Irvine Housing Blog

“hooo, I just love the smell of CDO’s burning in the morning!”
——-

I am going to be away from the computer most of the day, so I am apologizing in advance for not participating in the comments today. I will answer questions as soon as I can.

If I didn’t know better (apologies if you have already answered this), I would say that you are planning on assembling these articles into a book.

Fannie, Freddie Agree to New Appraisal Standards

http://www.nytimes.com/reuters/business/business-mortgages-newyork-investigation.html?_r=1&ref=patrick.net&oref=slogin

This is nice, but it doesn’t address the underlying problem of appraisers using an incorrect method of valuation.

WASHINGTON (Reuters) - The two largest sources of U.S. mortgage financing agreed on Monday to sponsor a new home appraisal watchdog to prevent inflated home values.

Fannie Mae <FNM.N> and Freddie Mac <FRE.N> will uphold a new code of conduct meant to keep mortgage lenders at arm’s length from home appraisers and will also spend $24 million to jump-start the new oversight body in a deal to prevent lawsuits from New York Attorney General Andrew Cuomo.

Starting January 1, 2009, the government-sponsored enterprises will buy home loans only from lenders that endorse an appraiser code of conduct that Cuomo said he hopes will become an industry standard.

“This is one of the greatest, most dramatic reforms of the housing industry in the last 20 years,” Cuomo said at a press event in New York announcing the deal. “We believe as a group that this will be a significant and dramatically positive reform.”

Since Wall Street gladly bought and bundled home loans for investors during the housing boom, lenders may have felt more comfortable inflating loan amounts. Cuomo filed subpoenas against Fannie Mae and Freddie Mac to determine whether the companies stood by as that happened.

The new code will prohibit mortgage brokers from selecting a home appraiser, while lenders may not use in-house assessors for initial reports on the value of homes. In another provision of the settlement, Fannie Mae and Freddie Mac will each provide $12 million over the next five years to help establish an appraisal oversight body.

The companies’ federal regulator, the Office of Federal Housing Enterprise Oversight, will host the new watchdog group, which will maintain a consumer hotline and promote appraiser independence.

The new standards will help break long-standing business practices under which lenders often had close ties to home appraisers, said David Berenbaum, an executive with the National Community Reinvestment Coalition.

“Many lenders have had business interests in appraisers,” he said. “Unless you have independent appraisers, you are losing consumer protections.”

Sheila Bair, chair of the Federal Deposit Insurance Corp., said the public was served by honest appraisals and that the mortgage industry would have time to comment on the proposal before it was implemented.

“The integrity of the appraisal process is fundamentally necessary to the effective functioning of the primary and secondary mortgage markets,” Bair said in a statement.

In a joint letter to Cuomo, several appraisal trade groups wrote that they would use the comment period to “provide input to you on the development and completion of your plan.”

But one regulator expressed disappointment that the accord with Fannie Mae and Freddie Mac did not have broader input.

“We are concerned that the closed-door fashion in which (the deal) was reached could result in negative unintended consequences,” the Office of Thrift Supervision said in a statement. “The proposal should be discussed among the bank regulatory agencies and go out for public comment before being adopted.”

It is a poorly kept secret…

Great post, IR.  I love this blog!  To be honest, interesting times like these make me glad I stuck it out to get my Finance MBA.  I will say, though, that I find the general public’s lack of knowledge in the subject to be frightening.  IMO, that’s the major reason these cycles can happen in the first place.  Though it is easier to change CDO valuation standards than to educate the public.  Anyway, keep it up! 

Kris
(quietly saving a down payment)

Well written IR.  The thing that still suprises me is the extent to which the banks and financial industry propelled the mania instead of restraining it with fundamental evaluation of home values.  As you say in your post people should be free to ‘overpay for a home with their own money’ but, never be allowed to overpay with someone elses money.  I’m in healthcare and it reminds me of what people really think of healthcare - and that is they want the absolute best healthcare someone elses money can buy!  Nobody cares what things cost if they don’t pay for it…  Yet another example of how prices get perverted when basic market forces are removed from the equation.

In practice and politically correct, it is one step in the right direction.

Jumping to the ultimate income based appraisal method is likely too remote from reality of today’s market and political environment.

Personally, I’d like to see resolution as to the treatment and sometimes penalty on the fraud and crime committed during the great real estate bubble, such as falsify documents and lying on the applications, etc.

After all, no rules is better than rules that are not enforced.

The banks and financial industry had management and employees whose bonuses were predicated on higher loan volume - that’s why they enabled the mania.

Excellent analysis IR.

Basing appraisals strictly on rental value will have an unrealistic flattening effect on larger homes—nationwide (i.e., California may well be different), there is only so much demand for 4000+ sq. foot rental homes.  Indeed, in many cases, a rent-based approach might not even reach the replacement cost of the structure, never mind assigning some value to the underlying land. 

Income-based valuation is fine for a market with ready comparisons—condos v. apartments fit the bill.  But what do you do in Peoria, IL, where most renters are in apartments and most buyers are in SFRs?  Do you base rental values for SFRs on the (mainly) old, run-down rental stock of SFRs?  Or the handful of newer/updated SFR rentals?  Or an adjusted RSF based on apartments?

It smells ... of victory.

looks like Ben is on drug today too:

http://www.federalreserve.gov/newsevents/speech/bernanke20080304a.htm

This is perfect because it provides a concise and incredibly well-reasoned analysis.  This (and Part I - Structured Finance) should be mandatory reading for anyone thinking of buying.  There should be a Q&A Section in the escrow process making sure every potential buyer scores a 95 or better before escrow closes!

I can see it now, “I’m sorry Mr. GF, we can’t close this escrow because you’re an idiot.  Read these four pages again and take the test over.  And in the essay portion, ‘but I saw a TV ad from the Realtards saying “It’s A Great Time To Buy” is not an acceptable answer.’”

I can see how the income method represents the floor to which house prices might descend.  Its how you would value any investment, by the cash flows it produces.  However it fails in valuing the intangibles - the value of being able to customize your house with luxury items, the value of living in a nice neighborhood or having a nice view, the value of not having to move your kids to a new school every few years, etc.  As others have mentioned, the rental market is neither transparent or liquid in nicer areas with large SFRs.  And those homes that are rentals tend to be dated and/or run-down - hardly good comparables.

Very good post. Well written and sane view of the situation. I worked at New Century and saw first hand the greed. While many of the people were clueless to the risk and impending doom, they were very talented and clever people that will find a way to make a buck.

This is way it will happen again. People will find a crack in the system and use it to make a buck. On the bright side these market bubbles create opportunities for the patient buyer. I have a lump of cash and a good job and I am hoping a great buying opportunity is soon approaching.

I agree that there was waaaay to much fraud involved in the appraisal process; however, I don’t believe in totally eliminating sales price approach.

A home has an intrinsic value (cost to completely construct) and a market value.  The market value is whatever someone is willing to pay for it.  Since this is inherent in the price of sold homes, I can’t imagine removing the sales approach to appraising a home.

I think the answer—and this is already done with super jumbo mortgages—is the lenders will hedge their risk by requiring more down payment and lower LTV ratios.  If a lender requires 25% down, they can afford to be a little off on an income based valuation of a 4000 sq ft house.

What? You don’t include refinancing or credit availability risk?

If houses were priced fairly compared to rents, and then credit availability contracted severely, defaults would go up.  People who needed to sell because of divorce, for example, would find themselves having a harder time finding buyers.  One income of the person staying in the house frequently wouldn’t be enough.

No.  An appraiser has no business incorporating rates or credit availability when valuing a home.  Now a lender can choose to view the collateral however it sees fit.  An appraiser’s job should be simple and non-influenced.

Do you think there should be a homeowner’s license or permit?  Like a driver’s license?

Perhaps people should get a lower interest rate if they were able to score well on some sort of test regarding homeownership and/or financing?

You don’t have to eliminate it. The amount you are allowed to borrow against stocks is not based on the income produced by the stock. However, you are also not allowed a 100% LTV on a stock even though the loan is a recourse type of loan. I think the typical margin requirement is 50%.

So, what you could do is set a margin requirement based on income and market value. Require different margins for the two different valuations. For example, 90% LTV for valuation based on income and 70% for valuation based on comparable sales. You can get a loan up to the larger of the two limits.

The problem with the sales approach is that home prices were artificially inflated due to a excess in purchase money supply.  If home purchase money is ‘cheap’ (1.5% teasers, no money down, no credit check, etc), then demand/prices goes sky high - along with income/price ratios. 

Interesting, since that money was very specific - people couldn’t borrow money at these terms for rents - rents have growed only at the pace of broader inflation and incomes - so GRMs grew.  Though remodel costs in our area also went up to $250-300 per sqft, due to cheap equity lines. 

The larger question is how ‘cheap’ will home purchase money be over the long term, or even 1-2 years from now?  Do we see a return to 20% down, income/credit verification, 30% DTI, and 30-year fixed around 7-9%?  If so, whatever is affordable at those terms for average area incomes would seem to be the expected target for home values.  I bet that number is probably around the historical 3-4 times income and/or 150-200 GRM metrics.  Or perhaps we see some new exotic loan structure (but with better risk controls) that makes 5-6 times or 250 GRM stable.

IR’s gone hip hop today! Strings of Elvis last year, and now Bow Wow…  Eclectic music taste!

...like victory (Colonel Kilgore).

I believe the market will self correct over a period of time through the process of new lending guidelines coming through the chain of stricter CDO risk appraisal standards. As IR said the CDO origination end of the process cycle has to drive the toughening up. Once the standards tighten at the top, then logically standards would have to tighten at lower rungs under increased scruitiny and concern about the associated risk.

IR, great article, it took me a while to read it through. But in my opinion this was the most coherent 2 parts I have read on this blog to date. The simplicity and yet the intricacies of the process cycle have been aptly described by you in this write up.
Thank you!

Yeah, I was also surprised by IR’s musical range today, going with Bow Wow.
“Shortie Like Mine” is also a great jam.
I’ve added it to the “convert a female friend” part of my toolbox.
Song was also featured in a recent episode of Lipstick Jungle.

“The Case for Foreclosures.”

Slate.com’s “Everday Economics” series features an article today that seems consistent with many of themes we see here on IHB.  The article is by Steven Landsburg, but if I recall correctly, isn’t Slate.com writer Daniel Gross one of the national journalists who has cited IHB in the past?  The influence of this blog seems to be growing.

Link:  http://www.slate.com/id/2185303/nav/tap3/

Key quotes:

After a foreclosure, one family moves out, and another moves in. We see the sad faces of the people moving out, but we don’t as often see the happy faces of the new homeowners moving in.

[snip]

If you get to live in a nice home for a few years and then lose it to foreclosure, you are not worse off than someone who never got to live in a nice home in the first place.

[snip]

There’s at least one more reason to regret Secretary Paulson’s eagerness to forestall foreclosures: If banks can’t enforce contracts (or even if they “voluntarily” forgo the enforcement of contracts under pressure from the Treasury Department), they will undoubtedly be more reluctant to make loans in the future.

Surely not true in Irvine, kis.  there are plenty of large beautiful houses for rent (I am living in one of them). We are not talking about Pennsylvania here, but Irvine - where beautiful empty homes are in ample supply.  The intangibles you are talking about are emotional constraints and, of course, should be noted.  However, it has been my experience with Irvine houses that they are so similar (some are practically identical) that unless you are extremely particular with your layout or feng shui, you will always find a comparable home.  Irvine models kinda remind me of old Soviet planning where evrything had to be if not identical, then quite uniform.

Yes, but.  IR is moving beyond just Irvine with this analysis.  If the analysis is going to be of the overall market (I’m unaware of an Irvine-only RMBS issuance), then it has to make sense for the overall market.  You just don’t have enough comparable rentals in a “nicer” area of SFRs everywhere.

I want my copy to be autographed

BTW another great post.

A government test for home ownership? LOL

If its anything like the drivers’ tests, you could get it in 100 different languages and cheat off the guy next to you…and you’d have to stand in line for three hours just to take it.

I almost forgot. How are the music videos going to fit into the book? E-book time…

Publishers are very squeamish about potential copyright violations…

Agreed, but this can be more art than science in a rapidly changing environment (increasing or decreasing).

Really Scary Fed Charts

http://benbittrolff.blogspot.com/2008/03/really-scary-fed-charts-march.html

Get ready debtors, the axe is fixing to come down hard on you….

Not to mention the useless questions like “What is the most common reason people do <name of dangerous behavior>?”  How does this help?  If people think that the reason justifies the behavior, won’t this just expose more people to the most popular justification and thus probably increase the prevalence of the dangerous behavior?

“If you owe the bank $100 that’s your problem. If you owe the bank $100 million, that’s the bank’s problem.” J. Paul Getty

You might see some flattening of prices because loans would be capped by the income, but people who want bigger, fancier homes can always use their own money to get it. The whole idea behind using comparative rents is to limit the exposure of banks.

In areas where there are limited rental comps, the government’s equivalent rent numbers can be a guide. The basically do what you are describing and attempt to find a relationship between various home types. They survey 2 bedroom units and they provide a multiplier for 1, 3 and 4 bedroom units. It is not a direct comparable, but it is a reasonable estimate.

“The market value is whatever someone is willing to pay for it. Since this is inherent in the price of sold homes, I can’t imagine removing the sales approach to appraising a home.”

This is also the mechanism for inflating a bubble based on irrational exuberance. The only way to eliminate the “greater fool” problem from market valuations is to stop accepting appraisals based on the foolish behavior of buyers. Let people do it with their own money if they want, but when you start doing it with the bank’s money, you end up where we are today.

“Or perhaps we see some new exotic loan structure (but with better risk controls) that makes 5-6 times or 250 GRM stable.”

This is certainly what the inventors of the Option ARM and other loan programs attempted to do. So far, they have failed miserably.

Countrywide admits to ticking time bombs on balance sheet.
http://thegreatloanblog.blogspot.com

That’s good!,

A blog to book deal is a good incentive for bloggers, and as a reader, that’s an incentive to keep coming back for independent, unbiased thinking.

This is an outstanding post which successfully puts the complicated CDO process into a layman’s understanding. I recommend a reading of Mish’s take on Bernanke’s pitch for saving the banks and originators responsible for all of this here: http://globaleconomicanalysis.blogspot.com/2008/03/bernanke-asks-taxpayers-to-bail-out.html

Thanks for the great work.  I will visit your site more often.

Getting accurate monthly rental info for sfr’s is toughest information for an appraiser to get their hands on.
  The MLS offers lease info, but in my experience, it only represents about 5% of the market (maybe a 15% in Irvine). Most transactions are completed privately and some with property management.
      Residential appraisal is quite different from commercial appraisal when it comes to data sources regarding rental info. I’m sure most of you know that residential appraisers rely on a public record system to verify a closed sale and then cross reference it with the mls and a physical inspection of the comparable to confirm accuracy of all data. Appraisers worth their salt will call agents to further investigate a comparable transaction when the info looks shady. This method has weight as it can be proven, quickly and efficiently on a daily basis. It can also hold up in court.
      This is the valuation process for residential homes. Is it the best way??? Probably not. But using rents to value homes is nearly impossible because their is no official rental data source. The mls info cannot be considered accurate. The agent types in whatever he/she wants in the closed lease price box. We all know they lie their asses off, I’m sure some pump up that price to attract more listings.
      Also, an appraiser cannot rely on what Ned down the street told Joe homeowner he is getting for his condo per month. Appraisers are responsible for every letter and figure in their reports:
        “Your Honor, His neighbor said he was getting $3,500 per month, Why would he lie to Joe???”

Residential property management is a dead end. This is what a conversation sounds like between an appraiser calling for rental info from a property management company…1st attempt:“Hi, this is Bill from Acme appraisal…CLICK!!!...Hello, Hello!
2nd try: “Hi this is Bill calling ba…CLICK!!!...ck.

“Basing appraisals strictly on rental value will have an unrealistic flattening effect on larger homes… there is only so much demand for 4000+ sq. foot rental homes”

I think it is a hallmark of conspicious consumption that we buy 4000 SF homes on an installment plan.  They aren’t bought on an installment plan because it’s good finance and tool to manage their wealth, but the majority bought with mortgage and 30 years of installment payments because that is the only way they can do it.

IrvineRenter, yet another good article.  Only one minor point to make, it is dependent on the financial houses and other involved parties being concerned with it being a sustainable business and market.

They aren’t.  It’s the same problem many publically traded corporations have, they are literally being fleeced from the inside out by their management chain trying to drive short-term explosive stock growth so they can cash out and go away.

You are a great writer, IR.  I agree with 99% of what you say, in general.  But I totally disagree with the premise that the income approach is the way that SFR’s should be valued.  Please, please spend some time researching the history of the appraisal process, USPAP guidelines, etc.  and spend some time picking the brain of a competent appraiser (there are some out there!) I could go on and as to why but it will be a dissertation…but as some other commenters have touched on it previously here,  the benefits one feels are derived from owning a particular home, aside from potential rent, are reflected…in the sales price itself.  I have commented in other posts that it is completely irrelevant to me what my house would rent for.  The value I ascribe to being able to do what I want aesthetically, when I want, how I want, on my property (non-HOA ), down to the swingset in my backyard,etc., is reflected in my willingness to purchase a particular property for a certain price!  My primary residence is not an ‘investment’ that I consider to be part of my wealth generating portfolio of assets.  That’s a mistake a lot of people made. This bubble resulted from lax underwriting, greed, anxiety for income, etc.  and unscrupulous lenders who pressured appraisers (and less than ethical appraisals) made the situation terrible…and if LTV’s required borrowers to have some skin in the game, even 10%, geez we’d be in a different boat now.  But using the sales approach to value real estate ?  not the reason.

I agree with your comments on the intangible benefits of ownership, and nothing in my proposal would stop you from obtaining these benefits, and even overpaying for them, if you do it with your money. The comparative sales approach allows people to overpay with the bank’s money which is why the collapse of the bubble is causing problems with our banking system. The main purpose of mandating the income approach is to reduce the risk lenders face.

They aren’t bought on an installment plan because it’s good finance and tool to manage their wealth

Uh, yes, yes, it is a good finance/wealth-management tool.  In what other way can an individual borrow $500,000 (or $1mm) for a net interest rate of under 5%?  If you have that kind of investable cash sitting around, you should be able to profitably arbitrage. 

There are frequent questions here about why corporations get to do certain things that individuals can’t—well, financing assets is something that corps do as a matter of course—and individuals should to.  If you have an irrational hatred of debt, so be it, but don’t think that the use of debt by someone else is stupid or only “because they have to”.

How is the “mandate” going to be enforced?  Does it involve passage of laws of general application?  Or would it just be limitations on Fannie/Freddie? 

Interest only mortgages and option ARMs and other “exotic” mortgages have been around for a (relatively) long time, but had been the near-exclusive province of high net worth clients of wealth management firms.  Would you propose to prohibit such accomodations?

Sure, it would be great (in some ways) if everyone in the financial markets acted in a prudent manner all of the time.  But the downside is that a large part of the success of the American economy is the very freedom (and even encouragement through gov’t policy) to sometimes act very stupidly. 

There is no doubt that lax standards and non-existant underwriting has caused a tremendous problem, but that doesn’t necessarily call for drastic measures.  Overreaction to prevent similar problems in the future often has unintended consequences.  Maybe any FDIC-insured entity should be prohibited from holding potentially problematic mortgages directly or indirectly to prevent the government from having to bail them out. But to require that all lenders of all types comply with a set of rigid standards is going too far.

I hear your point, IR…

obviously, in a free market economy, there is no one forcing investors to buy the stock of a company that is making ridiculous loans, or buy the securities backed by them.  Clearly the rating agencies missed the boat big time in this mess.  The risk was there all along.  I have no doubt that many who evaluated these loans as part of their jobs (either working for rating agencies, credit risk managers at banks, etc.) knew it.  I was in a position to walk when I thought things were getting out of control from a credit perspective (did not deal with subprime, but did deal with jumbo stated income product), and that was back in late 2003.  But most people need to work and everyone in town was playing the same game.  Tough times.