REQUIRED READING: Do you remember the children's game musical chairs? When the music stopped, nobody wanted to be left standing with no chair. The current foreclosure crisis in the mortgage industry is the same: When loans go sour, no investor or lender wants to be the one stuck holding the bad loan.
For many lenders, one of the most costly threats is the potential for a lawsuit from investors to cover the costs of a defaulted loan. Often, these lawsuits focus on the original appraisal, because an investor may claim that a faulty appraisal constitutes fraud or willful inflation of value, or that it violates the representations and warranties outlined in the loan. These lawsuits promise to be very expensive.
In May, the Federal Deposit Insurance Corp. (FDIC) filed lawsuits as a receiver of loans inherited from Washington Mutual Bank against two of the largest appraisal management companies, LSI Appraisal and CoreLogic. They accused the companies with gross negligence, breach of reps and warranties, and other breaches of contract for providing defective or inflated appraisals. The FDIC is seeking damages upwards of $120 million from each of these companies.
No one wants to face a lawsuit over appraisals conducted years ago, but lenders can protect themselves by understanding what investors will be looking for and take a few simple steps to ensure that every appraisal can withstand scrutiny.
Lawsuit triggers
The first step in avoiding litigation is also the most obvious one: responsible underwriting. A loan that remains out of default is not likely to end up in court. The underwriting of a loan is the quality control that determines the likelihood of profit. In every underwriting decision, there are two key factors.
The first and most important factor is the borrower's ability to repay the loan. Lenders look at income, payment histories and existing debt load, among other factors, to ensure the borrower's annual debt-service payments will be sustainable.
The other key factor is whether the home's price is commensurate with its value. Having a credible appraisal is the key to making responsible underwriting decisions that ensure the appropriate amount of capital is being lent relative to the value of the asset.
When loans go bad, the investor will want to mitigate losses on defaulted loans of securities. In many of the cases being filed, the value on the appraisal is the trigger for a claim. Rapidly dropping home values have made it easier for lawyers to argue that the initial valuation was artificially inflated or fraudulently obtained.
Investors, pursuant to sound banking practices, are conducting regular checks of their portfolios. If there are patterns of unusually high defaults – based on geography, appraiser, lender, etc. – they may file a lawsuit seeking compensation for their purchase. These claims can be made against the closing lender, the appraisal management company or the individual appraiser.
Appraisal-based actions focus on the appraisals' value conclusions. To prove that the original appraisals' value conclusions are incorrect, the plaintiff will typically use retrospective appraisals. These retrospective appraisals attempt to look back in time, using the comparable properties and market information available to the original appraiser.
In the middle part of the past decade, many appraisals were conducted while home values were rapidly rising across the country. Some appraisals have been targeted as being artificially inflated, but pricing trends at the time often supported these high values. While retrospective appraisers are not supposed to factor the actual performance of a neighborhood's values after the date of the original appraisal, it is difficult for the retrospective appraiser to completely ignore existing knowledge of market trends after the date the loan was cast.
If the value conclusion of the retrospective appraisal is significantly different from the original appraisal, it can trigger a lawsuit or, at a minimum, a buyback review of the property in question. The burden then lies on the lender to demonstrate that the original valuation stands up to scrutiny.
This means that the appraisal must be well supported and credibly reflect the market conditions that existed at that time. The report should include strong historical data and comparable sales, as well as sound explanations for its comparable-sales adjustments and its ultimate value conclusion.
Credibility concerns?
If a lender is facing a legal review of its portfolio, there are simple steps that can help validate the initial appraisal. If a loan passes these steps, the lender will be in a stronger position to defend against legal action.
The first step is to answer the question, ‘Is my appraiser more qualified than the retrospective appraiser?’ As the retrospective appraisals attendant to legal action or a buyback are typically conducted in bulk, it is not unusual for these appraisals to be completed by a few appraisers covering a large geographic area.
These appraisers may have less ‘geographic competency’ or familiarity with trends specific to the particular market in question. They may also have lower levels of certifications or designations than the original appraiser or a history of disciplinary action, or they may lack licensure altogether.
The second step is to determine whether the retrospective appraisal used involves the same type of inspection and the same depth of analysis as the original report. Most appraisals used for loan origination will involve a full interior and exterior inspection of the subject property and an exterior inspection of the comparable sales.
Retrospective appraisals, however, may only involve an exterior inspection of the subject property and, in some cases, may be done from the appraiser's desk. ‘Drive-by’ or ‘desktop’ appraisals rely on considerable assumptions about the condition of the subject, market and comparable sales that are compounded when these elements are addressed retrospectively.
By comparison, an original report that involves more complete inspections of the subject property, market area and comparable sales is supported by a more credible appraisal process. These first two steps are essential to defending an appraisal after the claims process or legal action have begun, but there are three additional steps for validating report credibility that can be taken to preempt these issues.
Applying either an appraiser review or an automated valuation model (AVM) to check the original appraiser's value conclusion can help preempt retrospective claims that the value conclusion is false. However, to truly demonstrate an appraisal's defensibility, a reasonable correlation between the original value and the value indicated by the appraiser's review or AVM should be supported by analyses of the comparable sales and market information.
An appraiser's review, as well as automated valuation and comparable sales research tools, can be used to identify a narrow field of comparable sales and to validate objective comparable property data. The less the objective data and the comparable sales vary between the original appraisal and these validating methods, the stronger the argument that the original appraisal's value conclusion is credibly supported.
Validating the market assumptions made by the original appraiser is the final piece of the puzzle. In addition to having an appraiser review the market conditions as of the appraisal date, lenders can use home-price indexes, home sales listing activity and historical sales reports to get a picture of what information was available at the time of the initial appraisal. This information is essential to the initial lending decision and the ongoing monitoring of the asset's performance.
The primary challenge in going through these steps is one of volume. Thousands of properties may be covered in a lawsuit involving securities, and the time needed to manually vet each loan is cost-prohibitive.
Lenders wanting to validate the valuations they have sold over the years can use automated tools and outside resources, such as appraisal management companies, to make the process more affordable and efficient. Lenders should also carefully consider the full scope of services offered by valuation partners. Many firms that offer data analytics do not offer appraisal management services.
The strongest firms are able to vet analytic tools with day-to-day appraisal operations to ensure that the tools work as needed. This integration of technology and ground-level appraisal operations provides the strongest combination of human expertise and automation to provide the highest-quality results in the shortest amount of time.
In the end, no investor, appraiser or lender wants to lose money on a real estate investment gone sour. When defaulted securities result in legal action, lenders should utilize all of the appraisal resources and automated tools needed to validate the quality of the initial appraisal. A well-documented appraisal could even save the lender millions of dollars.
John Hosey is chief appraiser for Wilmington, Del.-based DataQuick Lending Solutions Inc. He can be reached at (800) 238-1905.
