Who ya gonna blame?
Pumped-up trilogy, part 1: "The devil made me do it."
It's official now. My local newspaper just announced it: "Mortgage industry rife with scams many appraisers say mumble mumble".
And yesterday it asked the (possibly rhetorical) question, "Did pumped-up prices spur crisis?" This front-page headline was a leading-question headline, and a leading-question headline that has no intention of going through headline life as a mere question. Because you, gentle reader, caught on instantly, with plenty of unsubtle prompting, that pumped-up prices have created the foreclosure crisis—even if your neighborhood is one of many with no foreclosure crisis.
It's so simple, as life always is in headline-land. Venal real estate agents, mortgage brokers and lenders forced appraisers—honest God-fearing men and women yearning only to do surgically precise valuations—to inflate home prices. "If you don't make the price", these appraisers were scolded, "we'll never call you again." But now, thanks to the politicos and your local newspaper, the shocking truth is revealed. Now, thanks to the politicos and your local newspaper, you have yet another easy answer to yet another complex issue, served up by a reporter who probably knows as little about that complex issue as you do, just a few hours sooner.
Bubbleheads have always known that phony appraisals were part and parcel of the bubble. Because real estate prices aren't supposed to go up. Well, actually, real estate prices can go up, but not faster than the glacial slowness of the national average, and with the same monotonous consistency. And real estate prices certainly can't go up faster than a bubblehead's income, because that's not fair, and bubbleheads are entitled to own their own homes, without sacrifice, where, when and if they choose.
All this headline sturm und drang and playing to the peanut gallery raises several tough questions about the present and future prospects of the appraisal industry which, as far as I know, no one has raised, let alone answered. They're important questions, and I'll get to them in a moment. But first, I want to set the mood by telling you three of my favorite appraiser stories.
About a year ago I had a listing in a neighborhood that was just starting to feel the sub-prime mortgage crisis. Everywhere else I worked, the few homes that trickled on the market sold like hotcakes. But in this neighborhood, homes stopped selling. Period. But they didn't stop coming on the market.
At a list price of $629k, we were getting nibbles but no bites. Then one day an agent from the East Bay calls me with the heaven-sent answer to my prayers. Not only does he have a buyer for the house(!) but the buyer is willing to pay not just $629k but a whopping $700k(!!!). Thank you! thank you! thank you!
Now remember, we haven't been able to find any takers for this house at $629k. But the East Bay agent assures me that not only is his buyer real and not in a straightjacket, but that he also has an appraiser primed and ready to appraise the house at $700k!
Again, I'd like to draw your attention to the fact that up until now, and after months on the market, we haven't been able to sell this house at $629k. So what's the upside for a buyer to pay at least $71k over market? The East Bay agent explains that his buyer will use the additional $71k "to fix the place up", and it could certainly use it. What he fails to mention is that his buyer almost certainly plans to pocket his share of the $71k, walk away from the house and never make another payment after the first one paid through escrow. This is "a fairly common scam", according to a Department of Real Estate spokesman quoted by my local newspaper. Agent and appraiser split their share of the loot, and everyone rides into the sunset happy. And guilty as sin of lender fraud, a felony and a federal offense. Hel-lo Leavenworth!
Of course, I don't know the whole story. It may well be that the agent was holding the appraiser's family hostage. But somehow I think the appraiser's incentive was far less emotional. More likely it was a simple matter of money changing hands, and a lot more money than the usual appraisal fee.
Fast-forward a few months and I'm representing clients in contract to buy a condo. They're approved for a purchase price of up to $800k but, thanks to their perspicacious agent, they're in contract for just $729k. I meet the appraiser at the property and, as we walk through the home, I ask her where she thinks the market is going. After all, you'd think she'd know. After all, she's an appraiser. She probably sees more sales and runs more comps in a week than I see and do in a month. But her response—"I think prices are going up"—surprises me, because I know prices for this kind of property have been flat. In fact, my clients are paying the same price for this unit that a similar unit in the same building sold for a year ago. F-l-a-t.
As we're about to leave, I ask the usual alert agent question: "Do you think there'll be any problem with the appraisal?" It's an innocent question. We're facing the deadline of a financing contingency, and it's always better to get bad news early rather than late. That's a good rule of thumb in any business, unless you just like being blindsided. So if this appraiser thinks my buyers offered too much, I want to know today, not in three or four days when we're up against it. And you can bet the first question my clients and the seller's agent will ask me is, "How did the appraisal go?"
She says, "No, I don't think there'll be any problem appraising it at $800k".
Now, remember, my buyers have offered $729k. They're getting a good deal, yes, but not a screaming deal. You didn't get screaming deals in my market last year, and you don't this year. No way is this condo worth $800k. I know that. The appraiser doesn't.
So where does her $800k come from? On the appraisal order form the mortgage broker has mistakenly put the full amount the buyers were approved for, instead of the purchase price. Is this just another example of subtle mortgage broker pressure? I think you're giving this mortgage broker way too much credit. (And he could pressure the appraiser without putting it in writing.)
What's interesting is the appraiser's implicit acknowledgement that buyers, not appraisers, know and set value. If my clients do offer $800k for a condo that the comps say should be worth far less, then, yes, "prices are going up". And appraisers are tagging along, at least so far.
Do I straighten the appraiser out? Of course not. I do what any venal agent would do. I split the difference with my buyers, and I'm writing this from a cell in Leavenworth.
Last story. Early this year I had a listing coming up, a two-bedroom/two-bath condo in a large development I know well because I've had several listings there recently. As usual, I give the list price much thought. The location is outstanding, arguably the best in the development, a top-floor end unit with from one side a tranquil vista of beautiful pool and treed courtyard, and from the other a narrow but deep shot of greenery that ends far away at the main street. When serenity bores you, you can shift your gaze and watch the world go by. Rarely do views like these come with a condo (or any home). Usually you're lucky if a condo offers a brief glimpse of lawn and a splendid view of the parking lot.
Yes, we have something special here, but the market is uncertain at best and dire at worst, or so the headlines say. My comps, on the other hand, suggest otherwise:
1) A two-bedroom/one-bath condo, partly remodeled, in the same development, that just closed for about $20k more than I expected. This suggests a rising market, but one sale does not a market make.
2) A two-bedroom/two-bath condo, also in the same development, a dark downstairs unit with a flashy but cheap remodel thrown on it, and offering the usual brief glimpse of lawn from one side and parking lot from the other. It hasn't closed, but the listing agent tells me it's in contract at $580k, a new record for the development, with three offers.
So where should I list mine? The kitchen, "the most important room in the house", is thirty years old and lacks not just flash but identifiable charm. Both baths are remodeled, but with quiet, not glitzy, taste. If this condo was a blind date, it'd be described as having a great personality. And if buyers believe the newspapers, none will show up.
I price it at $545k. Over two hundred people go through two open houses. The next week we have eight offers. All of them are over list price. All of them beg to be countered if they're too low.
Two offers stand out. One weighs in at a hefty $599k but has a three-day appraisal contingency. The other gives up some weight at $590k but has no contingencies. Hmm. Should we go for the big money or the sure thing? I'm not confident the condo will appraise at $599k. That's kind of a stretch, not a big one, granted, and appraisers have been known to stretch. But these days the word on the street is that lenders have told their appraisers to be more conservative (the kind of "guidance", incidentally, that makes it harder to believe that appraisers are, were or ever could be neutral third parties).
This calls for the wisdom of Solomon, but I do the best I can. We counter the $599k offer at $595k and ask that she remove the appraisal contingency, in effect paying her $4k to accept more risk. We also counter the $590k offer that has no contingencies at $595k. We step back and hope the buyers sort things out.
They do. $599k counter-counters us by reducing her appraisal contingency from three days to two and dropping her offer to $590k, asking us to pay $9k for one less day of uncertainty. Fair enough, but not good enough, because $590k doesn't wait to get our counter. She rewrites her offer at $600k, again with no contingencies. Bingo. Sold.
Two weeks after we close, I happen to hear that the condo appraised at $580k, not the purchase price of $600k. No one had told me and I hadn't bothered to ask, because it didn't matter. There was no appraisal contingency. The buyer didn't care either, because she was downsizing from a big house and could easily cover the difference between the appraised value and purchase price. She appreciated the things that made the condo special, and she could afford to pay a slight premium for them. She was the most motivated, and most qualified, of all the buyers.
Did she pay too much? Sales in the development over the next few months easily supported the price she'd paid. My listing had been, as they say, the tip of the spear. My gut had been right: prices were on their way up. The appraiser hadn't seen that coming, but strictly speaking, that wasn't his job. His job was to come up with a market value that could be supported by sales immediately prior to the transaction. Yes, appraisers have leeway, up to a point. They can adjust recent sales to reflect condition, location and market. But it may well be that the buyer's lender was one of those asking for more conservative valuations.
So what do these three appraiser stories suggest about the real and potential role of the appraisal industry in residential sales?
In the case of the appraiser not just willing but anxious to write a $700k appraisal on a property that a few weeks later sold for $609k net, we might justifiably call him or her either grossly incompetent or a crook, and in either case a menace to the marketplace. And according to the DRE, he or she has company.
In the case of the appraiser willing to write an $800k appraisal on a $729k property, we might just call her "overly helpful" or perhaps "overly susceptible to suggestion". A real "team player". We might also speculate about how well she knew that market.
And in the case of the appraiser unwilling or unable to recognize a rising market, we might call him or her "overly conservative". A "strict constructionist" rather than an "activist". Or maybe just good at following orders. Maybe as usual. Another "team player".
Perhaps you see where I'm going with this.
First, let's envision the perfect real estate world according to bubbleheads and attorneys-general, where appraisers need never worry about "making the price". That's because their word is law. Ask if there'll be a problem with the appraisal and you're keel-hauled. Argue with an appraiser over the phone and it's an automatic five-year term in federal prison. If an appraiser says that recent sales make a condo worth just $580k, then, by God, it's worth just $580k. Anything over $580k is a "pumped-up price", and we all know where that leads (or do we?).
Let's also say that not every buyer can or wants to make up the difference between appraised value and purchase price. Remember, we're still in a perfect safe-and-sane real estate world where the purchase price can't exceed the appraisal. Very scientific. Yes folks, we're now in a nice tidy market driven, not by consumers, but by spreadsheets. Very bubblehead. It's a market that, in effect, has price controls. And these price controls are set and enforced by those new market kingpins and paragons of virtue, appraisers. Yes, folks, step right into the wacky world of regulation and unintended consequences, with today's home values inalterably bound to yesterday's home values inalterably bound to the previous day's home values inalterably bound to...and no agent, lender or other market pressure allowed to reflect the sudden real-world changes in values so typical of built-out, desirable areas.
Well, it'd certainly remove the volatility from our local real estate market. It wouldn't exactly eliminate price increases, but it'd certainly make them more gradual. Much more gradual. So gradual as to be almost imperceptible. No more market cycles. Hallelujah. They've finally de-fanged the real estate market. They've finally de-fanged the market economy.
At least in theory. Because anytime you have price controls, you have a disconnect between how much consumers value the regulated good and what they're officially allowed to pay. Markets don't like artificial restraints which, come to think of it, happens to be the theoretical basis for the market economy this country believes in as strongly as it believes in mom and apple pie. If demand goes up and supply stays constant or goes down, then prices go up. Yes sir, the market, not some pointy-headed official watchdog, is always right. That's the American Way and, since the end of World War II, one of our leading exports.
So if home prices go up 10 percent during a month or two of early spring, as they can and often have here in Silicon Valley, well, they just won't anymore in that sanitized perfect world, because they can't, because the appraisers are using comps from late winter, when prices are usually lowest.
Except that prices would shoot up anyway, at least in my area, since most buyers here could make up the difference between appraised and market value, either over or under the table. Because price controls always create black markets which reflect real, not regulated, conditions.
Except that this perfect world would have a disproportionate effect on prices in lower-priced, more affordable markets where buyers often need help just paying their closing costs.
This perfect world certainly simplifies things, doesn't it? Next, let's take a closer look at where this nefarious pressure on appraisers comes from.
My local newspaper mentions just once that consumers have also been known to apply pressure on appraisers to "hit the number". Then it conveniently forgets this tidbit throughout the rest of a lengthy article and mentions only the usual suspects, the industry scapegoats of the moment. Yet a bar graph accompanying the article shows that between 2003 and 2006 consumers replaced lenders as the third-most common source of pressure, according to appraisers. In fact, pressure from lenders had fallen significantly by 2006, something I alluded to in my last appraiser story.
And, in fact, all pressure comes from consumers, also known as "the market" all rise! directly or indirectly. Because mortgage brokers, real estate agents, lenders and appraisal management companies don't exhort appraisers to "hit the number" just to throw their weight around. When prices were going up in most markets, every mortgage broker, real estate agent and in-house loan agent was working with a client who'd had to offer more than recent sales justified. That's how it is when prices go up, especially in high-demand markets with low inventory.
Appraisers in these rising markets had two choices. They could either fulminate against a market out of control, cling stubbornly to the old prices and not get work (a possible example of survival of the fittest) or they could recognize that if there is such as thing as collective wisdom (usually a dubious proposition), then its finest expression is market demand, and rising prices are a legitimate reflection of that demand. We either believe in free markets or we don't (see American Way, above). We can't believe that some markets make sense and some don't. We can't believe that supply and demand in the market for, say, cars, always produces correct market valuations, while supply and demand in the market for homes doesn't. We can't insist that home prices are distorted simply because we're willing to buy a car but not a home.
When does market demand become wisdom? Madison Avenue may have turned most of us into impulse-buying machines, but it's my experience that consumers get real savvy when asked to write really big checks.
Of course, implicit in all this hoopla about booby-trapped real estate markets is the idea, never openly expressed except by bubbleheads, regulators and real estate economists, that consumers need protection from themselves. This sentiment is perhaps the greatest irony of real estate, but let's take a moment to look at who the appraisal is meant to protect, and how well it's doing.
Many will be surprised to learn that the appraisal is done to protect the lender, not the consumer. This would explain why lenders seem to control the appraisal system. Where does the consumer fit in? The consumer keeps the system perking along by paying for the appraisal. One would assume that at some point in the development of the modern real estate market, lenders saw a need for this protection and nurtured an appraisal industry to provide it. Entire industries don't spring up and endure on a whim. But the appraisal industry has hit a rough patch lately, as lenders depend more and more on automated appraisals cranked out by software programs.
And recently there's been some doubt as to whether lenders want to be protected. After all, it's said, if most loans are sold to Wall Street as soon as they're originated, then the lenders are passing the risk to bond investors. That late-2005 guidance to appraisers I mentioned, to come in with more conservative valuations, as well as the graph showing lender pressure on appraisers down substantially by 2006, suggests that conventional wisdom may be wrong. Back then I suspected that lenders were thinking the boom was almost over and cutting their exposure. Now I wonder if maybe they didn't realize, long before the bond rating agencies did, that what they were selling Wall Street might cause grief down the road.
It also suggests that appraisers have become simply another valve in the lender machine. Lenders open the appraisal valve when they want to enter markets. Lenders start to close the appraisal valve when they want to leave.
All of this suggests that the original function of the appraiser is now a hollow shell. Whether appraisers let lenders down or lenders shot themselves in the foot, the appraiser apparently no longer protects the lender and instead has become part of its product distribution channel. But if lenders don't need protection these days, somebody else does, and that's the bond investor who buys securitized loans. The bond rating agencies such as Moody's and Standard & Poor's failed badly in evaluating the risk these loans offered, but they'd never lived with them through a complete market cycle. Now that they have, perhaps they can do better. Of course, rating agencies are also subject to pressure, from the Wall Street investment firms who package loans. But when there's big money at stake, there will always be pressure on everyone in the system. My guess is that it'd be easier to police a handful of bond raters than hundreds of thousands of appraisers.
So here's a novel, even seemingly radical idea: why not take appraisers out of the purchase system? It doesn't look like they're consistently performing their intended function. Just ask them, or at least the ones speaking up these days. Many if not most are susceptible to pressure. Just ask them. One appraiser claims he's had to branch out into expert witnessing to stay in business and keep his integrity. If that's true, what does it say about the ones who are still doing appraisals?
After all this fulminating I should mention that it's crossed my mind that maybe the appraisers-versus-agents battle is largely media-induced, or at least media-enhanced. I've met appraisers who are extremely knowledgeable and take their responsibilities as seriously as I take mine. I don't know if they're typical of the industry or just represent the top 20 or 30 percent; probably the latter, although I suspect you could say that of every industry, real estate included. Do these top-notch appraisers protect their clients, the lenders, and society at large better than the rest? It's certainly possible, but how could you tell? You can identify the appraisers linked to high loan default rates, but it's not nearly that simple. Would inflated valuations have occurred even if every appraiser was a top-notch professional? I'll venture to guess that market movements are bigger than any group, small or large, no matter how professional. Which raises two questions: was anyone, aside from the obvious candidates, the fly-by-night subprime lenders, largely responsible for the current debacle, or was it a team effort involving many parts of society; and can a pattern that's happened so often before be prevented from happening again?
But no one's saying that pressure on appraisers to make the number is new. Which might make the appraisal industry a little like a team with a history of losing seasons. Most of the best players have left, the good players around the league avoid the team, and the players still there have gotten comfortable with losing. A manager brought in to turn the team around has little choice but to clean house and rebuild from the ground up.
I'm not sure why the consumer groups always looking for ways to save buyers money haven't hit on this solution. Why should buyers pay $250 to $500 for an appraisal that was never intended to protect them in the first place and supposedly doesn't protect lenders (and society) from their own stupidity and greed? Why not shift the emphasis from protecting lenders who don't want or need protection, and can manipulate the system at will, to protecting investors? Why not face the new reality of the marketplace and shift the job of risk mitigation from appraisers to bond rating agencies?
Sure, before the recent revelations you could make a case that appraisers at least indirectly protected the public by validating home prices. But it ain't working, folks. Maybe it never did. And despite pronouncements that "my bill will end this abuse once and for all", new state and federal laws designed to protect appraisers from pressure will be almost impossible to enforce since, as one appraiser admits, "actual proof of coercion is difficult to come by". Political grandstanding not only won't fix a disfunctional system, it'll make things worse by making it appear that the system is fixed. And from what I've seen and read, it's entirely possible that it can't be fixed. Money and human nature being what they are, there seems nothing to prevent industry pressure and appraiser compliance from being a fact of life in the residential sales market forever and ever, amen.
Finally, let's examine the credibility of the "last honest men" of real estate, those would-be guardians of real estate chastity, the appraisal industry.
I have a confession to make. When I first got into this business, I was much better at figuring out a home's worth than I was at finding a buyer for, or seller of, that home. Month after pointless unrenumerative month had me wondering if maybe I should have gone into appraising instead. But even then, as naive as I was about this business, I knew that appraisers who didn't consistently "make the price" didn't consistently get the calls. And being nothing more than a human rubber stamp seemed even more pointless than being the best agent to never made a sale.
But apparently it does make sense to many if not most of the people who stay in residential appraisal. They may grumble but, if we can believe their grumbling, they've shown themselves willing to work under conditions that aren't exactly uplifting, year after year after year.
If, in fact, an appraiser has to collude with agents and lenders to stay in business, then am I wrong to assume that it's the rare veteran residential appraiser who hasn't, shall we say, cut a few corners and bent a few rules just to get along? Am I wrong to think that appraisers can't have it both ways? Am I wrong to think that appraisers can't claim they have to sell their souls to stay in business, then claim they're the last honest men in real estate?
Am I wrong to wonder if the appraisal industry is, or could ever be, the unyielding guardian of real estate's virginity when, according to its own testimony, it hasn't done too well protecting its own? Am I wrong to think that virginity, once lost, is extremely hard to recover?
And does real estate need safeguarding?
It seems to have escaped the attention of my local newspaper that the foreclosure crisis hasn't hit every neighborhood equally hard. In fact, it's been darn selective. Foreclosure tracker DataQuick says "most California neighborhoods do not have much of a foreclosure problem. But where there is a problem, it's getting nasty...Half the state's default activity is concentrated in 293 [of California's 1465] zip codes, almost all of which are in the Inland Empire and Central Valley".
So what does this mean? That the Central Valley and Inland Empire somehow got half the inflated appraisals? That the other 80 percent of California's zip codes somehow got mostly bona fide appraisals?
Or does it mean that pressure on appraisers to "pump up prices" has little or nothing to do with the foreclosure crisis? Maybe the foreclosure crisis has a lot more to do with that old standby of real estate collapses, overbuilding, and its effect on resale prices. Maybe it has a lot more to do with that other old standby of any financial crisis, speculators, who get caught in the downdraft. Maybe it has a lot more to do with loosened underwriting standards, inevitable whenever money from big institutional investors pours into a marketplace looking for high return and supposedly minimal risk. Maybe it has a lot more to do with high-risk loans, not inherently bad, but poor choices for unsophisticated borrowers. And maybe the foreclosure crisis has at least something to do with consumers tapping (sometimes illusory) home equity like the well-known ATM machine.
Maybe after the media and political dust settles, we'll find out that consumers did it to themselves. With help, yes, but that's nothing new. Maybe we'll find out that very little of this, from breathless reporting to solutions that trade new problems for old, is new.
I don't expect my local newspaper to think this through. First of all, bad news sells, and second, scapegoats sell, and my local newspaper just laid off 25 percent of its newsroom staff and desperately needs something to sell. And third, most reporters don't appear equipped for the heavy lifting of thinking things through.
But I do expect elected officials to think things through before they start throwing brickbats at an industry. But really, I don't. Because I know they know their audience, better than their audience knows itself. It's the usual audience, clamoring for blood sacrifices and grateful for easy answers.