A Home Without Equity Is Just a Rental With Debt

Effective Demand quotes from this 2001 paper by Josh Rosner. Here’s an excerpt from the abstract:

This report assesses the prospects of the U.S. housing/mortgage sector over the next several years. Based on our analysis, we believe there are elements in place for the housing sector to continue to experience growth well above GDP. However, we believe there are risks that can materially distort the growth prospects of the sector. Specifically, it appears that a large portion of the housing sector’s growth in the 1990’s came from the easing of the credit underwriting process. Such easing includes:
* The drastic reduction of minimum down payment levels from 20% to 0%
* A focused effort to target the “low income” borrower
* The reduction in private mortgage insurance requirements on high loan to value mortgages
* The increasing use of software to streamline the origination process and modify/recast delinquent loans in order to keep them classified as “current”
* Changes in the appraisal process which has led to widespread overappraisal/over-valuation problems
If these trends remain in place, it is likely that the home purchase boom of the past decade will continue unabated. Despite the increasingly more difficult economic environment, it may be possible for lenders to further ease credit standards and more fully exploit less penetrated markets. Recently targeted populations that have historically been denied homeownership opportunities have offered the mortgage industry novel hurdles to overcome. Industry participants in combination with eased regulatory standards and the support of the GSEs (Government Sponsored Enterprises) have overcome many of them.

And an excerpt from the section on appraisals:

“We have spoken with real estate-appraisers, fraud appraisers and national appraisal organizations and have been told, almost unanimously, that the changes in the appraisal process, over the past decade, have jeopardized the soundness of the process and skewed real estate prices. Of the approximately 85,000 real estate appraisers in the country, roughly 40,000 appraisers are members of professional societies with ongoing educational requirements, standards and ethical codes. The remaining 45,000 are unaffiliated and subject only to varying state licensing requirements. Many or most regional markets have moved away from the traditional practice of randomly assigned appraisers chosen from organized blind pools. With the elimination of the objectivity that blind pool appraisers brought to the process, the process deteriorated. Today, appraisers are, generally, hand picked by agents and brokers and are compensated for each appraisal. The system of checks and balances that the appraisal process was created to secure has become fraught with conflicts of interest.
Both real estate agent and mortgage brokers are compensated for “closing the deal”. In the purchase of a home, the seller pays the agent a fee, generally a percentage of the sales price. Therefore, the agent has incentive to increase the sale price of the home. Similarly, in the refinancing of a mortgage, the homeowner pays the mortgage broker an origination fee, generally a percentage of the refinanced mortgage. The broker has incentive to increase the appraised value of the home, thereby allowing the homeowner to extract more equity from the home. Almost all of the appraisers with whom we spoke stated that they have felt pressure to “hit the bid”. Those who are unwilling to succumb to these pressures face the risk of lost business. Unfortunately for the honest appraiser, there always seems to be an appraiser willing to ‘hit that bid’. The professional societies within the appraisal industry have sought help from federal regulators but have neither the lobbying dollars to advocate change nor the voice to stimulate it. Over-appraisal distorts value and undermines the integrity of the loan even before it is originated. It also reduces the ability of servicers to estimate default rates and losses in a declining real estate markets.
Over-appraisal creates a false market and risks increasing the debt of both homebuyers and refinancing homeowners. This economic risk is magnified in the event of a layoff or other adverse economic shock.”

• » Read Full Story