C&B Notes

Incentives Matter!: Inflating Appraisals Again

Inflated appraisals are one structural issue in the residential real estate industry.  It’s a classic principal-agent problem:  appraisers (the agents) want to keep mortgage bankers and real estate agents happy because they all get paid on a transactional basis.  Because most loans are pooled and sold, the protection of the eventual lenders (the principals) becomes a secondary consideration.  Ostensibly ratings agencies can help, but they, too, are paid by the seller rather than the buyer.  The industry has tried to innovate around the problem by making the assignment of appraisers independent from the bankers and agents, but conflicts have again crept in.  Lender beware.

Home appraisers are inflating the values of some properties they assess, often at the behest of loan officers and real-estate agents, in what industry executives say is a return to practices seen before the financial crisis.  An estimated one in seven appraisals conducted from 2011 through early 2014 inflated home values by 20% or more, according to data provided to The Wall Street Journal by Digital Risk Analytics, a subsidiary of Digital Risk LLC.  The mortgage-analysis and consulting firm based in Maitland, Fla., was hired by some of the 20 largest lenders to review their loan files.  The firm reviewed more than 200,000 mortgages, parsing the homes’ appraised values and other information, including the properties’ sizes and similar homes sold in the areas at the times.  The review was conducted using the firm’s software and staff appraisers.

Bankers, appraisers and federal officials in interviews said inflated appraisals are becoming more widespread as the recovery in the housing market cools.  While home prices are increasing generally, their appreciation is slowing, and sales have been weak despite low interest rates.  The dollar amount of new mortgages issued this year is expected to be down 39% from last year, at about $1.12 trillion, according to the Mortgage Bankers Association.  That has put increasing pressure on loan officers, who depend on originating new mortgages for their income, as well as real-estate agents, who live on sales commissions.  That in turn is raising the heat on appraisers, whose valuations can make or break a sale.  Banks generally won’t agree to a mortgage if the purchase price or the refinancing amount is higher than the appraised value…

Almost 40% of appraisers surveyed from Sept. 15 through Nov. 7 reported experiencing pressure to inflate values, according to Allterra Group LLC, a for-profit appraiser-advocacy firm based in Salisbury, Md.  That figure was 37% in the survey for the previous year.  “If you thought what was happening before was an embarrassment, wait until the second time around,” said Joan Trice, Allterra’s chief executive and founder of the Collateral Risk Network, which represents appraisers employed by lenders and other companies and has been meeting with regulators to discuss concerns about appraisers being pressured into inflating values.

To determine a home’s value, appraisers assess a property’s condition, size and location, among other factors.  They use similar properties that have been recently sold as one key basis for comparison.  Digital Risk found that some appraised values were off the mark based on discrepancies that appeared unintentional, though, “at other times, the appraiser’s selection of [comparable properties]…is very hard to justify,” said Thomas Showalter, chief analytics officer at Digital Risk.  The firm saw cases where values for decades-old homes were determined based on sales prices for newly constructed ones, and homes blocks from shorelines were compared with waterfront properties, he said…

Much of the pressure, appraisers say, is being applied by companies hired by banks to assign appraisal work, known as appraisal-management companies, or AMCs.  A much larger share of appraisals have been filtered through these companies since the introduction of new financial rules and other requirements that seek to prohibit appraiser coercion.  Banks turned to AMCs to help maintain a distance between loan officers and appraisers.  That distance is intended to eliminate pressure on the appraiser to hit a certain price.  But some in the industry say AMCs are now applying pressure in a bid to keep the lenders’ business.

Within lenders’ ranks, tensions are also rising.  While loan officers may be trying to boost the number of home loans they give out, their superiors and risk officers are charged with ensuring the quality of those loans.  “The lender is held accountable — they need the appraisal to be accurate and to defend it years down the road,” said Michael Fratantoni, chief economist at the Mortgage Bankers Association.  He cited the agreed-upon purchase price as among the best measures of a home’s value.

Tom Allen, who says he has been an appraiser for 44 years, recalled appraising a house in April for about $450,000 for a loan application with J.P. Morgan Chase  & Co.  About a week later, Mr. Allen, 68 years old, says he received a request from the appraisal-management company to use two different properties as comparables that had recently sold for around $525,000 and $540,000.  Mr. Allen says he refused because the homes were larger, in a more expensive neighborhood and built about 10 years after the property in question. Since then, Mr. Allen says he mostly accepts appraisal requests for homes that have several similar nearby sales.