It is easy for most of us to look at mortgage loan origination as the only time the real estate valuation is used. Certainly it is most important since the lending decision is made based partly on the collateral valuation presented in the loan package. But, after the loan transaction is closed the valuation lives on throughout the life of the loan.
There is little understanding of the loan life-cycle within the secondary market. To many, the secondary market is some type of hidden mystery that is an unknown frontier. Outside of hearing about the problems that existed in the secondary market during the last financial crisis, it has little press, and little understanding. Terms such as traunches and Residential Mortgage Backed Securities (RMBS) were first heard and read about in the many articles and documentaries that came about after the crash. It was only then that the American public truly understood the risks of certain lending products and valuation products that had become popular over the previous years.
With the financial crisis behind us and the problems fresh in our minds, why then does there seem to be a push towards alternative lending products and valuation products again? Are we heading down the same old road? Some say that we are, and some say that we are not. With that question in mind, there are obvious concerns surrounding how the secondary market is treating these new products. Are the concerns recognized, and if so, how are they being addressed? Armed with the questions, I reached out to some of the leading rating agencies to see how the secondary market is viewing the changes in valuation that are being discussed and proposed.
What I found was that when it comes to the potential increased risks of alternative valuations on RMBS the agencies are not oblivious to the new products being proposed. The types of appraisal alternatives that they were analyzing included hybrid appraisals, broker price opinions (BPOs), and automated valuation models (AVMs). They found that the types of appraisal alternatives vary across RMBS products, and the risks vary across the appraisal alternatives. Each valuation method presented different strengths and challenges.
As for specific concerns with the increased use of other types of valuation products outside the traditional appraisal the agencies are uneasy that alternatives to traditional appraisals are drawing increasing interest among US mortgage market participants, signaling the likelihood of increased use of these alternatives over the coming months and years. They found that such a shift would weaken the credit quality of new residential mortgage-backed securities (RMBS) unless the transactions mitigate certain risks.
The specific types of mitigants were, among other things, (1) use of products with stronger profiles, (2) the nature of their use, such as in quality control or as a primary valuation, (3) borrower or loan attributes that result in stronger and/or more predictable mortgage performance, or (4) additional RMBS credit enhancement.
With increased risks being such a concern, there is an upside to the use of these products for specific uses. In some situations, greater use of the alternatives could potentially improve RMBS credit quality; for example, decisions to deploy cheaper valuation options could help preempt a shift toward smaller sampling during quality control or due diligence.
Even though the use of these products creates concerns about potential elevated risks, these products appear to be gaining momentum. This popularity is based on reduction of operational costs, increased efficiencies and/or response to the shrinking and aging ranks of US appraisers. This is why mortgage market participants are increasingly exploring the use of these alternatives to traditional appraisals for property valuations and, in some cases, starting to use them more. However, the rating agencies understand that the increased interest that they are drawing signal greater potential risks.
Loans which do not get a full appraisal would be exposed to new risks such as the quality of the evaluation as well as the lack of standardization of the evaluation process. The level of risk would also depend on certain offsetting factors, such as recently performed appraisals. Other limitations include the inability to pinpoint emerging risks critical to supporting the property valuation due to the inability to incorporate appraisal commentary or recent local news in the analysis.
In addition to the risks proposed by the alternative valuations, the concerns of increased risks are compounded when coupled with the increase in the threshold balance from $250,000 to $400,000 for loans made by banks that could use a property evaluation rather than full appraisals. Lima Ekram, AVP, Moody’s who spoke at the Valuation Expo in Chicago, provided the following response after the US Treasury’s report recommended the increased use of other valuation products:
“ If implemented, the policy would likely lead to the increased use of automated valuation models (AVMs) and hybrid appraisals to value residential properties in lieu of full appraisals, which could introduce new risks for RMBS, such as systemic model and data errors for AVMs, and for hybrid appraisals, the use of poorer quality information.”
While there is certainly no one advocating that the US housing market and economy are in a similar situation to that which occurred prior to the previous financial crisis, there are signs that point to obvious concerns which must be addressed. It is clear that there are red flags that must be fully observed and addressed, and the results fully vetted for worst-case scenarios.
No one wants to go down the same road we have traveled before. Therefore, it is imperative that all the caution signs are observed, and we are not just trying to change the name of the same old road we have traveled before.