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The Fraud of Appraisal Regulation
by Larry S. Levy
~ Guest Editorial ~
Let us be clear before getting too deeply into this subject. The bread and butter of the real estate appraisal industry are provided by the financial services sector. No other class of clientele comes close, and most appraisers know no other source of business. Given that so many are so dependent on lenders as their source of work, they are quite subject to that outside influence over their standards of practice, even if they don't see it themselves. Any class of business as powerful as the financial services industry would be foolish not to recognize, and not employ such an opportunity to advance their own interests.
With that fact of life out of the way, let us take a cursory look at the current regulatory environment influencing the appraisal industry, and the ramifications to the public interest. Our backdrop is The Savings and Loan Crisis of the 1980s. It culminated in the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA). That was the outgrowth of Congressional inquiry into the reasons behind the S&L debacle. Among other things, Congress found repeated instances of disreputable appraisers working in collusion with unethical lenders to fraudulently inflate the appearance of property values. Though well intended, FIRREA did little to prevent such abuses.
None-the-less, FIRREA did mandate that states regulate the activities of real estate appraisers. Oversight is by way of Federally supervised guidelines promulgated by the newly formed -- and by all appearances independent -- Appraisal Foundation. Separately, guidelines for appraisal practice and the engagement of appraisal services are issued by certain government sponsored entities (GSEs). [Examples of GSEs are agencies such as Freddie Mac and Fannie Mae, etc.]
From the beginning of this new era, however, and with a compound effect over time, appraisal usage standards and guidelines have been changed (centralized) at various levels in ways shocking to conscientious appraisers familiar with 1980s practices. What we have now is heavily influenced by the lending industry, which continues an increasing level of de facto usurpation of appraisal practice standards. New, "improved" appraisal reporting abbreviates former practices, helping to speed along the loan process and lower fees, particularly in the housing market. ["Lower fees" is in terms of overall annual costs to borrowers compared to what would be the case without these changes in reporting practices, including di minimus thresholds.] Who, then, can expect the general quality of appraisal work to exceed that of earlier times?
The system, as it has evolved since FIRREA, has helped financial institutions earn higher returns, at least in part, because appraisals are delivered swiftly, at low cost, and with more leverage toward influencing market prices. Note that the current regulator environment allows packages of loans (backed in part by regulated appraisal products) to be more easily bundled and sold to global investors. These are mortgaged backed securities in the game of two-tiered structured finance. In the process, risk is shifted to the buyer, and liability is transferred to the government (i.e., the taxpayer).
In one example, there are now "thresholds" of value below which appraisals are not required at all, or which may be conducted by appraisers who have demonstrated the lowest levels of competency. Would it surprise you to know that Federally related lending institutions (i.e., those covered by various forms of Federal oversight) have the option to avoid acquiring appraisals on real estate loans of $250,000, or less? It's true, and such things did not exist prior to "reforms."
Under the current system of funneling money into the mortgage system, appraisals more than ever impart a high level of security. That is because they appear to come from unbiased experts who are regulated by Federal mandate. Further, the higher the volume of loans, and the higher the appraised values of the collateral, the greater the power to increase the size of the lending institutions. Lenders, and GSE to some extent, therefore, have a very great interest in influencing the results of appraisal reports (and if risk can be transferred in the process, so much the better).
Appraisal regulation, it would appear, assists in pushing up the money supply (by way of helping to increase the value of collateral), economic activity (via higher and higher loan amounts in "cash out" refinancings), and lender profits. As such, regulation is little more than a ruse designed to shift financial liability for losses from the appraisal client (i.e., the lending industry) to the Federal government who is now responsible for appraisal oversight.
Should the Nation experience another serious financial "adjustment" like the S&L Crisis, lenders (and GSEs) will be able to point to Federally mandated appraisal regulation as their free pass to escape a Congressional inquisition (where property valuations may be called into question). They will have the appearance of having done everything according to "the book." The investor groups suffering damages from having purchased loan packages (with this designer gift wrap) will have to seek a bail out from the government, the ultimate underwriter (and the overseer of lending and appraisal regulation). Naturally, the government will not accept blame, but it will go looking for a villain. Guess whom they will find?
This is not to say, of course, that we are going to suffer through another event like the Savings and Loan Crisis. But if we do, the foundations for lenders and GSEs to escape culpability have been laid (in so far as valuations may be to blame), and appraisal regulation in it's current form will have assisted.
Meanwhile, users of appraisal services have become less selective in regards to the quality performance of their contractors. Why bother? They are all regulated, right? Contrary to intent, the quality of service has diminished with the advent of regulation. This is not surprising when seeing that reform means faster and cheaper appraisals. [Again, fees for some types of appraisal services have gone up in the last 15 years, but comparatively speaking, the overall cost in bundles of loans is much lower than would be experienced otherwise. Lower, too, are the overall returns to the appraisal industry.]
The decline in appraisal quality is also revealed when contemplating the development, and dramatic growth of the independent appraisal review field, something that was a nominal part of appraisal quality control before the introduction of regulation. If appraisal quality has been improved by regulation, would this large appraisal review field be necessary?
In actuality, it came about because of the higher incidences of failed quality control examinations on bundled loans. This generally lower quality performance from appraisers as revealed in these examinations is what forced the blossoming of the review field. It assists in providing cleaner looking appraisals in bundled loans, not necessarily more reliable valuations.
And, just as appraisal regulation tends to lower the general quality of appraisal performance, so does it also in the review field, and for the very same reason. It does, however, provide the user of appraisal services another level for escaping liability, while reducing the perception of risk. In other words, it's the existence of the process that matters, and not the quality of it. If an appraisal has been performed by a Federally regulated individual, and been successfully reviewed by another regulated individual, it has an enhanced appearance of quality. That makes it much more attractive as wrapping paper for bundled loans. In practice, however, many competent appraisers will tell of a need for a review of the reviewers. The quality implied by the practice is generally lacking, and it often contributes to higher closing costs for borrowers, who are sometimes asked to pay this cost. The loan seller, however, does not care, so long as the appraisal and the formal review (if needed) look good on paper. It is the appearance of quality valuations that helps to make loans marketable, not the competence, dedication, experience, or ethical conduct of the appraisers.
Another development since FIRREA is the massive expansion of so-called appraisal management companies. These are firms that effectively warrant lenders a passable appraisal, supplied speedily, in any location, and for a competitive fee. On the surface, nothing is wrong in that. It is business fulfilling a need. These firms, however, generally award appraisal assignments to most any appraiser who is willing work for half the fee they could get on their own, and who must bear all the expenses of providing the report - office space, clerical support, computers, software, research materials, photographic equipment, supplies, etc. This is quite unlike earlier times, when substantially more of the after expenses fee went to the appraiser who accomplished the work.
This system of engaging appraisal management companies benefits lenders in their not having to maintain lists of qualified appraisers, and not having to engage staff for the purposes of supervising appraisal orders and fulfillment. The result, of course, is legions of lesser skilled appraisers who are willing to accept after cost returns far lower than the industry had been used to receiving. It cannot be unexpected, then, that quality is diminished. The practice also contributes to driving the more experienced and better skilled appraisers into other lines of work, because the appraisal management companies have commandeered so much of the national volume of appraisal requests. The best appraisers, therefore, generally are not as well rewarded for their more advanced years of experience, or their generally higher propensity toward professional self-improvement.
Another damaging part of the system is that which divides appraisers into two different classes of competency - one for the minimally qualified (the licensed level), and another for the more highly qualified (the certified level). The dividing line for appraisal assignments is based on rather randomly chosen benchmarks of loan value, or assignment complexity. [This is a separate issue from the distinction between commercial versus residential property.] The result of this division, however, is that highly qualified appraisers, particularly in the residential field, are forced to compete for the same assignments (and fees) as the lesser skilled appraisers. It gives a competitive advantage to the lesser skilled who are more eager to accept lower fees. It also results in higher proportions of mortgage portfolios containing valuations by the most minimally qualified valuers. Does this not actually increase risk, while disadvantaging the most qualified appraisers in the industry? Of course!
Don't the lenders/mortgage brokers care? Not really. They are increasingly playing the odds, knowing that, historically speaking, very few real estate loans end in foreclosure anyway, and the risk is transferred to investor groups in bundled loans.
Consider also that the lending industry routinely supplies appraisers with the very essence of what produces bias in the valuation process, the loan amount. By providing the loan information, the typical appraiser responds by trying to make the appraisal fit the loan request. Obviously this has little effect on markets where borrowers are seeking mortgages with low loan-to-value ratios. In the case of 80, 90, and 100%+ loans -- the majority of transactions -- appraisers who "make the deal work" are influencing the market cycle, whether they know it, or not, and increasing the risk to the ultimate holders of these loans. Were facts otherwise, real estate lenders would be less inclined to reveal the size of a loan when requesting appraisal services. In that they do so routinely (in purchase money appraisals as well as in refinancings), it must serve their purposes. And it does.
Appraisal industry mantra says appraisals do not influence market prices. Yet, when nearly 100% of purchase money appraisals "hit the number," and when the vast majority of real estate sales are facilitated with high loan-to-value ratios, appraisers are pushing the envelope of real estate prices. To argue otherwise says that every buyer and every seller is typically motivated in almost every real estate transaction, and that they fully appreciate the concept of Market Value when negotiating their deals. It ain't so, or the words "typical" and "normal" would not appear in the formal definitions of Market Value. "Typical" and "normal" mean "most often," not "all of the time." Most transactions, therefore, will qualify as "typical" or "normal," when others should not. Therefore, if the facts are known, not all sales contracts should be able to meet the test of Market Value.
Further, industry guidelines say that purchase contracts may represent the best "evidence" of value in an appraisal. "Evidence" is not proof, yet the "typical" appraiser will represent the contract as "typical," though in practice they never see the contract, nor interview buyer and seller about their motivations. They also accept the negotiated price as "proof" of value. Were it indeed "proof," appraisals for purchase money would not be needed. However, as appraisals are a required part of prudent lending behavior, and because the typical appraiser always, or almost always tends to prove the evidence of value disclosed in the contract price, appraisers have the effect of helping to push prices higher. It cannot be otherwise. Part of the proof in that comes from the fact that every appraiser uses comparative market data wherein the "evidence" of value behind those transactions was accepted as "proof" of value by other appraisers writing purchase money appraisal reports, and who also assumed those contracts were "typical."
And, while real estate buyers may be relying to some degree on the loan appraisal to tell them whether, or not they may be overpaying for a property, appraisers routinely give no thought to that possibility. They labor under the impression that their job is to help complete the transaction for the lender. The cycle, then, as it gets repeated in purchase money transactions, tends to assist in ratcheting sales prices higher and higher, at least for as long as the market can tolerate that effect. [Please note, however, I am not arguing that appraisers are the cause of escalating property values, only that they play some part in it.]
Lest anyone think otherwise, consider what the effect on real estate values might be if appraisers were denied the information on their subject properties proposed loan-to-value ratios. In fact, the loan amount is completely irrelevant to the appraisal process most of the time in residential matters, and regulation does nothing to remove this form of manipulation. [We are speaking here, of course, about typical financings from traditional lenders. Atypical financings, even as components of financial packages, are relevant to the appraisal process where they exist. Such is rare in today's market, however.]
Most appraisers are caught in this game 1) because they are paid employees of the lender (sometimes quite indirectly), or 2) are contractors who will suffer a loss of repeat business for not "hitting the number." Some appraisers wisely and routinely discount the loan information, but not the vast majority who depend on the lending industry for their bread and butter, if not their entire means of sustenance. Hence, far too many appraisers are motivated by the need for sustained income, and have little regard for the lack of bias intended by regulation. This makes most of them little more than clerks, filling out forms and/or expressing narrative talents in completing commercial reports, all the while the users of appraisal services provide increasing influence over what constitutes their work product. Here may be at least one of the reasons industry vernacular has appraisers working out of "shops," as opposed to offices. Offices are where professionals work. Shops, however, cater to customers, and "the customer is always right."
OK, you may say, but isn't regulation supposed to mitigate lender influence in the appraisal process? Perhaps, but as has been shown, the reality is something else. Besides, regulation does not make work product more professional, more ethical, or more accurate. It merely serves to support attractive "wrapping," if you will, of a more easily marketable product. That product is globally marketed bundled loans, and therein is how collateral risk -- supposedly mitigated with quality appraisals -- is transferred.
So, does this not sound like a flawed system, or even a fraud? If it does, and it does to many observers, can appraisals backing the Nation's mortgage portfolios generally pass the test as being truly unbiased documents? Probably not.
What's the answer? How do we improve the quality of appraisals backing the nation's mortgage loan portfolios?
I'm not sure anything can be done at this stage. Practical and feasible solutions are not going be considered by anyone at any level, until the fact of a problem is understood. That will take some looming threat, or actual damage to the system. By then, it may be too late. That aside for the moment, I have a few thoughts I will share with the reader. One place to start might well be to trash appraisal regulation and GSE appraisal guidelines in their current forms.
Doing away with the system and starting over is hard for me to propose. I was one of the early supporters of the concept of appraisal regulation, and I volunteered long hours to help ensure its creation. Like many, I was under the mistaken impression that regulation would lead to generally higher standards of performance from the industry, and a new level of recognition as a profession. Against my own expectations and that of others, the effect of the Federal mandate, born of the S&L calamity, never materialized in an independent committee of broad jurisdictional authority capable of discounting the needs of lenders in favor of the public interest.
On a personal level, I moved on some years ago -- retired from the appraisal field after nearly 30 years of practice. In my time I worked several years as an in-house appraiser for a blue chip corporation that was then the largest private property owner in the United States. Thereafter, I was an independent appraiser. In the last half of my career, and while carrying leading credentials from two major trade groups, I almost never accepted appraisal assignments from traditional mortgage lenders, or brokers, except for reviews under special circumstances. I intentionally avoided these types of clients, having learned that they are generally the most cost and time sensitive of clients. Additionally, they are also the most demanding, the most fickle, and the least appreciative of all users of appraisal services. And they can afford to be arrogant toward appraisers. There are far too many willing to do their bidding, and herein lies the source of their power (to say nothing of their dominance at public hearings on appraisal subjects).
Though retired, I still remain in touch with the appraisal field. I have an emotional vested interest, social contacts, and I am a taxpayer who may one day be called upon to help pay for the errors of the current regulatory environment. I am, therefore, not an inexperienced, or out-of-touch observer. Having set the stage by that let me offer a few thoughts toward more responsible appraisal oversight in the public interest.
- Especially in regards to residential property, any communication between lender and appraiser regarding loan amounts, or other suggestions toward appraisal conclusions should be prohibited by all authorities supervising the activities of lenders, and loan brokers, unless the loan structure happens to be atypical. Fines and other penalties should be imposed for violations.
- All lenders and mortgage brokers who retain appraisal services should be made primarily responsible for the value of assets held as collateral (as of the valuation date) for the life of the loans, whether sold or not, keeping the taxpayer out of the loop. If the responsibility for appraisal quality were entirely that of the lender for the life of the loan, appraisal regulation would be less an issue, and the relationship between lender and appraiser would tend to be self-policing to a much larger degree.
- Eliminate the division of lesser qualified and higher qualified appraisers in Federally related transactions. Make them all qualify at the same high standards, dividing only residential and commercial appraisal skills.
- Require all appraisals reports and reviews thereof to include the appraiser's/reviewer's Statement of Qualifications, professional resume, or other such document, allowing readers to better evaluate the experience, training, trade group association(s), and conceivably, the competence of the author. A mere signature over a typed name and license number generates no credibility of it's own. Though such "brag sheets" are often ridiculed, the fact of such a requirement will force many minimally qualified appraisers to improve their credentials, or expose themselves too appearing unprofessional. Users of appraisal services and the public will benefit. The leading trade groups should recommend common guidelines for such disclosures.
- Force appraisers to organize in a more efficient manner to effect self-regulation removed from the influence of their major clients, the financial services industry. In this way, they can be more collectively sensitive to the public interest, while discounting the clients need for faster, cheaper -- but not better quality -- appraisal reports.
In regards to point five, an industry fragmented by as many special interests groups as the appraisal field, is no profession, no matter how the various trade groups view themselves. Society cannot have scattered clusters of specialists in the same field calling themselves professionals, while each group tries separately to advance their own membership base, and public visibility. Such fractionalization promotes manipulation through weakness (as in the current situation), and suppresses the appearance of professionalism in the public's eye.
Appraisers need one representative organization emphasizing qualifications, and standards of practice, while maintaining an overriding interest in, and dedication to self-regulation in the public interest. Is that possible? I don't think so, but without it, the industry will remain a tool of its primary client, and a participant in the fraud of appraisal regulation.
© 2004 Larry S. Levy
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Larry S. Levy
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About the Author
In his retirement, Larry S. Levy is a private email newsletter writer on metals and mining shares, and occasionally contributes economic and historical commentary on these subjects to international publications. In his former practice as a professional real estate appraiser, he held leadership roles in the leading trade associations, lectured, and published articles on valuation topics.
Editor's Note by Gale Bullock:
Mr. Levy describes in his succinct essay the stranglehold that the banking cartel has on the realty valuation industry. The Appraisal Institute has an affiliate appraisal management company called REAS (Real Estate Appraisal Services) which operates http://www.aidirectconnection.com. REAS is owned by Charter One Financial Corporation, the 25th largest bank holding company in the USA, home based in Ohio. Royal Bank of Scotland is in merger and acquisition negotiations with Charter One to become the 7th largest bank holding company in the USA, after the Bank One and JPChase Manhattan merger as the second largest banking conglomerate. This conflict of interest doesn't get any more blatant than these facts.
In Mr. Levy's professional career as a realty valuation expert he attained a high level of proficiency, exemplary of expertise in both residential and commercial realty valuation. We are grateful for Mr. Levy's guest essay, which documents the centralization of the realty valuation profession since the scam of FIRREA in 1989 -- basically the setup for The Sting.
