The Appraisal Debacle: An Example of How Not to Regulate
July 6, 2009, Revised December 12, 2010

Enacting rules to curb abuses arising during a housing bubble, which don’t take effect until the succeeding financial crisis, can easily do more harm than good. This is the case with new rules requiring that property appraisals be insulated from pressures exerted by any of the parties with a financial interest in an appraised value: primarily lenders, mortgage brokers and Realtors.

Appraisals are informed judgments regarding the value of specific properties. They are not perfect because appraisers must work with incomplete information. Further, appraisers are subject to bias, the more so the less complete the information available to them,

During periods of rising house prices, such as 2000-2006, many appraisers erred on the upside, because they were part of a community that expected further price increases. This tendency was sometimes reinforced by pressures exerted by lenders, Realtors and mortgage brokers. None of them wanted to see deals torpedoed by appraisals below the prices buyers had agreed to pay. 

In late 2007, attorney general of NY State Andrew Cuomo sued the appraisal subsidiary of title insurer First American for allegedly conspiring with WAMU, a major mortgage lender at the time, to inflate appraisals. Because WAMU sold a large portion of its mortgages to Fannie Mae and Freddie Mac, Coumo embarrassed the agencies into issuing a Home Valuation Code of Conduct (HVCC). The code declared that the agencies thenceforth would only purchase mortgages that were supported by an “independent” appraisal.

The objective of HVCC was to insulate the appraisal process from influence by any of the parties with an interest in the outcome. Mortgage brokers and Realtors could no longer have any contact with appraisers, and lenders had to obtain appraisals in some manner that prevented them from exercising any control.

The problem with this well-intentioned rule is that it was issued in December 2008 to become effective May 1, 2009, or squarely in the middle of the worst housing market since the 1930s. With house prices declining, the upward bias in appraisals that had prevailed during the bubble had morphed into a downward bias. Many deals are not getting done because appraisals are coming in too low, and HVCC is seriously aggravating the problem.

To protect themselves from liability, most lenders are ordering appraisals from appraisal management companies (AMCs), which intermediate between the lender and the appraiser. The AMC selects and pays the appraiser, receives and evaluates the appraisal, and passes it to the lender, who has no direct contact with the appraiser.

Because AMCs operate nationally but do not have appraisers everywhere, more appraisals are being done by appraisers who are not familiar with the local market. Less knowledge by appraisers means more scope for bias, and in a declining price market, the prevailing bias is toward lower values. Appraisers working for AMCs are also paid less per appraisal than independents --  it is common practice for AMCs to put appraisal assignments up for bid, with the low bidder winning the assignment. This may induce them to invest less time. Intermediation by AMCs also lengthens the period required to complete purchase transactions. People involved in the process tell me that it can add an extra week. In an increasing number of cases, the paperwork doesn’t get done by the contracted due date, or the buyer’s mortgage lock expires, either of which can derail the transaction.

The objective of HVCC was to prevent pressures being imposed on appraisers to raise values. But HVCC also prevents the loan officers, mortgage brokers and Realtors who work with borrowers from pressuring appraisers to get a deal done in time to meet a deadline. Further, they can no longer keep their clients informed about the status of an appraisal because they are no longer in the loop..

In addition, the loan officers, brokers and Realtors who fashion deals for consumers used to have access to informal value opinions from the appraisers with whom they worked. Such opinions allowed them to abort house purchases and refinances that clearly would not fly because of inadequate property value. This source of information is now closed to them, with the result that deals that previously would have been screened out are now going through the system to be rejected, imposing needless costs on everyone involved.

HVCC has also pretty much eliminated the ability of a borrower to use the same appraisal with multiple loan providers. Before HVCC, mortgage brokers could use one appraisal with any of the wholesale lenders with which they dealt, and lenders sometimes accepted appraisals ordered by others. Today, brokers are out of it and lenders using AMCs will not accept appraisals ordered by other lenders because they cannot be sure that the other lenders are following the HVCC rules. The upshot is that borrowers who change lenders have to pay for more than one appraisal.

In sum, the HVCC “cure” for the appraisal problem of over-valuation has been implemented in a market where the problem has become under-valuation, and HVCC is making that problem much worse. It should be scrapped. When normal markets re-emerge will be time enough to reconsider how appraisals can be made independent without disrupting business relationships that have served borrowers well.

NOTE: I am grateful to Kevin Iverson for insightful comments.  

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