Calculated Risk

by Anonymous on 11/10/2007 02:11:00 PM

My recent posts on WaMu’s Very Bad No Good Rotten Day involving inflated appraisals have drawn a lot of questions. One question I keep getting is a variant of “What’s so wrong with the alleged conduct anyway? Why is it such a big deal for WaMu to insist on a list of approved appraisers? Isn’t that just good risk management on WaMu’s part?”

Possibly it is just good risk management on WaMu’s part: an indictment is, after all, an allegation of misconduct, not a verdict. However, what WaMu is alleged to have done is itself the kind of conduct that is an automatic “red flag” for anyone who knows anything about how the appraisal management business works. Since most of you are fortunate enough to be entirely innocent of that, I thought I’d go through some issues here.

First off, I’m talking about how the business works, not about how the principles of appraiser independence are derived by the Appraisal Foundation or why they matter so much. I’m taking as a given that we accept the axiom that when an appraiser’s compensation is based on his or her willingness to come up with the answer an interested party wants, instead of the answer he or she thinks the facts of the subject property, the transaction requested, and the local real estate market warrant, an appraisal is nothing more than a ratification of the loan amount someone has already decided on, and that “someone” isn’t the ultimate bagholder. The real bagholder wants to know whether it is lending too much or risking owning an unsalable piece of REO. That an individual loan officer or broker just wants to know how high we can make the loan amount—and thus a commission—is an artifact of a business structure in which a lender’s own employees or agents are not aligned with its own corporate best interests. At some level the appraisal problem will never get solved until the compensation of loan processing employees and intermediaries gets solved, but that’s not today’s argument.

In the olden days of local lenders, you had either staff appraisers or “fee appraisers.” You could actually have appraisers on your payroll because you lent in a defined local area: you didn’t have to worry about needing an appraisal for a property six states away that your staff appraisers couldn’t get to, even if they were licensed in that state. If you relied on fee appraisers, possibly because it was too expensive to keep appraisers on the payroll during down-cycles in RE, you still worked in a local market, you got to know all of them, and you could order appraisals from people whose work was familiar. If you were smart, you worked with the best appraisers there were. If you were stupid, you channeled business to your golf buddies. A number of S&Ls did the latter, and they did not live happily ever after. We have this thing called FIRREA, which brought into being USPAP, in large part because of that second option.

Once local lenders became regional lenders and then national lenders, the distance between corporate headquarters, the Appraisal Department, and the actual properties and markets grew to the point that having staff appraisers was impractical and hiring fee appraisers was a crap-shoot. You can pick up the Yellow Pages to find an appraiser in a market you just entered, but this means you will learn by doing in terms of quality. That goes double if you entered this market via wholesale lending: you now have a broker you don’t know much about hiring an appraiser you don’t know anything about in an RE market you’ve never done business in before.

The early years of national wholesale lending supplied lots of excitement, as Podunk National Bank changed its name to Ubiquitous, Inc. and charged into market areas about which it knew nothing, on the assumption that, say, Miami is just like Podunk except the loan amounts are bigger. Sometimes this was actually retail lending: Ubiquitous, Inc. started buying up branches in all these new and exciting markets, with the plan of managing them long-distance from corporate headquarters. Often those branches (complete with their employees) could be acquired for amazingly cheap sums of money. The Lender Formerly Known As Podunk often didn’t ask itself why the current owner of that branch wanted out so badly, but that’s hardly a problem unique to mortgage lending or banking.

Eventually, everyone had to deal with the hard knocks. You might be able to justify taking risks on the unknown when you move into a new market, but you still have to do something about the problems that crop up. Everyone got at least some really bad appraisals from the Yellow Pages approach, and had to start making some lists. I really think that a major problem lurking in the industry happened right here, when wholesalers and correspondent lenders made a decision about what kind of list to make. Do you make an “Approved Appraiser” list of the ones you haven’t had problems with, or do you make an “Excluded Appraiser” list of the ones you have had problems with?

There is no question that logically, the most efficient thing to do is make the exclusion list. Even if you believe that there are more than just a few bad apples, you don’t get into the national mortgage lending business if you believe that bad appraisers outnumber good appraisers by a wide margin. Exclusionary lists are just shorter and easier to administrate.

If you’re still a retail lender (just a long-distance one), you can keep the shorter exclusionary list internal to your own organization. The major disadvantage of exclusionary lists developed for the wholesale and correspondent lenders, and for any lender in the “originate and sell” rather than “originate and hold” business. If you are contracting with brokers, correspondent lenders, third-party investors and servicers and other folks who need to conduct due diligence on your loans, you end up having to make your list available to all those parties. It becomes nearly impossible to keep it confidential.

And that started the defamation fear. Too many lenders faced real or imagined threats of lawsuits from appraisers who did not want their names appearing on what had basically become a public hall of shame list. (I hasten to add that these things were not “public” to you, the consumer. They were an open secret to everyone in the business except the consumer.) So even though an approved appraiser list was a much more expensive, time-consuming, cumbersome way to get there, more and more big operations started keeping one. (Why not go to the regulators and beg for a "safe harbor" against defamation liability for exclusion lists? Because lenders are almost never long-sighted enough to ask for regulation that benefits them. They're too afraid that it always comes with the wrong strings attached. Then after the criminal probes and class actions and general shirt-losing, we look back wistfully on those strings we were so afraid of, wondering why we didn't snap that deal right up.)

The alternative to exclusionary lists opened up the problem of what it means to be “approved.” The handy thing about the exclusionary list was that its criteria were easier to understand: anyone on that list gave me at least one bogus appraisal, or a series of very weak appraisals, or did some other bad thing like turning in all assignments late and never answering the phone. The lender would have documentation of this, since that’s where the exclusionary lists came from: a review of the lender’s internal notes and logs and quality control reports and so on. The approved appraiser list, however, didn’t just include appraisers whose work you really liked; it included appraisers whom you hadn’t yet caught red-handed, at least in theory. Many people became a bit queasy about the potential liability of appearing to put the Good Housekeeping Seal of Approval on a bunch of appraisers when the actual purpose of the list was just to indicate ones that could still be hired by the branches or brokers because we don’t know any reason why not yet.

Furthermore, these lists were (and are) huge work projects. It’s not just that a national lender has thousands and thousands of appraisers to deal with. It’s that if you’re any kind of conscientious about risks, you don’t limit your internal appraiser management functions to sitting around waiting for your QC department to find an obviously bogus one. You get a giant database going of all your appraisals, including the appraiser’s name and license number and a bunch of other facts, and you manipulate that information looking for patterns. A lot of lenders actually started stratifying the approved appraiser list: there was the A-team, whose appraisals got normal review, and the B-team, whose work could be ordered by a branch, but which had to undergo an extra layer of review or an AVM backup or something. The results of that had to be fed back into the model to see if anybody qualified for upgrade or downgrade. Plus you had to have a “probationary” list or some way of dealing with a new appraiser you’d never done business with before. Plus somebody had to monitor state licensing boards and other sources to pick up on appraisers with invalid or expired licenses or insufficient certification to handle large jumbo loans and so on.

Even worse, every big national lender was doing the same tedious expensive administrative work independently. This is why companies like eAppraiseIT exist. It didn’t take all that long for the lenders to figure out that this work could be outsourced, and for some enterprising party to offer to do it. Besides offloading the liability onto the vendor, the big lenders offloaded a whole bunch of those back-office corporate mouths to feed in the appraisal analysis department.

So fast forward to the specific allegations about WaMu and eAppraiseIT. It is utterly normal in the current environment for a big national wholesaler/correspondent buyer like WaMu to outsource appraisal administration. It is not usual for a lender to pay a vendor to make up a list of approved appraisers, and then for that company to continue to make its own list, and to demand that the vendor use the lender’s list. The whole idea is getting out from under having to make and maintain these lists, not to pay someone to do something and then incur all the expenses of doing it yourself at the same time. This would be a bug, not a feature.

I am theorizing that this is one reason why what WaMu wanted struck at least one manager at eAppraiseIT as out of line. It doesn’t have to involve any evidence anywhere that any individual appraisal is bad: you have to wonder what’s in it for WaMu to do business this way. From the facts alleged in the indictment, it sounds like eAppraiseIT asked why this was happening, and WaMu admitted that it was happening because WaMu wanted to make sure that one criterion for the “real” approved appraiser list was “the ones who hit the numbers we like,” not the ones eAppraiseIT’s database shows are not subject to documented lender or licensing board complaints.

You have to be aware that eAppraiseIT and its competitors do not base their management of individual appraisers on just one lender’s experience: that’s the beauty of the service they offer. To an individual lender, the sales pitch is something like this: why should you make the same mistakes Ubiquitous, Inc. has already made? With a third-party vendor, you get the benefit of the collective experience of every client. No appraisal management vendor expects a client to pipe up and say we want an “approved panel” that includes appraisers we know will wag their tails, roll over, and show us their bellies when one of our loan officers or correspondents or brokers asks for a certain value. Or if they do, they expect some circumspection about it. I don’t know if WaMu’s request was unusual because of its nature or because of its brazenness, but it seems to have struck someone at eAppraiseIT as a downright regulatory violation. Given the amount of interpretation and so on of a lot of regulations, many practices can be considered kinda squirrelly but allowable. It’s not that common for an outfit like eAppraiseIT to baldly assert that what’s going on is a clear violation of FIRREA.

That’s actually why I find those emails quoted in the indictment to be so explosive. I have spent a lot of years learning to decipher coded language about regulatory-not-exactly-improprieties-but-perhaps-areas-of-concern and other corporate-speak ways of putting it that I’m utterly blown away by the unvarnished language being used here. You just don’t accuse a major account like WaMu of out-and-out violation of safety and soundness regulation unless the conduct is egregious in the extreme, or you think it is clear that you are being lined up for bagholder duty, or both. It sure sounds to me like WaMu wanted to tell eAppraiseIT what to do, while having eAppraiseIT do the scut work plus the small matter of making all the relevant warranties in the utterly certain event it backfired. Mortgage market participants can be so amazingly short-sighted sometimes it’s hard to believe, but somebody at eAppraiseIT seems to have figured out who the sucker at the table was. No doubt they wouldn’t be on the receiving end of a civil suit from Mr. Cuomo if someone higher-up had listened to whatever internal employee called bull on this one.

Why didn’t they listen? Why doesn’t any corporation ever listen? Because the WaMu account is huge, and nobody wants to stop a gravy train. The indictment also includes snippets of emails suggesting that WaMu dangled other business relationships outside the appraisal management function in front of First American if it rolled over. Which is more or less exactly what lenders to do appraisers all the time: offer repeat business if they play ball, or being kicked off the team if they don’t.

I don’t want to sound too terribly nostalgic for the old days. Was it impossible to manipulate a staff appraiser? Of course not. They worked for you. You could saunter down the hall to their cubicles and make their lives a living hell in a very direct and personal way. As long as you didn’t think of yourself as the bagholder. And staff appraisers would roll over because you do that for the party paying your health insurance premiums. Especially when you believe that if it blows up, your employer, not you personally, is going to be liable.

These days appraisers have the same pressures to play ball and absolutely none of the protections of being employees. I wonder if we haven’t gotten to that point where someone with nothing left to lose has nothing left to lose. The lenders are asking appraisers to take personal liability for inflated appraisals, while offering them no salary (protection from falling volume cycles), no benefits, no institutional legal or compliance support. Even the per-deal fee we pay has become typically paid only out of closing proceeds. (We used to pay for the appraisals up front out of an application fee, so the appraiser got paid even if the loan didn’t close. These days the appraiser often never gets paid if the loan doesn’t close because the broker has nothing to pay it with.) And guess who is the target of the Cuomo indictment? Not the lender doing the bullying. At some point these appraisers have to realize that they don’t lose much by going state’s evidence and providing the other half of those email chains. And that would mean a Very Bad No Good Rotten Day for everybody.

The Census Bureau reported today for September 2007:

"a goods and services deficit of $56.5 billion, compared
with $56.8 billion in August"

Click on graph for larger image.

The red line is the trade deficit excluding petroleum products. (Blue is the total deficit, and black is the petroleum deficit).

The ex-petroleum deficit is falling fairly rapidly, almost entirely because of weak imports (export growth is still strong). But unlike the previous decline in the trade deficit (during the '01 recession), petroleum imports are still strong.

UPDATE: Petroleum imports are strong in dollar terms, but they appear to be declining in BBLs, see exhibit 17. Imports are noisy month to month, but BBLs imported has declined year over year for the last several months. Also note the price per barrel. This will increase sharply over the next few months (but not to the spot level). Hat tip dryfly.

Normally oil prices would now be falling as the U.S. economy weakens - instead we are seeing margins shrinks for U.S. refiners and record high oil prices. This would imply that global demand for oil is strong, while domestic consumption is weak. This evidence supports the "decoupling" argument: that the U.S. economy could slow, but economic growth in the rest of the World would stay strong. I'm not convinced by the decoupling argument, and my view is that there is simply a lag between a slowing U.S. economy and a slowdown for the rest of the world.

Looking at the trade balance, excluding petroleum products, it appears the deficit peaked at about the same time as the housing market / mortgage equity withdrawal in the U.S. This is an interesting correlation (but not does imply causation).

"Interestingly, the change in U.S. home mortgage debt over the past half-century correlates significantly with our current account deficit. To be sure, correlation is not causation, and there have been many influences on both mortgage debt and the current account."
Alan Greenspan, Feb, 2005

Trade Deficit Mortgage Equity Withdrawal

The second graph shows the trade deficit and mortgage equity withdrawal as a percent of GDP.

Declining MEW is one of the reasons I forecast the trade deficit to decline in '07. And a declining trade deficit also has possible implications for U.S. interest rates; as the trade deficit declines, rates may rise in the U.S. because foreign CBs will have less to invest in the U.S..

Note also that import prices are surging. From Greg Ip at the WSJ:

Import prices jumped 1.8% in October from September and are up 9.6% from the previous year. To be sure, most of that was due to rising oil and natural-gas prices. But even excluding fuels, prices were 0.3% higher from September and up 2.4% from a year earlier.

The import prices problem will only get worse in October and November with surging oil prices and the falling dollar.

Saturday, November 10, 2007

What's Wrong With Approved Appraiser Lists

Music for the Weekend

Friday, November 09, 2007

Beazer to delay paying subcontractors

Home Builder Levitt & Sons Files Bankruptcy

S&P Lowers Credit Outlook on WaMu, IndyMac, Capital One

E-Trade Warns

Home Builder Dunmore Homes Files Bankruptcy

BofA Anticipates Q4 Hit from CDOs

S&P: 547 U.S. Alt-A RMBS And NIMS Ratings Placed On CreditWatch Negative

September Trade Deficit

Last 10 Posts

In Memoriam: Doris "Tanta" Dungey

Archive

Econbrowser

Pettis: China Financial Markets

NY Times Upshot

The Big Picture

Economic Sites