Thursday, April 03, 2008
Stripped Bare - Beneath the Feel Good Veneer of Subprime Lending
Chapter 8 - The Appraisal Game
In the arena of subprime lending, though the borrower’s ability to repay a mortgage was reviewed, underwritten per the subprime lender’s guidelines, the value of the borrower’s property, the property’s appraised value, played a more prominent role than the borrower’s ability to repay the mortgage.
Subprime lending risk assessment was heavily weighted to what is called the loan-to-value ratio of a borrower’s property. The loan-to-value ratio is simply illustrated this way. If you own a home that is appraised at $100,000.00, and you borrow $80,000.00, with your home as collateral, your loan-to-value ratio is eighty percent (80%). If you borrow $90,000.00 against your $100,000.00 home, your loan-to-value ratio is ninety percent (90%).
Though appraisals have always played an integral part in any mortgage loan application, whether for a prime loan, or subprime loan, the lack of creditworthiness on the part of subprime borrowers made the appraised value of a property in the subprime lending field, much more important than in the prime lending field. In fact, in the subprime lending field, the appraised value of a property could hold the golden key to make or break a potential deal, and this fact led to the distinct possibility of a property appraisal being manipulated, so the golden key could turn in the lock to release cash which could be dropped into a subprime borrower’s pocket.
Why was the appraisal so integral in the subprime lending industry? Because subprime borrowers’ loan- to-values, how much they can borrower against their homes, were limited by the borrower’s individual credit score and grade. If a borrower’s credit score was high, basically 620 or above in subprime lending, they could borrow up to one-hundred percent (100%) of the value of their home. If the borrower’s credit score was exceedingly low, a credit score of 500 was the cutoff point in subprime lending, they could only borrow sixty-five percent (65%) of the value of their property. Thus, the lower the borrower’s credit score, the higher the probability an appraisal with a possibly artificially high value would be required to put together a deal that the subprime borrower would be willing to go for. Remember, the promise of cash in a borrower’s pocket was one of the biggest motivators for borrowers in subprime lending, and if an artificially high appraisal was at times required to make this happen, well, then it could happen.
But how could this happen, isn’t a property appraisal typically an independent evaluation of the value of a given property? Yes it is. And don’t appraisal guidelines typically require the value of a given property be calculated based on the three comparable properties? Yes they do. Well, how is the value of a given property then manipulated?
One of the ways a property appraisal could be manipulated was by utilizing comparable properties that actually were not comparable to the borrower’s property (the subject property). For example, typical appraisal guidelines state that comparable properties utilized in an appraisal report should be properties similar to the subject property in style, square footage, and geographical area. Of course this is not always possible, so an appraiser may select properties that are larger in square footage, or smaller in square footage for that matter, which are then “adjusted” to come up with a value for the subject property.
Another way a property appraisal could be manipulated was by utilizing comparable properties which were not actually in the same type of neighborhood as the subject property. For example, a borrower’s property is located in one geographical area in a given city, and the comparable properties utilized in the appraisal report are located in another geographical area, but in the same given city. Well, wouldn’t those properties still be comparable properties? Probably not. Drive around your own city, neighborhoods can change dramatically from block to block, as can appraised values, and utilization of properties such as these could lead to an erroneous value being applied to a borrower’s subject property, and national subprime lenders may not be fully cognizant of this.
Additionally, in real estate markets where demand was seemingly insatiable, sudden economic downturns could lead to property values stagnating, or, even worse, dropping so precipitously the value of homeowners’ houses eroded to the point where the borrower owed more on their home than its current value. Properties such as these were also utilized as comparable properties in appraisal reports, which of course would result in an inaccurate value for the subject property.
Manipulation of appraisals was not necessarily systematic in the subprime lending industry. Most national subprime lenders had controls in place to limit the possibility of manipulated appraisals being utilized when evaluating lending risk. Where manipulation of appraisals was most apt to occur was in the mortgage brokering industry, but the subprime loans which may have been written based on these inaccurate appraisals still ended up in national subprime lenders’ servicing portfolios.
As mentioned earlier, the appraisal was of utmost importance when evaluating risk in the subprime lending industry. Though the impact of a manipulated appraisal for the subprime borrower would be felt much closer to home.
If a subprime borrower had received a loan where a manipulated appraisal had been utilized; and appraisal manipulations which transpired occurred without their knowledge; the consequences could be dire. In numerous cases, a current subprime borrower with an adjustable rate mortgage (ARM), who had relied on assurances from a subprime lender that “this loan will get you on the right track to be a prime borrower,” and who had reapplied for a new subprime refinance a year down the road based on these assurances, could very well find that the value of their home had not increased in value; which subprime lenders and borrowers had been betting on in order to facilitate the next refinance; and quite possibly the value of the home had declined. Top this with no change in the borrower’s credit rating, due to no credit problem corrections being required by the subprime lender in the previous refinance, and the borrower could very well find themselves stuck in their existing ARM and staring down an imminent increase in their mortgage payment which they would be hard pressed to contend with.
Another scenario where the consequences of a manipulated appraisal came into play is when a current subprime borrower approached a different subprime lender to refinance their current subprime loan. Often, when this new subprime lender appraised the property, the value came in substantially less than the appraisal that had been completed by the borrower’s current lender a year, or even less, ago. This was a scenario that I saw acted out many times, and for the subprime borrower it was devastating news.
Even if a subprime borrower did not fall prey to a manipulated appraisal, the appraisal of their property could still have a huge impact on their immediate future. This is because the majority of subprime loans written on subprime borrowers were high loan-to-value loans, gambling on continued increases in property values to mitigate the risks associated with the loan. When this aspect of subprime lending is tied to subprime borrowers’ hopes of becoming a prime borrower in one year’s time, as intimated by subprime lenders as part of the sales pitch, unless the subprime borrower’s home was located in a high appreciating real estate market, their home’s appraised value would have, at best, only appreciated in value approximately three or four percent. An increase in appraised value which would not even cover the costs associated with refinancing again, or, allow the lender to supply the borrower with that “cash in the pocket” which was so integral to the sale of subprime loans.
Because the vast majority of subprime loans written over the years were high loan-to-value loans, the importance of the appraisal cannot be downplayed. Both prime borrowers and subprime borrowers desire that appraisals completed on their properties come in high, but this was most assuredly so for subprime borrowers whose low credit scores and credit grades limited the amount they could borrow due to loan-to-value restrictions. A manipulated appraisal may have unlocked the golden cash drawer initially, but in the future, as is so evident today, they simply became another weight pulling the subprime borrower, and the industry, into the depths.