Tuesday, November 27, 2007

Did Mortgage Bankers Puff Up Appraisals?

The attorney general of New York, Andrew Cuomo, has sued a mortgage appraisal firm for allegedly inflating its appraisals under pressure from a major mortgage bank, Washington Mutual. At the same time, the New York A.G.’s office is reportedly conducting an investigation of other participants in the mortgage markets, including Fannie Mae and Freddie Mac.

If it turns out that appraisals have been puffed up due to pressure from mortgage bankers, the impact on the mortgage mess could be enormous. Appraisals are supposed to verify for lenders the value of the property being bought. If its value is less than the mortgage loan, the lenders, rationally speaking, wouldn’t want to make the loan. The borrower would have little or no stake in the house. If the borrower has trouble making payments, refinancing would be impossible and the borrower might just walk away. The loan wouldn’t be well-supported by its collateral, and the lender would be likely to take losses.

The NY AG alleges that at least one mortgage lender pressured an appraisal firm to inflate its valuations. In other words, the lender supposedly did something that would be economically irrational—lean on an appraisal firm to phony up documentation so the lender could make a risky loan that had an increased risk of nonpayment. Why would a banker do that?

The defendant in the NY AG’s case has denied liability. But if the facts are as alleged, a possible motive might be that the lender would make a lot of money from fees while selling the loan in the mortgage markets and thereby dodging the risk of default and foreclosure. In other words, the availability of the securities market as a dumping ground for phonied up loans may have made it all too tempting to play this game. And the more you play the game, the more money you make. As we know, huge quantities of dumb mortgage loans have been made. Did mortgage lenders lean on appraisal firms to phony up the numbers so the mortgage lenders could make and sell more loans in order to get more fees?

A rising market covers up a multitude of frauds. And a rising real estate market would have covered up appraisal fraud, if it occurred. Indeed, phonying up appraisals would have boosted the market higher. Thus the fraud could have assisted in covering up the fraud with more fraud.

However, we know from the Dutch experiment with tulip bulbs that no market can rise continuously forever. And so it was with the real estate markets. This, like all balloons, deflated; and we are left to sort things out.

If appraisals were phonied up, the consequences would have rippled out in many directions. Homes will be worth less than expected. That will hinder refinancings and resales, which will heighten the risks of defaults and foreclosures. Investors in mortgage-backed securities and CDOs will have paid too much for their investments, and might become new best friends with plaintiffs lawyers. Banks that pressured appraisers to pretty things up and then sold the mortgages into the secondary mortgage market might face increased capital requirements, and mega civil and even criminal liability. Investors will be hurt when losses from mortgage-backed securities and CDOs prove to be even greater than already expected as recoveries from foreclosures disappoint. Insurers of mortgage-backed securities and CDOs may face even greater liabilities on their guarantees. Consequently, other investments they’ve guaranteed, such as municipal bonds, could suffer as the insurers’ creditworthiness declines. In short, a lot of people might end up in a deep, dark vat.

The NY AG deserves credit for acting. Appraisal fraud, if it occurred, would present a fundamental threat to the integrity of the real estate market; and, derivatively, to the secondary mortgage market, the CDO market, and any other markets they might affect. We need to do more than provide liquidity to distressed banks and accommodations for victimized borrowers. We need to deal with wrongdoers, and ensure that there are consequences for engaging in fraud.

Legal Footnote: standing on a New York sidewalk is not a crime. http://www.wtop.com/?nid=456&sid=1272256.

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