On May 1, a sweeping change took effect that was meant to reduce the conflicts of interest in home appraisals while safeguarding the independence of the people who do them. Brokers and real estate agents can no longer order appraisals. Lenders now control the entire process.
Why do we have appraisals at all?
Suppose I went to an auction, bid on a Picasso, and had my bid accepted. I then went to you and asked you if you’d lend me 80% of the money at a fixed rate, with a priority return in exchange for the cap.
What could I tell you that would interest you in the deal?
What if I brought an art professor with me, and he told you that it was an incredibly important work and I had gotten a terrific deal. The painting is worth much more than I paid.
It is possible, of course, to get a wonderful deal at an auction. Plenty of people make a living buying cars at auction and reselling them in showrooms. Since the most recent price check for my painting had me as the high bidder, however, you will probably be a bit skeptical.
What I paid should be of very little consequence to you in deciding whether you should invest. The question is what would you pay, and what discount to the price you would pay for the entire asset reflects the benefit of priority return and the cost of an assymetric return (you can lose all of your principal, just like an equity investor, but you can only earn a fixed rate of return no matter how well things turn out).
You would focus all of your attention on this appraisal. You wouldn’t care what I said, or what the professors I brought to you said, you would go out and do your own market test and understand the work from your own perspective. You would be buying 80% of the painting; should plan on doing at least as much work as the guy putting up 20% of the cash for a much better return distribution.
Back to houses. You would think shifting to a lender-based appraisal system solves all problems. But it doesn’t, for a reason the Times is onto:
But the reality is that many companies that write home loans these days do not have much incentive to worry about the accuracy of appraisals. That is because the companies do not keep the loans on their own books, instead selling them to Fannie Mae or Freddie Mac.
Why do Fannie/Freddie put up with this? Why don’t they treat the situation the same way a person making a loan would think about it? Why don’t they insist on appraising every property themselves, or at least appraising a meaningful sample? Because they cannot fail.
If there were any need to show a direct connection between an institution’s immunity to adverse consequences and the selection of those adverse consequences in its market, I hope this small example puts it to rest. Fannie buys up all the junk in the system, so there is no point writing loans to anything other than Fannie’s standards. And Fannie will not impose meaningful standards because it has no incentive to do so.
The combination of a low-information population and a political process that puts some of these less-than-intelligent people in power is that simple philosophies interject themselves all over the place. Government bad. Homeownership good. Pentagon heroes. It gives us absurd defense procurement and inexplicable programs, such as Medicare Advantage, which amazingly combines the confidence that the private sector can deliver care less expensively than Medicare with the touching faith of not even bothering to verify this premise, and somehow manages to provide a 14% markup on a government service.
In the case of Fannie/Freddie, the error is even more basic: even if they did their job well and did not have constant accounting issues, what would be the point? It’s like the offsides rule in soccer, something that has been around so long no one noticed that it is optional. Why would we want the government to buy mortgages from banks? Presumably because we want the banks to take that capital and lend again, which is another way of saying that we don’t think the private banking sector has enough capital and would like to add government capital to the mix. Or perhaps we want to deposit mortgages in a central warehouse to standardize the mortgage bond business.
Suppose the government simply put Fannie in run-off. Fannie refuses to buy additional loans, although it continues to pay out on its current obligations. It shrinks rapidly, then tails off to nothing in thirty years. What would be the harm? Banks might be more strict with their lending or charge higher interest rates, but tighter lending standards are probably a positive and higher rates across the board are balanced by lower house prices (the cover bidder gets hit too).
It amazes me that the Republican party wants to kill government involvement in health care, which is very far from behaving like a market, and yet encourages government involvement in the secondary mortgage market, which is the perfect place for the market. Since the Democrats are unable to crack down on the GSEs, why not take it as a key Republican request? It’s easy to explain: shut down Fannie/Freddie, and give us a system where whoever ends up with a lousy mortgage eats a loss that is meaningful to him. People will still make mistakes and blow themselves up, but you won’t have to worry about who hires the appraisers then.
I suppose it is a good sign for politics, if not for government, that once the Republicans discovered that the Community Reinvestment Act had nothing to do with the meltdown, they lost interest in taking aim at the folks who did. If you can’t pin it on a coastal city, what’s the point?