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RESOLVING THE SUB PRIME DILEMMA
Applying lessons from the S&L crisis will restore stability and market confidence
By Thomas Inserra, MAI, SRA
CEO, Zaio Inc.
History is repeating itself.
The conditions surrounding the current sub prime mortgage crisis and the 1980-95
savings and loan crisis are eerily similar: An oversupply of property for sale.
A sharp drop in new home construction and mortgage lending volumes. Huge loan losses.
Heightened foreclosure rates. Lenders going out of business. Turmoil in security
markets, with global implications. Action from the Fed to stimulate the economy.
Congressional hearings to assign blame and write new regulations.
During the S&L crisis, federally insured financial institutions with combined
assets of $924 billion failed over a 15-year period. Like today’s sub prime
mortgage problem, the root cause was a breakdown in credit and appraisal processes.
To address the S&L issue, a government-funded corporation called the Resolution
Trust Corp. (RTC) was created in 1989. The RTC managed 747 financial institutions
with $402.6 billion in assets, making it one of the largest corporations in the
world.
The RTC succeeded in resolving the S&L dilemma by revamping credit and appraisal
processes, improving investor access to appraisal data, and revaluing mortgage assets
to reflect current market values. Over time, restored confidence in credit and appraisal
processes led to improved marketability and liquidity of mortgage assets.
Ironically, in 1994, at a time when the S&L crisis was still underway, lenders
successfully lobbied for new regulatory loopholes, including an exemption from appraisal
regulations for loans under $250,000. The $250,000 loophole, along with the failure
to extend appraisal regulations to sub prime lenders, mortgage brokers and state-regulated
institutions, sowed the seeds for the current sub prime crisis.
In some of the worst losses in the S&L breakdown, lenders bribed or coerced
appraisers, partnerships flipped property back and forth to artificially increase
value, and appraisers inflated values to help make more loans. It’s alarming
to note that 90 percent of today’s appraisers have reported that lenders have
attempted to influence their “independent” conclusions.
Lenders have also migrated away from appraisal reports. Some found that, instead
of encouraging an appraiser to inflate values, they could avoid the appraiser altogether,
and use less expensive broker price opinions (BPOs) from real estate agents or computer-generated
AVMs (automated valuation models). The widespread use of BPOs and AVMs significantly
increased sub prime loan losses, and represents yet another breakdown in the appraisal
process.
Clearly, current issues will not be resolved until regulatory loopholes are closed
and lenders take measures to improve credit and appraisal processes – essential
steps in restoring market confidence, and preventing a future crisis.
Lenders and regulators need to re-engineer the appraisal process so that values
cannot be manipulated, and so that pressure exerted by loan officers on appraisers
is eliminated.
A very promising example of appraisal reform is a nationwide group of licensed appraisers
who are beginning to draft reports in advance, prior to any transaction, and storing
them in a secure database. Lenders are already benefiting from this approach, and
are better able to meet the needs of borrowers because they can retrieve their pre-manufactured
appraisals in seconds, instead of days or weeks.
Although regulatory loopholes have not yet been closed, many lenders have already
strengthened their own credit and appraisal policies. Some have eliminated BPOs
and AVMs, and reinstated mandatory appraisals on all mortgage loans. Lenders are
also implementing new accounting regulations requiring assets to be based on current
market value rather than historic costs. In addition, many lenders are now revaluing
assets on a quarterly or even monthly basis. This improves transparency, while allowing
lenders to react quickly to changing market conditions, establish appropriate loan
loss reserves, and improve investor confidence.
Eventually, this mortgage dilemma, like the last one, will pass, and it will be
resolved in the same manner: by restoring proven credit and appraisal procedures,
by revaluating all mortgage assets to reflect realistic, current market values,
and by restoring confidence.
Investors – then and now – demand proof of underlying market value before
they will act. And it’s the investors, lenders and portfolio owners who have
learned the lessons of the past who will lead the market recovery.
This article is an abridged version of a story featured in the book “The Subprime
Crisis – Perspectives and Legal Insights on the Subprime Lending Crisis,”
recently published by Thomson West. Please click here
to read the full-length article.
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