Finding accurate values of collateral remains a major challenge for mortgage industry players. Servicers want valuation estimates before trying to modify mortgages. Banks and other financial institutions holding loan portfolios or mortgage-backed securities (MBS) want to know the value of collateral backing their bonds. MBS and whole-loan portfolio investors want to know values before bidding on the assets.
As foreclosures mount, opportunistic investors hoping to buy distressed assets for pennies on the dollar are particularly interested in determining the condition of properties. And for servicers, the property value is one of the most important factors when considering modifying a mortgage.Â
Full appraisals are the most accurate but are far too costly and time-consuming to be a realistic option for the thousands of properties in a single security. Automated valuation models (AVMs) are the main option for estimating home values, but those computerized tools have significant shortcomings. For instance, they cannot investigate the condition of the property. As houses age, this drawback becomes more problematic, as properties undergo varying degrees of upkeep and remodeling.
Although many in the mortgage industry are well aware of the shortcomings of AVMs, they depend on them more than ever. Concerned about falling home prices, investors insist that loans be reviewed by AVMs, but instead of abandoning them altogether, they tend to use the more conservative valuation.
Companies trading mortgages currently treat all collateral as prime loans, assuming property conditions have not changed since homes were purchased even if credit scores have plummeted. That assumption is mistaken. Properties receive varying degrees of maintenance. Some have been painted, have had roofs replaced, and amenities added and updated.
Somehow, the industry must find a way to determine the probable condition of properties in loan portfolios.
The solution is to analyze borrower credit score histories to measure how responsible they are likely to be as homeowners. Lenders and investors have long used credit scores to measure the financial responsibility of borrowers based on their past use of credit. It turns out that credit scores can be used to gauge how well borrowers maintain their homes.
The concept of the patent-pending technology rests on the fact that people who are irresponsible in other aspects of life are also irresponsible financially. Research has shown that those who get into car accidents are more likely not to pay their bills, more likely not to exercise and more likely to be in poor health.
Those with consistently higher scores are more likely to be responsible homeowners who maintain properties at good to average condition. Those with persistently low scores typically do a poor job of maintaining their properties, which, in time, results in homes that sell for lower prices. If the score is medium, the property is probably in adequate condition with only updating needed for proper maintenance.
Determining the probable condition is not as simple as reporting the most recent credit score. The long-term history of the homeowner's score and its pattern of past changes may need to be taken into account. In addition, credit scores of former owners may also need to be considered.
An early low score followed by improvement could indicate hidden damage, such as water damage caused by the electricity's being cut off, causing mold that has been painted over or otherwise hidden in recent years. Sudden, drastic changes in credit scores also indicate possible maintenance issues.
A score that was previously persistently high but has recently dropped may mean deteriorating property conditions that are readily apparent, such as unmowed lawns and uncleaned gutters. Curb appeal is the first to drop.
A short dip in a consistently high score means the home has a chance of condition problems but that the chance is not significant. A short high period in a score that was usually low has a significant chance of condition problems, but a smaller chance than a consistently low score.
Credit scores are a reflection of consumers' financial circumstances. Their financial circumstances dictate if they will have money to fix the roof and pay for other needed repairs. When consumers are financially stressed, they don't have money to properly maintain their homes, not to mention upgrade amenities.
Over time, that will become evident in the property's condition. Credit scores identify sellers in the same financial circumstances, with a similar willingness or urgency to sell.
An ownership responsibility indicator can also help select more relevant comparables. Current valuation methods discard comparable sales that are far higher or lower than the median or mode. But this may actually decrease valuation accuracy. All things remaining equal, comparables with credit scores similar to those of the owner of the subject property are a better indicator of the value, even if they are far higher or lower than the median or mode.
The practice of rejecting high and low values leads to inaccurate valuations in both rundown and well-maintained neighborhoods.
Urban areas with an abundance of abandoned, foreclosed and dilapidated properties have some well-maintained homes that sold in arms-length transactions.
Yet AVMs will view these sales as anomalies and discard them, mistakenly comparing the pristine properties to their more dilapidated neighbors. In reality, these sales are more relevant to sales involving similar credit scores and should be weighted more heavily.
Conversely, good neighborhoods with mostly well-maintained homes have some properties in poor condition that are incorrectly compared to their better neighbors, when greater credence should be given to properties associated with persistently low credit scores.
[b][i]In other industries[/i][/b]
Although the mortgage industry has never used a responsibility indicator to gauge past behavior involving property maintenance, the concept of responsibility as a prediction for future behavior has been recognized in other industries. The responsibility score is essentially a reverse of the likelihood principal – an accepted insurance company practice of using credit scores to determine the likelihood that consumers will file home or auto insurance claims. Years of use have proven that consumers with lower scores tend to file more claims.
Researchers outside of the mortgage realm are already trying to use behavioral analytics to devise a responsibility score – a score that could be used to judge a person's worthiness on such disparate benefits as employment, car insurance and college admission.
Such scores are years down the road. Developing them requires mountains of data from different sources, such as school grades, police reports and even eBay rankings. While some fear consumers could be discriminated against and some areas effectively redlined, innovative behavioral analysis could help many consumers obtain benefits they previously had not enjoyed.
Several tests using proxies for credit scores confirm the link between credit scores and property condition. More exhaustive studies that track credit score histories and match them to properties of known conditions will verify the connection between credit scores and property maintenance.
The entire mortgage industry could benefit from using an ownership responsibility indicator to obtain more accurate collateral valuations. Opportunistic investors taking advantage of the Treasury Department's plan to remove illiquid, distressed assets from banks' balance sheets would benefit from a responsibility score. Armed with a better understanding of property conditions, potential MBS purchasers could improve their bids for mortgage securities, offering higher prices for securities backed by generally well-maintained properties and lowballing those with poor collateral.
Companies holding loan portfolios could reassess their assets to obtain more accurate valuations. Those improved valuations can, in turn, lead to greater accuracy in the Treasury Department's stress tests of banks.
In addition, ratings of mortgage securities, which rely heavily on AVMs, will also improve their accuracy by using an ownership responsibility indicator. In fact, anyone wanting more accurate AVMs, including title companies and loan underwriters, can benefit by putting the concept into practice.
With improved understanding of the collateral value, servicers can streamline their decision-making process and obtain a better understanding of expected losses, enabling better decision making when modifying loans and reducing the principal balance.
Modifying the mortgage can lead to improving the collateral. If homeowners have extra money, they may invest more in maintaining the property, replacing the roof or siding. Plus, they will be more likely to invest in maintenance if they are confident they will be in the home for the long term and not in danger of imminent foreclosure.
The possible impact of poor maintenance is probably more important than ever. Properties with declining conditions due to deferred maintenance have become more common due to the large numbers of subprime and Alt-A mortgages originated earlier this decade and the increasing numbers of homeowners now suffering economic stress.Â
Some securities will look worse after credit score trends are taken into account to determine more precise valuations, while others will appear better. But either way, using credit scores in valuation estimates will help bring order to the confusion caused by quickly changing housing markets and the large number of real estate owned properties and distressed sales.
[i]Steve Weise is a real estate appraiser based in Farmington, Mich. He can be reached at (248) 568-5903 or firstname.lastname@example.org.[/i] Â