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
Great article Michael. I wish I knew of better solutions than have been offered recently.
I just read the play "The Crucible" by Arthur Miller that gives some insight into the Salem Witch Trials. I saw some definite parallels with those trial and what we are experiencing today in real estate origination except that back then, everything was out in the open and today there are (possibly inappropriate) "deals" being made behind closed doors.
I'd be curious as to what alternatives you might offer that might clean up the current mess and prevent it from happening again.