Widespread misunderstanding of risk has led banks, property investors and homeowners off a cliff. This could have been prevented; who knew?
Appraisers did. Appraisers knew there was a bubble as it was occurring; they have the capability to understand what underlies the real, long-term supported value of real estate assets. Unfortunately, this knowledge does no one any good, because the appraiser’s role in the lending process is focused on current market value, by law, which amounts to
asking the wrong question: What is market value?
Relying on current market value as a reference point from which to manage risk is a mistake, for which we have paid dearly. Using appraisers to answer the right question would be one of the most concrete steps we could take to stabilize our thinking about asset values, push against bubbles, mitigate systemic risk, more effectively allocate resources, become more productive, and prevent the kind of wholesale dislocation that is afflicting millions. The solution is surprisingly straightforward.
Appraisals are supposed to give lenders some assurance that the market value of the property, at the date the loan is made, is sufficiently greater than the loan amount that it will cover future value fluctuations, making the bank whole on default/foreclosure. Most of the attention on appraisals concerns any difference between market value and the deal price; low is seen as a deal-killer, and is heavily resisted by loan officers. Appraisals accepting of unsupported high deal prices, on the other hand, are seen as a bias that increases lending risk. Finally, appraisals that give weight to low-priced foreclosure transactions are currently seen as making mortgages unnecessarily hard to obtain because their concluded values are below the “normal market,” as described by Leonard Nakamura in a paper published by the Philadelphia Fed, How Much Is That Home Really Worth? Appraisal Bias and House-Price Uncertainty. None of these views gives a useful picture of risk, and actually provides lenders and regulators with only an illusion of safety. See my response in What Do We Know About Lender Risk. The appraisal profession has been marginalized by a system that does not appear to understand risk at all.
Loan originations have historically relied on a safety margin of around 20% for primary residential and 30-40% for commercial properties, so that if values declined, the asset would still secure the remaining loan principal. Over time, the loan balance would be reduced and at least inflation (if not additional market gains) would increase nominal values to further increase this margin of safety. So long as prices follow a relatively low, stable rate of inflation, this can work reasonably well. What if they don’t? By 2005, prices were rising so fast that lenders had become unconcerned with safety margins. Down payments became unnecessary; at a more than 10% annual value increase, the lender would soon have its 20% margin even if the loan were 100% of the sale price. Even the ability of the borrower to repay became largely irrelevant, an underwriting decision that rested on the ever-increasing value of the underlying security. The widespread belief was that rapidly increasing prices can decrease risk, automatically washing away all sins. Right?
Reality cannot be denied. Prices were increasing far above any long-term historic measure, and as the bubble inflated, risk for new loans and to new buyers became greater and greater. Our faulty beliefs caused long-established underwriting standards to be jettisoned. Properties were eagerly purchased, at a time when greater caution was essential. Risk was rapidly increasing, and red flags should have been raised all over the place. Alas, based on a widespread misunderstanding of risk, meaningful flags were not raised, and the game continued unabated. Those taken out (those few sellers who did not repurchase) and those who were never in (brokers and lenders whose benefits were front-loaded) did just fine. Banks and holders of derivative securities were seriously hurt; but debt holders could at least foreclose and try to sell the assets (or sell the “toxic” paper to the Federal Reserve). Newer (or heavily refinanced) equity positions – homeowners and commercial property investors – are largely wiped out. Millions who “got in” to take advantage of the bonanza, trading up and reallocating assets, came out the losers.
Risk has everything to do with value over time. The lender should be concerned with value at the time of foreclosure, and equity holders at time of the eventual sale. The property isn’t (hopefully) being foreclosed or again sold at the origination date, and value at that date is largely irrelevant to ongoing risk. Thus, knowing current market value has limited usefulness, and concern about the accuracy of appraisals going in is pretty much a red herring. (An accurate appraisal as of the origination date is indeed useful in finding decidedly nonmarket pricing, which can result from fraud or a host of other conditions that legitimately should be identified, but it is of little help with the value at foreclosure.) I have noted that appraisers knew that values were hyper-inflated, but they were only being asked for an opinion about current market value, which is not the most meaningful question. Worse, the opportunity for appraisers to advocate for the truth about even current market value was frequently blocked, as appraisers were often seen as impediments to closing transactions. They gummed up the system. The appraisers who might have contributed greater understanding of value were largely pushed aside, and many were replaced. Of course, since lenders and regulators believed that risk was decreasing, did any of this really matter?
The concept of market value is inherently a short-term proposition. Appraisers interpret the actions of buyers and sellers on their terms, to find how they would price a property on a particular date. But what if the entire market is skewed by short-term conditions (say, by very low interest rates and hopelessly lax lending standards)? What if it is temporarily skewed the other way, by a large number of foreclosed homes on the market? Lending and other long-term positions are not well-served by snapshot information, as conditions will change over the life of the loan/investment, and it is largely exposure to changes that determine risk to both debt and equity.
What if we were to first look at property values over a long period (say, at least 20 years)? We would see short-term price movements, but a long-term trend line as well. We would see correlations with rents and incomes, the influences of interest rates, persistence of demand/supply imbalances, consistency in capitalization rates and many others. The historic view also captures the effects of unexpected events, such as natural and man-made disasters, economic dislocations and the like. While the future remains unknown, risk derives from exposure to unexpected events, and such exposures can be minimized by taking the long view. A well-formed opinion of long-term, stable value can go a long way to mitigating future risk, since the dimensionality of facts that are considered is greatly increased, and the likelihood that a random event will change the outcome is substantially reduced. This is not an idle theory, or an impossible task (see Short- and Long-Term (Sustainable) Property Valuation). Far from it.
The current standard of value—the short-term standard—is market value. A standard that addresses many of the issues raised above is mortgage lending value (MLV). The Basel II Accord provides for consideration of both valuation approaches for commercial real estate. Mortgage Lending Value is considered a long-term, risk assessment technique, and is defined as: “The value that can be expected with a high level of surety, derived from the historic perspective of market events at the time of the valuation, on the basis of the durable characteristics, and which will be achieved in normal property transactions over a long period in the future.” German Pfandbrief mortgage banks have used this system to collateralize highly rated covered bonds with great success. The system identifies a baseline level of value and risk, and recognizes a positive margin between such long-term and market values as an increased risk. A negative margin might represent a decreased risk. Suitable loan coverage ratios and interest rates then manage this risk, and have the effect of pushing against price bubbles.
We have seen that the system, as it is currently designed, clearly does not work, under either bubble or depressed market conditions. To create a shift that allows us to see real solutions, we need to reassess our understanding of risk, and develop systematic and institutional perspectives that address it in a realistic and forthright way. In other words, we have to summon the courage to tell ourselves the truth about value. Lack of understanding, and lack of willingness to question prevailing beliefs, opened the door to wild excesses. Now is the time to adopt a valuation system that is far more truthful about risk.