over-inflated home values significantly contributed to the national housing debacle [1].   Read Irrational Exhuberance and learn from Yale University Professor Robert Shiller that many U.S. metropolitan areas became woefully over-inflated during the first several years of the 21st Century.  From my own perspective as a former residential mortgage underwriter, I assert here that one root cause of the housing bubble is found within the single accepted method of appraising home values.  The widespread use of the Comparative Sales Method as a sole source for appraising the value of mortgage security (the home) causes values to detach from economic reality under conditions of very lax credit. There are actually three real estate appraisal methods available for use by banks; and the two that are not generally used reflect economic reality much better than the comparative sales method.

Congress should amend the National Bank Act to mandate that all FDIC insured institutions must average at least two of three separate residential appraisal methods in determining a homes value, if a home will serve as security for a bank loan.

The appraisal process establishes the value of the security that will back a mortgage loan; here the value of the security is the appraised value of a home. If the security backing a loan is significantly over-valued, then the mortgage bank carries a much greater risk than is apparent on the face of a loan. Where a group of national banks convey tens of thousands of mortgage loans annually, the undisclosed risk will permeate the entire national banking system.

The Appraisal Methods

According to accepted real estate and banking practice, state-licensed home appraisers provide valuation reports to lending institutions; the mortgage lenders then use those reports to establish the value of the security. As it stands, in many U.S. states the comparative sales appraisal method is the only one used in valuing the security that backs a mortgage loan, even though three appraisal methods exist. Among the three appraisal methods, only that of comparative sales prices has the potential to completely detach home values from economic reality. Here is a short synopsis of three real estate appraisal methods, only the first of which is generally used for establishing the value of owner-occupied homes.

The Problem with the Comparative Sales Method

Returning to the comparative sales approach, we must recognize that several implicit assumptions are built into the derived prices for homes A, B, and C.  For example, under traditional lending standards, no prudent banker would typically allow a borrower (even with good credit) to commit more than approximately 30% of household income to a proposed monthly mortgage payment. That traditional truism automatically helped moderate the growth of home prices. Fewer buyers qualifying for a particular range of mortgage loans meant prices could not go into runaway mode, as there would be less overall demand at a given price. However, consider what could happen to prices if the implicit assumption of the prudent banker were dead wrong? What if prudence gave way to a five-year flight to Fairyland, a land where borrowers were granted loans without regard to their incomes?  Additionally, under traditional mortgage lending standards, homes could not be purchased (without special Government-backed programs), unless the buyer gave at least 5% (and typically 10 to 20%) of the purchase price as a down-payment. The most prudent lending standards call for borrowers to give at least 20%, so that the bank is comfortable that its loan amount can be recovered, even under a duress sale.  However, what might happen to sales prices in a highly competitive market, a market flooded with buyers specifically because homes could be purchased without any down-payment?  The combination of ignoring borrower income levels and dispensing with downpayments directly fuels a massive, but artificial, demand for housing.  Upwardly spiraling demand causes people to try and outbid one another; the overbidding process leads to grossly over-inflated home values.  And those artifically inflated values (because the demand was artificially created) are then used for the comparative sales figures to value the next set of loans for the bank.  With a systemic cause in place for over-inflated loan security (one greatly exacerbated by lax credit standards), the banks cannot help but get into trouble. 

Conclusion:

In the final analysis, there is a systemic flaw in the current practice of using only the comparative sales method for valuing owner-occupied homes in the United States. Compelling FDIC-insured banks to use one or both of the two additional appraisal methods that are standard in the commercial and investment segments of the real estate industry would most likely circumvent another housing bubble from developing when the next generation forgets this one.

For a fanciful illustration of the comparative sales method, see below.

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The comparative sales method (CSM) plays out like this: the proper value of Home X is sought. Homes A, B, and C have all sold in the same neighborhood within the past six months for $220,000, $250,000, and $280,000, respectively. For simplicity, Homes A, B, and C all have very similar square footage, fixtures, and other amenities as home X. All four homes are considered very close equivalents. Therefore, the appraiser will provide a value very close to the median price among the three recent comparable sales and will provide a certified opinion that Home X is worth approximately $250,000. According to the current rules of the real estate game, this is both ethical and accurate. The problem is that the comparable sales method, without design or mal-intent, fuels home prices without any anchoring in economic reality. Un-tethered by extremely easy credit and public policy that ignores economic reality, this appraisal method essentially facilitates a positive feedback loop that continues to accelerate until a critical breaking point is reached.

Fanciful Illustration:

To further illustrate how the comparative sales method breaks down under certain conditions, consider two homes being valued in two different states within the United States of Make-Believe. Home A will be valued in the State of Sobriety and Home B will be valued in the adjoining State of Euphoria. The same development company simultaneously built the same home to the exact same standards in the two neighboring states. The only difference between the two homes is the jurisdiction in which they were built. Sobriety has traditional, prudent home lending standards that will not be broken under any circumstance. Euphoria, on the other hand, has developed a system of exceptionally lax credit standards and also maintains a policy that seeks to maximize its home ownership rate. The lending standards of Sobriety reflect more than five decades of borrower-creditor experience; the lending standards of Euphoria reflect a combination of investment banking greed and less-than-well-reasoned policy.

In the state of Sobriety, Home A will be compared against three other recent home sales in its neighborhood. Since borrowers must have 20% as a down-payment and will not be allowed to commit more than approximately one-third of income to Principal, Interest, Taxes, and Insurance (PITI), there are comparatively few buyers in the market. With so few buyers, sellers are compelled to negotiate; and, generally, reasonable final sales prices result. Those final sales prices are then used as comparative sales figures for future values that will be derived under the comparative sales method by appraisers. Without a flood of buyers, the comparative sales method will work reasonably well. For our purposes, Home A will be valued at $200,000.

In the state of Euphoria, appraisers have no problem finding comparable sales for Home B. Within the past three months, six homes sold (in less than 15 days) for an average price of $299,000. And the reason is easy enough: many, many more people in Euphoria were allowed to bid up the prices of the other homes in the neighborhood through a combined mechanism of extremely lax credit standards, abandonment of down-payments, and the requirement to provide verifiable evidence of income. Additionally, even where documented, borrowers in Euphoria were allowed to pledge 40 and 50% of income, no matter what the economic consequences of these ratios would mean. Euphoria artificially inflated the value of Home B by an additional 50% above the Sobriety value through a combination very lax credit standards and a home appraisal process (CSM) that, without design or intent, acted as a catalyst for artificial inflation.   


[1] http://www.washingtontimes.com/news/2008/jan/21/overvalued-homes32discourage-buyers/

 

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Comments

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Walter's Comments:
Great article! Congress should act on this!

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Evan's Comments:
interesting; hope it gains some steam

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Keith's Comments:
Excellent article providing easily understood language and analysis. There is a message here for everyone.

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