Fraud and the Home Appraisal Business

Submitted by Rich Toscano on December 30, 2005 - 11:16am

The Voice of San Diego is at it again, this time with an article about appraisal fraud.

In the past, appraisers would estimate the fair market value of a house based on comparable sales, construction costs, and various other methods. If the appraised value came in too low, the mortgage would not be approved because the bank would want to ensure that the collateral on the loan (i.e. the house itself) was worth a certain amount in comparison to the loan amount.

Now, though, many appraisers claim that there is enormous pressure from some mortgage brokers to appraise homes based not on their actual value, but on the figure necessary to close the loan. The mortgage brokers, after all, are not the ones lending the money, so their main incentive is to close the deal. And since they are often the ones who hire the appraisers, it's possible to see how there would be a conflict of interest.

For now it appears that we are still at the "he said/she said" stage, with some players claiming that fraud is rampant, and others saying that while there are a few bad apples, everything is for the most part legitimate. The truth, as usual, probably lies somewhere in between.

What can we learn here from the lessons of history? According to financial analyst and historian Marc Faber:

"The 'bubble' model always involves a 'displacement,' which leads to extraordinary profit opportunities, overtrading, overborrowing, speculative excesses, swindles and catchpenny schemes, followed by a crisis during which fraud on a massive scale comes to light, then by the closing act, during which the outraged public calls for the culprits to be taken to account. In each case, excessive monetary stimulus and the use of credit fuel the flames of irrational speculation and public participation, which involve a larger and larger group of people seeking to become rich without any understanding of the object of speculation."

Well, that sounds sort of familiar. And if Dr. Faber's pattern holds true, "fraud on a massive scale" may be going on under our noses, only to come to light after the bubble has begun to deflate and the market has turned ugly.

It makes intuitive sense: on the way up, it would be human nature to turn a blind eye to questionable behavior, because everyone is getting rich and there is seemingly no harm done. But there is harm done, because the fraudulent behavior has helped to push valuations above where they'd be otherwise, and set the market up for a serious correction. The harm comes later, in other words. Or, to quote another financial market luminary (Warren Buffett):

"It's only when the tide goes out that you learn who's been swimming naked."

As to the existence of appraisal fraud, only time will tell for sure. But if history rhymes yet again, I'll bet we find that a surprising amount of fraudulent behavior has been taking place throughout the housing business.

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Submitted by Bugs on December 30, 2005 - 8:21pm.

Speaking as an appraiser, I can tell you that there is indeed some level of fraud going on in the housing market here in San Diego. The FBI is on the case. Nationwide, hardly a week doesn't go by where some appraiser gets sent to jail for violating the public trust by overstating values in one or more appraisals. Often, the appraiser gets punished more than any of the other participants in the scheme, even though the appraiser's fee at $300 or $400 is a drop in the bucket compared with what the others are making. That punishment is well deserved, too. Our society will punish a corrupt policeman more heavily than the average drug dealer because the betrayal of the public trust is considered worse than actually comitting the crime. The same goes for appraisers who sell out to greedy clients.

So yes, there are some appraisers here in town who are enabling mortgage fraud by overstating values on appraisals, virtually always at the behest of the loan originator who has ordered the appraisal. This is a problem with a simple solution, but space does not permit me to address it here in this feedback column.

Instead, I would point to the issue of relevance with respect to the pricing trends for the entire region. In order for fraudulent appraisals to contribute significantly to the 300% price increases in the market it would have to be so widespread as to encompass over 50% of the sales transactions. That's definitely not happening.

Think about what a bad appraisal does. At most, a fraudulent appraisal *merely* ratifies or enables the close of a transaction that has already been negotiated between a buyer and seller. Almost all of those transactions involve open exposure to the market in the MLS by professional realty agents as well as buyers and sellers who each think they're acting within their own self-interests. Overstated appraisals probably are exacerbating the effects of irrational exuberance in the market - and there is no excuse for that - but the impetus for that exuberance originates at ground level, where the contract is negotiated.

By the way, the same loan files that contain an overstated appraisal will also include other manipulated documentation in the form of overstated income and employment verifications, re-worked credit reports, and applications signed by the loan originators that fraudently attest that everything in the package is truthful and correct. The "cooperative" appraiser is indeed guilty for their misdeeds, but it would take a real stretch to hold them accountable for non-appraisal problems in those loan files.

Submitted by powayseller on December 30, 2005 - 9:17pm.

A buyer's offer and comps set the basis for valuation. Can't you justify an appraisal based on the what the seller is wiling to pay, and on the comps? If the house next door sold for $750K last month, and with multiple offers, a climate of rising prices could validate the house in question to be worth $780K. Next month, the next house on the block is appraised at $810K, and so on it goes. It's the value of the land that is rising. How is the appraiser's work immoral?

After all, a house is worth what someone is willing to pay for it. The value depends on location, which creates a certain demand. Houses in the city cost more than those in the rural area, because fewer people want to drive to outlying areas. The same house can cost much less in the rural area. So the appraiser would appraise the exact same construction differently based on the location and the comps.

Please explain where you think this has been immoral. Are you saying there are cases where, based on comps, a house should have a certain value that is exceeded so someone can do a cash-out refi or get a HELOC? I have a hard time seeing an overvaluation on a purchase.

A buyer bids what he thinks is a fair value. Buyers have looked at many properties, and bid based on everything else they have seen.

It's the loose lending that has enabled the rapid appreciation, particularly the elimination of at least 10% down payment. That is the real problem.

Submitted by rrmarks on December 30, 2005 - 9:22pm.

You make some excellent points. It is likely a basket of seemingly innocuous factors that, taken together, are greater than the sum of their parts that will bring the house of cards down. A $30K overstatement in the appraisal is far less significant than a $30K overstatement in declared income in the overall equation.

Submitted by rrmarks on December 30, 2005 - 9:34pm.

If every piece of information upon which an appraiser makes a value judgment is based on an economic environment of rampant speculation it does not mean they are dishonest or unethical.

It means they are uninformed. Based on the criteria they used they are staistically correct and woefully wrong.

Submitted by powayseller on December 31, 2005 - 9:56am.

Good point.

Submitted by peterh on December 31, 2005 - 1:14pm.

I believe fraud and "shill" bidding have driven a good part of this market up in San Diego. It would be interesting, if possible, to address the shill bidding aspect of the market here since the "bidding" wars were so prevalent her a year or 2 ago.

Pete

Submitted by Bugs on December 31, 2005 - 2:43pm.

If all of the data available to the appraiser point to an increase in value in the market, then that's how the appraisal should go. If (and when) all the data in the market point to a decrease in value that then becomes the direction the appraisal should go. (just wait until that happens).

It is not the appraiser's job to question the wisdom of the market or to tell the market it's going in the wrong direction or that the values are not sustainable. The appraiser's job is to observe and report the data so that (in the case of an appraisal being used for a mortgage transaction) the lender can make their own decision.

One more thing: Market Value as used in appraisals is NOT defined by the one willing buyer and the one willing seller. Only a realty agent or a speculator looks at market value in that manner. Market Value as defined uses a number of assumptions, including the assumption of the TYPICAL buyer and seller, each being adequately informed and acting in what they believe are their own best interests. So appraisers are supposed to seek the trend, not the exceptions to the trend.

If the one sale next door at $750k is truly equal in all respects to the house being appraised then that is a valid indicator. The less similar that sale is the less directly comparable that $750k indicator is. People always assume that their house is worth what their neighbors' homes are worth, but 50% of those assumptions are automatically incorrect just because not all of the houses in that neighborhood are of the same size, quality, condition, etc. Some are better and some are worse. Some buyers are smarter and have done their homework and some haven't. The really high sales and the really low sales are supposed to be disregarded in favor of the sales that comprise the predominant trends.

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Submitted by illegrine on November 2, 2012 - 6:01am.

The point is that things really could become simpler. All you need to do is to cast a second glance at everything around you and see where you can apply cost reduction. For instance, this year for holidays, we stayed at home instead of planning a trip, went to ski in austria, invited our friends over and had a really pleasant time. Indeed, on a lower spending level, but you can do it.

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