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Subprime debacle – the truth emerges: Part 2

Subprime mortgage crisis | Subprime debacle – the truth emerges: Part 2 Anthony Harrington

Amongst the real horrors perpetrated during the subprime disaster, such as the many outright frauds practised on US homebuyers who should never have been re-mortgaging their homes in the first place, the testimony of real estate appraiser Karen Mann to the Financial Crisis Inquiry Commission (FCIC) sounds a barely heard note but it is an eloquent account of the law of unintended consequences in full cry.

The background is simple. For decades US mortgage lenders used professionally qualified appraisers to check the value of the “collateral”, namely the home that was the subject of the mortgage. This was the equivalent of the UK surveyor’s valuation report and was required by the Federal National Mortgage Association (FNMA), aka Fannie Mae, and by Freddie Mac, both of which carry out the securitization of mortgage assets.

However, by 1994 a political view developed that the expense of having proper valuations (appraisals) was deterring poorer folk from buying homes. Accordingly, bending with the times, and with the prevailing view in the US Congress, US regulators, including the FDIC (Federal Deposit Insurance Corporation) decided that it was no longer necessary to have homes over $100,000 subject to an appraisal. They moved the bar up to $250,000 in the interests of “improving credit availability… without threatening the safety and soundness of financial institutions”. With the benefit of hindsight, sentences like that make one’s eyes water. For loans under $250,000 what would be important henceforth was more the borrower’s creditworthiness than the collateral value of the house, according to Mann.

Instead of formal appraisals by professional appraisers, lenders could rely on statistical services which provided views on the value of homes in particular areas, or on “evaluations”. These were different from “appraisals” in that they could be done by anyone who fancied being an “evaluator” and who felt that they could stick a finger in the wind and come up with a price for a property. No training required. The benefit to the lending organisation was that it could pay peanuts, $40 dollars for an evaluation, in Mann’s testimony, versus $430 for an appraisal.

The short sightedness of this policy, from the lender’s perspective, is obvious. If the loan goes bad and the lender forecloses, the value remaining in the property is the only thing that stops the lender from taking a total write off. If the valuation is a massive overstatement, the lender takes a bath.

Even worse, Mann points out that since between 1994 and 2003 Bank Regulators left the oversight of real estate appraisal to state regulatory agencies, and since there are states with no oversight appraisal boards, many people were licensed as real estate appraisers who had no proper training or mentoring at all. As Mann diplomatically puts it, “We had a vast increase of licensed appraisers in the State of California (which does not have an oversight appraisal board) despite the lack of qualified/experienced trainers.” In other words, the distinction between professional appraisers and “evaluators” was itself being heavily diluted. Mann told the FCIC: “It would be curious" - an understatement if ever there was one - "to know the percentage of subprime loans which were Evaluations versus Appraisal Reports…”

Mann then told the FCIC of the difficulties that appraisers encountered when the housing bubble began to show signs of strain in late 2005 and 2006. Through 2003 to 2005 house prices had been going up by 30% year on year as the housing bubble peaked under the influence of cheap money and lax mortgage underwriting policies. However, by 2006, Mann says, she and her colleagues were starting to register a downturn in housing prices and were disappointing sellers by coming up with appraisals that were well under the seller’s expectations. For example, a $500,000 dollar house in 2005 had slipped back to just over $300,000 by 2008, and under that by 2009. The median price for a property in West Sacramento, California, leapt from $90,000 in 2000, to $478,000 in January 2006 and has since wandered down to just over $200,000. This is for all housing, not just subprime.

For Mann, what happened through to 2007 was that market commentators, including noted economists, generally became extremely lax in observing market signs which many appraisers were picking up on. This created a false confidence and fed the myth that real estate would henceforth never go down in value.

Absolutely basic underwriting practices went out the window. For example, although most mortgages sold were adjustable rate mortgages, Mann points out that lenders and underwriters were qualifying borrowers only at the introductory rate of the loan (often set artificially low to lure in the unwary) and not at the maximum rate that the loan could be adjusted to. This did the consumer a very poor service and stored up huge problems for the securitized mortgage industry, as we all now know.

Mann’s testimony is about regulatory muddle and the makings of the mess that allowed a sub prime bubble to grow to such toxic proportions. It is not as dramatic as some of the testimony before the FCIC, but it should be mandatory reading for regulators everywhere….

Further reading on the subprime mortgage crisis:

Tags: Fannie Mae , FCIC , FDIC , Federal Deposit Insurance Corporation , Federal National Mortgage Association , Financial Crisis Inquiry Commission , real estate appraisor , subprime
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  1. helgam says:
    Mon Jan 31 06:23:41 GMT 2011

    FCIC reported its findings in January 2011. According to them, the crisis was avoidable and was caused by many factors. The Financial Crisis Inquiry Commission released its final report Wednesday, Republicans dismissed its conclusions. FCIC report on financial crisis sparks routine partisan bickering. By standing on the sidelines with full knowledge of the danger, the government was held liable by the Financial Crisis Inquiry Commission for the consequences of the monetary meltdown. The FCIC report was endorsed by six Democratic members of the commission, while the four Republicans disagreed with its conclusions and published their own.

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