Market Bottoms, Foreclosures, Mark to Market Appraisals

Sean O'Toole, founder of ForeclosureRadar.com, wrote an interesting blog at ForeclosureTruth.com titled Death Spiral? How to find the bottom in your market. Here he suggested that to find the bottom of the market one should use cap rates. The details you can read for yourself, but he closes the post with this paragraph:

"The one reform I'd really like to see before this mess is over is the death of the comparable sales appraisal approach. By tying lending limits to local rents, we can ensure that homes remain a great investment for everyone. In places like Stockton, where prices have fallen as much as 40%, cap rates are quickly becoming attractive. While inventories are still downright scary, agents are seeing a noticeable uptick in sales...."

Here's what I wrote in response: 

"Terrific post up until the sales comparison comment. I know exactly what you're saying though, but what lenders need to do is revamp the whole way they think about appraisal. Instead of being a single point in time incident, it should be a continuous and on-going valuation dialogue. Think of it this way, if they "mark to market" securities, they should treat the assets collateralizing pools similarly versus relying on automation or other 3rd party analysis that was not a party to the origination of the debt. Appraisals, industry wide, tied to securities, should have a present and "future value" component to be recertified a period later, say 1 year. In doing so, they can appropriate provisions adequately against losses necessary to adjust rates or upfront premiums with the market, not in perpetuity of the market.

As to relying on a cap rates in a residential assignment, it would be done in addendum to the sale comparison method anyway. But what is more important, in my judgment, is median income analysis. A bank simply can not lend 80/20 finance on $850,000 in a $60,000 a year median area. Lenders were not absent the resource to be prudent, hence Paul Volkers' recent comment that the system failed the test of the market. Securitization is great as long as incentives to originate/distribute quality, not quantity, are aligned throughout the money chain."

In reference to his point about cap rates. I think that's a very local issue. In Southern California, for example, residential cap rates will likely remain skewed in perpetuity since home prices completely decoupled from rent/price fundamentals long ago. Not to mention the fact that cap rates are a moving target depending on the types of loans and guidelines available which lever affordability.

Whether or not investors inflate markets is a moot point if the owner-occupant crowd decides those prices are reasonable and are willing to pay them. This is the very definition of market value. It's fundamentally off-base to assume recapitalization is a reflection of market value especially in the residential market where the participants are not fundamentals' based. I would suggest instead that area median incomes be part of the underlying lending decision as yet another mechanism to temper risk.

Regarding my comments on Sean's post, they're points I've made in the past. If almost every residential loan is sold and securitized, and these debt securities are "marked to model"/"market", then why are the assets - the real estate - securing these debt obligations not subject to the same treatment?

Food for thought.

Federal Trade Commission Cautious Of The Home Valuation Code of Conduct

The FTC recently penned a letter to Freddie Mac (cc: Fannie Mae, OFHEO, NY AG "Cuomo") regarding the soon to be enacted "Home Valuation Code of Conduct" which bans the mortgage giants from buying loans with brokered-ordered appraisals.

The letter citied "competitive concerns" and potential regulatory redundancy with language that begs an impact study to fully consider the effects of the HVCC on the mortgage industry and the borrowing public before its' enactment.

(Boy does this sounds familiar)

The meats and bones are here in Section IV:

[...]

IV.    Potential Concerns Raised by the Code of Conduct

The FTC staff is concerned about recent mortgage market turmoil and its effects on individuals, families, neighborhoods, and the overall economy. Some of the current problems in mortgage markets may be attributable to abuses in the appraisals of residential homes. In comments recently filed with the Federal Reserve Board ("Board"), the FTC staff supported the Board's proposed rule to protect appraiser independence, noting that pressuring an appraiser to misrepresent the value of a property distorts the lending process and harms consumers. Section I of the Code of Conduct would provide similar protections for appraiser independence.

Prohibiting specific conduct that may undermine the independence of the appraisal process - as Section I of the Code of Conduct would do - is the most direct means of protecting such independence. In contrast, limiting the way in which participants in the mortgage lending industry can contract with each other and thus imposing potentially significant changes in the structure and functioning of that industry - as Sections III and VI of the Code of Conduct apparently would do - is a much more indirect means of protecting appraiser independence.

The use of such indirect means also creates concerns that, notwithstanding the laudable goal of appraiser independence animating the requirements and prohibitions in the proposed Code of Conduct, such provisions may have unintended adverse consequences for competition and consumers in the mortgage lending area, including, for example, higher prices for consumers without sufficient protections or other benefits to offset such costs.

Based on its experience, the FTC staff recognizes the need to consider all of the implications - including both the benefits and costs to consumers - of imposing restrictions in the mortgage lending area because of the potential for such restrictions to impair consumers' access to mortgage credit.

[...] 

Partial Footnotes:

FTC STAFF, 23 COMMENTS TO THE BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM ON PROPOSED RULE RESTRICTING CERTAIN MORTGAGE PRACTICES 9 (Apr. 8, 2008), available at http://www.ftc.gov/os/2008/04/V080008frb.pdf.

Given the significant roles that Freddie Mac and Fannie Mae serve in the secondary mortgage market, it seems likely that the Code of Conduct will have a significant impact on the structure and functioning of the primary mortgage lending industry.Code of Conduct § VI(5). Section VI(6) extends th 25 is prohibition to any entity owned in whole or in part by a settlement services provider. Id. § VI(6). 26 Id. § III. See also id. § V (requiring certain training for lender employees or, if the lender retains an AMC, employees of the AMC responsible for selecting appraisers).

Advisory Email Message to Seller/Servicers, Freddie Mac, Important Information about Home Valuation Code of Conduct (Mar. 3, 2008) (emphasis added), available at http://www.freddiemac.com/singlefamily/20080303_advisory.html. 28 It is unclear from the language of the email advisory whether prohibited appraisals include those "done" or "ordered" by "an entity that offers any other services other than appraisals" - or both.

Read Complete FTC Response to The Home Valuation Code of Conduct

Also See: An Industry's Fall From Grace...

British Subprime Humor (Video)

California Taking Blows to the Head - Realtytrac Q1 2008 US Foreclosure Market Report Shows

Realtytrac released this week its Q1 2008 Foreclosure Market Report^TM citing a 23 percent quarter-to-quarter rise in nationwide filings, and a stunning 112 percent increase from Q1 2007.

Filings rose in 46 out of 50 states and 90 out of 100 of the nation's largest metros, per the report. The three states with the most filings per household were the usual suspects: Nevada (1:54), California (1:78) and Arizona (1:97). Filings reflect households linked to a default notice, auction sale notice or bank repossession. Click for Full Map 

California's numbers were particularly troubling. Default filings topped the charts with a whopping 108,109 NODs (Notices of Default). That's 108,109 mortgages that are 90 days or more past due. Nevada placed a distant second with a meager 13,424. Adding salt to injury, California registered a whopping 40,023 REOs in the pipe.

NODs ("Pre-foreclosures") are critical because they reflect the number of REOs potentially in the wake. And as a greater number of NODs materialize in foreclosure, the more intense is the negative-feedback dynamic of price declines feeding foreclosures begetting more declines and so on.

But of course, not all NODs end in foreclosure. And I suspect (or hope) that a large number of the 100,000+ NODs are being worked-out in some way. Assuming a troubled borrower is willing and able, foreclosure can be avoided by paying arrearages, qualifying for loan modification, filing for bankruptcy (thereby "staying" default actions) or selling the property.

However, an issue facing most hot spots like California is the problem of mounting negative equity. The growing number of households faced with loans greater than the property's worth has servicers, lenders and analysts fearing the worst case scenario: a proliferation of ruthless defaults. This swanky term coined recently by Wachovia describes the choice by many underwater borrowers to voluntarily stop making payments on mortgages they could otherwise afford. Evidence of voluntary defaults lays with the fact that a large number of NODs are not on properties faced with a mortgage reset. Just Google mortgage rate resets aren't the problem to find plenty of coverage on this topic.

So what does all this mean? It means that so long as NOD cure-rates remain exceedingly low and auctions continue to poorly perform, expect really really elevated REO activity through the end of the year.

  See also: "Wachovia on Ruthless Defaults - Borrowers Gone Wild"

Stable Loan Limits Mean Stable Housing Markets

The Office of Federal Housing Enterprise Oversight (OFHEO) recently issued final guidance on how fluxing house prices would affect Conforming Loan Limits (CLLs) in the future. In a nutshell, the loan ceiling is no longer subject to reduction regardless of declines in price metrics - ever. The ceiling can go up but it will not come down. (Group hug?)

To appreciate the magnitude of this decision, background is in order. OFHEO, the safety and soundness regulator of Fannie Mae and Freddie Mac, govern loan limits to temper the GSEs exposure to the market. Since combined the enterprises fund about 70% of US mortgages, unsafe and unsound practices or policies can threaten the housing market and broader economy. Because of the massive buying power of the companies, their implied government guarantees, and "perceived" quality of their securities, lower rates are afforded to lower/middle class Americans as part of their core mission.

This said - every October the Federal Housing Finance Board (FHFB) issues its Monthly Interest Rate Survey (MIRS) which OFHEO relies on to set limits for the following year. When the MIRS report reveals house price increases, limits go up accordingly. When it reports declines however, OFHEO defers the reduction for 1-year following the results for the subsequent year. Somewhat of a wait and see thing. If indeed there is a persistent fall in prices, theoretically reductions would be in order the year after. This is why a reduction in loan limit was not seen in 2008 despite declines in 2006 and 2007.

As prices skyrocketed this decade, loan limits increased from $252,700 in 2000 to its present ceiling of $417,000 in 2006. That's nearly 40% growth in only 6 years. (See historic limits here). Inversely, imagine if years of decline occurred and this policy was not in place, indeed loan ceilings would have to recede sharply.

There have only been three instances when a reduction in CLL's occurred since established back in the seventies'. They were faint to say the least and rather disorderly (you should read the guidance for details). Given the enormity of the modern mortgage market and severity of declines in recent quarters - any open-ended question about limit drops next year was of high concern (at least to those who thought about this).

Here's an example of what it would mean to NOT have this policy.

Let's assume you bought a house this year and financed $400,000. Then next year the limit dropped to $370,000. Without clear grandfathering provisions, you'd be in a precarious situation if you wanted to refinance since your loan no longer qualified for favorable agency guides' and rates. Now imagine if you had to sell this house. The reduction in loan ceiling for access to GSE-insured financing would require your prospect buyers to; (a) put more money down, or (b) accept less-than-favorable non-conforming/jumbo financing. Either of these two options would materially affect its market value.

But OFHEO finally laid those uncertainties to rest.  

In the guidance, it explains that it will defer percentage drops in the MIRS report until such time increases offset the net decreases. In other words, it will only raise the loan ceiling by the net percentage of growth based on the average of positive net-change in the MIRS report over many years. Once again, it will only raise the loan ceiling by the net percentage of growth based on the average of positive net-change in the MIRS report over many years.

For example: If the October MIRS report for 2007, 2008, and 2009 net a total of a 5% decline in prices (yeah right, probably more), and the subsequent 3 years yield an increase of 7% (yeah right, probably less); We could expect a net 2% raise in loan limits the year after the net increase was calculated. (Not too shabby, huh? At the very least it adds to long-term stability).

If you agree that Fannie/Freddie are the underlying force bolstering property values as we know them, then you appreciate significance of this policy. It is one thing for mortgage rates to change with the market's ebbs and flows, but it's entirely another to have volatility in the access threshold to prime financing.

Should we be breathing easier? I think so.

***

Conforming Loan Limits No Longer Subject to Decrease - OFHEO Examination Guidance EG-08-001

Fannie, Freddie and the Future of Property Values (Original Post 11/20/07)

Wachovia on "Ruthless Defaults" - Borrowers Gone Wild

On Monday, Wachovia's earnings call highlighted grave concerns of over "ruthless defaults", or "walk aways"; both terms describing voluntary defaults by upside-down borrowers.

In short, Wachovia's risk models (and that of all lenders) failed to take into consideration borrower behavior when faced with negative equity.

The question here is simple: What happens when borrowers reach LTV's greater than 100%? This previously unasked question is wreaking havoc on Wachovia's blance sheets, manifesting defaults in big numbers in of all places, The Golden State.

(Hmmm. A case of California borrowers gone wild? Who'd a guessed?)

From Housing Wire, "Wachovia: Borrowers in California are going AWOL":

Calculated Risk posted some highlights of the transcript from the Wachovia earnings call yesterday - and in it are some interesting details about how new modeling efforts at the bank led it to write down so much of the value of some of its loans.

Specifically, Wachovia has discovered the phenomena known as "ruthless defaults," where a troubled borrower faced with an insurmountable mountain of debt simply walks off into the night, never to be heard from again.

From the call, and Wachovia's chief risk officer Don Truslow:

I don't know where the tipping point is, but somewhere when a borrower crosses the 100% loan to value, somewhere north of that ... their propensity to just default and stop paying their mortgage rises dramatically and I mean really accelerates up and it's almost regardless of how they scored, say, on FICO or other kinds of character, credit characteristics.

It's difficult on the walk-away part of the question, that is going on, clearly and there's lots of evidence of that in the market ... And so we do our best to try to gauge but that portion of the defaults is just kind of hard to quantify. But that behavior is going on. We're seeing in our portfolio the most significant declines and defaults activity in California and of course it's the largest concentration for us in the pick a payment portfolio by far. What I don't know and I guess we're just learning over time is whether the same sort of behavioral trends and patterns will spread to other markets or be observed in other markets at the same pace that they have been in California.

In plain English, Wachovia is saying that prior models didn't account for what overextended, upside-down borrowers would do when faced with a mortgage on an asset worth less than they owe on it.

The above should make anyone in the industry take pause, and think about what an extended downturn and recession could mean for millions more borrowers who have either extracted their equity cushion or never had one to begin with.

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CBO Director's Blog

It's amazing what you can find on the internet these days. Would you guess that the Director of the Congressional Budget Office (CBO), blogs?

Well, he does.

Dr. Peter Orszag, the young director who strikingly resembles the kid you'd expect was bullied by the Varsity team, is a modern day "econo-pimp" (pardon the colloquial) that puts out tons of useful information direct from the CBO. I check in with his blog frequently for updates on economic issues. In particular, updates to past testimonies and analysis on housing. I've watched him testify before Congress, and he's quite the intellect you'd expect, with a bit of a humourous side, too.

Below is an April 11^th update on previous analysis of various policy options for the housing mess. Check out the graph below...

Housing policy options

This morning, CBO released a new study on policy options for the housing and mortgage markets. The paper discusses the potential for federal intervention to ameliorate the situation, by encouraging and removing impediments to private mortgage restructuring or by providing federal financial support. (It does not, however, address the question of what regulatory changes might be warranted over the longer term, either to address the problems that led to the current situation or to support any wider federal role in the financial markets.) CBO finds that:

• The current economic situation is quite fragile, largely as a result of the difficulties in mortgage markets and other financial markets. Much of that fragility arises from falling house prices, which affect consumers through their housing wealth and lenders through their loss of collateral. It is exacerbated by the growing complexity of financial instruments and entities, which may make it difficult for participants to know what risks they are assuming, and by the leverage of both borrowers and financial market intermediaries, which means that it is difficult to prevent liquidity and solvency problems from spreading throughout the financial markets.   
  
  
  
• Foreclosures are an expensive way to resolve delinquencies. A large number of foreclosures is also likely to reduce the demand for houses, as potential purchasers conclude it would be better to wait until prices stop falling. Thus, excessive foreclosures could trigger a downward spiral of house prices that could take them below what would be justified on the basis of normal relationships to income and production costs. Such a downward spiral would exacerbate the problems in the financial markets, and...
  
  
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President of Netherlands Bank on Basel II - FT.com

Basel II and Cornflakes® rarely mix. But while headed for some light reading on FT this morning, I caught an article written by Nout Wellink who is chairman of the Basel committee. Here he address's the core principles of BII and responds to critics of the framework who argue it is procyclical versus anticyclical - a key distinction worthy of address by the chairman himself.

From the Financial Times:

Basel II is sophisticated and sorely needed
By Nout Wellink
Published: April 9 2008 19:21 | Last updated: April 9 2008 19:21

The current financial market turmoil underscores the importa­nce of strongly capitalised banking systems. It also highlights the shortcomings of the Basel I capital regime, which has been in place since 1988 and has contributed in the past few years to the concentration of risk in the banking sector.

There is a strong consensus that the implementation of Basel II will put capital regulation on a sounder footing. Among other things, Basel II will enhance capital regulation, super­vision, risk management and market transparency. All exposures, whether on or off the balance sheet, will be subject to regulatory capital charges. There will be greater differentiation in the capital requirements for high and low-risk exposures. Basel II will create more neutral incentives between retaining exposures on the balance sheet and distributing them to investors through securitisations. It will introduce more robust capital requirements for banks' rapidly growing trading and derivatives activities. Supervisors will be given the tools to help strengthen banks' risk management and governance. Better disclosure of banks' risk profiles, including structured credit and securitisation activities, will be required.

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Here's the article he's rebuffing.

Turmoil reveals the inadequacy of Basel II
By Harald Benink and George Kaufman
Published: February 27 2008 19:23 | Last updated: February 27 2008 19:23

The turmoil in world financial markets, triggered by defaults on subprime mortgages in the US, raises questions about macroeconomic policy, financial stability and the design of financial regulation, including the new Basel II capital adequacy framework for banks.

The implementation of Basel II coincides with massive losses reported by some of the world's largest banks, requiring large-scale recapitalisations. The risk models that anchor Basel II are basically the same as the ones many of these banks have been using in recent years. Sheila Bair, chairman of the Federal Deposit Insurance Corporation in the US, recently noted that these models had important weaknesses which, in the light of today's market turmoil, were a flashing yellow light to drive carefully.

Basel II aims to address weaknesses in the Basel I capital adequacy framework for banks by incorporating more detailed calibration of credit risk and by requiring the pricing of other forms of risk. Under the Basel II framework, regulators allow large banks with sophisticated risk management systems to use risk assessment based on their own models in determining the minimum amount of capital they are required to hold by the regulators as a buffer against unexpected losses.

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An Industry's Fall from Grace – A Few Words About the HVCC

Lot's been said about the OFHEO/GSE/Cuomo agreements made public last month. I've kept a tight lip on the issue since from the onset; it felt like appraisers were getting Punk'd by the brass above. But kidding aside, the Cooperation Agreement - and its offspring the Home Valuation Code of Conduct (HVCC) - is no joke and aimed clearly at dismantling the status quo for all independent practitioners.

The agreement, which bars Fannie Mae or Freddie Mac from purchasing loans where the appraisal was ordered by an interested party in a transaction, speaks volumes about regulator distrust of the industry as a whole. The logic behind this agreement is simple. Loan originators (and/or realtors) pressured appraisers to inflate appraisals; and inflated appraisals are to blame for the housing collapse. To praise this agreement one has to accept this premise as fact. A tenet I wholly reject. In the name of promoting "appraiser independence", this agreement severs long-standing relationships among industry professionals, ultimately shackling appraisers to intermediary firms to receive assignments.

This agreement, through and through, is suspect to say the least. The New York Attorney General Andrew Cuomo leveraged the GSE's buying power in efforts to alter industry practices instead of legislating the deal through Congress. Off the bat, this is a no, no. Especially since other Congressional and Federal proposals reforming appraisal and industry practices are still in the works. And with waning investor confidence in the backdrop, Cuomo took advantage of the GSE's fragile reputation recovering from the 2004 accounting scandals and struck an accord. OFHEO, the GSE regulator with a track record of inconsistent oversight of the two lending giants, was complicit by its impotency. And adding to the hypocrisy, the HVCC empowers the very institutions that were at the root of last year's investigation by the attorney generals office. Does anybody else see a problem with this?

Those who've been in the business for any length of time realize Cuomo and OFHEO clearly missed the mark.

Industry interaction is not the cause of the ailing housing market nor is industry segregation the remedy. The root cause of the problem lies in systemic misfeasance. If you envision the US real estate industry as one giant corporation, including investors and hedge funds, this visual makes a lot of sense.

At the top of the food-chain, bond and securities investors are the source of funds for US home loans. This group keeps the likes of Fannie and Freddie, the primary conduit for risk dispersion across the globe, in business. In recent years, this group took way too much risk without proper due diligence. Their reliance on independent analysts to price assets (determine risk) is akin to funding institutions (banks) that lent against appraisals or AVM's without the benefit peer review. Even today, an appraisal review is not policy but rather a precaution at the behest of underwriting unless investor guides or program matrices dictate otherwise. Fathom that.

The risk that investors took of course trickled down to the consumer space and dawned a toxic way of looking at housing debt. The consumer, guided by professionals empowered by the commercialization of home loans and the political rhetoric of the "American Dream", surely felt secure assuming debt that "never gets repaid anyways" and would be hedged against "a life-long appreciating asset". This logic wasn't, or isn't entirely without merit since few could have imagined how homeowners would react to negative-equity regardless of the long-term objective. But the snow-balling effect on housing prices increased the demand for more innovative ways to distribute risk "up above" in order to dull the sticker shock "down below" and perpetuate the buying party.

While these were the dynamics in play, the root cause for current woes was ineffective regulation over competition among primary market participants. The fierce competition at the origination and funding levels, combined with investors' insatiable thirst for yield, encouraged lax loan parameters which lead to over-borrowing, the prevalence of short-sighted mortgage products, and the dissemination of unconscionable levels of risk across the globe. However, this could not have become reality if it wasn't for the Fed's inaction (or inability in some cases) to moderate the market. Hence the Treasury plan.

Contrary to popular belief, regulation is not a four-letter word. The rule of law shapes social behavior and can do so towards positive outcomes so long as the right economic incentives are in place. However, the current system dubbed the "originate-to-distribute" model is no doubt the root cause of the pressure-cooker that became the housing industry.

Here's what Frederic Mishkin of the Federal Reserve said in a speech at the US Monetary Policy Forum in New York in February:

"As has been true of many financial innovations in the past, the benefits of this disaggregated originate-to-distribute model may have been obvious, but the problems less so.  The originate-to-distribute model, unfortunately, created some severe incentive problems, which are referred to as principal-agent problems, or more simply as agency problems, in which the agent (the originator of the loans) did not have the incentives to act fully in the interest of the principal (the ultimate holder of the loan).  Originators had every incentive to maintain origination volume, because that would allow them to earn substantial fees, but they had weak incentives to maintain loan quality.  When loans went bad, originators lost money, mainly because of the warranties they provided on loans; however, those warranties often expired as quickly as ninety days after origination.  Furthermore, unlike traditional players in mortgage markets, originators often saw little value in their charters, because they often had little capital tied up in their firm.  When hit with a wave of early payment defaults and the associated warranty claims, they simply went out of business.  While the lending boom lasted, however, originators earned large profits."  

Originators in the Mishkin speech refer to funding institutions e.g. Washington Mutual or Countrywide Home Loans, etc. This umbrella however, also includes their wholesale and correspondent business vis-a-vis mortgage brokerages.

You don't need a degree in behavioral economics or finance to understand the point here. (Though reading a few chapters out of "Freakonomics" might help). The idea of "having skin in the game" is surfacing and spurring deliberation on an international level. But OFHEO and Cuomo clearly felt it was best to simply remove the ability to do bad rather than redress the incentives to do good. Both took a short-sighted solution to a long standing, long-term fundamental problem.

Ever since the Financial Institutions Reform, Recovery and Enforcement Act of 1989, appraisers have been on the radar of state regulators and federally-chartered agencies. Implicit in our licensing is the mandate of our strict adherence to the Uniform Standards of Professional Appraisal Practice (USPAP). Otherwise regarded as the appraisers' bible, this book of ethics, standards and conduct is stringent and carries with it the weight of public sanctions and civil penalties with no uncertain terms. Our role and fiduciary obligations to society is clearly defined and well understood by its members. The road to self-reliance in this business is long and arduous one hence the economic incentives to get it right and behave accordingly are quite pronounced.

Our counterpart, the independent loan originator, suffers a more complex identity problem. On the one hand, originators assume the role of a trusted financial advisor. On the other, they're under competitive sales pressure rewarded for closing deals regardless of the quality of the advice and subsequent risk distributed to investors. The ends often justify the means, and they are rarely, if ever, subject to the losses when they occur. Socially, loan originators are lauded when they get the "really tough ones" done and "shopped" when refusing to defraud institutions to meet client objectives. (This much appraisers relate too since the pressure often gets transferred on to the appraiser for desired results). It's a precarious role where the incentives to exercise prudential underwriting at origination is simply non-existent and taking the "high road" could drive you out of business. Many may disagree with this characterization, but any generalization to the contrary is surely disingenuous.

But here's the irony in all of this. If hypothetically all low-doc/no-doc loans programs were eliminated and every person had to qualify on their true merits of income, credit, and full-appraisal subject to peer review, risk undertones inherent in today's market would dissipate over time. Under that scenario, investor yields would also fade as the flight "from" quality would eventually ensue in search for better returns. This is not a pretty scenario if you know such flights from safety historically account for higher mortgage rates as bond prices drop. Herein lays the quagmire. Risk is necessary, even dumb risk. And the risk layer proposition of the relationships of the marketplace feeds the gamble conducive to premium returns.

All this may seem somewhat on a tangent, but the point is clear. Economic incentives at the investor level have absolutely everything to do with how business is conducted here on earth. The kinetics of trickle-down theory are wholly in affect. Which is why arresting the broker/appraiser relationship as outlined in the HVCC is tantamount to prescribing Advil to treat a chronic autoimmune disorder. It only creates a damaging barrier that will amount to greater public expense and potential for broader dismay towards the system as a whole by it's most competent and ethical practitioners.

Under the recently announced Treasury proposal, imbalances in conduct standards would be essentially wiped out. Originators would be tested, licensed and governed almost identically to appraisers. This raises the logical question of whether or not the HVCC would still be a needed. If brokers acting in a manner unbecoming are faced with bonafide sanctions and civil penalties under the mandated supervision of the state by the Feds, then is the HVCC really necessary?

Many appraisers have voiced concerns that under the HVCC, large Appraisal Management Companies (AMCs) would earn full market share. I personally see no other alternative, either. So here is the inherent problem with this outcome.

AMC fees are notoriously low with little room to negotiate earnings on more complex assignments. As such, many foresee the fallout among the most skilled appraisers who are able to pursue other areas of valuation-there are many. Consequently this means less qualified or less experienced appraisers would dominate the roster in a "reduced fee", "fast turn-time" environment with no real incentive to get it right. As it is, the incentives are already marginal since full reports for AMCs pay roughly 50% of an independent appraiser's fee. (No, the savings are not passed on to the consumer, it becomes margin).

There are a number of appraisers who've acclimated long-ago to this regime and therefore see no issue with the HVCC. I recommend this group imagine for a moment how well they would fare when every appraiser was forced to compete for the same work. Can we say, no longer financially feasible? Let's not forget that origination volume is definitely slowing. The notion that criminal fee pressures net different results than lender pressure for value is ludicrous. Both equally create duress on the practitioner compromising both objectivity and quality.

Nonetheless, it's quality appraisers that may shun this model at a time in history when more valuable than appraiser independence is appraiser competency.

How could this adversely affect the public? How about investors buying mortgage pools?

When appraisers do not get it right, investors either assume too much risk relative to the investment terms, or loose in the form of unrealized volume due to conservative valuations that scuttle otherwise eligible loans. The same is true for consumers. They will either over-borrower or fail to qualify. Here is where the continuity of relationships and interaction between industries has been effective in promoting a robust housing market.

The notion that the HVCC promotes consumer and investor protections is a farce. Indeed, it will be damaging. There is a difference between promoting appraiser independence and controlling the independence of appraisers. True independence is not achieved through firewalls or segregation. Independence has always been a matter of strong moral character, competency and sound judgment of the practitioners. A fragile principle that poorly planned economics will quickly stifle in the name of survival. Competency, embodying all the qualities of independence and impartiality, also carries the spirit of industry stewardship which trumps the pseudo-independence implied in the HVCC.

For more than a decade, appraiser competency was a premium the broader mortgage industry shunned in pursuit of profits. In the name of greater efficiency, AMCs became subsidiaries of the national players whom today are on life support. My hope is that present losses serve as a stark reminder that "you get what you pay for". Given the promise of strong, viable regulatory proposals from the Treasury, Congress and the Federal Reserve (none of which were consulted on this matter to my knowledge) and the high degree of international cooperation for risk and capital standards broadening the interest of systemic good conduct; I say with conviction that this agreement will be nullified and void before years end. However, any outcome to the contrary will clearly label January 1st, 2009, the date when the valuation industry fell from grace. 

*** UPDATES ***

04/16/2008 - Link to Seattle Times article dated 04/15/2008: Appraisers say WaMu cut corners to increase its mortgage business

04/16/2008 - Link to Appraisal Press (a la mode) article dated 04/16/2008: HVCC:  The Cure Is Worse Than The Disease 

FDIC, OCC Bracing for Bank Failures

The "run" on banks in the depression era brought waves of depository failures forming the Federal Deposit Insurance Corporation (FDIC) in 1933. The modern day alternative known as a "liquidity crisis"; has 76 "problem banks" on the FDIC's watch list prompting their Division of Resolutions and Receiverships to once again place wanted ads on Craigslist.

From FT.com:

US bank regulator hires crisis experts
By Joanna Chung in Washington
Published: April 8 2008 22:32 | Last updated: April 8 2008 22:32

A US bank regulator is recruiting retirees who worked during the savings-and-loan crisis of the 1980s and 1990s as it seeks to boost staff ahead of an expected increase in bankruptcies.

The Federal Deposit Insurance Corporation (FDIC) is planning to increase numbers by about 60 per cent at the division that handles depository bank closures.

John Bovenzi, chief operating officer at the FDIC, said he expected at least two dozen new recruits to be former employees who could help train less-experienced staff in the Division of Resolutions and Receiverships. The division is expected to raise its head count by about 140 in the next few months.

The hiring drive at the FDIC, which insures US cheque, savings and money market accounts for up to $100,000 (€64,000, £51,000) underscores widespread expectations that market turmoil could lead to an increase in bank closures.

The resolutions division at the FDIC - which was formed in 1933 following a wave of Depression-era bank failures - saw the first bank failures since 2004 last year, when it managed three closures. It has overseen two bank failures so far this year and currently has 76 names on its list of problem banks.

"The hiring should not scare people," said Mr Bovenzi. "It is part of our job to prepare for contingencies, given the problems in the markets right now."

Mr Bovenzi added that the staffing increase was prompted in part because of the expected retirement of current employees, with many of the existing 240 people in the resolutions division eligible to retire in the next five years. Half of the new hires would be in place only temporarily.

The FDIC is not the only regulator rehiring former employees in the face of the credit squeeze. The Office of the Comptroller of the Currency, the main US bank regulator, announced last week that it was hiring Michael Brosnan - a former deputy comptroller for risk evaluation who left the agency in 2004 to join the private sector - to oversee large banks.

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I'm just wonder if any of these "problem banks" are on the "ailing list" of the Implode-o-meter?