Saturday, December 27, 2008

A Home Without Equity Is Just a Rental With Debt

Housing in the New Millennium: A Home Without Equity is Just a Rental with Debt -Josh Rosner June 29, 2001

I was able to read through this paper today which was written back in 2001 and was remarkably prescient for its time. It covers the rise of home ownership rates to that point and the dangers present in the steps necessary to get home ownership rates even that far. The author was warning about issues such as relaxed underwriting standards, high consumer debt, compromised appraisal process, automated underwriting systems, low interest rates and lack of any of these to be tested in a large down cycle.

There are several interesting points made about processes that are so commonplace today such that they aren't even looked at as a major part of the problems we are facing. Here is a snippet regarding appraisals change in the late 90's:

"We have spoken with real estate-appraisers, fraud appraisers and
national appraisal organizations and have been told, almost
unanimously, that the changes in the appraisal process, over the
past decade, have jeopardized the soundness of the process and
skewed real estate prices. Of the approximately 85,000 real estate
appraisers in the country, roughly 40,000 appraisers are members
of professional societies with ongoing educational requirements,
standards and ethical codes. The remaining 45,000 are
unaffiliated and subject only to varying state licensing
requirements. Many or most regional markets have moved away
from the traditional practice of randomly assigned appraisers
chosen from organized blind pools. With the elimination of the objectivity that blind pool appraisers brought to the process, the process deteriorated. Today, appraisers are, generally, hand picked by agents and brokers and are compensated for each appraisal. The system of checks and balances that the appraisal process was created to secure has become fraught with conflicts of interest.

Both real estate agent and mortgage brokers are compensated for
“closing the deal”. In the purchase of a home, the seller pays the
agent a fee, generally a percentage of the sales price. Therefore,
the agent has incentive to increase the sale price of the home.
Similarly, in the refinancing of a mortgage, the homeowner pays
the mortgage broker an origination fee, generally a percentage of
the refinanced mortgage. The broker has incentive to increase the
appraised value of the home, thereby allowing the homeowner to
extract more equity from the home. Almost all of the appraisers
with whom we spoke stated that they have felt pressure to “hit the
bid”. Those who are unwilling to succumb to these pressures face
the risk of lost business. Unfortunately for the honest appraiser,
there always seems to be an appraiser willing to ‘hit that bid’. The
professional societies within the appraisal industry have sought
help from federal regulators but have neither the lobbying dollars
to advocate change nor the voice to stimulate it. Over-appraisal
distorts value and undermines the integrity of the loan even
before it is originated. It also reduces the ability of servicers to
estimate default rates and losses in a declining real estate markets.

Over-appraisal creates a false market and risks increasing the
debt of both homebuyers and refinancing homeowners. This
economic risk is magnified in the event of a layoff or other
adverse economic shock."

One of the reasons low down payments like FHA are so dangerous is that the appraisal process is such an inexact science and unknowledgeable buyers can be easily put into homes that aren't really 96.5% LTV homes but considerably more underwater. The GSE's & FHA (and by extension, the taxpayer) should be much more concerned about the appraisal issue but they and the other RE related groups are fighting any meaningful appraisal reform.

There is much more in the paper and it makes me wonder just how far back things would go if the government wouldn't try and prop up the market with its massive subsidies. It is clear many of the uneconomical practices that would be removed from the market if the market was left in private hands will not be eliminated. The question becomes if these inefficiencies are enough to blow up the market or just simply create a long term drag on the USA and reduce our worldwide competitiveness. Either course isn't desirable but the process is so highly politicized and voters of all parties are clearly voting themselves entitlements and politicians are pandering to the masses that it is just a reality that will have to be lived with.

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