House Financial Services Subcommittee Receives Testimony from Mountain State Justice
"Chairman and Members of the Committee, on behalf of Mountain State Justice, the
"I am here today to thank
"It is common knowledge that lax regulation of the mortgage and appraisal market led directly to the financial collapse of 2008.2 Prior to that collapse, unscrupulous mortgage brokers and lenders joined forces with a handful of appraisers to fraudulently inflate home values to enable property flipping schemes and other home-secured lending of increasingly large amounts. Many of these loans contained adjustable rate or interest only features that would cause payments to skyrocket after a teaser period. Even before the market collapse in 2008, consumers and their advocates began to see this house of cards topple, as homeowners trapped in these underwater loans were unable to refinance when their adjustable rates spiked.3 Thousands--and soon millions--of homeowners faced foreclosure.4
"This bubble in housing prices was not just created by a spike in consumer demand. Rather, in many cases throughout country, it was created as the direct result of intentional fraud and lack of oversight.
"The Dodd-Frank Act required essential increased regulation of appraisals, building on necessary safety and soundness requirements passed after the savings and loan crisis. These recent changes have been instrumental in ending the practice of fraudulent appraisals, primarily by requiring appraisal independence. Appraisal independence ensures that lenders and brokers cannot intentionally choose appraisers who will deliver implicitly (and sometimes explicitly) requested inflated appraisals. Reforms requiring true, in-person appraisals by qualified appraisers similarly have ensured not only a healthy appraisal industry, but also that lenders and investors can be certain that they have sufficient collateral to protect their risk. These reforms have been an unqualified success. They have worked.
"Because the reforms did exactly what they were intended--they stopped appraisal fraud--we urge you to leave these requirements in place. Appraisal oversight does not just help consumers, it also supports honest appraisers and lending institutions, and protects investors and the economy as a whole.
Background
"Home appraisals are required to safeguard homeowners, home mortgage investors, and government insurance programs alike. Appraisals protect homeowners who are making the largest investment--and taking on the largest debt--of their lives, by enabling them to make wise and well-informed financial decisions. Appraisals are necessary to ensure that loans do not exceed the values of homes that serve as their collateral. This collateral protects investors and insurers, such as the
"Home appraisals are supposed to be conducted by highly trained and skilled professionals with knowledge of the local area. Appraisals, under current standards, require the appraiser to personally view both the interior and exterior of the home, the surrounding area, and comparable homes that have recently sold on the open market, in order to ensure an accurate opinion of value. Appraisers are educated in a classroom and serve as an apprentice under the supervision of an experienced appraiser before they obtain their final certification. All of these requirements ensure that appraisers are qualified and competent to complete their essential work.
Widespread Appraisal Fraud5
"Without independent and qualified appraisals, home secured lending poses significant risks to consumers, investors, as well as the entire economy. Two main types of appraisal fraud in particular led to the market collapse in the 2000s: property flipping scams and refinance fraud.
Property Flipping
"Property flipping scams involve speculators who buy dilapidated residential properties or develop shoddy new construction at low prices and resell them to unsophisticated first time home buyers at huge markups.6 Homeowners end up saddled debt load that exceeds the market value of the property. These homeowners are unable to resell the home in an arms-length transaction because the mortgage indebtedness exceeds the fair market value of the property. Ultimately, the homeowners may lose their homes due to foreclosure sales7 because the home's condition is much worse than represented, promised repairs are not performed, and the consumer's mortgage payments may be higher than the consumer can afford.8 Then the scams can begin again against different homeowners if the wrongdoers or their confederates purchase the homes at the foreclosure sales.
"An inflated appraisal, which is necessary to both reassure the homeowner and to secure an inflated loan, is the linchpin of these transactions.9 While many property flipping schemes rely on steering borrowers to high-cost lenders,10 other schemes depend on the availability of government insurance.11
"Many of Mountain State Justice's clients suffered from these dynamics. For example, the S family is extremely low-income and had never before owned a home, but were desperate to find a safe place for themselves and their five children. In 2007, Mr. and Mrs. S family visited a loan officer at a national lender that had a storefront office in their community, and were preapproved for a loan. Mr. S then located a home and contacted the lender. The loan officer promptly contacted an appraiser from a different region of the state who reliably inflated appraisals, and provided her with the requested target figure. The S family purchased the home for
Bogus Refinances
"In addition to being the linchpins of property flipping schemes,14 inflated appraisals are also the key to predatory mortgage refinances that directly led to the 2008 market collapse.15 For instance, loan churning, which involves repeated refinancing with additional fees and costs rolled into the new principal balance, often depends on inflated appraisals to justify higher loan amounts.16 Without the inflated appraisal, these loans would be denied for insufficient equity.17
"My office, like others across the country, has worked with countless homeowners facing foreclosure as the result of these schemes. One of my first clients were an elderly couple from
"Another client was Mrs. R, a single, middle-aged woman. Mrs. R was repeatedly solicited to refinance her loan in the early 2000s. After purchasing her home for
"Mrs. R's situation highlights the need for appraisals conducted by properly educated and regulated appraisers, rather than alternative methods. The automated valuation used by her lender was based on aggregate data from unverified public records that is often inaccurate, incomplete, or outdated. Moreover, programs like these cannot adequately consider neighborhood, condition of the property, location appeal, or altered building characteristics. Each of these factors is essential in understanding the true value of a home.
Incentives for Appraisal Fraud
"Without the strict requirements imposed by the Dodd Frank Act, the financial incentives of those involved in the mortgage loan process work against honest appraisals.18 Origination fees for lenders and loan brokers are commonly based on the amount of the mortgage loan.19 This can make lenders and brokers complicit in, or simply indifferent to, appraisal fraud because higher loan volume and higher loan amounts lead to greater profits.20 Some lenders may deliberately seek inflated appraisals in order to trap borrowers in abusive loans and prevent them from refinancing.21 Lenders' indifference to appraisal fraud may be traceable, at least in part, to securitization, which allows them to pass on the risk of loss while retaining minimal liability in the event of default by the borrower.22 Lenders also rely on mortgage insurance to insulate them either partially (or fully, in the case of the government-backed FHA insurance), from the risk of loss after foreclosure. Secondary market participants, those who buy loans from lax lenders, can also purchase their own insurance against failure and so have reduced incentives to police the pool,23 even if the disclosures are enough to put them on notice of the inflated appraisals.24
"In some cases, appraisers received direct benefits for their participation in the fraud, through the promise of repeat business or more overt kickbacks or payment schemes.25 Other times, lenders and brokers pressure appraisers to hit or exceed a predetermined value.26 Failure to do so could lead the lender or broker to withhold business from the appraiser, to refuse to pay the appraiser, or to blacklist the appraiser.27
"Appraisers themselves advocated for tighter regulation to protect their industry. In 2007, a petition with 11,000 appraiser signatures was delivered to
Consequences of Appraisal Fraud
"The consequences of appraisal fraud are far reaching.31 When a borrower becomes bound to a mortgage that exceeds the value of his home at origination, he is immediately prohibited from refinancing to obtain better loan terms, such as a fixed interest rate or lower interest rate. Unlike with other types of loans, this is of significant import because the borrower's home is placed at risk. Moreover, predatory lenders often pair overvalue mortgages with other exploitative terms that make a borrower's need to refinance even more pressing.32 In addition, the borrower cannot sell his home to relocate, even if he needs to do so to find work.33 And when the borrower finds himself in this dire situation, the last resort protections provided by the bankruptcy code provide him with little assistance. Even if he chooses to declare bankruptcy, the homeowner must pay the full balance of the mortgage or forfeit his home; he cannot avail himself of the relief available for unsecured debts or debts secured by personal property, which can be discharged or reduced to the value of the collateral.34 The homeowner becomes trapped with no way out of the loan except foreclosure. Finally, unlike with other loans, realizing on the security interest for a home-secured loan can result in homelessness, a far greater impact than loss of personal goods or loss of credit, and has negative spillover onto the surrounding community.35
"Indeed, for many of these reasons, placing a borrower underwater significantly increases the risk of foreclosure.36 Empirical data demonstrates that higher loan to value ratios lead to an increased risk of foreclosure. For example, securities ratings agencies have determined that loans with LTV ratios between 95% and 100% are 4.5 times more likely to enter foreclosure than loans with ratios below 80%. Loans that exceed 100% of the market value of the collateral are even more likely to enter foreclosure.37 As a HUD-Treasury Report during the
"Many of the borrowers who are victims of this [fraudulent appraisal] scheme cannot afford to repay or refinance the mortgage based on the inflated price, and these loans may go into default and foreclosure quickly. Appraisers and others engaging in this fraudulent practice are helping to send first-time home buyers and whole communities into economic ruin.38
"While homeowners feel the direct impact of these foreclosures, investors, insurers, neighboring homeowners, and ultimately taxpayers incur significant losses from foreclosures caused by appraisal fraud.
Regulation
FIRREA
"In 1989,
"Federal financial and public policy interests in real estate related transactions will be protected by requiring that real estate appraisals utilized in connection with federally related transactions are performed . . . by individuals whose competency has been demonstrated and whose professional conduct will be subject to effective supervision.40
"Guidelines promulgated by the federal banking agencies under FIRREA require covered institutions to establish an effective real estate and evaluation program that, among other things, ensures appraiser independence, provides for adequate review of appraisals, and monitors appraisers and reviewers. Institutions are also directed to establish policies and procedures for resolving any inaccuracies or weaknesses in an appraisal prior to the credit decision.41
"As part of FIRREA,42 in order to ensure that appraisals were conducted according to "uniform standards,"43
Truth in Lending Act
"Regulations issued under the Truth in Lending Act set some additional requirements for appraisals done in connection with higher-priced mortgage loans,46 including that the appraisal be completed by a licensed appraiser who conducts a physical inspection of the interior of the home.47
"If the loan is a purchase-money loan, the property was purchased by the seller within the previous six months, and the new purchase price exceeds the old by certain amounts, the lender is responsible for getting two written appraisals.48
Dodd-Frank Act
"Additionally, regulations promulgated in the Truth in Lending Act, pursuant to the Dodd-Frank Act, regulate the supervision of appraisers.49 Lenders are prohibited from extending credit when they know that an appraisal materially misrepresents the value of the consumer's principal dwelling. Creditors may only escape liability if they exercised "reasonable diligence."50 Creditors and settlement service providers are required to report any material failure to follow USPAP by an appraiser.51
Appraiser Independence
"Standards for appraisals and review of appraisals are not, by themselves, enough to prevent coercion of appraisers by lenders and brokers anxious to make the deal. Independence is a key component of protecting the market from the widespread overvaluation that triggered the savings and loan crisis in the 1980s and the subprime collapse in the 2000s. Since 1989, federal law has attempted to protect appraisers by forbidding lenders from offering anything of value in exchange for an appraisal performed by other than a certified or licensed appraiser.52 In 2008, the
"Regulations promulgated under the Dodd-Frank Act's amendments to the Truth in Lending Act have prohibited the falsification or alteration of an appraisal and a number of coercive practices that might influence an appraiser's valuation.57 In addition, the regulations limit conflicts of interest and require reasonable compensation of appraisers.58 The Dodd-Frank Act also included provisions regarding licensure of appraisers and appraisal management companies.59
Impact of Regulation & Discussion Topics
"These reforms have worked. Unethical lenders, brokers, and appraisers can no longer join forces to defraud homeowners, communities, investors, and insurers. Appraisal independence is the cornerstone of this regime. These requirements build upon earlier steps taken under FIRREA to ensure minimum standards for appraisals and appropriate training. The requirement of a complete appraisal by a licensed and educated appraiser further protects the market.
"The home buying and refinancing process is not currently complicated or difficult, and minimum regulatory requirements are necessary to protect homeowners and the economy at large. Any appraiser shortage would be appropriately addressed through market forces: increased demand would lead to increased customary rates, which would accordingly lead to a greater supply of appraisers entering the marketplace. Moreover, any shortage is likely to be temporary and to disappear as interest rates increase and the demand for mortgage refinances decreases. Lowering standards and qualifications, including permitting lenders to rely on alternative valuation products and broker price opinions, will further increase any such shortage, rather than remedy the need for qualified appraisers. Such reliance would further enable lenders to return to obtaining unreliable reports which, in turn, create instability in the market. In short, the regulatory regime is a floor that is essential to avoid both unintentional errors as well as fraud.
"Indeed, lowering the de minimis appraisal threshold for Federally Related Transactions would assist in addressing any appraiser shortage. More importantly, lowering this threshold--which currently only requires an appraisal for loans over
"A floor of overarching federal regulatory standards for lending and appraisals is necessary to ensure that both consumers and others impacted by the mortgage market are uniformly protected from fraud nationwide. National standards are appropriate for a national market in mortgage lending, investment, and insurance; and to enable appraisers to more easily act with reciprocity in jurisdictions and across state lines, where appropriate. Without this uniform baseline, the marketplace would become more costly and complicated for participants. Both the savings and loan crisis of the 1980s and the mortgage industry collapse in the 2000s demonstrate the clear and pressing need for this federal regulatory framework to establish a floor for acceptable appraisal conduct. Eliminating these protections and relying solely on the states would open the door to more economic crises that devastate homeowners and financial institutions alike. Of course, these federal protections are, appropriately, a floor and not a ceiling on appraisal safeguards. States have always been and continue to be able to create additional, state appropriate protections. This interplay between basic protections on a federal level with additional localized regulation is necessary and positive for the market and consumers.
Conclusion
"In sum, it is essential that a national regulatory floor be retained and built upon to protect the American dream of homeownership into the future. Without these protections, the market will become more costly in the short term, and lead to new financial crises in the future, even while we have barely recovered from the last one. The appraisal protections were wisely adopted by
* * *
Footnotes:
1 More information about Mountain State Justice can be found at www.mountainstatejustice.org.
2 See, e.g., The Financial Crisis Inquiry Report: Final Report of the
3 Mountain State Justice's Executive Director testified before this Subcommittee in 2005 about these very practices. See
4 The Financial Crisis Inquiry Report: Final Report of the
5Significant portions of the following text, especially background on appraisal fraud, the mortgage market, and regulatory overviews are drawn from the
6 See, e.g.,
7 See, e.g.,
8 See Edmonds v. Hough, 344 S.W.3d 219 (Mo. Ct. App. 2011).
9 See United States v. Owens, 301 F.3d 521 (6th Cir. 2002) (describing appraiser's key role in a property flipping scheme); Vaughn v. Consumer Home Mortg.
10 See, e.g.,
11 See, e.g., Vaughn v. Consumer Home Mortg.,
12 See M & T Mortg. Corp. v. White, 2006 WL 47467 (E.D.N.Y.
13 E.g., Saucier v.
14 See United States v. Curtis, 635 F.3d 704, 709 (5th Cir.
15 Cf. Wallace v. Midwest Fin. & Mortg.
16 See, e.g., Hill v. Meritech Mortg.
17 See, e.g., Wallace v. Midwest Fin. & Mortg.
18 See Wallace v. Midwest Fin. & Mortg.
19 Cf. 15 U.S.C. section 1639b(c)(1) (explicitly permitting compensation for loan originators to be based on loan amount).
20 See Fed. Hous. Fin. Auth. v. JPMorgan Chase & Co., 902 F. Supp. 2d 476 (S.D.N.Y. 2012) (quoting amended complaint, "WaMu falsely overstated appraisals in order to secure low LTV ratios for mortgages, thereby making the loans more attractive to prospective purchasers of certificates"); In re Bear Stearns Mortg. Pass-Through Certificates Litig., 851 F. Supp. 2d 746 (S.D.N.Y. 2012) ("[L]oan officers applied 'intense' pressure on underwriters to approve risky loans and rewarded 'high producers.'"); Cedeno v.
21 See, e.g., Tocco v. Argent Mortg. Co., 2007 WL 170855 (
22 See, e.g., Wallace v. Midwest Fin. & Mortg.
Secondary market purchasers may not be vigilant in policing lenders because they underestimate the risk of inflated appraisals or because they may be insured against this kind of fraud. See, e.g., Mass. Mut. Life Ins. Co. v.
Some of the notorious FAMCO loan trusts were insured by mortgage guaranty policies issued by
23 See, e.g., Stipulation of Settlement, Fed.
24 See, e.g., Mass. Mut. Life Ins. Co. v.
25 See First
26 See, e.g., Wallace v. Midwest Fin. & Mortg.
27 See Davis v.
28 Appraisers Petition, available at http://appraiserspetition.com.
29 Id.
30
31 As the Sixth Circuit noted, "a borrower has much to lose from entering into a too-big loan." Wallace v. Midwest Fin. & Mortg.
32 See, e.g., id. at 421 (noting key role of inflated appraisal in inducing borrower to take out overpriced payment-option ARM, with high fees and "unreasonable" terms, resulting ultimately in borrower's loss of home and bankruptcy).
33 The public policy against such transactions tracks the longstanding public policy against restraints on landowners that limit their ability to transfer or otherwise control their real property. See, e.g., McCreery v. Johnston, 110 S.E. 464, 466 (
34 See 11 U.S.C. sections 521(a)(2)(A), 1322(b)(2).
35 See
36
37
38
39 Financial Institutions Reform, Recovery, and Enforcement Act of 1989, Pub. L. No. 101-73, 103 Stat. 183; H. Rep. No. 101-54(I), at 311, reprinted in 1989 U.S.C.C.A.N. 86 (discussing role of faulty appraisals in the crisis).
40 12 U.S.C. section 3331.
41 75 Fed. Reg. 77,450, 77,463 (
42 Financial Institutions Reform, Recovery, and Enforcement Act of 1989, Pub. L. No. 101-73, 103 Stat. 183.
43 12 U.S.C. section 3331.
44 Financial Institutions Reform, Recovery, and Enforcement Act of 1989, Pub. L. No. 101-73, tit. XI, section 1110, 103 Stat. 183 (as codified at 12 U.S.C. section 3339).
45 2016-2017 USPAP at 8-9, available at www.appraisalfoundation.org.
46
47
48 12 C.F.R. section 1026.35(c)(4) (eff. Jan. 18, 2014). See generally
49 See generally
50 12 C.F.R. section 1026.42(e).
51 12 C.F.R. section 1026.42(g)(1). See generally
52 12 U.S.C. section 3349(a)(1).
53 12 C.F.R. section 1026.42.
54
55
56 Pub. L. No. 111-203, sections 1472, 1473, 124 Stat. 1376 (2010); 75 Fed. Reg. 66,554 (
57 See 12 C.F.R. section 1026.42;
58
59 Pub. L. No. 111-203, section 1473, 124 Stat. 1376 (2010).
60
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