Background
The origin of the concept of land as an asset is lost in the mists of time. Ancient Greece adhered to it, and the 8th century Franks featured fiefs and personal vassalage which bound the vassal to their king. In 1066 the Normans took the system with them when they invaded England. As the concept spread, governments, banks, sellers and buyers found it necessary to know its worth. Soon it became obvious, long before the advent of paper money in Europe, that measuring its value required specialized knowledge and experience.
The modern American concept of appraising property -including the methodology of determining value based on a history of like comparable sales in similar locations- descends from that feudal system. The first appraisal firms appeared in the late 1800s. During the Great Depression that followed the stock market crash of 1929, when the U.S. abandoned the gold standard, appraisal agencies began to self-regulate. The American Institute of Real Estate Appraisers and the Society of Real Estate Appraisals formed to create appraisal standards as well as certification standards for appraisers. Eventually they merged to form the Appraisal Institute.
A Schism
The creation of the Federal Deposit Insurance Corporation in 1933, which insured deposits (originally for $2,500 per person for each deposit category in each insured bank in 1934, now $250,000 as of 2010), and the Gold Reserve Act of 1934 were watershed events. The latter nationalized all gold and authorized the President to devalue the gold dollar by over 40%, from $20.67 to the troy ounce, to $35. Federal Reserve (the Fed) banks turned over their gold in exchange for gold certificates to be used as reserves against deposits and Federal Reserve notes.
Prior to these events, banks actually feared the consequences of making unsafe loans. Accurate appraisals –and appraiser independence- were considered essential components of risk management that reassured depositors and encouraged mortgage investors not to withdraw funds from the market, for without them the system would collapse.
Though urgent and necessary to combat the Depression, the new laws had unintended consequences. The FDIC did succeed in stopping bank runs, however it also tempted some banks to make riskier but more profitable loans. It made sense; if the banks failed, its executives would not have to answer to thousands, in some cases millions of irate depositors; the government would refund their losses, and the central bank, now off the gold standard and free to create money at will, could and would loan however much it wished to its member banks and/or buy government bonds should tax receipts be insufficient to meet the latter’s needs. The dangers inherent to this nascent symbiotic relationship between the banks, the Fed and the government –known to President Roosevelt- paled in comparison to the distractions of the time: the Depression, World War II, and his own death. But the damage was done. Each and every bank with federally insured deposits became a latent federal liability.
After the war, the destruction of much of Europe, Japan, Russia and China and the abysmal weakness of the rest of the world left the U.S. dollar, by default, the undisputed global reserve currency. Oil was cheap and abundant, the factories hummed, construction boomed, excess capital was plentiful, and the overwhelmingly white American middle class prospered.
The Clouds Gather
The building boom after World War II led to the formation of a large number of lending institutions known as savings and loan associations, or S&Ls. These institutions competed fiercely in all-out “rate wars” by raising rates paid on savings to lure deposits. Alarmed, in 1966 the U.S. Congress took the unusual step to set limits on savings rates for both commercial banks and S&Ls. During the mid 1970s, the economy descended into “stagflation” – slow growth, high interest rates and inflation- a toxic environment for long-term lending funded by short term deposits. In 1979 the doubling of oil prices exacerbated the situation. In response, Congress enacted the Depository Institutions Deregulation and Monetary Control Act of 1980, signed by President Carter, a Democrat, and the Garn-St. Germain Depository Institutions Act of 1982, signed by President Reagan, a Republican. Combined, they allowed thrifts to offer a wider array of savings products and deregulated the industry, which invited fraud.
A Storm
Sure enough, many thrifts embarked into imprudent lending and fraudulent schemes, epitomized by the Lincoln Savings tragedy that wiped out the life savings of over 20,000 mostly elderly people. Thrifts had been chartered to make long-term loans at fixed interest rates funded with short-term money at variable interest rates. When rates increased, they found themselves paying more to their depositors than they received from the loans they had made, an unsustainable situation; soon, unable to attract additional capital, many became insolvent. But rather than admit to insolvency, some CEOs turned their businesses into Ponzi schemes. To do so, they required inflated values; they got them by pressuring appraisers.
All told, by the late 1980s 1,043 out of 3,234 S&Ls in the United States had failed. The Federal Savings and Loan Insurance Corporation (FSLIC) closed 296 institutions and repaid all the depositors whose money was lost, and the Resolution Trust Corporation (a U.S. government-owned asset management company charged with liquidating assets, established in 1989 by the Financial Institutions Reform Recovery and Enforcement Act (FIRREA) and overhauled in 1991) closed 747 additional S&Ls at a cost to the taxpayers of $341 billion. FIRREA ended self-regulation for appraisers and their efforts to create a path leading to college level degrees. Instead, it established the Appraisal Subcommittee (ASC) within the Federal Financial Institutions Examinations Council.
Henceforth, lenders would control every aspect of appraisals and appraisers even though it was they, not the appraisers, who created the crisis that resulted in FIRREA.
A Hurricane
The lessons of the savings and loan crisis were not heeded. Over-speculation and fraud ran rampant again in the first decade of the 21st Century, leading yet again to government bailouts, bank mergers, and the worst financial crisis since the Great Depression. Suffice it to say that in January 2011, after a two-year investigation that amassed 56 million pages of memos and documents, the Financial Crisis Inquiry Commission –headed by Senators Carl Levin and Tom Coburn- issued a report on it. In an interview, Senator Levin noted that “The overwhelming evidence is that those institutions deceived their clients and deceived the public, and they were aided and abetted by deferential regulators and credit ratings agencies who had conflicts of interest.” The Commission found that lenders sold and securitized high-risk, complex home loans, practiced sub par underwriting, and preyed on unqualified buyers to maximize profits. This activity was exacerbated by federal securities regulators who failed to take action to enforce sound lending and risk management by lenders and allowed investors to use credit default swaps to bet on the failure of the very financial products that they then sold to their own clients. Their collusion led to the rise of a gigantic bubble of securities; when the scheme finally collapsed the entire global financial system incurred unprecedented losses.
How did appraisers fare with these “high-risk, complex home loans?” The device fraudulent lenders typically used to ensure the endemic inflation of appraised values was to blacklist honest appraisers. These lenders took what had once been a very good practice and perverted it into an instrument of extortion and fraud by blacklisting and not using appraisers who refused to aid their fraud schemes by inflating appraisals. The root cause of it is that the first line of defense against loan fraud consists of individuals who are either commission-based or salaried with supplemental bonuses and quotas they must meet on pain of losing their jobs. As a result, sales agents, brokers and loan originators are under great pressure to get appraisals with values that make a deal work, and so the pressure is passed on to the appraisers. Fraudulent lenders, of course, do not have to successfully suborn every appraiser or even most appraisers. A fairly small minority of suborned appraisers can provide all the inflated appraisals required. In contrast, many honest appraisers lose a great deal of income and are forced out of business.
There have been plenty of warnings.
• In September 2004, the FBI official charged with responsibility for mortgage fraud began warning publicly that an “epidemic” of mortgage fraud was developing and predicted that it would cause a financial “crisis” if it were not contained.
• An official from the Appraisal Institute stated in a letter to federal regulators, “For years- and more so recently- our members have reported the loss of appraiser independence when they are directed to provide predetermined opinions of value to help facilitate transactions. Failure to adhere to such requests from loan officers, mortgage brokers, and others has resulted in honest and ethical appraisers being placed on an exclusionary or “do-not-use” list.”
• From 2000 to 2007, a public petition signed by 11,000 appraisers was delivered to Washington officials charging lenders were pressuring them to place artificially high prices on properties. According to the petition, lenders were ‘blacklisting honest appraisers’ and instead assigning business only to appraisers who would hit the desired price targets” (FCIC 2011: 18).
• Former chief appraisers of appraisal management companies wholly or partially owned by dishonest lenders have written detailing how their bosses attempted to force them to go along with their fraudulent procedures, yet no law enforcement agency has taken any action against the lenders or individuals concerned.
Of course, not all lenders are dishonest. Honest mortgage lenders have known for decades how to prevent appraisals fraud. They create the proper financial incentives for the appraisers and they use review appraisers to ensure competence and honest appraisals. They refuse to hire appraisers who are incompetent or unethical. But the competition for a shrinking pool of qualified borrowers is brutal, and too often honest lenders must face a choice of going out of business or emulating their dishonest piers. To this day, not a single controlling bank executive has been charged with extorting appraisers to inflate appraisals.
Laws
In response to the two crises, two laws addressing appraisal issues were passed: Title XI of Financial Institutions Recovery, Reform, and Enforcement Act of 1989 (FIRREA), and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank). As noted, neither law prevents lenders from blacklisting appraisers.
The Menace
Whether by design or coincidence, the appraisal profession is threatened with extinction. Here’s a partial account of how it’s being done:
- Coercion is alive and well. Dodd-Frank allows government sponsored enterprises (Fannie Mae, Freddie Mac [GSEs] which purchase most new loans), lenders and appraisal management companies, whether affiliated with, or that own or are owned in whole or in part, by a lender or lender-affiliate or a franchise of lenders, to blacklist appraisers at their sole discretion without the due process that almost anyone else is normally entitled to. Since most lenders sell most of their loans to the GSEs, blacklisted appraisers are effectively put out of business, even if their state-issued licenses remain in good standing. This is akin to having a state-issued driver’s license (the norm in the United States) and not being able to drive because a federal agency (in practice, GSEs are currently owned by the Federal Government) decides otherwise and denies the driver the right to defend him/herself.
- Not content with proprietary blacklists, lenders use a shared database of sanctioned individuals (including appraisers) and companies in financial services, the Mortgage Asset Research Institute (MARI). Anyone in the database, for any reason, is in effect simultaneously blacklisted by some or all subscriber.
- Lenders have in effect forced appraisers to fund their appraisal quality control operations by appropriating, directly or through their agents (which include but are not limited to appraisal management companies) 50% or more of the appraisal fees they collect from borrowers (who pay for, but do not own the appraisal report) on behalf of the lenders, not the appraisers. In addition, Dodd-Frank allows them to add as many “client-specific” requirements (known as mission creep) as they wish without compensating appraisers for the significant extra time it takes, in the aggregate, to comply with them.
- There are four levels of licenses, in increasing level of expertise: trainee, licensed, certified residential and certified general. The Federal Housing Administration (FHA) and most lenders do not accept work from the first two. As a result, experienced appraisers are leaving the profession in droves and there is no incentive for younger people to replace them. Since most appraisers are at or near retirement age, it does not take rocket science to extrapolate the precise year when the number of active appraisers will be too small to protect the public, and by extension, the entire economy.
- Universities and colleges determine the curriculum that lawyers, accountants, engineers, architects, doctors, and mathematicians must follow to earn a degree and become proficient in their fields. The government and the banks use the services of these as well as other specialists in many other disciplines but they make no attempt to dictate the scope of training. Appraisers are the exception; the government and lenders do control every aspect of the appraisal profession. Imagine for a moment what would happen, for example, if plaintiffs or defendants were to dictate to attorneys, who among other things write almost all our laws, the scope and depth of their training.
Already Dodd-Frank permits the use of computer-generated automated valuation models, which are not appraisals, to determine the value of property up to $250,000. Studies show that about 70% of loans prior to the last crisis were under that threshold; therefore 70% of the collapse can be traced to them. The FHA and the government sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, did require appraisals for their loans, therefore the vast majority of the loans included appraisals. The collapse occurred to a large extent because some lenders were able to extort inflated values from some appraisers. The question is, what would have happened had there not been any appraisals at all?
Why Everyone Should Care
It is clear that each financial crisis originated with fraudulent lenders, and that:
- With a few exceptions, none of the guilty executives went to jail.
- The government bailed them out.
- Trillions of dollars were added to the national debt as a result of high unemployment and underemployment attributable to the crisis.
- The government’s risk exposure from real estate loans stands at 90%.
- The same conditions that caused the crises remain in place.
- The impoverishment of the middle class continues unabated.
- The wealthy stand to lose far more in absolute dollars than those who have nothing to begin with if the economy collapses.
Consider: the Fed has had to inject $85 billion per month to keep it liquid because the country has a deficit of private capital flowing into it. The Fed now holds in its balance sheet trillions of dollars in bonds it has purchased that will need to be sold to investors -easier said than done since they’re presently not buying nearly as much as they used to- and the government’s deficit now stands at $14 trillion and counting to the tune of at least $600 billion per year (approximately the entire Pentagon’s budget) with no end in sight. Furthermore, just talk of “tapering off” the program impacts interest rates and reduces the number of domestic qualified first-time buyers (wealthy foreigners do not have the same problem and help keep prices high), particularly college graduates who have a hard time finding well-paying jobs. Despite this, the obvious trend is to eliminate the one profession that protects borrowers, investors, and ultimately, the entire economy.
A Solution
Given the symbiotic relationship between the government and the banks, the appraisal profession should be completely independent and fully insulated from both. Only thus would they fulfill their role as guardians of public trust and the economy at large. Here is a list of steps that might do so.
1) Statutory recognition that appraisals of any type of asset, including but not limited to real estate, are written, formal judgments of value prepared by qualified licensed professionals.
2) Have accredited colleges and universities create programs leading to degrees in appraising, the same as any other profession, with a curriculum designed by qualified, experienced appraisers with advisory input from the government, lenders, and other users.
3) Recognize statutorily that the entire fee paid by anyone for an appraisal, at any time and for any purpose, is the sole exclusive property of the appraiser(s), not the lenders’ or their agents.
4) Have appraisals statutorily classified as intellectual property, entitled to copyright protection, and, as with software producers, to license their product.
5) Create a Federal Court of Value directly under the Supreme Court of the United States to provide swift due process and resolve complaints from appraisers as well as users of appraisals. From time to time, and in a manner akin to FHA’s asset management program, the Court would award contracts to local appraisal management companies that would be responsible for quality control and final delivery to authorized end users. The system would be supported by fees paid by lenders, insurance companies and other institutional end users for the (licensed) right to use copyrighted appraisals.
6) Contracted AMCs would collect the appraisal fees on behalf of appraisers, not lenders, and assign cases on a rotating basis within well defined geographical areas.
7) Anyone, including members of the public, brokers and agents would be entitled to order (and pay for) an appraisal from a Court-designated AMC but without the right to request or select a specific appraiser.
8) Portability of appraisals prepared by duly licensed/certified, Court-recognized, unsanctioned appraisers to be mandatory for the GSEs and lenders.
9) Automated valuation models are computer-generated products which can be controlled or altered at will and are therefore a portal to fraud; for that reason they would be banned for new originations.
10) The GSEs, lenders, or any other end users to be statutorily required to accept reports prepared and signed by trainees and/or licensed appraisers but signed by supervisory appraisers, as needed, who would be equally responsible for the reports. That would renovate the appraiser pool by attracting honest young people who currently have absolutely no incentive to enter the profession, create a mechanism to allow them to acquire real-world experience that cannot be taught in classrooms, and minimize errors.
Ultimately, the people of this country will decide what to do; after all, that’s how a democracy works.
