October 15 2008 With the capital markets frozen and the world economy in crisis, everyone is looking for someone to blame. The airwaves are full of politicians and pundits lashing out at this party or that party. The Obama-Biden team blames runaway de-regulation dating back to the Reagan administration. John McCain blames the rampant “greed and corruption on Wall Street” while his running mate likes to wave her school-marm finger at the “predatory lenders”. Some conservative talk radio hosts blame consumers for not taking “personal responsibility” while more liberal commentators lay the blame squarely at the Bush administration.
We’re all swayed by our own reality and frame of reference. But I can tell you one thing, I’ve worked inside the system and I could see things unraveling years ago. The system is broken and has been rotting from the inside-out for many years.
When I got into real estate investing full time, the first thing I did was get my appraiser’s license as I felt that was the best way to learn the fundamentals of the industry. I freelanced for two appraisal companies (more on the life of an appraiser in a separate posting) and had a handful of my own clients who were mortgage brokers. Banks worked only with the most senior, experienced appraisers who might sub-contract the work to less-experienced appraisers such as myself. But mortgage brokers preyed on new appraisers who they knew were the most desperate for the work and would do whatever it takes to deliver the desired outcome. Banks paid their appraisers within days – mortgage brokers paid whenever they felt like it, if at all. And if pressed for payment, they’d drop you for another new appraiser.
I can attest first-hand that appraisers have been under tremendous pressure to “hit the number” – that is, bring the appraisal in at the value needed by all parties – sellers, buyers, agents, mortgage brokers and bankers – for the deal to go through.
What does this mean? OK, think back to the go-go years of 2003, 2004, 2005. Values are rising up to 20% per year. An aggressive seller prices his house high. An eager buyer, convinced by his agent and financial advisors that values are rising fast, agrees to the price – or offers an even higher price to best any competitive bids – and applies for a mortgage. Both the buyer’s and seller’s real estate agents as well as the mortgage broker and bank all have an incentive for that price to be as high as possible as everyone along the chain is earning a commission on that sale price. The mortgage broker – or the bank – hires the appraiser and seeks the one who they know will turn the appraisal around the fastest (2-3 days) with the fewest problems.
The appraisal must be based on “comps” – or the actual sales of comparable homes in the neighborhood during the past few months. Not listings, not pending sales, not sales that fell out of escrow but actual closed sales. There are tight guidelines for what kinds of sales are appropriate comps – they must be in the immediate neighborhood – across a busy road or higher up a hill should not be used as neighborhoods can change within a block or two. Houses larger or smaller by a factor of 20% should not be used. Houses of similar condition are sought – if the “subject property” (the house being appraised) is a fixer or newly renovated, than the comps should also be fixers or recently renovated. Amenities such as room counts, bathroom counts, fireplaces, pools, views and number of garage spaces are all considered. The appraiser finds anywhere from eight, nine, ten or more potential comps and narrows the choice down to three to five for the appraisal report. Adjustments are made to each comp – adding or deducting value to account for differences from the subject property. It is three parts science and one part art and requires sound judgment, in-depth knowledge of the area and experience. The appraiser has the most at stake here as any mistakes or the slightest appearance of fraud can lead to loss of work or worse – lawsuits or loss of their license.
Aggressive seller’s agents often meet the appraiser with stacks of “comps” they’ve pulled. They do this under the guise of being helpful but their real motive is to try to ensure that the appraiser uses the best comps – the highest sales – for their reports. These comps, however, are rarely useful and the appraiser is discouraged from accepting them. They pull from better neighborhoods or larger homes in better condition. Since refusing them will raise red-flags with the agent, the savvy appraiser accepts them with a smile then throws them away.
During the recent real estate boom, mortgage brokers (like my clients) would call and say “I need this house to come in at $X”. Right off the bat, this is a violation of the ethics rules as they are not supposed to pressure the appraiser or influence the outcome. It wasn’t unusual for the mortgage broker to call two or three appraisers and ask each one for a verbal confirmation on that phone call that they could “hit it” before they’d be hired – also a violation. If the appraiser couldn’t meet that number, this could kill the sale which would incur the wrath of all parties so that appraisal would be thrown away and a new appraiser hired until they got the results they wanted. When this happened, everyone accused the appraiser of incompetence and that appraiser would not only not get paid for his work (anywhere from $350 to $1,200) but would be black-balled from any future work from all parties involved in that deal. It only took one or two such instances to kill a career. Appraisers who cooperated were highly sought-after and got lots of work from strong referrals throughout the industry.
So who’s to blame for the current crisis? I blame the legislators who created a system that motivated and rewarded inflated values if not outright fraud. The consumer is the hapless victim and is the last person who should be blamed. The consumer was just following the advice of experts they relied on and the government who encouraged them through tax incentives and a steady drumbeat of homeownership as “The American Dream”.