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January 2005 - Crisis coming so more attention should be paid to the value of the collateral backing the mortgage loan

Real Estate Agent with a la mode

Home equity crisis coming, report says; blames lender pressure in part

January 20, 2005

American households cashed out $333 billion worth of equity from homes   between 2001 and 2003, the beginning of the refinancing boom - levels three   times higher than any period since Freddie Mac started tracking the data in   1993, a new report highlighted.

A House of Cards: Refinancing The American Dream is a new report   released last week by Demos, a nonpartisan public policy organization based in   New York. The problem is not that so many Americans took advantage of   historically low rates and relaxed credit qualifications, the group said:  Rather, a majority of households that refinanced between 2001 and 2003 used cash   equity from their homes to cover living expenses and pay down credit card debt,  further eroding their home's cash value, which many families rely on for   economic security.

A striking finding from the report: Between 1973 and 2004, homeowner's equity   actually fell - from 68.3 percent to 55 percent. In other words, Americans own   less of their homes today than they did in the 1970s and early 1980s.

The report highlights the dangers of Adjustable Rate Mortgages (like we did, here).  As the Federal Reserve continues to raise interest rates, a mortgaged family   with an adjustable rate mortgage will experience a significant increase in their   monthly mortgage payments, the group said. The combination of higher mortgage   payments coupled with rising costs of basic living expenses represents a growing   financial threat.

Of most immediate interest to appraisers, the report fingered "appraisal   fraud" as one of the main culprits of the crisis it predicts. Happily, it hits   on the culprit: pressure from clients. "One of the most alarming findings in the   report is the role that mortgage fraud, in particular appraisal fraud, plays in   the refinancing process," the group said in its press release.  "There are growing numbers of third party brokers pressuring appraisers to   inflate home values in order to ‘close the deal' and reap larger fees or   bonuses. The consequence can be dire for homeowners who refinance and draw out   more cash equity than their home is actually worth."

Its report, viewable here (12-page PDF), states "Who wins? Third party mortgage   brokers, primarily, reap significant rewards in this process with increased   commissions or closing fees. The banks providing the loans also benefit,  although they may be left in the dark on illegalities. These mortgages are   purchased from banks at the inflated appraisal price and bundled into risk pools   by governmental, quasi-governmental, or private firms. Government agencies that   participate in the securitization of mortgages include Ginnie Mae, Fannie Mae,  and Freddie Mac. Because the loans are held for such a short period by mortgage   issuers, due diligence is an often ignored concept."

The report also points out (as we did here and in the   pages of the latest Mortgage Technology magazine) that the amount of debt   American homeowners have taken on is staggering. "As home equity has fallen,  household debt service burdens have risen to record levels. Between 2001 and   2003, the ‘financial obligations ratio' - the amount of disposable income needed   to pay down debt - averaged 18.44 percent. Since 1980, the first year data was   collected, the single year record occurred in 2002 with a financial obligations   ratio of 18.56 percent."

The report does not conclude based on this (but we do) that more   debt-burdened homeowners (and consumers in general who will be homeowners in the   next few years) means lower credit-quality borrowers, means more attention   needed to be paid to the likelihood of default, and therefore the value of the   collateral for the mortgage loan. Appraisers are poised to be the solution to   this next crisis, if it comes, not scapegoated as the problem.