Posted by Jonathan J. Miller -Monday, March 19, 2012, 1:11 PM
I ran across this story in the Financial Times, based on a research piece by the Cleveland Fed, called Overvaluing Residential Properties and the Growing Glut of REO.
ALERT: There is a significant financial penalty to banks and homeowners when a lender uses shoddy valuation methods to determine the market value of a home.
This finding especially interesting to me because so many rant about appraisal values being too low, when in the case of REO, its because the values are too high. In either scenario it comes down to the banks’ reliance on cheap and fast automated valuation models (think garbage data in, garbage results out interpreted by gum chewing teenagers just out of high school) or appraisal management companies who rely on appraisers with limited, if any local market (requirement: licensed in the state, 24-48 hour turn times, agree to work for 50% of market rate).
Call me crazy but I have been ranting about this for years and yes, I have a vested interest in the outcome. The banking industry now sees the appraisal process as a cost function have-to-do and not a tool to mitigate risk. By encouraging the use of cheap automated valuation models and appraisal management companies to save money, they end up with an invalid benchmark to make a decision that adversely impact people’s lives. Crappy appraisal quality becomes a self-fulfilling prophecy for the bank which then drives their desire to automate and pay virtually nothing for valuation services even though the product is awful.
The research suggests banks could reduce the number of foreclosures by improving their estimates of what such homes will be worth. If their estimate of foreclosure value is lower, banks may choose to offer a loan modification to a struggling borrower instead, letting them stay in their house.
The Cleveland Fed concluded from their research the following items that impact REO policy decisions as a result of faulty valuations:
- The first is that they may not actually be overvaluing property at all, but rather placing the minimum bid knowing the property is not worth it.
- Lenders may be overvaluing properties because their valuation methods—which they use because they work well in most markets—don’t happen to work well in weak ones.
- Finally, there may be incentives that encourage lenders to overvalue foreclosed properties. Doing so would allow them to shift accounting losses from their loan portfolio to their REO portfolio.
- Overvaluing Residential Properties and the Growing Glut of REO [Federal Reserve Bank of Cleveland]
- Banks overbid in home foreclosure auctions [Financial Times]