If you fix the problem on Main Street, you fix the problem on Wall Street, right?
We're spending billions, if not trillions, of dollars on stimulus and the bailout, when there is a much simpler solution available that will cost virtually nothing and can help slow the descent into a deep recession, if not reinflate confidence in our economy.
The solution is to fix our broken real estate appraisal system. Our housing market (and the commercial paper market it supports) is built on sand. By fixing the foundation, we can quickly and cheaply make sure that our bailout money doesn't go to waste.
To back up for a second, understand that the present crisis is, in large part, a housing crisis. Yes, the Big 3 automakers are in trouble. Yes, manufacturing continues to decline. Yes, there are other exogenous factors, such as the volatility of energy prices or food prices. However, all those things predated this past year and will most likely survive it.
The housing crisis of confidence in the value of mortgage-backed derivatives. At its core, nobody knows what the value of anything is anymore.
Homeowners are stuck, either with mortgages they can't afford, with homes they can't sell or next to neighbors where distressed housing continues to bring down surrounding property values.
We're engulfed in this vicious cycle," said Mark Zandi, chief economist of Moody's Economy.com. "We don't see any recovery until well into 2010. Sales will start to rebound in early 2010, but construction and prices won't until late in the year. There is just too much inventory, too many vacant homes for sale, and it's just going to take a couple years to work that inventory off."
Illinois Housing Prices, Sales Plunge
Nobody trusts mortgage-backed commercial paper because nobody knows where the bottom of the housing market is. Loans that looked good a year ago (even without assuming real estate appreciation) are looking risky because there is active deflation in real estate. Loans that look good today may look worse tomorrow, so the paper they support today is worthless.
What is so puzzling is that these loans (and their derivative securities) are obviously not all worthless. Homeowners are largely still paying their mortgages on time. Not everyone was speculating or subprime. Not everyone has lost their jobs - unemployment has increased, but not dramatically. Wages and salaries have not deflated substantially. Cost of living (including cost of food and gas) has actually decreased lately.
The problem?
"I've never seen buyers more trepidacious," said Paris Smith, broker-owner of Home Finders Real Estate Inc. "People are analyzing to the 100th degree their decisions. The problem is, you can become paralyzed and, unfortunately, that's feeding the monster. We're feeding the monster by not spending but we're too afraid to spend."
The problem is with the system of real estate appraising. It's not a system. It's profit-driven guesswork that puts a great deal of stock on the discretion and experties of real estate profesionals. That's right - our system of appraisal, which functionally determines the liquidity and velocity of the housing market - is based on the discretion of the very professionals that got us into this mess in the first place.
Appraisers have for too long been ignored. Before, the big banks considered appraisal as a mere formality. Appraisers, who wanted to curry favor with banks, produced reports validating the transaction. They were, in large part, the facilitator of the housing bubble.
As soaring home prices set the stage for America's great housing meltdown, a critical step in making sure those home sales were a fair deal - the real estate appraisal - was undermined from within.
After the nation's last major banking disaster, Congress set up a system to catch rogue appraisers. Their game: inflating the value of homes at the direction of equally unscrupulous real estate agents and mortgage brokers, whose commissions are determined by the size of the deals.
But a six-month Associated Press investigation found that the system is crippled by both the bumbling of its policemen and their inability to effectively punish those caught committing fraud.
And despite ample evidence appraisers are pressured into inflating home values - sometimes to prices in support of loans that are more than buyers can afford - the federal regulators charged with protecting consumers have thus far made a conscious choice not to act.
"The system is completely broken," Marc Weinberg, the former acting director at the federal agency charged with monitoring the appraisal industry, told the AP before he retired earlier this year. "It's amazing that the system ever worked at all."
Mitch Weiss, AP Investigation, 8/18/2008, System Regulating Real Estate Appraisers Is Completely Broken
Now, banks feel chastened. The incentives for appraisers have reversed. Now, appraisers curry favor by producing reports undervaluing real estate. They insulate themselves from criticism by claiming that they are merely being conservative and sober.
The problem is that they are simply following the herd, and leading it at the same time. Transactions don't close without financing, and financing doesn't happen if the property doesn't appraise at or above the contract price. Either the seller makes a concession (driving down the value of not only his property but his neighbors), or the deal falls through. If the deal falls through, that simply increases the inventory of unsold properties, driving down the market price even further. All because of an appraiser, who gets paid either way (but might get more future business if he appraises "correctly").
[A]ppraisers may face pressure to provide a low estimate of value. When a lender judges an appraiser based on the number of percentage of appraisals that lead to bad loans, it will be in the appraiser's best interest to provide a low estimate of value. Lenders under regulatory pressure to make onyl "good loans" may desire appraisals that undervalue collateral to justify lending limitations. Moreover, lenders who engage in discriminatory lending practices may desire appraisals that undervalue collateral to support redlining practices.
George H. Lentz, Ko Wang, "Residential Appraisal and the Lending Process: A Survey of Issues," JOURNAL OF REAL ESTATE RESEARCH, v. 15, n. 1/2, p. 25 (1998)
Thus, unscrupulous appraisers inflate the bubble on the way up, and rapidly deflate the bubble on the way down.
There is a law - the FIRREA - that was supposed to regulate the real estate appraisal industry. However, as the AP investigation above shows, the FIRREA is largely a regulation without teeth. The responsibilities were delegated to states who refused to investigate complaints or otherwise act.
As the AP investigation concluded:
In the last three years alone - when the nation's housing market went from boom to bust - 27 states or territories failed to investigate and resolve complaints within a year.
The failings of the appraisal regulatory system and its impact on the nation's housing market led Andrew Cuomo, the New York attorney general, to reach a deal in March with Fannie Mae and Freddie Mac, which purchase mortgages from other financial institutions.
The agreement, which will take effect in 2009, will create a watchdog to monitor the appraisal business: Fannie Mae and Freddie Mac will spend $24 million to create the Independent Valuation Protection Institute, which will accept complaints from consumers and appraisers. It will also monitor the enforcement and report to Cuomo's office.
But such a system duplicates the regulations already in place, including the same lack of enforcement tools that led the existing system to failure. Cuomo didn't return repeated requests for comment.
A Specific Example
I have recently been on both sides of a real estate transaction, and have witnessed the farce that is the appraisal industry first hand. As a buyer, in May, I bid on a beautiful gut rehab greystone condo. The price seemed reasonable to me after the developer's concessions. We struck a deal. However, the appraisal came back from the bank - the appraised value was substantially less than the contract price. So, using my carefully negotiated mortgage contingency (and by conceding part of my earnest money deposit), I ran from the deal.
Later, I ended up buying a house - a much better value, although more of a fixer-upper. I was then left needing to sell my condo downtown that I had held onto for 5 years. Amidst the credit crisis and the gloom-and-doom, I found a willing buyer. After I made substantial and painful price concessions, we struck a deal. Of course, the appraisal came in too low and now this buyer wants to back out. His attorney, however, did not negotiate such a strong mortgage contingency, so it's questionable whether I will let him go.
I'm looking at two separate appraisals on two separate properties within the past 6 months. In both cases, the appraisers performed a "sales comparison approach," which is essentially evaluating the recent sales on like properties, or "comps," and also evaluating other properties actively for sale or pending under contract in the same area. Then, adjustments are made according to a grid of variables, so that a gross adjusted comparative value is produced that allows for "apples-to-apples" comparisons. Typically, this produces a range of values, some lower than the contract price, some higher.
Here's the problem: appraisers then simply "eyeball" those three - six comp figures and pinpoint a value. Typically, it's a round number, to the penny. This is not a methodology - it's a game of "pick a number, any number." It's guesswork.
Believe it or not, this is apparently what the Appraisal Institute considers professional practice.
What's crazy is that the appraiser knows the contract price ahead of time. So, the appraiser knows the target and depending on his incentive, he can pinpoint a value above or below.
Update [2008-11-25 10:52:21 by Greuben]: This line of argument convinced the buyer to reenter the deal. I'm gonna sell my place!
My $0 Solution
Blind appraisals. Appraisers should never see the contract price if they are using the Sales Comparison Approach. That way, the "agency problem" of appraising is largely removed because appraisers don't know what number to shoot for. Their job is to apply the Sales Comparison Approach to arrive at an appraised value, not to evaluate whether the appraised value and the contract price are close enough. That's the loan officer's job.
Ban "Pick A Number, Any Number." Create Government Appraisal Standards. Require that appraisers, in applying the Sales Comparison Approach, arrive at values using the recognized methods of calculating "means" and "medians." Or allow appraisers to simply arrive at a range of values. Yes, there's a "small sample" problem with most comps, and yes, there's a subjective element involved. However, it cannot be considered professional to play, "pick a number, any number." If appraisers need to create "weighted averages," there should be a uniform system, established by the government, for estimating and applying such weights. Whatever method they employ, it has to involve actual statistical analysis, not guesswork.
Why This Will Work
It's cliche that appraisal is considered "more art than science." This is the fig leaf that the appraisal industry has hid behind for years, especailly when sued or regulated.
By removing that fig leaf, and holding appraisers accountable to real standards and methodologies based more in science than in art, we can resolve the biggest problem in the residential real estate market today: the problem of value. This would restore confidence not only on Main Street, but also on Wall Street. Better appraisal means more deals. More deals means that the market can see the bottom quicker and more clearly. A clear bottom will restore value to commercial paper. Commercial paper with value restores value to the banks. In other words, reforming the appraisal industry will add liquidity to the current housing glut and strengthen existing (and future issued) mortgage-backed commercial paper.
It's not a panacea, but from a cost-benefit perspective, you can't beat free