If You Think it's Hard to Get Loans Closed Now...

On October 4, 2010, the SEC published notice of a proposed rule for comment regarding requiring new reviews for asset backed securities.  According to the summary, the SEC is "proposing new requirements in order to implement Section 945 and a portion of Section 932 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010...First we are proposing a new rule under the Securities Act of 1933 to require any issuer registering the offer and sale of an asset-backed security (ABS) to perform a review of the underlying ABS...We are also proposing amendments to Item 1111 of Regulation AB that would require an ABS issuer to disclose the nature of its review of the assets and the findings and conclusions of the issuer's review of the assets.  If the issuer has engaged a third party for the purposes of reviewing the assets, we propose to require that the issuer disclose the third-party's findings and conclusions."  The asset backed securities covered by the SEC's request specifically include credit cards, commercial real loans and residential real estate loans.  The comment period ended November 15, 2010.

The request for comments is a 58 page document which asks for input on a number of issues, including whether the issuer of the securities should be able to rely on the underwriter's decisioning as part of the review.  If they do rely on the underwriter's decisioning, should the underwriter be subject to "expert liability'? (Would you want to be underwriting residential loans these days and suddenly find yourself subject to "expert liability" if your decision to approve John and Mary Smith's loan turns out to be a mistake after John has a massive heart attack, Mary gets laid off, and the house goes into foreclosure?  I don't think so.)  If the underwriter's decision cannot be relied upon, what sort of review process should be in place?  Can it be outsourced to third parties?

A specific area of comment was in section 4 regarding real estate appraisals.  The SEC requested comments on whether specific types of appraisal reviews should be conducted for real estate transactions and whether the SEC should establish standards for those reviews to determine whether the property values stated by loan originators are indeed accurate.  The SEC also asked for comments about whether these reviews should be required for both commercial and residential loans and what types of reviews would be appropriate.

In response to the SECs call for information, the Appraisal Institute and the American Society of Farm Managers and Rural Appraisers responded with a letter to the SEC containing its recommendations with regard to reviews.  This letter is dated November 15, 2010.    "In an ideal world, every appraisal would receive an appraisal review in accordance with Standard 3 of USPAP and completed by a certified or licensed appraiser.  However, the industry standard has traditionally been a 10 percent random review of a portfolio.  We believe that this would be an appropriate minimum measure for the SEC to adopt.  We do not believe that automated valuation models and broker price opinions should be the primary or exclusive source for residential appraisal reviews.  Despite this, we acknowledge that the use of AVMs and BPOs in the review process has gained some acceptance.  We strongly believe that any properties that are found to fall below recognized statistical confidence levels using these abbreviated tools should be field reviewed by a qualified appraiser or trigger a second appraisal altogether.  For instance, if an appraisal reported a value of a residential property of $300,000 and an AVM reported a value of $200,000, this should trigger some additional action.  However, if the AVM resulted in a value of $290,000 under the scenario above, the margin of variance is likely acceptable, so long as appropriate due diligence is conducted on the entire pool."

A few years ago, appraisal reviews were fairly common because when the originator ordered the appraisals, it was assumed that the originator had exercised influence over the appraiser to bring in a higher value than the property deserved.  But when the Home Valuation Code of Conduct was implemented last year, the appraisal process became totally independent of the originator.  Originators could no longer have any contact with the appraiser, and in most cases that meant that an appraisal was ordered through a third-party appraisal management company which had its own quality control procedures. Although HVCC is technically gone, as part of the Dodd Frank bill the appraiser independence regulations are now permanently in place.

Over the last year, however, Fannie Mae has expanded its internal valuation model to include a greater number of properties.  This means that an increasing number of properties being secured by loans sold to Fannie Mae don't need appraisals at all, or they need very minimal appraisals.  So while the average appraisal costs more than it did two years ago, more properties do not require appraisals at all.  But the SEC's new rule could mean that all properties require at least one appraisal to independently verify the automated valuation model and a larger majority of homes will require a second appraisal or a review. And since this review will be a field review, the borrower will essentially be paying for 2 appraisals at a cost of $400 a piece or more.

Of course, when an underwriter calls for a field review or a second appraisal, if there is a difference in value between the original appraisal and the second appraisal, the underwriter uses the lower of the two to establish value.  The net result of this will be that once again we are going to see more appraisals for less than the sales price of the house.

What all of this means to the average home buyer is that costs to get a home loan are about to go up and underwriting times are about to increase.  The bottom line for companies originating loans is that those loans have to be sold on the secondary market.  And no loan is good if it cannot be sold.  So the underwriter is not going to sign off on a deal if she can be subject to "expert liability" when the loan is sold. That may mean second level underwriting reviews for all files and appraisal reviews on most files.  We can look for lenders to increase their underwriting fees since they can expect to have to pay for additional underwriting reviews,  and we can expect to see the appraisal costs on a transaction effectively double. These additional costs and delays--which also result in more costs--make the homebuying process more difficult and more expensive.  Continuing tightening of credit standards is going to keep the real estate market stagnant.  So these new rules, which are supposed to inspire greater investor confidence in asset backed securities, in the end could help to keep the housing market flat.  And that is bad news for all of us.