Friday, March 29, 2024 | The Latest Buzz for the Appraisal Industry

The Collateral Valuation Battle: Will Technological Improvements Actually Lead to Greater Mortgage Risk?

This article was first published here.

Over the last decade, the US housing market has made a slow recovery of sorts, most notably reaching a major milestone almost a year ago when the S&P/Case-Shiller US National Home Price Index surpassed its pre-crisis peak level. This overall picture of health, however, belies a spottier record at the local market level, and there are now questions about the riskiness of technological advancements in mortgage appraisals.

Recently, CoreLogic announced that in its analysis of the 50 largest metropolitan housing markets, half were overvalued. At the same time, many markets have struggled to find footing in the years following the mortgage crisis. Abnormally low inventory levels have been cited as a major culprit in explaining why markets such as Denver, Miami and Las Vegas exhibit home prices that are more than 10% above the long-term trend.

Affordability issues and/or an economic slowdown may eventually tug home prices downward. In this environment, a silent battle is being waged in the housing collateral valuation process between the old guard appraisal industry and new-age adherents to automated valuation models (AVMs). Technology appears to be winning this fight, but poses significant risk to the mortgage industry that is worth investigating.

The Appraisal Industry’s Scarlet Letter

The housing appraisal industry bears a stigma to this day for egregious breakdowns in the appraisal process during the boom years preceding the mortgage crisis. Well-documented practices of appraisal units embedded with loan production departments led to substantial over-inflation of property values that were exacerbated by lax credit standards on such critical risk factors as loan-to-value (LTV) ratio. Indeed, in the race for market share, lenders of the time fought for dominance in part by jettisoning best practices of appraisal independence.

In the years since the crisis, new standards regarding appraisal independence were introduced and, over time, appraisal management companies (AMCs) proliferated as intermediaries in the appraisal process. However, while these middlemen have improved the independence issue, they have simultaneously increased appraisal timelines and costs.

Moreover, the appraisal industry has not adapted to the times. The appraisal process remains cumbersome and largely manual, with a good dose of subjectivity, limited training on a national level and over-reliance on worn-out methodologies.

Vices and Virtues of AVMs

These deficiencies have ushered in a golden age of collateral valuation technology that has evolved in the years since the crisis. AVM models are not new to the mortgage industry. In fact, a number were in use during the pre-crisis era and were being abused by several lenders, just like standard appraisals.

In some cases, AVMs were used as a cost-efficiency tool at the expense of accuracy. As a result, a model’s hit rate – or the instances in which a model estimate could be produced from the AVM – won out over accurate depictions of property value.

The statistical models behind AVMs rely, like all other models, on feeding them the right data and appropriate econometric specification. In the early going, AVMs were criticized for their inability to discern the marketability and condition of a subject property, as well as their ineffectiveness in assessing different properties with heterogeneous characteristics.

Though these issues remain today, AVMs have become much more accurate over the years, as data and techniques have evolved and developers have begun tapping AI methods to augment their traditional data sources. Whereas appraisals are slow, prone to manual error, costly and at times inconsistent, AVMs are fast, accurate, cost-efficient and relatively consistent. Such qualities make AVMs a natural choice as the solution for the ills that have plagued the appraisal industry for years.

GSEs, to be clear, have imposed LTV limits on the use of AVMs. For example, Fannie Mae limits LTVs on a purchase transaction to 80%. However, recently, when both Fannie Mae and Freddie Mac announced that they would grant waivers to property inspection requirements for qualified AVM-approved loans, AVMs achieved an even more prominent role in the mortgage underwriting process.

Advances in data and modeling – combined with the appraisal industry’s crisis of confidence and ability to adapt to a technology-driven mortgage market – have naturally positioned AVMs as the future of mortgage collateral valuation.

AVMs: A Panacea for Poor Appraisal Processes or a Long-Term Risk?

While the benefits are clear, this shift toward automation comes at a price. As AVMs continue to find favor among the GSEs, it puts enormous pressure on just two AVM models for the accuracy of industry collateral valuation for a significant number of properties.

When manual appraisals dominated the stage, a benefit of the process was that valuation errors were spread across thousands of appraisers. Unfortunately, this diversification effect was upended by the process integrity issues noted earlier. Moreover, we must now ask ourselves whether we have traded appraisal process deficiencies for AVM model risk in the long-run.

Eventually, all models deteriorate, and AVMs are no exception. What’s more, the vast majority of loans originated today wind up in a GSE mortgage-backed security that may rely on either of the two GSE-developed AVM models. Taking all of these factors into account, we have the potential to create a systemic risk for the mortgage sector from over-reliance on just a couple of analytical tools.

Let me be clear: the risk today from GSE use of AVMs is small, but could grow over time as market conditions and collateral and credit policies change. Combined with this risk is the fact that AVMs are only as good as the data on which they are trained.

One of the touted advantages of AVM models is their reliance on updated market data from local offices throughout the country. But in an abnormal housing market where prices are rising more quickly than expected (due to such forces as inventory constraints), an AVM might build abnormal pricing into its estimates of value, reinforcing market outcomes rather than reflecting long-term market fundamentals.

Parting Thoughts

AVMs have come into their own as accepted methodologies embraced by the dominant mortgage market participants, and that is unlikely to change. However, the broken appraisal process must also be fixed.

Improved oversight of the appraisal process is required, along with a focus on improving appraisal methods, data and training. The collateral valuation process cannot become essentially a two-AVM world.

If we have learned one thing from the last crisis, it is that the best processes fuse the human element with technology, providing proper checks and balances while leveraging the best of both man and machine.

If you would like to submit an article to Appraisal Buzz please contact us at comments@appraisalbuzz.com.

Brent Bowen

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