New Appraisal Rules and the Law of Unintended Consequences

One of the biggest mortgage frauds over the last ten years was appraisal fraud. Unscrupulous mortgage brokers would get together with unscrupulous appraisers and the appraisers would create values that were simply not there. Other times, unscrupulous mortgage brokers would pressure appraisers to inflate values. In any case, it created an epidemic and lead in part to the place we are in now.

So, the government sprung into action and through their intermediaries, Fannie Mae and Freddie Mac, created the Home Valuation Code of Conduct. This was borne out of a lawsuit filed by Andrew Cuomo, the AG of New York, against First American. The point of the new rule was to put an firewall between the broker/bank and the appraiser. So, now, when an appraisal is ordered, it first goes to an appraisal management company and then that AMC orders it through one of their appraisers. Now, instantaneously, you seen a potential problem. Mortgages, already a business with many moving parts, has just created another moving part, the AMC. More than that, the fee now gets split. So, either the appraiser makes less or it costs more to the borrower.

Currently though, there are more immediate problems.

In the past month, we have suddenly been bombarded with many stories of, at the last moment, transactions falling apart because appraisals are coming in unrealistically low,” said National Association of Realtors Chief Economist Lawrence Yun. “As a result it opens up a new round of negotiations between a buyer and a seller or in many cases the buyer just steps away.”

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Now, lenders and brokers are forced to use appraisal management companies (ironically – or maybe not so ironically—many of which are owned by the big banks). These companies hire independent appraisers across the country and call on them to do the local appraisals.

Realtors say some of these appraisers are not only not local, they don’t even have access to the local MLS. They are doing appraisals using computer models, often incorporating distressed sales as comps, and often not even knowing that the home had extensive renovations or an addition. As a result, the appraisals are coming in far lower than the agreed-upon purchase price.

There are several problems here. The first problem is the most pernicious. This new regulation was supposed to set a firewall between banks/brokers and the appraisers. Yet, these AMC's are often owned by the banks. If that's the case, then ultimately, this law is not only worthless but counter productive. The whole point was to create a firewall. Yet, the new regulation allows the banks to own the very companies that are the firewall.

The second problem is more predictable. Whenever there is a significant new regulation, it takes any industry a while to figure out how to use it properly. In this case, these new AMC's are figuring out how to manage the appraisals well. As such, they often call upon out of town appraisers who don't know the area. It probably costs them less and so it means more money in their own pockets. These out of towners don't know the area and so they often come up with values that aren't very legitimate. They don't know the area. They often don't know much about the property. Worse yet, they often don't even have access to a local MLS system (the system that shows recent sales).

As such, appraisal values have been getting cut at extraordinarily high rates ever since the system has been put in. Beyond this, appraisers have seen their businesses get turned totally upside down. Good appraisers used to enjoy longstanding relationships with banks and brokers. Now, it is the AMC's that are the conduits. Furthermore, by adding another middleman, it means that appraisers don't make as much.

All of this wouldn't necessarily be so horrible. I personally believe there needs to be a firewall between the lender and the appraiser. I think good regulation can be created in this area. The problem is that it takes time for good regulation to evolve. During normal economic times, we could all manage. Now, this adds all sorts of unnecessary burdens to the real estate market. Many appraisers will be out of work. Many real estate deals will fall apart needlessly. Many other refinance loans will also be lost needlessly. All of it will happen in the middle of a serious economic downturn and one centered in real estate.

So, as we move forward with massive new financial regulations, we should take note of the laws of unintended consequences. Granting the Fed all sorts of new powers has unintended consequences. Creating a new consumer financial regulator has unintended consequences. Often in situations like this, you solve one problem by creating all sorts of new ones. That's what happened with the appraisal regulations. You can bet that the entire regulatory framework will also be open to the law of unintended consequences.