Look Out for Morty!

I recently took part in a discussion where the topic was the ability of a lender to call a loan; in that specific instance, a businessman's line of credit. This discussion covered the reappraisal of mortgaged real estate. In a changing market, a lender may want to gauge the change in the degree of risk (lenders may require additional collateral or may reduce the line of credit if the value of the collateral becomes less than the loan amount), and also touched upon "due on sale" clauses.

A typical mortgage deed might contain something like the following (which is the actual text from an actual mortgage):

"18. Transfer of the Property or a Beneficial Interest in Borrower. As used in this Section 18, "Interest in the Property" means any legal or beneficial interest in the Property, including, but not limited to, those beneficial interests transferred in a bond for deed, contract for deed, installment sales contract or escrow agreement, the intent of which is the transfer of title by Borrower at a future date to a purchaser.

If all or any part of the Property or any Interest in the Property is sold or transferred (or if Borrower is not a natural person and a beneficial interest in Borrower is sold or transferred) without Lender's prior written consent, Lender may require immediate payment in full of all sums secured by this Security Instrument. However, this option shall not be exercised by Lender if such exercise is prohibited by Applicable Law.

If Lender exercises this option, Lender shall give Borrower notice of acceleration. The notice shall provide a period of not less than 30 days from the date the notice is given in accordance with Section 15 within which Borrower must pay all sums secured by this Security Instrument. If Borrower fails to pay these sums prior to the expiration of this period, Lender may invoke any remedies permitted by this Security Instrument without further notice or demand on Borrower."

While the likelihood of foreclosure on a residential property due to the above clause is currently not very high because there are so many foreclosures clogging the market, an understanding of what is actually owned and mortgaged is frequently missing in the mind of a typical homeowner.

The popular view of a piece of residential real estate is a plot of dirt with a house on it. While it is true that these items are useful, the actual real estate is something different. Some definitions are in order.

estate : A right or interest in property. Defines an owner’s degree, quantity, nature, and extent of interest in real property. There are many different types of estates, including freehold (fee simple, determinable fee, and life estate) and leasehold. To be an estate in land, an interest must allow possession (either now or in the future) and be differentiated primarily by its duration.

freehold estate : An estate or possessory interest in land that lasts for an indeterminable length of time, such as for a lifetime or forever. Examples include fee simple (also called an indefeasible fee), defeasible fee, and life estates. The first two continue for an indefinite period and are inheritable by the heirs of the owner. The life estate terminates upon the death of the person on whose life it is based.

fee simple estate : Absolute ownership unencumbered by any other interest or estate, subject only to the limitations imposed by the governmental powers of taxation, eminent domain, police power, and escheat.

leased fee interest : A freehold (ownership interest) where the possessory interest has been granted to another party by creation of a contractual landlord-tenant relationship (i.e., a lease).

leasehold interest : The tenant’s possessory interest created by a lease.

Source: Appraisal Institute, The Dictionary of Real Estate Appraisal, 5th ed. (Chicago: Appraisal Institute, 2010).

Typically, when the buyer and seller of a residential property reach a meeting of the minds, the transaction that takes place is a transfer of a fee simple interest in the land and improvements. Theoretically (within the limits imposed by government), the owner of the fee simple interest may sell off all the materials that make up the improvements, and/or all the dirt, rocks, water, oil, or other minerals within the bounds of the property to the center of the Earth and still have the fee simple rights to the empty space left. He would have sold all the "stuff" that was on his real estate, but not the actual real estate itself.

This is one of the hardest concepts to pound into the heads of real estate appraisers, their lender clients, and the borrowers against the real estate. What is being appraised for a mortgage loan is not the dirt and sticks (although they play a part in determining what is available for quiet enjoyment of the real estate) but the market value of the bundle of rights that belong to the mortgagor. In fact, the FNMA/FHLMC forms used to report the appraisal clearly identify the Property Rights Appraised at the very top of the first page. In most cases, the lender is loaning money on the fee simple interest.

This creates some interesting potential problems for the mortgagor. Note that the lender reserves the right to call the loan if any interest in the property is sold without the lender's prior written consent. Let's look at some scenarios.

Pitfall #1. Big Bean Gas Company is aggregating parcels for a drilling unit, and strikes a deal with a group of owners in a subdivision for rights to the shale gas under their lots. Selling the rights to any possible underlying gas is a reduction of the fee simple interest in the property; under clause #18 in the mortgage above, it could trigger an acceleration of the loan payback, including a demand for immediate payment in full.

Pitfall #2. Joe Homeowner wants to move but can't sell his home due to the poor real estate market. He can, however, rent it out. He finds a perfect tenant, and signs a one year lease. The tenant now has a leasehold interest; the fee simple interest has been diminished (even if only for 12 months), and if the lease was entered into without the prior written consent of the mortgagee, acceleration is possible.

It is vital to remember that when a person mortgages real estate, he is signing a deed which gives most of his rights in the estate to the mortgagee in the event that a default situation occurs. It is a sale with a right of redemption. The mortgagor retains the rights to possession and quiet enjoyment of the estate, but those rights are only on loan from the new owner, the mortgagee, until the terms of the mortgage are complete. The rest of the rights to the estate may belong to the lender, and if the mortgagor attempts to take those rights back without the mortgagee's approval, it could be a trespass which could forfeit the entire estate to the mortgagee in foreclosure. When you borrow money, and grant a mortgage deed to the lender, be sure to carefully read the terms of that deed.

Comparing Oranges to Oranges

I get some interesting questions from time to time. While I cannot directly address the concerns some people have about home value (the instant I utter my opinion of value, even orally and/or "off the cuff", I have done a certified appraisal and am required to submit to the person receiving the opinion (even though a client relationship may not exist) a signed certification. So, I have to be careful. Still, as I said, some of these things are interesting and bear a little research.

Here is a sample, dated today:

Jim,

We just had an appraisal completed, which feel $105,000 short of the appraisal completed 11/07 KeyBank. We understand the market trend in today's economy. However we live in an area that is still maintaining a good home value- Orange Village. The appraiser used comps that are 3 bdrm 2 to 1 full baths 2 car garage and the homes are 48, 53 & 35 years old which our is 30. Also our home sits on 2.65 acres heavily wood lot and the comps are 1.65, 1.48 & .35 not on wood lots. We have put 62,000+ in home improvement in the last 2 years, Pella windows & all entry doors & sliding door, new boiler, new hot water tank, new roof, remodeled kitchen, new built in appliances, porcelain floor, 2 full baths taken down to the studs granite & silestone vanity tops porcelain tile floor and shower, all new interior doors, closet doors, all new light fixtures interior & exterior, new carpet, baseboard, interior paint through out.

With all that said he noted $15,000 in home improvements and a few windows replaced all but 5 windows have been replaced. He adjusted the replacement sq. ft @ $79. The acres he gave $5,750 for adjustment, 1 acres lot in Solon is selling for $78,000.
He appraised our property @ $291,000 which we needed $347,000. Why didn't he use comps that are apples to apples not apples to zucchini ? QuickenLoans will not order a second appraisal even through I was able to give them comps that just sold last month @ $380,000 which was built the same year close to the acreage and 4 bdrms & 3 full baths. We have lost our 4.375% rate lock and have no recourse. And our $500 lock rate deposit. What happened????? Can you shed any light on this and suggestions?

Thanks for your time.

Curious George being a monkey, I did a little look-see in the MLS and sent the following reply :

Thanks for the query.

I assume that you are referring to the home at --- Road, 44022. The Cuyahoga County Auditor shows that the home is a 2436 sf ranch, on about 2.65 acres, built about 1979 with 3 bedrooms, 2 full baths, a half bath, full basement, and a 3-car garage. The tax appraised value for 2008 was $292,400, including the tax appraised land value of $68,400.

You need to realize that the lender will be looking at the same public records information, and underwriters are currently being very conservative.

I cannot address specifics in your question since I do not appraise in Cuyahoga County and cannot claim competence in that market area. There are, however, some very general items that you might want to look at.

You imply that only three comparables were used. I am finding that I have to use from 5-9 comps on the grid, including 1 or 2 active listings to show the market trend. Because of the scarcity of sales, the first three comps may be "ugly" due to the need to keep their sales dates within 6 months; it is not always easy to "bracket" under tough market conditions.

You also need to remember that cost is not the same as value. You may want to take a look at Remodeling Magazine's Cost vs Value Report .

I performed a search of the MLS looking for sales only in Orange. In 2006, there were 33 sales with a median price of $307,000, in 2007 there were 24 sales with a median price of $348,875, in 2008 there were 27 sales with a median price of $260,000, and for the first five months of 2009, there were only 5 sales with a median price of $165,600. While the MLS does not show all the sales that have taken place, it does show the brokered sales that most likely have occurred with adequate market exposure and can be used to form a value opinion which meets the FNMA definition of "market value". The statistics show the actual trend in prices for brokered sales in the Orange market.



I would suggest that you examine the appraisal report done in November 2007. You have implied that the value opinion was $396,000, or about $162/sf. There was a home which sold at 28700 Jackson Road on 4/26/2007 for $290,000 ($120/sf). That home was a 2413 sf ranch on 2.55 acres built in 1962. While it did not have a basement, in my opinion it would be a logical candidate as a comparable sale even though it might have to be heavily adjusted for that feature. In fact, examination of the MLS sales data shows that even in 2007, with a much higher median price than now, there were very few single-story homes in Orange that sold for more than $130/sf.

You may want to write a letter to the Ohio Division of Real Estate expressing your concerns, and forward to them copies of both appraisals for their review.

Sincerely,

Without a doubt this homeowner is feeling the pain of current market conditions on his financial situation. He may be under the impression that all is well in his neighborhood, but there are very few locales where real estate prices have not dipped. I have been tracking the MLS statistical reports for the entire state since 2003 (via the updates published in Ohio Realtor) and for the first 4 months of 2009, the median sales price across the entire NEOHREX MLS area is down more than 21% from the same period in 2008. I don't think we have hit bottom yet, either. My opinion.

If Congress Were Serious... Or Even Semi-Intelligent...

Is there intelligent life on Capitol Hill?  How many fingers do those weird politicians have, and can they use them to count?  Has the concept of a zero made it into their culture?

First they conjured a few hundred million to bail out some banks. Then they had seven hundred billion added to the pot. Let us write that on the blackboard, students.

$700,000,000,000.  Seven hundred billion.  The number of seconds that have elapsed since Julius Caesar was assassinated (44 BC - 2009 AD, 2052 years): 60 seconds/minute x 60 minutes/hour x 24 hours/day x 365.3 days/year x 2052 years = 64,765,059,840. If you spent $10/second for 2052 years, you would still not have spent $700,000,000,000!

The Honorable Lunatics voted in October 2008 to spend up to $700,000,000,000 to bail out the failing banks. $350,000,000,000 remains unspent, and there is a strong push by the Obama Regime to have Congress add another $850,000,000,000 to that. Because there is no way the Loyal Opposition can halt this juggernaut, within a short time there may be $1,200,000,000,000 in the pig-trough (that is $100/second for over 380 years, or since the time the Pilgrims landed here).

Let us do this another way. We all remember story problems from high school math. According to the US Census Bureau estimates for 2005-2007 (Table B25087) there are just over 51,000,000 US housing units with a mortgage. Of those, about 23,639,036 (46.2%) had mortgage payments over $1500 per month. The data from the Census Bureau is tabulated below; the upper mortgage payment amount was assigned at $6000/month for calculation purposes. I added the fourth column to arrive at the estimated mean monthly mortgage payment for each category. The final figure of $88,531,316,700 is taken to represent the average monthly US mortgage payment total.

(Sorry about the formatting. I am still trying to figure out why Blogger screws up simple html formatting)


TABLE B25087.
MORTGAGE STATUS AND SELECTED MONTHLY OWNER COSTS
Universe: OWNER-OCCUPIED HOUSING UNITS
Data Set: 2005-2007 American Community Survey 3-Year Estimates
Survey: American Community Survey

United States
	Estimate	Margin of Error	Mean Payment Subtotal
Total:	75,072,666	+/-172,605
Housing units with a mortgage:	51,164,197	+/-123,611
Less than $200	25,783	+/-1,536	$2,578,300
$200 to $299	126,355	+/-2,860	$31,588,750
$300 to $399	381,877	+/-5,296	$133,656,950
$400 to $499	822,717	+/-7,688	$370,222,650
$500 to $599	1,376,810	+/-10,365	$757,245,500
$600 to $699	1,947,454	+/-12,985	$1,265,845,100
$700 to $799	2,462,599	+/-12,073	$1,846,949,250
$800 to $899	2,855,941	+/-15,590	$2,427,549,850
$900 to $999	3,069,593	+/-16,378	$2,916,113,350
$1,000 to $1,249	7,679,899	+/-30,119	$8,639,886,375
$1,250 to $1,499	6,809,133	+/-24,825	$9,362,557,875
$1,500 to $1,999	9,848,125	+/-36,793	$17,234,218,750
$2,000 to $2,499	5,648,279	+/-21,249	$12,708,627,750
$2,500 to $2,999	3,233,753	+/-16,491	$8,892,820,750
$3,000 or more	4,875,879	+/-16,814	$21,941,455,500
Mean Total Payment			$88,531,316,700

Based on the above, $1,200,000,000,000 would pay all of the mortgage payments for everyone in the USofA for about 13.5 months. However, it has been projected that only 10% of the mortgages in the country are likely to default. Since the depression is gathering steam, that is likely an underestimate, but if one could assume that a successful solution could be applied within, say, 6 months time, the default rate might be held to no more than 25%.

The current economic crisis was begun by a collapse of the sub-prime loan market, and spread to the prime market due to fear in the investment arena that further lending would not be secure. IF the government were to somehow guarantee that NO mortgage would be allowed to go into default (in effect, guaranteeing that the investor would be paid for his risk, mortgage lending would once again be viewed as relatively safe and profitable.

As much as the above plan would sell every man, woman, and child in the country into slavery to the off-shore lenders who would once more be emboldened to loan in the American housing market, it would be far more sensible than the current balloons being floated that have to do with judges being able to re-write the terms of loans. It would also lend itself to being implemented as a refundable tax credit, paid in advance, and as such, would offer almost immediate relief (at least as soon as the rules could be drawn and the forms printed). Finally, while it would not deliver any pots of money to the scum-bag bankers that got us into this mess, it would directly benefit the general population, and, in restoring confidence to the money markets, would ultimately create jobs, allowing people to work themselves off the program over time.

Details would have to be hammered out; cut-off dates (I would suggest rescuing only loans made prior to 1-20-2009), tax refund rules, possible upper limits to payments (the current regime made a big campaign point of not giving tax breaks to the RICH), and restrictions on passing the bailout to third parties, are items that would have to be fought over.

If a worst case scenario of 25% potential default (25% of all mortgages needing such insurance), the bill would come to roughly $265,593,950,100 per year. There would be enough in the pig-trough to pay one-fourth of all USofA mortgages for about 4.5 years. That should be sufficient time to get over our economic sniffles, and would guarantee a resounding re-election for BO & Company.

A Rent Survey

Well, I guess I'd better get started on this.

First, we need to do a rent survey, to see what investors are asking in the Akron area. Checking the Akron Beacon Journal for November 20, 2008, we find 241 rental ads running and 43 single-family homes for rent that we can identify by address. Using the Auditor's website, we fill in the missing data -- sometimes the bath count, always the GLA, separating out attic finish (which may contain a room used as a bedroom, but which many investors seal off as a liability concern), and checking for a garage.

The rent survey follows:
It appears that on average, there is a $37/bedroom difference between a 4-bedroom rental and a 3-bedroom rental, and about a $92/bedroom difference between a 3-bedroom rental and a 2-bedroom rental. It also appears that the 2-bedroom rentals, being smaller and possibly easier to maintain, return a higher rent/square foot ($0.63) than the others.

Our investor may possibly want to concentrate on 2-bedroom homes, which will likely fit his purchase budget more easily as well.

Finding the First Corner

Fable of the Day

An old man watched a young boy tease a bear that was tied to a tree with a rope. Each time the bear would rise, the boy would back off. Each time the bear would sink back down, the boy would poke it with a long stick. The old man asked, "Sonny, what do you think you are doing? If that bear gets loose, it will tear you and everybody else in the neighborhood to shreds."

"No worry, old man." says the boy. "I'm just playing the stock market."

.........................................

We proceed with my underlying claim that an investment whose value is based solely on the ability to "flip" an asset is on shaky ground.

The Fannie Mae Form 216 (Aug '88), Operating Income Statement, is a frequently neglected tool that should be included with any appraisal of a 1-4 family income residence and critically scrutinized. The biggest problems (at least from my perspective) center around the facts that:

• most appraisers have no real-world experience or training in the maintenance and operation of a residential rental
• most appraisers lack the experience to adequately address the need for periodic repairs to real property, and,
• as a result, appraisers using the 216 generally accept borrower estimates or simply PFA to fill in the blanks.

When this is followed by a reviewer or an underwriter who may not have been adequately trained to spot inconsistencies between the appraisal report and the 216, the Monthly Operating Income developed on the 216 will provide an unrealistic or even fraudulent indication of the property's net income generation potential. Fannie Mae requires this form to be properly filled out and submitted with every Fannie Mae 1025, Small Residential Income Property Appraisal.

The 216 should also be completed for every single-family appraisal (Fannie Mae Form 1004) where the home is to be used as a rental. It usually is not, however, because loan officers do not want to pay the additional fee most appraisers charge to do extra work, and in any event, it is easy to get around by simply claiming that the home is to be owner occupied. Unfortunately, there is no space on the forms to indicate whether the borrower already owns a dozen single-family homes within the county. (Such information is embarrassingly easy to find and is sometimes very difficult to hide, but has nothing to do with the valuation of the subject property. The amount of fraud seen by the average appraiser is incredible, but reporting it can be hazardous to his business. Maybe I should post a few war stories?)

If the subject property is a single-family residence that will be used as a rental, the Fannie Mae 1007 (8/88), Single Family Comparable Rent Schedule should also be filled out. This will provide an estimate of the subject's gross income potential, as of the appraisal date. In general, the rent comparables used in the Fannie Mae 1025 will be used for the same purpose if the property is a 2-4 family rental.

The front of the 216 is used to project the anticipated income and expenses for the next 12 months. It is sometimes necessary to survey income property owners to get a feel for what is typical in a given neighborhood; quite often the subject property's owner will underestimate his actual expenses. The form carries this statement :

"If the appraiser is retained to complete the form instead of the applicant, the lender must provide to the appraiser the aforementioned operating statements (n.b ' actual year-end operating statements for the past two years'), mortgage insurance premium, HOA dues, leasehold payments, subordinate financing, and/or any other relevant information as to the income and expenses of the subject property received from the applicant to substantiate the projections."

In over 20 years of residential appraisal practice, I have never had a lender provide that information. I always had to acquire it from the applicant, the property owner (if it was a sale), or market surveys. Many borrowers treat a request for such information with an attitude of offense, and market surveys are time-consuming because the competition in the rental market makes landlords treat such information as proprietary. It is, nevertheless, critical data, and on more than one occasion I have had to conclude that the projected Net Operating Income shows that the landlord's business is not viable. Once that happens, you have a very unhappy investor, who will never again willingly give you data about his investment plan. You also will have a very unhappy loan officer, who will try to guarantee that you never again get an appraisal order from his company.

So, what is so difficult about this Form 216? For one thing, is asks for items like projected vacancy and the "customary expenses that a professional management company would charge to manage the property". Those two items alone can sink the NOI. The second page, though, is the real killer. On page 2 is the Replacement Reserve Schedule. Many investors will ask, "What is THAT?". THAT is what causes many of the investors in my market to lose their investment.

Even assuming that the rental is unfurnished, and the tenant must supply stove and refrigerator, items like dishwashers, furnaces, central air units, and water heaters need periodic replacement. It is not unusual to see an appraiser indicate on a form that a home has a Remaining Economic Life of 40-50 years (hey - would you make a 30 year loan if the REL was 30 years or less?). Let us suppose you are talking about a duplex, with two of each. Assuming the equipment is brand spanking new the day of the appraisal, in a 50 year period the investor will need to buy and install two furnaces, four central air units, eight water heaters, and eight dishwashers. That is based on average life expectancies for those items. He will also need to re-roof the building at least once, and, based on my experience and the experiences related to me by local investors, will need to totally replace the flooring -- carpet and vinyl -- about nine times. Assuming he sells it at the end of the fifty year period, on that schedule, all of the replacement items would be needing to be replaced at that point, and he would be selling a building in need of updating.

The Replacement Reserve Schedule provides an amount that should be set aside each month to have money in reserve to complete the repairs that will be required over time. A wise lender would require an escrow account for those items, but using that criterion, I have never done business with a wise lender. Those figures are totaled and transferred to page 1 and added to all the other expenses to give the Total Operating Expenses. The numbers are then reconciled: the Total Operating Expenses are subtracted from the Effective Gross Income and divided by 12 to give a Monthly Operating Income. The Monthly Operating Income is then reduced by the Monthly Housing Expense (P & I on the mortgage, hazard insurance, property taxes, MIP, etc) to give a Net Cash Flow. If this form were completed honestly and properly, the percentage of loans made on residential rental real estate would plummet. In most cases, the only way to generate a positive cash flow is to reduce the amount that is to be borrowed, since that is usually the largest single monthly expense. This calls for a bigger down payment, and would spell the end of cash-out refinancing of most rental properties.

Next time we will look into the case of the honest investor who wants to actually get an income from real estate rental property, and expects to hold the property for a lengthy period of time.

Cornering a Market

As a review appraiser, one of the biggest problems with appraisals of residential investment properties -- rental homes -- has been the lack of careful attention by the appraiser to the actual return on investment anticipated by the investor. If the investor were putting money into a stock, he would surely be interested in whether that stock was likely to earn money and pay dividends. The investor would look at the money in hand, examine the alternate choices (i.e., bank interest, other stocks, bonds, state lottery, etc) and see what rate of return could be expected. That caution has been lacking in recent decades, as investors look at stocks from the standpoint of their possible resale value (buy low, sell high) rather than their income generation potential (long term gain through dividends).

When it is realized that the entire rationale for the existence of the stock market is the generation of capital for start-up and expansion of a business enterprise, the prostitution of the market by those who use the change in stock price as their sole reason for participation should give shareholders and directors reason to very seriously consider the potential negative consequences of going public with the stock, for, at that point, the financial stability of the company becomes hostage to the perceived profit-taking ability by the market at large.

The real estate industry has been taken over by this same mind-set. It was the anticipation of a quick profit by the property "flippers" that drove the real estate bubble, much the same way that stock "flippers" have driven other "bubbles" in financial markets. The "flippers" made their money by buying low and selling high. Just as the stock market attracted non-traditional investors, the real estate market attracted "flippers" across the spectrum. It was not unusual during the bubble years for Average Joe to buy a house, live in it for a year or so, then sell and buy another, making a small (sometimes large) profit and moving up in the world. Indeed, there is nothing wrong with that kind of approach to real estate. The problem arises when Other Peoples' Money (OPM) enters the equation.

If you have a few spare shekels of your own, what you do with them is your own business. You can engage in risky economic behavior because it is YOUR money. If you went to the local bank and said, "I would like a personal loan so I can buy some lottery tickets, and I will offer the tickets as collateral", any rational banker would either throw you out or die from laughter. (That is not to say that if you looked hard enough, you could find an irrational banker.)

The basic underpinning of the study of economics is an understanding of the relationship between supply and demand. That relationship is never perfect; it is always in flux. Today I demand eggs for breakfast, tomorrow I demand cereal. What I pay for breakfast today is determined by how many eggs there are to be had, and how many other people want eggs. If eggs are scarce, and many people want them today, I may have to pay the California Gold Rush price of $100 per egg today, and if everybody wants cereal tomorrow, the guy who wants to sell a dozen eggs tomorrow may not get $1 for the whole dozen. Supply and demand; the market works in cycles and despite the claims of experts, is unpredictable because it involves the perceived wants and needs of people, and every day brings a new itch to be scratched.

Therefore, if I go to the bank to borrow money for an investment, the banker wants to know what the value of that investment will be over the life of the loan. He wants to know if it will be a winner or a loser. If I want to invest in Pet Rocks, he wants to know if they produce dividend income, or if they have good resale potential. For that reason, few sane bankers will loan money for an investment in a day at the horse races, or even an investment in the stock market. Such gambles are heavily regulated.

When the public fell for the canard that residential real estate was a good investment, most people failed to recognize that what they were falling for was a property flipping scheme, and not a dividend stream investment. The mantra was that real estate never goes down in value, therefore it was "safe". It was thus felt that using OPM was legitimate for property "flipping", whether done by investors who had that as their sole objective, or by Average Joe, who just wanted to make a profit when he sold his house.

Enter government social engineering. Very few economists are elected to Congress. This is also a result of the Law of Supply and Demand, but I will leave the reader to figure out what I mean by that. Official government policy for several decades has tried to maximize home ownership, without regard to whether the new homeowners understood their responsibilities. This has resulted in lowering the equity barrier for entry into the real estate market, and the lowered requirements have been extended even to non-owner-occupied dwellings.

In previous years, it was believed that a loan to value ratio of 80% was a reasonable risk, and borrowers with less than 20% down were required to purchase mortgage insurance, either through a GSE (FHA insurance) or through private mortgage insurance (PMI) companies. The insurance was then used to guarantee the repayment to the lender in the event of default.

Because of the common belief that values were increasing (based partly on government indexes that measure the buying power of the dollar) the property "flipping" could continue as long as a higher resale price could be obtained by the investor. Little real attention was paid to the actual return earned on the investment. This was where the Operating Income Statement -- the Form 216 -- should have been of greater concern. It is also where the use of Gross Rent Multipliers (GRMs) lead to false impressions of value.

Enough for now, I have other things that must be done at the moment. The investment idea that I am toying with will be developed over the next few posts.

Let's Hope She Still Has Her Voice

I am glad I am not Ben Bernanke. Or George W. Bush. Or the head of the OTC, Fannie, Freddie, or Ginnie, or the Secretary of the Treasury. Or a CEO of any of the major lenders.

One reason is that I do not at all understand the machinations occurring in the financial markets right now. I do understand a few basic themes :

• when supply is low and demand is high, prices go up


• when supply is high and demand is low, prices go down


• when people cannot afford to pay their debts, they default


• when risk is high, investors look for high yields


• when a man is broke and his credit is bad, he goes without

I also see the following things in the marketplace :

• incomes have not kept pace with expenses for the majority of Americans


• residential real estate lending provided much of the means for consumption in the past decade


• there are far more houses in the market than there are buyers who can afford them


• the loans that were made in 2005-2006 are at their peak for their first reset

For a decade I have been warning that the use of Home Equity Lines of Credit are not only dangerous, but have the effect of robbing the Average Joe's piggy bank. Most Joes have no idea that when they borrow against their home, they sell an interest to the lender. They do not stop to consider that when Sharkey loans them the money, he expects to make a profit. Therefore, the interest he takes in the home is ALWAYS greater than the amount of money lent. In good times, this fact is difficult to visualize. Joe rarely thinks about his home as a savings account; he is often told that it is an investment. Nothing could be farther from the truth.

An investment is a vehicle for providing a return on capital. An investment that does not keep pace with inflation is a bad deal. A home is a place to live. No matter where Joe wants to live, he must pay rent. If the price of houses goes up, the landlord will raise the rent. If Joe buys the house, and sells an interest to Sharkey at a fixed rate, he has purchased a form of rent control. Then, if the price of houses goes up, Joe's monthly rent stays the same, and the equity he builds in the house becomes a hedge against future rent inflation. The hedge is usually not very high, because while land does not suffer from obsolescence, the improvements (der hut?) will depreciate (translation : deteriorate) and will need repairs from time to time. Joe will normally pay for those repairs out of his pocket.

Over time -- the life of the improvement or the life of the owner, whichever comes to an end first -- it is almost certain that the cost of maintaining and repairing the improvement will, with any inflation, equal the total equity Joe has in his home. New roofing, siding, windows, furnaces, water heaters, paint, carpeting, cabinets, etc. will have to be purchased and installed at least once (and maybe more -- figure three times for a water heater) during the typical 30 year amortization period. Joe will also need to address the cost of taxes and insurance. If Joe does not need to touch his equity in that time period, he will indeed have a lump-sum amount available if he would sell his home. But --

What if Joe borrows against that equity? For one thing, it is almost certain that the interest rate charged for a second mortgage or a line of credit will be higher than the rate on the first mortgage. If it is not, then Joe has been sleeping at the wheel and should have already refinanced his principal balance at a lower fixed rate. By borrowing against his equity, Joe has just raised his own rent. If he uses the money to repair his home, he might have made a wise move, especially if the cost could not be paid out of pocket and the repair was essential for maintaining the structure or systems and preventing further deterioration. Use of the equity for any other purpose is foolish unless Joe is fully willing to surrender to Sharkey (who is really his landlord, you see) control over the monthly rent.

What if Joe does not borrow against the equity, but sells the house he now owns free and clear and buys another? If he pays the same amount for his new home that he got for his old home, he will have actually gotten a raw deal unless his intent was only to move to a new location. If he moved up in the world and bought a more expensive home, he will borrow again; the cost of fancy digs is higher rent. A home is not an investment; at best it is a forced savings account and rent control device.

Alas, Joe has been suckered by Sharkey into a cash-out refinancing or a HELOC. Worse yet, Sharkey has convinced Joe that since house prices are rising, the value of Joe's house must be increasing, and therefore Joe can borrow MORE than the difference between what he originally paid and what he still owes. And, even worse, Sharkey has talked Joe into an adjustable rate loan -- a loan which Joe is qualified to take on at its lowest increment, but which he has no hope of keeping up the payments on after it resets a time or two.

By now we see that Average Joe has no idea what he is doing. (But if you ask him, he will tell you how good a deal he got from Sharkey. At least until the first reset of his loan.) Joe sells Sharkey the rest of his interest in his house, and spends the money on a new pickup and a bassboat and a cute car for the wife; they also go to Disney World and watch the Pirates of the Caribbean without catching the joke underneath. And, guess what? His neighbors, Harry and Sam and Bebop (have to be multi-cultural in this neighborhood, you know) do exactly the same thing. Twenty-four months later they each get a letter from Sharkey. Sharkey is raising their rent by 2% of the total amount they each owe.

Joe and Harry and Sam and Bebop each get together with their wives to discuss this new development. Harry's wife, Zelda Sue, tells him he was stupid, walks out, gets a divorce, and the house has to be sold for the settlement. Joe's wife and Bebop's wife agree with them that they had better sell their houses; the signs go up the next day. Sam has a heart attack over the whole matter and his widow is forced to sell to settle the estate. Suddenly, there are four houses for sale on Joe's block.

Think : when supply is high and demand is low, prices go down. Three months later, all four houses are still on the market, and the four neighbors (OK, so they do miss old Sam) are now busy trying to undercut each other with the prices. Sam's widow gets desperate, and sells the house for the loan balance just to get out from under it.

Think : when people cannot afford to pay their debts, they default. Harry gets fed up with the situation and disappears; he does send Joe a postcard from Ecuador where he has a new job with a pharmaceutical company.

Think : when risk is high, investors look for high yields. Bebop finally gets a buyer, but has to do a short sale. His credit is no good, but he does manage to get another house in a poorer section of town, buying it on Land Contract at 15% interest (but look at the bright side -- it's a fixed rate!).

Think : when a man is broke and his credit is bad, he goes without. Joe? Joe is evicted by the foreclosure order. He and his wife are living in the pickup, and they aren't planning any vacations for a while.

Wait a minute, you say. You forgot the first one : when supply is low and demand is high, prices go up. No, I didn't forget the first one. Sharkey convinced Joe that prices were going up. Sharkey had an appraiser who would hit his numbers. Sharkey quoted government figures that painted a rosy economic picture. Sharkey lied; he didn't tell Joe that the neighborhood was overbuilt and that there were lots of empty houses to go around.

So here is a snapshot of the economy. For a decade it was buoyed by consumer spending while American industrial production fell and imports rose. For a decade the Sharkeys convinced people that they could borrow their way to prosperity. For a decade the economy was based on mortgage fraud and government economic deceit. For a decade, the money supply was artificially inflated by low interest rates, and foreign investors were suckered into buying overvalued mortgage backed securities.

All good things (and all bad things) come to an end. When the money supply could no longer be stretched because the foreign balance of payments was causing imported goods to rise in cost, interest rates were raised. At the same time, the adjustable rate mortgages began to reset, and the borrowers could no longer afford their rent. As they began to default in large numbers, sales prices on existing homes began to drop in a competitive spiral. As the money supply tightened, new constructions became harder to sell, their prices also declined, and defaults among the buyers of more recent new homes rose, again dragging prices downward.

When it became apparent that the margin of profit on the adjustable rate mortgages was declining, the investors began to look for more profitable venues, and as they sold their securities, first the sub-prime lenders, and then the mainstream lenders began to suffer from a lack of cash to continue lending, even to good credit risks.

We are now in the second full year of this debacle. The peak number of first-time resets is now occurring. That means that the peak number of foreclosures from default will begin in about six months. Through this entire time period, some real estate sales have been occurring. As I examine the lending data, it is appalling to see the high percentage of 100% finances; a huge number of homes in the past two years, in the face of the subprime melt-down, have been financed with 80% conventional fixed first mortgages and 20% adjustable second mortgages to make the down payment. I can easily see strong foreclosure activity occurring as far along as three years from now, short of draconian measures on the order of nationalization of the lending industry and restructuring of the loans.

America has been cash poor for some time now. Foreign investors, lured by the seeming stability of the mortgage backed securities, provided a significant portion of the cash that fueled residential real estate finance and consumer spending, all the while piling up an imbalance in foreign debt. The recent forced buyout of Bear Stearns at the command of the Federal Reserve did little but lower foreign confidence in the securities. There are other brokerages just as upside down in their portfolios; an investor needs to ask whether the risk of losing equity in a fire sale such as the Bear sale is worth taking on.

Remember that it was the oversupply of money created by the Fed's low interest rate policy that drove the consumer spending and foreign payment imbalance. The willingness of the Fed to lend money to the troubled lenders by allowing them to borrow against shaky securities cannot make our foreign trading partners see the dollar as a currency worth holding. The lowering of the discount rate will make taking on additional debt backed by US assets even less palatable. It could even be that lowing the discount rate could make mortgage lending more difficult since there would be fewer foreign investors willing to risk such a low-paying venture. And what will Big Ben do if lowering the discount rate does not cure the problem? Lower it to 0%? Offer to PAY investors to take Fed money?

We are living in interesting times. As I said above I do not understand what is happening in the financial markets. I only know one little saying that might fit the situation.

"it ain't over until the Fat Lady sings."

Project Wrapup

Just out of curiosity (bad character trait, that) I decided to take a look at the median prices for brokered sales in the Kenmore (North) and Summit Lake markets, then compare those figures with the data drawn from the foreclosure/REO sales studied and the public records data available in the MLS from Realist.com.

Several things need to be kept in mind. The public record data in Realist.com has some quirks. Not all sales are to be found there, since the search was done by using the 510 Land Use Code on the Auditor's Card, and that information is not entirely accurate. It is not unusual to find single family homes mis-filed under LUCs 520 and 530, and to also find 2- and 3-family homes showing up under LUC 510. This is one of those little caveats to keep in the back of the noodle when thinking about Automated Valuation Models (AVMs) that have become favorite tools of the banks and which are used by the mass appraisal folks (gummint fellers, fer the most part). I will say it once more : I think a lot of the statistics blown our way by the government are economically incorrect even though they may be politically correct.

Also, the public records data in Realist.com, as reported for the end of a calendar year, will only show the final transfer of a parcel. If it was foreclosed and sold at Sheriff Sale, then sold by the bank as an REO, and then "flipped" by the REO buyer, all in the same year, only the last sale will show. This has a tendency to skew the statistics in Realist.com upward. Theoretically, it should all even out in the end, but it never seems to work that way.

Finally, the MLS sales include only brokered transactions by MLS members -- Realtors. Sales brokered by members of the Realtist organization do not show up there unless the Realtist broker is also a Realtor (most are).

OK. Here comes the data table.

	Appraisal: Auditor	Appraisal: Sheriff	Realist.com SP	REO SP	MLS Non-REO SP
Kenmore (N) Mean	$65,031.78	$67,931.51	$64,581.00	$29,929.19	$71,789.00
Kenmore (N) Median	$61,860.00	$69,000.00	$66,454.00	$30,000.00	$71,000.00
Summit Lake Mean	$39,802.00	$44,700.00	$46,074.00	$11,218.03	$21,125.00
Summit Lake Median	$38,720.00	$48,000.00	$43,553.00	$7,587.50	$22,750.00

Cute, isn't it? I see some very interesting correlations that could lead to some questions. However, I'm not going to beat this horse any more. The entire spreadsheet is available for download from my website, www.hrubikappraisal.com/, as
February 2008 Blog Project Data
Excel Spreadsheet, 60kB.

Project Results

The hypothesis : there is a correlation between either the Auditor's appraised value (which is not market value) and the foreclosure appraisal value (which is supposed to be at market value), or between the outstanding loan balance and the foreclosure appraisal value.

The procedure : both the Kenmore (North) and Summit Lake neighborhoods were searched via a polygon map search for REO sales which took place in 2007. The sales were cross-checked with the Summit County Common Pleas Court Records and the Summit Count Sheriff's Sales data. The data was entered in an Excel spreadsheet, and included the names of the appraisers used by the Sheriff, and also included pre- and post REO sales data where it was deemed pertinent. The ratios of appraisal:auditor's appraisal for the prior tax year, the appraisal:judgment amount, and the appraisal:REO sales price were calculated, along with the range of ratios, the mean, median, and mode values for the ratios, and one standard deviation from the mean of the ratios.

Unfortunately, before the project began, no confidence level was chosen for rejecting the null hypotheses, namely, that no correlation would be found. The following items must be considered :

• standard practice allows for a variation of +/- 5% between the value opinions provided by two or more individual appraisers before serious questions about the methodolgy or data are raised


• no standard ratio exists for determining the amount of a loan to be made relative to the appraised value (underwriting guidelines which allow 100% financing have made such determinations impossible)


• the REO sales price does not meet the definition of market value as set forth in 12 CFR Part 34, but because all of the REO sales had open market exposure in the MLS, there is some reason to treat those sales as though they approximate the market value for REO sales as a class

With these things in mind, the percentage data was tabulated as follows :

	Appraisal: Auditor	Appraisal: Judgment	Appraisal: REO SP
Minimum Ratio	56.26	31.36	114.62
Maximum Ratio	165.12	247.81	1500.00
Mean Ratio	107.56	101.96	366.34
Median Ratio	104.12	98.63	276.00
Standard Deviation	15.92	28.29	238.74

Conclusion : The range of the ratios was quite wide, and only the median ratio of the appraisal:judgment amount was below 100%. There does, however, seem to be a very close correlation in the median ratio of the appraisal to the judgment amount (within 2% either direction). It would thus be interesting to know if the appraisers had knowledge of the judgment amount prior to providing their analysis.

The fact that the mean and median ratios for the appraisal to the eventual REO sales price are 366% and 276% respectively is an area of concern. It can be accepted that the appraised value prior to the foreclosure would be higher than the REO sales price, since there would be both effects present regarding the condition of the foreclosed home, and the fact that the REO sale would take place under conditions of duress.

Because it was possible to separate REO sales from non-REO sales in the analysis, there was some other very interesting stuff that came out of this exercise. More Later.

Oooof!

Just a quicky update. Grabbed all the MLS REO sales I could locate for the Kenmore (North) and Summit Lake neighborhoods in Akron, for the 2007 calendar year. This is some interesting stuff.

75 of the 125 sales in Kenmore (North) were REOs (60%); 37 of the 43 sales (86%) in the Summit Lake neighborhood were REOs. Thus I have a sample size of 118 sales.

For some I will not be able to get the foreclosure sale price, or the foreclosure appraisal amount (unless I can find a way to access the data for the Federal Court sales). Still, it is the county sheriff sale information I am interested in, and I now have the names of all the defendants in the foreclosure cases for these properties.

I also have the seller names and sales prices for some really spectacular post-REO flip sales!! (And here we thought the lenders were becoming cautious because of the sub-prime meltdown. They seem as stupid as ever. And there appear to be some really clueless appraisers out there yet as well -- maybe they are coming to appraise in Akron from Cleveland and Columbus and Upstate New York.)

This project will take some time, but I have already laid out the Excel spreadsheet for the project. Stay tuned!

Musings on Market Collapse Disorder

Value is a personal concept. To the extent that we are ego-centric, that statement may be easy or difficult to grasp. Each person observes his world and ranks the objects and ideas within his understanding in a hierarchy; every thing and object, including life itself, has a "value" which is assigned according to perceived importance.

Further, the position in the ranking is subject to change, based on the person's perceived needs. Thus, value is merely a perception, and it is common for items which are more easily obtainable to be substituted for scarcer items whenever they are in close proximity on the hierarchy.

An example in the ethical realm would be the conflict between self-preservation and self-esteem. If a choice must be made between going hungry and stealing food, or between lying and dying, the closer together the choices are in importance to the person, the easier it is to substitute one for the other.

In the realm of currency exchange, the closer to parity two currencies are, the more equal their value appears, and the less resistance there is to trading one for the other. When real property is considered, the principle of substitution drives the appraisal process.

Whenever real property is appraised, the object of the assignment is to locate the subject within a universe of other "things" which can be substituted for it without causing cognitive distress. The "things" may be a sum of money, other real property, security, or the potential to profit in some other way via the asset. For this reason it is critical that the "value" be defined prior to any attempt to give an opinion of value (appraisal) of the property.

"Market Value" has been defined by agencies of the U.S Government (12 CFR Part 34, Office of the Comptroller of Currency) as:

34.42 (g) Market value means the most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus. Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby:

1. Buyer and seller are typically motivated;
   
2. Both parties are well informed or well advised, and acting in what they consider their own best interests;
   
3. A reasonable time is allowed for exposure in the open market;
   
4. Payment is made in terms of cash in U.S. dollars or in terms of financial arrangements comparable thereto; and
   
5. The price represents the normal consideration for the property sold unaffected by special or creative financing or
   sales concessions granted by anyone associated with the sale.

As we go further into this discussion, it is essential to note that 12 CFR 34.44 (d) requires that for any Federally Related Transaction, i.e., a transaction as defined in 34.42 (f), the appraisal must "Be based upon the definition of market value as set forth in this subpart".

The tricky part is meeting all the requirements of 12 CFR 34.42 (g). If the predominant buyers and sellers in a market are not owner occupants, are they "typically motivated" from the standpoint of residential mortgage lending? If there is no way to judge the exposure time on the open market because the majority of sales are private transactions, can statistical data from such sales be used to describe the market for the purpose of informing the residential mortgage underwriter of "typical" market conditions?

There is no question in my mind that the reliance of many lenders on AVMs, the failure of appraisers to understand 12 CFR 34 and the characteristics of their own markets, and the willful disregard of 12 CFR 34 by the residential lenders has resulted in extension of inadequately secured credit to borrowers.

The "collapse" of many real estate markets around the country has not been due to a decline in market value of the homes. It has been due to a phony inflation of prices based on the ability to obtain undersecured financing. We are simply finding out that the emperor has no clothes.

Incompetence Corrupts...

and just a little incompetence can corrupt absolutely.

Lord Acton may not have considered the above twist, but my new analysis of market areas in the City of Akron is raising some significant questions in my mind about the whole process of determining a "market value" for residential property in some markets. Conventional practice relies upon the Sales Comparison Approach to provide a means of forming an opinion of value. The data I am finding, however, seems to imply that sales comparison may be entirely inappropriate in some markets, and the insistence by lenders on the use of the technique may be an important contributor to the current difficulties in the mortgage lending arena.

Most appraisers are familiar with the "big three" approaches to deriving a value opinion : cost, income, and sales comparison. In residential mortgage lending, underwriting doctrine insists that sales comparison is most appropriate. Lenders (as well as most appraisers) have believed that by comparing a subject property to the market experience of other nearby homes of the same age, size, type, and condition, it is possible to predict the reaction of "typical" buyers to an attempt to market the subject. What has been ignored are the basic assumptions that must be present in developing an opinion regarding "what if we tried to sell it?".

The market area I was researching was the Summit Lake Neighborhood in the City of Akron. The city's official neighborhood data sheet for that neighborhood gives a year 2000 owner-occupancy statistic for "South Akron" as 57.3%, but also has a note that "Slightly over one-third of housing units are owner-occupied, significantly less than 55% in the City." My research from the Census 2000 data shows an average tenant-occupancy rate in the Summit Lake Neighborhood of about 70%. Consequently, the most probable buyer for a single-family home in that neighborhood, at any given time, would be an investor.

In examining the statistics from brokered MLS sales and the public records data for all sales in that area, a serious discrepancy was evident. The mean sales price for brokered sales declined from $27,167 in 2001 to $13,741 in 2007, with the median declining from $24,000 to $10,000. In complete contrast, the mean for all sales increased from $44,347 in 2001 to $63, 509 in 2006, and the median for all sales increased from $42,700 to $70,000.

What is not evident from the raw stats is the fact that the MLS sales are mostly REO sales -- the banks have been hiring agents to dispose of their foreclosed properties -- whereas the public records stats only include the final transaction price for a given home at the end of the calendar year. The private sales by the investors, who are dealing both among themselves and also with owner-occupant buyers, involve numerous "flip" sales where the REO homes have been purchased, "rehabbed", and resold. There is no ready information with regard to marketing times or seller concessions and incentives. Further, if one looks closely at the major players in the high-end sales, one finds that at the end of 2007, a number of them were either under indictment or already in jail for mortgage fraud.

Even if all the transactions taking place were honest deals, there is still a problem with trying to determine what the typical buyer and seller would be willing to agree on in this market. An owner-occupant is usually looking for a house that is ready to move in to. An investor who wishes to be a landlord will be looking for a home that will be able to generate an income stream with minimal repairs and maintenance. The investor who is rehabbing to resell will be picking up the sales at the bottom of the pile. The "market value" of the home should not differ much between each category of buyer, since open market competition for the property should drive the final sales price. However, the appropriate method of arriving at the "market value" may be something other than simple sales comparison as anticipated by the standard appraisal forms.

Out-of-town appraisers, who may be relying on public records sales data without understanding the owner/tenant composition of the neighborhood, may be providing value opinions that do not really meet the needs of the intended users or their intended use. Users of AVMs in such a neighborhood run the risk of developing value estimates completely out of line with the reality of the marketplace. This situation warrants further exploration.

New USPAP

On January 1, 2008, the 2008-2009 revision of USPAP became the effective law of the land ("The Financial Institutions Reform, Recovery and Enforcement Act of 1989 recognizes USPAP as the generally accepted appraisal standards and requires USPAP compliance for appraisers in federally related transactions. State Appraiser Certification and Licensing Boards; federal, state, and local agencies, appraisal services; and appraisal trade associations require compliance with USPAP.") with regard to standards for appraisers in the USofA. It can be found at:

Table of Contents

Skimming through it, there have been a number of changes. The DEFINITIONS section drops the terms "advocacy" and "supplemental standards". The Conduct section of the ETHICS RULE now simply states, "An appraiser must not advocate the cause or interest of any party or issue.", and the comment that "An appraiser may be an advocate only in support of his or her assignment results." has been removed.

The SUPPLEMENTAL STANDARDS RULE has been removed. We will undoubtedly see many interpretations of this action. The Supplemental Standards Rule allowed "government agencies, government sponsored enterprises, or other entities that establish public policy" to add to (but never take away from) the requirements of USPAP. This requirement is now wrapped into the "Problem Identification" portion of the SCOPE OF WORK RULE. The phrase "supplemental standards" has been replaced with the phrase "laws and rules". The Second Exposure Draft (March 5, 2007) for the change shows the rationale :


"Today in USPAP, because Fannie Mae is a GSE, portions of the Fannie Mae guidelines are Supplemental Standards. Conversely, the guidelines of the Employee Relocation Council (ERC) are not Supplemental Standards simply because the ERC is not a GSE. Although both guidelines are recognized as part of competent performance when they apply, Fannie Mae’s guidelines are currently looked at differently because they are identified as Supplemental Standards under the current definition.

The guidelines of Fannie Mae are not laws or regulations. However, the proposed edits will not change: 1) the necessity for an appraiser acting in compliance with USPAP to follow Fannie Mae guidelines where applicable; and 2) the enforcement of USPAP, including those items necessary for competent performance and meaningful reporting. The appraisal guidelines of GSE’s such as Fannie Mae and Freddie Mac will remain part of proper development and reporting when they are applicable to a given assignment.

Eminent domain appraisal assignments are commonly subject to laws and regulations. The requirement to recognize and comply with such an assignment condition is part of competent performance in USPAP, but also has a clear and obvious basis outside of USPAP.

In both examples compliance with USPAP (today or under the proposed edits) requires adherence to those assignment conditions that are necessary for proper development and reporting. The appraiser’s identification of the intended use and intended users drives the applicable assignment conditions, such as the appraisal guidelines of Fannie Mae, the ERC, or the laws of eminent domain."


Other changes include:

• Advisory Opinion 5, "Assistance in the Preparation of an Appraisal" has been retired and replaced by Advisory Opinion 31, "Assignments Involving More Than One Appraiser".
  
• Advisory Opinion 30, "Appraisals for Use by a Federally Regulated Financial Institution" has been added, outlining the appraiser's obligations to understand the rules made by the Office of the Comptroller of the Currency, Federal Reserve Board, Federal Deposit Insurance Corporation, Office of Thrift Supervision, and National Credit Union Administration. (What may be interesting for non-appraisers is that the statement of the legal definition of market value promulgated by the Federal agencies is specifically quoted here).
  
• Advisory Opinion 32, "Ad Valorem Property Tax Appraisal and Mass Appraisal Assignments" has been added, outlining the applicability of USPAP to such people as county assessors. Individual jurisdictions need to specify whether or not their assessors must adhere to the Standards. The individual jurisdictions also need to specify the Intended User(s) of the mass appraisal report. There is a statement that in mass appraisal assignments, individual tax record cards for a particular property are not appraisal reports since the mass appraisal assignment takes in a universe of properties and not any specific property.
  

Interesting stuff, but not particularly easy reading. I am looking forward to my next 7-hour USPAP Update class, though.

New Year, Old Concerns

Well, I started off the new year with an update to my web page, to make it look more professional. It seems that with all the loss of confidence in the financials markets, it would be a better idea to have a "serious" web page rather than one which indicated a greater sense of humor. Nothing much humorous about loans going south in large flocks. We shall see if springtime sees the migration turn around. With all the financial climate change, though, a meltdown could be in the cards.

Which leads to the old business. It seems that borrowers are not the only entities going into default. Lenders who have ordered appraisals also appear to be defaulting on payment for the reports. If the the borrower has tapped out all his equity and the appraised value is so low that the lender can't make the loan at an appropriate loan-to-value ratio, the lenders are simply ignoring the appraisal invoices.

I've sent off a request for the Ohio Attorney General's office to look into this phenomenon. The O.R.C. provides for criminal penalties for appraiser coercion, and the AG's office issued a clarification (109:4-3-24) which states in part,

"Division (B)(10) of section 1345.031 of the Revised Code states that in connection with a consumer transaction, a supplier is prohibited from knowingly compensating, instructing, inducing, coercing, or intimidating, or attempting to compensate, instruct, induce, coerce, or intimidate, a person licensed or certified under Chapter 4763. of the Revised Code for the purpose of corrupting or improperly influencing the independent judgment of the person with respect to the value of the dwelling offered as security for repayment of a mortgage loan."

My question to the AG's office is whether they consider withholding payment for the report because the loan couldn't be closed an attempt to influence the judgment of the appraiser. I think it is.

Business is so slow right now that to start requiring payment in advance might cause any clients to look for suckers elsewhere. That may, however, be the only way to survive in this market.

Pop Go the Weasels!

The wheels of justice roll very slowly, but sometimes they find traction. The recent fraud indictments against a rehabber/flipper, a bank, appraisers, and a title company, acting in collusion, had tongues wagging in Akron. Unfortunately, the people whose houses are in foreclosure probably will not get much comfort from this. The story is at:

http://www.ohio.com/news/top_stories/12665796.html

and pictures of the indicted are here :

http://media.ohio.com/documents/Evergreen.pdf

Back in my May 7, 2007 post, I mentioned some of the appraiser discipline notices in the Ohio Division of Real Estate Newsletter (Winter 2007). It appears that the Division has only published two of the quarterly newsletters this year, but they have been busy. The Summer 2007 issue describes the penalties handed out to 27 appraisers who were allowed to stay in business, and three others who were forced to surrender their licenses because of misconduct. It used to be a rare occurrence when an appraiser lost his license, but the Division is working with the Ohio Attorney General, and I don't doubt that there may also be some criminal charges associated with some of these cases.

The Division Newsletter is at:

http://www.com.state.oh.us/real/documents/2007Summer.pdf

What Judge Boyko Actually Said

The best part are Judge Boyko's comments in the footnotes.  He does have a sense of humor!!

UNITED STATES DISTRICT COURT
NORTHERN DISTRICT OF OHIO
EASTERN DIVISION
IN RE FORECLOSURE CASES	)	CASE NO. NO.1:07CV2282
	)	07CV2532
	)	07CV2560
	)	07CV2602
	)	07CV2631
	)	07CV2638
	)	07CV2681
	)	07CV2695
	)	07CV2920
	)	07CV2930
	)	07CV2949
	)	07CV2950
	)	07CV3000
	)	07CV3029
	)
	)	JUDGE CHRISTOPHER A. BOYKO
	)
	)
	)
	)	OPINION AND ORDER
	)
	)

CHRISTOPHER A. BOYKO, J.:


    On October 10, 2007, this Court issued an Order requiring Plaintiff-Lenders in a number of pending foreclosure cases to file a copy of the executed Assignment demonstrating Plaintiff was the holder and owner of the Note and Mortgage as of the date the Complaint was filed, or the Court would enter a dismissal.  After considering the submissions, along with all the documents filed of record, the Court dismisses the captioned cases without prejudice.  The Court has reached today’s determination after a thorough review of all the relevant law and the briefs and arguments recently presented by the parties, including oral arguments heard on Plaintiff Deutsche Bank’s Motion for Reconsideration.  The decision, therefore, is applicable from this date forward, and shall not have retroactive effect.

LAW AND ANALYSIS

    A party seeking to bring a case into federal court on grounds of diversity carries the burden of establishing diversity jurisdiction.  Coyne v. American Tobacco Company, 183 F. 3d 488 6^th Cir. 1999).  Further, the plaintiff “bears the burden of demonstrating standing and must plead its components with specificity.” Coyne, 183 F. 3d at 494; Valley Forge Christian College v. Americans United for Separation of Church & State, Inc., 454 U.S. 464 (1982).  The minimum constitutional requirements for standing are: proof of injury in fact, causation, and redressability. Valley Forge, 454 U.S. at 472.  In addition, “the plaintiff must be a proper proponent, and the action a proper vehicle, to vindicate the rights asserted.” Coyne, 183 F. 3d at 494 (quoting Pestrak v. Ohio Elections Comm’n, 926 F. 2d 573, 576 (6^th Cir. 1991)).  To satisfy the requirements of Article III of the United States Constitution, the plaintiff must show he has personally suffered some actual injury as a result of the illegal conduct of the defendant.  (Emphasis added).  Coyne, 183 F. 3d at 494; Valley Forge, 454 U.S. at 472.

    In each of the above-captioned Complaints, the named Plaintiff alleges it is the holder and owner of the Note and Mortgage.  However, the attached Note and Mortgage identify the mortgagee and promisee as the original lending institution — one other than the named Plaintiff.  Further, the Preliminary Judicial Report attached as an exhibit to the Complaint makes no reference to the named Plaintiff in the recorded chain of title/interest.  The Court’s Amended General Order No. 2006-16 requires Plaintiff to submit an affidavit along with the Complaint, which identifies Plaintiff either as the original mortgage holder, or as an assignee, trustee or successor-in-interest.  Once again, the affidavits submitted in all these cases recite the averment that Plaintiff is the owner of the Note and Mortgage, without any mention of an assignment or trust or successor interest.  Consequently, the very filings and submissions of the Plaintiff create a conflict.  In every instance, then, Plaintiff has not satisfied its burden of demonstrating standing at the time of the filing of the Complaint.

    Understandably, the Court requested clarification by requiring each Plaintiff to submit a copy of the Assignment of the Note and Mortgage, executed as of the date of the Foreclosure Complaint.  In the above-captioned cases, none of the Assignments show the named Plaintiff to be the owner of the rights, title and interest under the Mortgage at issue as of the date of the Foreclosure Complaint.  The Assignments, in every instance, express a present intent to convey all rights, title and interest in the Mortgage and the accompanying Note to the Plaintiff named in the caption of the Foreclosure Complaint upon receipt of sufficient consideration on the date the Assignment was signed and notarized.  Further, the Assignment documents are all prepared by counsel for the named Plaintiffs. These proffered documents belie Plaintiffs’ assertion they own the Note and Mortgage by means of a purchase which pre-dated the Complaint by days, months or years.

    Plaintiff-Lenders shall take note, furthermore, that prior to the issuance of its October 10, 2007 Order, the Court considered the principles of “real party in interest,” and examined Fed. R. Civ. P. 17 — “Parties Plaintiff and Defendant; Capacity” and its associated Commentary.  The Rule is not apropos to the situation raised by these Foreclosure Complaints.  The Rule’s Commentary offers this explanation: “The provision should not be misunderstood or distorted.  It is intended to prevent forfeiture when determination of the proper party to sue is difficult or when an understandable mistake has been made. ... It is, in cases of this sort, intended to insure against forfeiture and injustice ...”  Plaintiff-Lenders do not allege mistake or that a party cannot be identified.  Nor will Plaintiff-Lenders suffer forfeiture or injustice by the dismissal of these defective complaints otherwise than on the merits.

    Moreover, this Court is obligated to carefully scrutinize all filings and pleadings in foreclosure actions, since the unique nature of real property requires contracts and transactions concerning real property to be in writing.  R.C. § 1335.04.  Ohio law holds that when a mortgage is assigned, moreover, the assignment is subject to the recording requirements of R.C. § 5301.25.  Creager v. Anderson (1934), 16 Ohio Law Abs. 400 (interpreting the former statute, G.C. § 8543).  “Thus, with regards to real property, before an entity assigned an interest in that property would be entitled to receive a distribution from the sale of the property, their interest therein must have been recorded in accordance with Ohio law.”  In re Ochmanek, 266 B.R. 114, 120 (Bkrtcy.N.D. Ohio 2000) (citing Pinney v. Merchants’ National Bank of Defiance, 71 Ohio St. 173, 177 (1904).¹

    This Court acknowledges the right of banks, holding valid mortgages, to receive timely payments.  And, if they do not receive timely payments, banks have the right to properly file actions on the defaulted notes — seeking foreclosure on the property securing the notes.  Yet, this Court possesses the independent obligations to preserve the judicial integrity of the federal court and to jealously guard federal jurisdiction.  Neither the fluidity of the secondary mortgage market, nor monetary or economic considerations of the parties, nor the convenience of the litigants supersede those obligations.

    Despite Plaintiffs’ counsel’s belief that “there appears to be some level of disagreement and/or misunderstanding amongst professionals, borrowers, attorneys and members of the judiciary,” the Court does not require instruction and is not operating under any misapprehension.  The “real party in interest” rule, to which the Plaintiff-Lenders continually refer in their responses or motions, is clearly comprehended by the Court and is not intended to assist banks in avoiding traditional federal diversity requirements.²  Unlike Ohio State law and procedure, as Plaintiffs perceive it, the federal judicial system need not, and will not, be “forgiving in this regard.”³


CONCLUSION

    For all the foregoing reasons, the above-captioned Foreclosure Complaints are dismissed without prejudice.

IT IS SO ORDERED.

DATE: October 31, 2007


S/Christopher A. Boyko

CHRISTOPHER A. BOYKO

United States District Judge

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¹  Astoundingly, counsel at oral argument stated that his client, the purchaser from the original mortgagee, acquired complete legal and equitable interest in land when money changed hands, even before the purchase agreement, let alone a proper assignment, made its way into his client’s possession.

²  Plaintiff’s reliance on Ohio’s “real party in interest rule” (ORCP 17) and on any Ohio case citations is misplaced.  Although Ohio law guides federal courts on substantive issues, state procedural law cannot be used to explain, modify or contradict a federal rule of procedure, which purpose is clearly spelled out in the Commentary.  “In federal diversity actions, state law governs substantive issues and federal law governs procedural issues.”  Erie R.R. Co. v. Tompkins, 304 U.S. 63 (1938); Legg v. Chopra, 286 F. 3d 286, 289 (6^th Cir. 2002); Gafford v. General Electric Company, 997 F. 2d 150, 165-6 (6^th Cir. 1993).

³  Plaintiff’s, “Judge, you just don’t understand how things work,” argument reveals a condescending mindset and quasi-monopolistic system where financial institutions have traditionally controlled, and still control, the foreclosure process.  Typically, the homeowner who finds himself/herself in financial straits, fails to make the required mortgage payments and faces a foreclosure suit, is not interested in testing state or federal jurisdictional requirements, either pro se or through counsel.  Their focus is either, “how do I save my home,” or “if I have to give it up, I’ll simply leave and find somewhere else to live.”

    In the meantime, the financial institutions or successors/assignees rush to foreclose, obtain a default judgment and then sit on the deed, avoiding responsibility for maintaining the property while reaping the financial benefits of interest running on a judgment. The financial institutions know the law charges the one with title (still the homeowner) with maintaining the property.

    There is no doubt every decision made by a financial institution in the foreclosure process is driven by money. And the legal work which flows from winning the financial institution’s favor is highly lucrative. There is nothing improper or wrong with financial institutions or law firms making a profit — to the contrary , they should be rewarded for sound business and legal practices.  However, unchallenged by underfinanced opponents, the institutions worry less about jurisdictional requirements and more about maximizing returns. Unlike the focus of financial institutions, the federal courts must act as gatekeepers, assuring that only those who meet diversity and standing requirements are allowed to pass through.  Counsel for the institutions are not without legal argument to support their position, but their arguments fall woefully short of justifying their premature filings, and utterly fail to satisfy their standing and jurisdictional burdens.  The institutions seem to adopt the attitude that since they have been doing this for so long, unchallenged, this practice equates with legal compliance.  Finally put to the test, their weak legal arguments compel the Court to stop them at the gate.

    The Court will illustrate in simple terms its decision:

• “Fluidity of the market”  —  “X” dollars,


• “contractual arrangements between institutions and counsel”  —  “X” dollars,


• “purchasing mortgages in bulk and securitizing”  —  “X” dollars,


• “rush to file, slow to record after judgment”  —  “X” dollars,


• “the jurisdictional integrity of United States District Court”  —  “Priceless.”

On Being Boyko-ed

The ruling by Judge Christopher Boyko (US District Court, Northern District of Ohio), on October 31, 2007, that Deutsche Bank could not proceed with the foreclosure of 14 Cleveland homes unless it could prove that it owned the mortgages at the time foreclosure began, has been a source of numerous questions, one of which was "Does that mean the homeowners now own their homes free and clear?".

Unfortunately for the homeowners, the answer is "No". Somebody still owns the mortgage deed to their property. What Judge Boyko addressed was the fact that Deutsche Bank had been named the trustee for the mortgage pool (the "derivatives" sold to investors), and could not show that the actual mortgage had been sold to them.

What is critical to understand is that the homeowners DID borrow the money, and they DID sell an interest in their homes (via the mortgage deed) to a lender. However, under Ohio law, all real estate transfers must be matters of public record, and the interest in those mortgage deeds, wherever they are, were never transferred to Deutsche Bank. Thus, the investors, for whom Deutsche Bank is the trustee, may not actually own anything other than a paper promise to repay issued by the mortgage originator. Sort of a play on Federal Reserve notes being a promise to pay but not being backed by anything but faith in the US Treasury (which faith appears to be evaporating).

What Judge Boyko verified was that only the entity that had a recorded interest in the property (i.e., was an owner of the actual mortgage deed, and not just somebody who had loaned money to the owner of the mortgage deed) had any standing in the foreclosure suit.

The unmentioned possible ramifications are a herd of different colored horses. Deutsche Bank's attorneys complained to the judge that nobody had ever asked them to prove ownership before. Deutsche Bank, moreover, has been the leader in foreclosing Cleveland homes. As foreclosure orders went out to hundreds of other homes without proof the plaintiff owned the mortgage, the homes were abandoned, vandalism destroyed much of the equity, and the homeowners and mortgage deed holders suffered some severe losses.

So now an important question : were all those uncontested foreclosures legal? If not, who is liable for the damages? I can think of some interesting possibilities.

• The holder of the actual mortgage deed sues Deutsche Bank for the damages caused by fraudulently foreclosing on its property. (Deutsche Bank may be in a bad position for countersuing over any amounts it might claim the mortgagee owes its investors because it initiated the foreclosures without legal standing.)


• The homeowners sue Deutsche bank for fraudulently forcing them out of their homes.


• The mortgagors and/or mortagees band together in class action and petition the court to void the foreclosures and Sheriff sales of the properties (and any subsequent REO sales) because the foreclosure suits were fraudulent. This could cause a cascade of losses to the lenders who loaned on the REO purchases.


• Angry citizens petition their legislators to remove the judges that allowed the foreclosures to take place without requiring proof of ownership.


• et cetera.

Indeed we live in interesting times. I foresee a need for hordes of new attorneys, and a doubling or tripling of the number of courts at all levels. As an owner of options for Royal Bank stock (option value = 517.67 pence, current market value 413 pence, down from over 600 pence last summer), I am certainly happy to not be holding options for or stock in Deutsche Bank. I have no problem seeing why bank stocks are being eyed with suspicion, especially those banks that have boldly sought to be trustees for mortgage derivative products.

Mining for Data - Part 9 : The Finale

We began with the recognition that understanding trends in a real estate market involves data collected not only over a historic time period, but that also the most current data may be several months out of date. We also stated that knowledge of current listings, their marketing histories, and the typical exposure time in the market helps us interpret current market pressures. Such information is important to investors in order for them to make sound financial decisions.

In the second installment, we pointed out that an accurate neighborhood description is critical to maintaining the credibility of an appraisal report that has come under scrutiny. The third installment pointed out some of the general difficulties that would be encountered in trying to nail down an accurate neighborhood description. It also outlined some sources that can be used to help build a good neighborhood description; one that lends itself to gathering sales data on an objective basis and without ambiguity.

Session four dealt with the mechanics of searching the public records section of Realist.com in the CRIS MLS system for the recorded sales and exporting the data to a file for later analysis. Installment five walked us through the process of converting the Realist.com data exports into Excel spreadsheets and formatting the spreadsheet into a more useable tool.

Session six dealt with making certain the data in the spreadsheet fit some basic assumptions, and then presented the mechanics of finding the measures of central tendency for the data. The seventh installment tabulated and compared six years' worth of statistics from Realist.com and the CRIS MLS, for the same neighborhood, and session eight discussed the discrepancies in the two statistical sets.

The sad truth is that all of this has been tedious work. It has been an exercise that would be totally unappreciated (and possibly resented) by the loan officers who order the appraisals, and the findings would possibly be an irritant or inconvenience for the administrative reviewer or underwriter who had to deal with the appraisal report containing them. In most cases, the appraiser doing this kind of analysis would find that if he were searching out and using truly comparable sales for the appraisal of his subject, the neighborhood description would make no difference whatsoever in his opinion of value. Why, then, go to all this trouble?

Value is a subjective matter. The appraiser renders an opinion of value that is uniquely his own. The client then relies on that opinion to make a decision. It must be assumed that the decision is significant enough that the client has required an unbiased opinion of value. The credibility of the opinion rests on the trust that the client places in the appraiser, and in a modern marketplace, it is not usual that the client personally knows and trusts the appraiser. The appraiser's credibility is established in the truthfulness and internal consistency of his appraisal report.

The appraiser may say, "I know this neighborhood. Houses sell for $X,000 - $Z,000 and I believe my subject is worth $Y,000." He may have a well reasoned value opinion -- but what if the rest of his report was "Plucked From Air" to suit the comfort of his client?

We have reached a point in history where irresponsible lending practices, founded in the greed and carelessness of both investors and borrowers, are generating widespread economic tragedy. Homeowners are losing their homes to foreclosure, and investors are losing their hope of long-term gain. Litigation to fix the blame for this tragedy will drag many appraisers into the courtroom to testify in their own defense. The simple fact is that the data existed all along to establish the characteristics of a neighborhood with acceptable accuracy, and yet many appraisers bungled that part of their job.

Even if the appraiser in litigation can show that his comparable sales were valid, and can explain his reasoning for making adjustments to those sales, a clever attorney for the plaintiff can avail himself of the true neighborhood description for the subject property. It will come down to the heart-wrenching plight of a destitute borrower, who has become homeless, against the appraiser who was relied upon to be accurate in his reporting of the facts. Then, if the appraiser has no factual basis for the neighborhood description in his report, even though his value opinion may have been reasonable when viewed against the comparables, his credibility before a jury will have been diminished and he may be seen as a contributor to the plaintiff's woes.

Set against this, taking a bit of time to find the facts and report them, distasteful as they may be to the loan officer or real estate agent who simply wants a quick close to the sale or refinance at "whatever number it takes", is cheap insurance.

Mining for Data - Part 8

Looking at the sales statistics from Realist.com, and the statistics from the same neighborhood, over the same time period, from the CRIS MLS, reveals some startling discrepancies. The mean sales price rose from $60,600 in 2001 to $73,000 (rounded) in 2006, according to the Realist.com figures -- a 20% increase. The MLS data, however, shows a decline from a mean sales price of $57,000 in 2001 to $39,300 in 2006, a 32% decrease. The Realist.com data shows an increase in the predominant (mode) sales price from $62,000 to $80,000; the MLS shows a decrease in the predominant price range. How could there be such a discrepancy?

Remember our assumptions from Part 6? We assumed that each transfer shown by Realist.com was the only transfer of the home that year. When we look at the MLS data and cross-check with the Auditor's sales histories, we find that a large number of the sales that are in the Realist data set are "flip" sales -- homes that sold earlier in the year as foreclosure and REO sales, and which were then resold at a much higher price by the investors who initially bought them.

The "flip" sales, for the most part, do not show up in the MLS because of a simple law of economics : real estate agents work on a commission basis and do not take on listings which they cannot sell on the open market. The majority of the "flip" sales are private sales made to buyers who do not understand the market, do not understand the terms of the financing that they are undertaking, and are not getting their money's worth in the deal. You can sometimes see these homes in the MLS as expired listings that failed to sell at their list price and went on to be sold for MORE THAN their open market list price.

If somebody offered to sell a home for $60,000 and nobody would buy it in a 60 or 90 day marketing period, would you pay $75,000 for that house? There seem to be people who are that stupid. There seem to be appraisers who are willing to value the real estate at the contract price regardless what the market as a whole is doing. There seem to be lenders who are willing to finance such deals. There seem to be securities investors who are willing to put such mortgages in the portfolios of 401(k) plans. Would you buy a stock or mutual fund that was based on such securities?

The situation is ready-made for a bookie. It is possible to examine the sales histories of many of these homes, drive by them to examine their physical condition, and then make a bet as to how long it will be before they are in foreclosure again. In fact, as I sorted through the sales data (and you probably saw it as well, if you did this exercise), some of these homes have been foreclosed two to three times in the past six years!! Some of the investors have bought a home from the bank, "flipped" it to a gullible buyer, and within the six year period, bought it back from another bank and "flipped" it again!

Maybe it is time for the Kingston Trio to redo "Tijuana Jail" with new lyrics?

Government statistics for real estate sales generally follow the path of the stats derived from the Realist.com data. To be sure, Realist.com DOES include all the sales, including the foreclosure/REO transactions, in the full report sheet for each property. It is the cumulative sales search that only reports the final price for the year in the search results. That is only logical; there is no practical way to report the multiple sales in a search which has fixed start and end time parameters. It is the negligence of the statistician, however, whether he be a bureaucrat or an appraiser, that is responsible for the misreporting and/or misinterpretation of the data.

Next -- finally -- a recap and conclusion.