User talk:Charles b warren

There is a fair amount of publicity about accounting irregularities at Fannie Mae. There is some interesting discussion of handling foreclosed collateral in the Point of View section already. (http://www.whereisthemoney.org/S00223_collateral.htm) What is not widely reported is the systematic degradation of collateral evaluation (appraisal) over decades.

For example, in 1982 Wells Fargo Bank layed off its appraisal department. Fine. Corporate decision, right? The rationale was that appraisers were not a revenue center for the bank. The next layer down was the conviction of management that collateral was far less important than credit, possibly true. At the bottom level, Wells advised its layed off appraisers that they could now contract work. But they would contract with the borrowers for submission to the bank. This was described as "putting the appraisers in closer touch with the client/borrower", streamlining the process if you will. Well, he who pays the piper calls the tune, and the list of ex-employee contractors was swiftly weeded out. The practice was specifically prohibited under FIRREA, almost a decade, and almost a quarter trillion dollars of loss, later.

That quarter trillion was about the all-in cost, including opportunity costs, of the savings and loan crisis, first reported in Real Estate Review. In gross terms it amounted to something on the order of ten percent of the two billion dollars or so that the S&L's loaned between about '82 and '89.

Now, if you steal a quarter of a million dollars, that's theft. A quarter trillion is politics. The enforcement effort nabbed a few. But when Keating announced to the press that he had only done what Congress wanted, it was clear that enforcement was out. Trivia quiz: what politician is the surviving member of the Keating Five?

But, back to collateral. Appraisers were widely and justifiably blamed for performing bad appraisals in the 1980's. But, just as the demise of Arthur Anderson did not result in any CPA's losing their designations, neither did the S&L meltdown result in any Members of the Appraisal Institute losing their hard won and coveted MAI's. Even those whose work wallpapered Bell Savings, default rate 98%, continued to appraise with hardly a hiccup, aside from the ensuing recession. By various devices appraisal, appraisers, had been subverted. FIRREA had an answer: licensing.

Licensing presumes that regulators will care about standards. As early as 1994 a compliance officer at the State of California Office of Real Estate Appraisers (OREA) announced to me, "The foxes have taken over the henhouse and established a breeding program." Today there are schools which will prepare license candidates to pass the test, without the least gesture toward ethics. In 1999 the head of Fannie Mae's appraisal quality control admitted that his own house loan was supported by an appraisal which grossly overstated the size of the house. In 2000 a software vendor made a presentation to the American Society of Appraisers. "You put the value you need in here, and the program gives you the comps (comparable sales) over here..." So, last week someone asked me to co-sign a ten million dollar appraisal. The property had been listed starting at four million and sold for two and one half million about a year ago. The market has been pretty static in that neighborhood and price range since. The screener at OREA called me about the referral. "If you don't have anything more to go on, I don't think there's a case here." A simple difference of opinion.

But, how does this come to pass? An article in the Journal of Real Estate Research concludes that a lender has no interest in obtaining an inflated appraisal to make an unsupported loan, because when it forecloses, they have to live with it and take the loss. But that is not strictly true.

If the bad loan is put into a mortgage backed security (MBS), the recourse to the initial lender is limited by the terms of that security. For that matter, if the original lender is a mortgage company, whatever the theoretical recourse may be is likely to be pretty nominal in actuality. The capital and business practice requirements for mortgage companies allow practically anyone with a telephone and articles of incorporation to act as a mortgage lender. Dataquick, an online source of real estate data, requires payment in advance for that type of account.

Now, from the point of view of any lender, money is made by making loans. If the discipline of portfolio loss is eliminated, then there is no particular reason not to make any and all loans. The limiting factor is the minimum requirements for the sale of those loans. Those minima are basically the province of Fannie Mae.

There are definitely good things that have come from Fannie Mae securitizing the real estate loan market. Liquidity improves pricing, which has probably saved borrowers something. And to some extent the lending process has been streamlined in good ways. Credit scoring, for example, facilitates lending. And the prevailing wisdom is that credit is the dominant driver of loan repayment.

But, then you have services like www.creditcleaners.net. So, maybe measuring credit risk isn't as easy as some might think. Today we've gone even further with loans which explicitly do not involve a credit check.

Why does this work? Those who buy a mortgage backed security have the firm faith that they can price it in the financial market without reference to the underwriting of the individual loans. And that has been true: in a healthy economy and a rising market. The main cause of default is unemployment. The main cause of foreclosure is that the loan amount exceeds the market value. As long as neither eventuality occurs, there is no strain on the system.

If those macroeconomic conditions no longer maintain, will there be any liquidity for these derivatives? Will this be more like Executive Life, or Enron? In the case of Executive Life the underlying assets had value. The buyer profited handsomely by holding to maturity. Would this be true for mortgage backed securities, or would it more resemble the Bell Savings portfolio where fifty cents on the dollar with seller financing looked pretty good?

And, there is a firm belief that the securitized mortgage market, embodied by Fannie Mae and the similar Freddie Mac, is "too big to fail". In fact, that may be true. It was reported in the Wall Street Journal (4-27-06) that Michael Oxley, who chairs the Congressional oversight of both, was the beneficiary of a large number of Freddie Mac fundraisers. So, if they do stumble, there is faith that the public will shoulder the cost, just as they did in the Savings and Loan crisis. The bottom line question is, if the S&L crisis involved an overall ten percent loss, what is ten percent of the outstanding residential mortgage backed securities?

After the fall, real estate lending will probably go back to an older model: portfolio lending, short term loans, low loan to value ratios. Higher ratio loans may still be available, but they are likely to be priced more like used car loans. Under the circumstances that's probably appropriate. And securitization of loans in general will probably get the sort of odor that investing on the margin had for at least half a century after 1929.