Top 10 reasons appraisals are here to stay, and critical to US and global markets

There is often commentary in the mortgage industry of plans to ‘replace residential appraisers and appraisals’; many feel this has been the case for the past two decades. Understandably, new government and agency initiatives can be met with suspicion and resistance from appraisers and others in the mortgage industry.

This article discusses the critical role of residential appraisals in US housing finance and the global fixed income securities markets, and highlights the contributions appraisers make, and why they can be confident about the future of their profession.

Highlights

The key takeaways from the article:

• Agency mortgage backed securities (MBS) are a critical asset class in sustaining global financial markets, and appraisers play a major role in their operation
• Liquidity, stability & confidence in the US housing market is based on well defined standards of GSE mortgage underwriting and originations, including for collateral
• AVMs will not be replacing appraisals as the property valuation for agency & portfolio 1st mortgages anytime soon
• Appraisers are the only trained & licensed professionals trusted to conclude value – other valuation types are either derived from, or due diligence checks of appraisals
• There are a number of housing finance initiatives working to improve the appraisal process, not eliminate it. All are being spearheaded or guided by senior appraisers.

1. Agency MBS are 10.4% of global fixed income

Appraisers play a critical role in global and US fixed income markets; here’s how:

‘The Ginnie Mae Global Capital Market report for June 2024 reports the US comprises 40.7% of global fixed income (from Bloomberg Global Aggregate Index), with the next largest being Japan at 10.0%. Looking just at the US, the Bloomberg U.S. Aggregate Index shows US Treasuries at 42.9% and Agency MBS (‘MBS Passthrough’) at 25.5%, with corporate bonds, municipal bonds and other ABS making up the remainder.

This puts Agency MBS at 10.4% of global total fixed income and the second largest asset class after US Treasuries; larger than the fixed income (debt) of any other country. In June 2024 Agency MBS comprised 39.63 million loans with an original loan balance of $10.0TN and current remaining balance of $8.7TN.

What does this mean? Since 80%* of existing loans (31.7 million) in agency MBS pools were originated with an appraisal, this means that appraisers concluded the value of the underlying assets or collateral of 8.32% of the global fixed income market today.

The fixed income (debt) market is generally three times the size of equity markets, and investors include governments, sovereign wealth funds, pension funds, insurance companies, banks, hedge funds, etc.

2. US Fixed Income average daily trading volume

Not only is the Agency MBS asset class large, it’s liquid. Especially the GSE To-Be-Announced (TBA) markets which are a tool to hedge mortgage pipelines (among other uses). So in addition to completing an appraisal to close a loan, appraisers are also enabling future mortgages for new borrowers.

After US Treasuries, Agency MBS trading volume is more than 4 times the remaining asset classes combined. In Q1 2024, the US fixed income average daily trading volumes (ADV) was $1,257.1BN, comprising US Treasuries $889.0BN, Agency MBS $292.9BN, Corporate Bonds $55.5BN, Municipal Bonds $12.4BN, Non-Agency MBS $1.6BN, Federal Agency Securities $3,5BN and ABS $2.2BN.

After US Treasuries at 70.7% of ADV, Agency & Non-Agency MBS represents 23.4% of the remaining trading. Corporate Bonds, the next closest, represent just 4.4%. This is at a time when US MBS issuance is at the lowest point for the last 5 years.

3. ABS 15E and the Securities & Exchange Commission

The very latest asset valuations must be shared with investors: The Securities & Exchange Commission (SEC) mandate it. This is true if the valuations is for ‘internal purposes only’ and if the issuer is/is not registered with the SEC.

SEC § 240.15Ga–2 Findings and conclusions of third-party due diligence reports, formulated in 2015, mandates that any Asset Backed Security (ABS) issuer or underwriter must file with the SEC, at least five business days before the first sale in the ABS offering, a Form ABS-15G containing the findings and conclusions of reports of any third-parties who have been employed to provide due diligence services.

This means that any and all loan level due diligence valuations checks completed on the underlying collateral must be filed as an ABS 15G statement at least 5 days before the security can be sold. These secondary valuations are checks against the origination appraisal as part of the securitization process, and if the variance is found to be greater than +/- 10% then the loan may be removed from the issue, or must be otherwise cured.

New originations (typically within 12 months of bond issue) will all be subject to a valuation check. Even seasoned performing (typically over 12 months) loan will be subject to broker price opinion or automated valuation model (AVM) to provide investors with an up-to-date validation of the collateral valuation.

4. Whole Loan Trading, NPLs and RPLs

When loans are not performing, CLTV becomes a critical metric; the appraiser opinion of value as the denominator.

Collateral valuation is not a major factor in the delinquency and foreclosure process; the ability to pay (‘capability’) and likelihood to pay (‘credit’ or sometimes ‘character’) are what underwriters will focus on, but when issues arrive collateral valuation becomes critical. When the agencies market Non-Performing Loans (NPLs) or Re-Performing Loans (RPLs) from their portfolio, a valuation is required to verify the original appraisal.

Whole loan trading & securitization desks have deep knowledge and experience of collateral – they know property, borrower, and credit characteristics – and model how pools and loans behave under different delinquency and stress scenarios.

5. Appraisal waivers rely on… appraisals

It’s going to be tough for appraisal waivers and inspection based waivers to replace appraisals, as among other criteria, they are based on a prior appraisal.

Appraisal waivers and inspection based waivers are offered based on the existing information in the GSE databases of prior appraisals, among other data sources. So without prior appraisals there will be no appraisal waivers. Also, when there are less appraisals completed in a certain timeframe there will be less appraisal waivers. Further, waivers are mostly driven by refinance volume, with lower take-up on purchase volume due to consumer familiarity with purchase contract ‘appraisal contingencies’.

Appraisal waivers are offered on a fraction of the total loans (with full appraisals) delivered. The waiver rates spiked in the COVID boom as many borrowers refinanced loans, and therefore the GSEs could refer to prior appraisals.

6. Automated Valuation Models (AVMs) and AI will replace appraisals

AVMs are complex proprietary models and play a critical role in primary and secondary markets valuations. But proprietary AVMs will not replace appraisals as main property valuation for agency and portfolio first mortgages.

While AVMs have benefited from big advances in artificial intelligence, machine learning and compute power, plus a consistent price appreciation over the past 15 years (of modeling), the availability of property and market data, complexity of modeling & adjustments, and geographic variations all impact the ‘confidence score’ of an AVM, and the confidence score has a big influence in how AVMs are viewed by investors.

The report by Fitch Ratings ‘2019 Conservatism Still the Best Path for AVMs in U.S. RMBS‘ says ‘In cases where AVMs are used as a primary value, Fitch Ratings will apply a haircut to the AVM of 2.5% for PP10’s 95% or greater (confidence score); this rises to 5% for PP10 90%, 10% for PP10 80%, and 20% for PP10’s below 80%. The PP10 value is defined as the percentage of the time that the AVM result is within +/- 10% of the target value for a testing sample of properties (the sale price). As an example, PP10 80% is +/- 10% of the sales price (80% of the time), but receives a further haircut of 10% from the AVM value; so a much greater tolerance than lenders and borrowers experience with appraisals.

Of the 144 million housing units in the US, between 100-120 million have AVM values. Of these ~40% have a confidence score below 80%, another 30% have a confidence score between 80-90%, and the remaining 30% are above 90%. In blind testing the PP10 of proprietary AVMs for purchase (where a contract price is known) is clustered around 80-90%, but the PP10 for refinance falls to around 60% (where an estimated value is not provided). The ‘hit-rate’, or percentage of time an AVM is returned for a given property address, also falls significantly from purchase to refinance.

Common use-cases for AVMs include second lien and HELOC origination, and secondary valuation checks for 1st mortgage origination, servicing portfolio valuation and marketing and securitization.

The GSEs use AVMs and Home Price Index (HPI) models to assess collateral valuation, but these models have the benefit of using and testing against the large and up-to-date GSE databases holding appraisal values and sale prices that are not publicly available.

7. UAD Redesign and URAR (part of UMDP)

The GSEs are implementing the future of appraisals for appraisers.

Since 2018 the GSEs, lenders and vendors have invested significant resources and dollars updating the Uniform Residential Appraisal Report (URAR) and Uniform Appraisal Dataset (UAD) and which are respectively new report and new dataset for appraisals. Resources are available from Fannie Mae UAD and Freddie Mac UAD.

If the GSEs were planning on eliminating appraisals and appraisers, it seems unlikely their regulator and conservator would be asking them to spend their human and capital resources in this area.

8. FIRREA and appraisals

Appraisals can only be performed by licensed appraisers: The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) says so.

Among other things, FIRREA set standards and rules for appraisals. It defines Appraisals, Appraisers and importantly a ‘Real estate-related financial transaction’ as any transaction involving sale, lease, purchase, investment, exchange, refinance, loan security (including MBS) of real property, or interests in real property; which basically covers any improved land or property for which we all may want a loan.

Whilst FIRREA provides many exceptions to the requirement for an appraisal to be performed, the majority of loans that qualify for these ‘exemptions’ have to be originated to standards determined by Ginnie Mae and the GSEs, who today require appraisals on approximately 90% of all loans issued.

9. Property Appraisal and Valuation Equity (PAVE)

If you are planning on eliminating appraisals and appraisers, why tackle an issue that is almost a century old and as politically and emotionally charged as racial bias. PAVE is working on ways to eliminate racial bias from appraisals, not eliminate appraisals.

The US Department of Housing and Urban Development (HUD) was instructed to launch an interagency task force of 13 federal agencies to advance (property) valuation equity. This initiative became the Property Appraisal and Valuation Equity (PAVE).

The agencies are the White House Domestic Policy Council (DPC), Appraisal Subcommittee of the Federal Financial Institutions Examination Council (ASC/FFIEC), Board of Governors of the Federal Reserve System (FED), Consumer Financial Protection Bureau (CFPB), Federal Deposit Insurance Corporation (FDIC), Federal Housing Finance Agency (FHFA), National Credit Union Administration (NCUA), Office of the Comptroller of the Currency (OCC), U.S. Department of Agriculture (USDA), U.S. Department of Justice (DOJ), U.S. Department of Labor (DOL), and U.S. Department of Veterans Affairs (VA). Additionally, experts from the Urban Institute, Brookings Metropolitan Policy Program, Zillow, the National Association of Hispanic Real Estate Professionals, the National Fair Housing Alliance (NFHA) and others are involved.

The most recent notification from the PAVE task force is a Mortgagee Letter (ML) that adds Borrower-Initiated Reconsideration of Value (ROV) requirements and will become active on October 31, 2024. The US Department of Housing & Urban Development (HUD) recently extended the effective date of their borrower-initiated ROV process to be implemented for FHA case numbers assigned on or after October 31, 2024.

10. The future of appraising and appraisals is being designed by… appraisers.

Valuation professionals & appraisers are driving GSE collateral strategy and policy:
This is the last, but in many ways the most important point in this article.

Collateral policy and strategy at the GSEs is being developed by appraisers. These are passionate, experienced and knowledgeable experts who’ve risen to the top of their profession and are now charting the course for the future of origination valuations.

Change understandably causes anxiety but who better to lead the industry and profession further than experts in their field.