Gaming Home Values and Their Consequences

by Morgan on January 7, 2009

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The plummeting Case-Shiller Index, which showcases the free fall that has become the housing market got me thinking about the bubble inflation during the preceding years and the role that house valuation played in this implosion. It also got me thinking about the difference between Case-Shiller price drops and actual price deflation for those people who manipulated (or were manipulated) their housing price during the boom.

Pushing Appraisals

Let’s start with the problem. In residential lending the broker or lender is the one who orders the appraisal of the property. Whether they pay for it or the borrower pays for it is moot. In theory, the appraiser is hand-selected by the lending institution to deliver a fair value of the property. However, in practice this process often works in reverse. The lending institution already has a number that they “want” for the property to make the financing “work” under bank guidelines. This creates a rather massive conflict of interest. The broker or lender originator is trying (for all intents and purposes) to find the maximum reasonable value of the home to secure either the lowest interest rate or the maximum cash out (on a refinance) for the loan. The bank on the other hand (one would think, but often be wrong) should be looking for the lowest reasonable value of the property to protect their position. This conflict played a major role in fueling the bubble.

A Positive Feedback Cycle

Home property values exist in a positive feedback cycle (no matter if the price is going up or down), that is, the current direction of the prices tend to reinforce that present direction. The effect builds on itself. For instance you have 5 homes of similar characteristics (bedrooms, lot size, make, materials, ammenities, etc.) and they all have a 2006 value of $400,000. These homes are called comparables or “comps”. If two of those homes sell in foreclosure or short sale for $320,000 (a 20% drop) then these will influence the price of the remaining three homes that were previously valued at $400,000. These new comps drag down the price of the surrounding homes. The converse is true as well, and it was this positive feedback cycle that fueled the massive escalation of home prices in the frothiest of markets. Each new comparable sale that came on to the market at a slightly higher price established a new “comp” which helped set the market price in the area higher.

Throwing Gas on the Fire

This positive feedback cycle was reinforced by originators trying to make loan terms work for their borrwer. Using automated underwriting or by hand with published underwriting matricies, they worked to fit loans in to approvable packages. Meanwhile, banks and their risk managers sought to “protect” themselves by making it easier to qualify at lower loan to value ratios (LTV). The key assumption there being that if a bad credit risk defaults the bank has a greater likelihood of recovering their investment the more equity is protecting their position. With that assumption in-hand they built their guidelines to allow for more risk the lower the LTV. The higher the LTV the “better” the borrower had to be in terms of credit scores, income, etc. These guidelines were banded so that there were very clear breaks that significantly changed at each tier. For example if you had a credit score of 580 you might be able to get financing up to 70% LTV ($70,000 on a $100,000 house) but if your LTV was 72% the borrower would have to qualify at the 80% LTV band, which could dramatically change the terms of the loan, such as jumping the interest rate by 1 or 2%, changing the monthly payment dramatically. It also might change other ratios required by the guidelines that would “kill” the deal.

And, conversely each 5% (typically) that you were able to drop the LTV of a loan the lower the interest rate would be for the borrower. So you can see there was immense pressure in an uber-competitive environment to get the “best” value for the customer to win the business. Best always meaning highest.

Competition and Gaming LTV Ratios

This led to increased competition among loan originators to get the highest value of the house because that often resulted in the lowest interest rate, or maximum cash-out of a refinance, and the lowest or the most would win the business. A typical borrower talking to 3 or 4 mortgage originators would of course go with the lowest rate or max cash, so the originators would try to find the highest value of the home to make their quote the best. For example if you were an originator and the borrower needed an $80,000 loan. If an originator thought that your home would only be appraised at $100,000 (80% LTV) they would quote the borrower on the terms and conditions and rates associated with an 80% LTV loan. However, if the originator thought that the house could be appraised at $107,000, the LTV is now 75% and the terms, conditions and rates improve dramatically. You can see the problem. With 3 people competing for the loan, the lowest loan to value means the most favorable terms (and usually a new customer).

How are the originators getting these new values precisely? They’re getting the recent comparable sales data from title reports for homes that have recently been financed in the area. They look at 10-12 homes, find ones that are comparable and estimate the value of the home. Then they assume that in a rising market that prices are naturally going up and build their assumption from there. Since they’ve never seen the property or the neighborhood this is all the information they go on. But it makes for a thinly plausible guess and that’s the number they work with.

Delivering the Value

Now comparable sales from title reports do not an appraisal make. The originator needs to “hire” the appraiser (even if they have the borrower pay for it they’ve chosen the appraiser to do the work (in most instances)). They send the appraiser a request for appraisal. On that request for appraisal they note the estimated value of the property. This is the number that they “need” to make the loan work at the terms they’ve quoted their recently-won customer. If this value doesn’t come in the terms of the loan changes and the customer walks (or is extremely upset about the bait and switch). This value while not explicitly stated as the needed value definitely has that need implied. Often the originator will talk to an appraiser about the value before even ordering the appraisal, just to make sure the appraiser can “get it.”

Rock and a Hard Place

This puts appraisers in an extremely difficult situation. Appraisers, often sole-propreitors or small shops, need business to feed their families, etc. They don’t get paid unless they complete an appraisal. And they often don’t get an appraisal order unless they can confirm that they can get the value requested ahead of time on the phone. While this is certainly illegal and not the way it is supposed to work (because the appraisal is supposed to be an independent valuation) it is a common practice. Now laws are going in place so that brokers and other folks can’t have business relationships with their appraisers for just this reason to eliminate this conflict. Additionally, if the appraiser goes out and assigns a value to the property that does not meet the “needed” value by the originator that appraiser will never (likely) receive another order from that company. If it’s a large company that appraiser will likely be noted in the system as “difficult” or “can’t get value” and they lose tons of business as the company goes with other appraisers in the area who are more “flexible” or those that “can get max value”.

Banks Worked to Protect Themselves

This is not rocket science. And banks and underwriting departments knew this. Often underwriters and appraisers had to bear ugly confrontations from originators and sales managers when the value didn’t “come in” as anticipated and the deal was lost. At my company I was responsible for running Automated Valuation Models on each of our banked loans to ensure that we weren’t being hung out to dry by aggressive appraisals. These AVMs were sophisticated models that tried to put a price on a property through all sorts of data. If the appraisal and the AVM were outside of 10% of one another we ordered a drive by appraisal or a desk review from a certified appraiser to ascertain a realistic value of the property. This double-checking did not make the sales people happy – as often, surprise, surprise, appraised values would be modified downward.

But no system is perfect and eventually we got burned on one appraisal on one loan. To the tune of about $70,000 when all was said and done.

Pushed Appraisals and the Effect of Falling Home Prices

Where this really gets interesting to me though (because malfeasance and greed-driven actions of the industry have been well-documented) is the plight that these home owners with “pushed” appraisals face today. Assume your home was worth $300,000 in 2005 and you decided to take out a loan of $180,000 to fix some things up and redo your higher-interest rate first mortgage. You’re at 60% LTV. If the value of your home over the course of the last two years has fallen 20% your LTV is now is now 75% (property $240,000 loan approx still $180,000). This means that if you had to you can still sell, or even refinance in to a lower rate, an FHA loan or some other type of program (say if your ARM loan was adjusting). However, assume that the $300,000 was really pushed 5% (so the actual value was $285,000. Now with home prices dropped 20% (plus your pushed ghost equity wiped out) you’re effective property value is now $228,000 which gives you a LTV of 79% (still a “doable” loan but very close). And if property values fall greater than 20% you’re basically stuck in a loan as underwriting guidelins get exceptionally difficult above 80% on refinances.

Getting Screwed

So the folks that bought or refinanced in the bubblicious markets are now duly screwed, because their home value was so jacked up that their properties are outliers to the average price value in the area. This means that for them a 20% drop in prices is really something like 22-25% or higher loss in their value. This reduces their options and may eliminate the chance at refinancing. I wonder how many homes out there are like that. When they see a 20% drop in home values but know that they are far worse off than that? It must be a nightmarish feeling. Because in going for the “best” they ended up in a situation far more damaging then if they had received the proper valuation in the first place.

Mea Culpa

Right now I’m saying that it’s late at night while I’m writing this, I have no internet access, I’m terrible at math and the math above is a little fuzzy. Also, I’ve been out of the industry for almost two years now, so I don’t know the guidelines for refinancing today. Maybe it’s still easy to get financing above 80% and this is all a worthless exercise. So apologies if the math or the severity of the changes is off. You’ve been warned, but hopefully you still catch my drift.

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Viewing 9 Comments

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    Near as I can tell, your math is fine. A variation on this was the Alt-A 100% investor purchase mortgage that allowed the seller to pay a 3-6% concession to the buyer for closing costs. Assuming a 5% push on the appraisal for a $200K purchase and that the retreating market started earlier than is generally recognized (say the middle of 2005), then you have 2 years of deals where buyers were upside down the minute they left the closing by $16-22K.

    The part I can't figure out (with any real precision) is the cumulative effect of using comps that are pushed, and then pushing even more. Transactional velocity (growing numbers of purchases and refis) created nearly all the appreciation, not ordinary supply and demand.
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    "The part I can't figure out (with any real precision) is the cumulative effect of using comps that are pushed, and then pushing even more. Transactional velocity (growing numbers of purchases and refis) created nearly all the appreciation, not ordinary supply and demand."

    This is what I'm wondering too. Great comment. Was it all just related to churn, or real demand? I'll hunt around to see if there are some opinions on it.
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    This was part of the problem, but the primary inflationary pressure came from too much easy credit. An appraisal is supposed to support what a willing buyer would pay for the property. The law of supply and demand determines values. The artificial demand for housing created by people who shouldn't have been in the housing market in the first place but were there nonetheless created enough demand that the prices were really being pushed up from an appraisers viewpoint.

    That being said. I think there it is a fundamental systemic flaw to have both originators and appraisers essentially working on commission. (Not technically in the appraisers case, but effectively. Due to the pressures you cite in the post.) I don't think it will be a very long time before those two groups are working on salary only.
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    I agree completely. I don't think that it was the primary problem, but definitely an important factor. I also agree with your assessment of the compensation structure of the model as it exists currently.
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    Humans are social animals. Herding or following the crowd is good for survival. If you walk alone into the wilderness, you often get a sense of vulnerability – yet, if you were in the wilderness with a group of people, you would feel invincible.
    Copying the actions of others is much easier… remember the high-tech stocks? I know I started to feel the pressure to invest in companies with no real product, assets and earning history. (Luckily I didn’t)

    I suggest that we have not had very many “normal” real estate markets in the past 20 years. When housing was appreciating and banks made it easy to obtain a loan; the human herd jumped aboard which perpetuates the appreciation. Now that housing is declining, the human herd is jumping ship, yet interest rates are still very low and there is an abundance of available housing. We have reached a point in the real estate market that foreclosure is now acceptable to the human herd.
    Now look at our “normal” markets… do you remember any of them? They were very brief in my market area. Home prices were not increasing or declining… there was a perfect number of homes on the market and available to potential buyers… Sellers didn’t need to offer major concessions or drop their list price. Buyers had time to shop and compare homes without the pressure of time - to quote Goldilocks "not too hot, not too cold, but just right."
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    This is very old (mostly) news. The appraisal process today is tight as a drum. And while there are plenty of exceptions, a 2005 FNMA white paper showed that appraised values were in fact lagging the rapidly rising market. The most likely cause being that new contracts for sale were always higher than the available compable properties.

    Sham appraisals have always existed, and he market held steady. However, cheap and easy credit, the real culprit in the housing bubble, has never existed for so long in our economic history.
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    Tobby,

    Yeah, wasn't meant as a news piece, just as a reflection looking back on the industry. I'm actually getting to meet Robert Shiller (of Case-Shiller fame) today so I'm going to ask him about the index and the effect of pushed appraisals in home value declines.
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    Fannie & Freddie helped create the problem of "pushed" appraisals. When they started charging 1/2 point (6-7 years ago) for a 71% loan-to-value "cash-out" refinance, and at the same time defined "cash-out" as a loan paying off any 2nd mortgage (even if it was "seasoned" for 29 years) that hadn't been used to purchase the property, they created an incentive to game the systme. I think they started charging that 1/2 point on 71% LTV cash-out refi's in part because they assumed that appraisals were bogus and that a purported 70 LTV might well really be an 80 LTV. Nevertheless, the fact that they started charging 1/2 pt for 71 LTV c/o refi's incented loanofficers to ask appraisers to push the appraisal a tad bit. Fannie's greed demanded it. Fannie & Freddie simply didn't deserve to get a $1,050 delivery fee on a $210,000 loan just because the appraisal came in at $299,000 instead of $300,000. The fact is that Fannie & Freddie got greedy with their delivery fees, creating a perverse incentive to push appraisals.
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    >>>The appraisal process today is tight as a drum.<<<

    Really..? .. maybe if you live in Tibet....

    One of the major reasons for the market collapse, is *because* of the phony appraisals...

    How many agent/realtors used "their" appraiser of their "A" list..? .. 1 out of 2000.? 1 out 1,500.? .. maybe 1 out 500.? ... how about 50%++..

    Realtors are in a commission driven business, they want their deals to travel the quickest way from point A to point B ....

    Do you think they're going to use an appraiser that is usually dead on the money, or .. are they going to use an appraiser they know will miss a bad roof tile from here to there and not be afraid boot an appraisal an extra $10/$30/$50,000.? --- it's *not* rare ---- it's Common.

    You can't really use a comp unless you've seen it, walked it and felt it ... anything else, is just paper-mâché ..

    I've been buying and selling real estate for over 30 years in 5 states .. If I was buying a piece of property, I always used my own appraiser - as always, it always seemed to be the one the one agents despised the most.

    The appraisal business (as well as the Real Estate business) should have come under scrutiny and changed 20 years ago ....

    Realtors telling potential buyers there is offers when they haven't seen one in 100 days is a farce, or.. the offers they have received, are by consumers that couldn't buy steam off a hotdog - another reason why home values are so distorted ... "buyers agents" telling consumers the house has only been on the market for 9 days, when it's actually been on the market 209 days (because it's been re-listed with it's 3rd realtor and they've lied about it's "actual" DOM) is not only a farce, but should be a Criminal Offense (and handled in that fashion) - how many folks paid $385,000 for a home yesterday that was listed 5 months ago for $345,000.? -- again, another major reason why home values are so distorted...

    Changing the "system" would be the quickest and the cleanest way, it would save the market billions ... anyone with $200 and 30 hours of time on a computer can get a real estate license (depending on the state) it's not much different for appraisers ... make it a college class with actual requirements and limitations and a degree, and you won't get a repeat of: 1999 - 500,000 agents ... 2008 - 1,800,000 agents, and all of them looking for that next commission, the same for appraisers.


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