Residential Appraisals: Opportunities to Enhance Oversight of an Evolving Industry
Published: 2011-07-13T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: This testimony discusses our work on residential real estate valuations. Real estate valuations, which encompass appraisals and other value estimation methods, play a critical role in mortgage underwriting by providing evidence that the market value of a property is sufficient to help mitigate losses if the borrower is unable to repay the loan. However, recent turmoil in the mortgage market has raised questions about mortgage underwriting practices, including the quality and credibility of some valuations. An investigation into industry appraisal practices by the New York State Attorney General led to an agreement in 2008 between the Attorney General; Fannie Mae and Freddie Mac (the enterprises); and the Federal Housing Finance Agency (FHFA), which regulates the enterprises. This agreement included the Home Valuation Code of Conduct (HVCC), which set forth certain appraiser independence requirements for loans sold to the enterprises and took effect in 2009. The Dodd-Frank Wall Street Reform and Consumer Protection Act (Pub. L. No. 111-203) (the Dodd-Frank Act) directed us to study the effectiveness and impact of various valuation methods and the options available for selecting appraisers, as well as the impact of HVCC. This testimony summarizes the report we are releasing today, which responds to the mandate in the Dodd-Frank Act. Our work focused on valuations of single-family residential properties for first-lien purchase and refinance mortgages. The report discusses (1) the use of different valuation methods and their advantages and disadvantages, (2) policies and other factors that affect consumer appraisal costs and requirements for lenders to disclose appraisal costs and valuation reports to consumers, and (3) conflict-of-interest and appraiser selection policies and views on the impact of these policies on industry stakeholders and appraisal quality. We consider the impact of HVCC throughout the report..
section_title: What GAO Found
paragraphs: Available data and interviews with lenders and other mortgage industry participants indicate that appraisals are the most frequently used valuation method for home purchase and refinance mortgage originations. Appraisals provide an opinion of market value at a point in time and reflect prevailing economic and housing market conditions. Data provided to us by the five largest lenders (measured by dollar volume of mortgage originations in 2010) show that, for the first-lien residential mortgages for which data were available, these lenders obtained appraisals for about 90 percent of the mortgages they made in 2009 and 2010, including 98 percent of home purchase mortgages. The data we obtained from lenders include mortgages sold to the enterprises and mortgages insured by the Federal Housing Administration (FHA), which together accounted for the bulk of the mortgages originated in 2009 and 2010. The enterprises and FHA require appraisals to be performed for a large majority of the mortgages they purchase or insure. For mortgages for which an appraisal was not done, the lenders we spoke with reported that they generally relied on validation of the sales price (or loan amount in the case of a refinance) against a value generated by an automated valuation model (AVM), in accordance with enterprise policies that permit this practice for some mortgages with characteristics associated with a lower default risk. Factors such as the location and complexity of the property affect consumer costs for appraisals. For example, a property may have unique characteristics that are more difficult to value, such as being much larger than nearby properties or being an oceanfront property, which may require the appraiser to take more time to gather and analyze data to produce a credible appraisal. Mortgage industry participants we spoke with told us that the amount a consumer pays for an appraisal is generally not affected by whether the lender engages an appraiser directly or uses an appraisal management company (AMC)--which manages the appraisal process on lenders' behalf--to select an appraiser. They said that AMCs typically charge lenders about the same amount that independent fee appraisers would charge lenders directly, and lenders generally pass on these charges to consumers. In general, lenders, AMC officials, appraisers, and other industry participants noted that consumer costs for appraisals have remained relatively stable in the past several years. However, appraisers have reported receiving lower fees when working with AMCs compared with working directly with lenders because AMCs keep a portion of the total fee. Recently issued policies reinforce long-standing requirements and guidance designed to address conflicts of interest that may arise when direct or indirect personal interests bias appraisers from exercising their independent professional judgment. In order to prevent appraisers from being pressured, the federal banking regulators, the enterprises, FHA, and other agencies have regulations and policies governing the selection of, communications with, and coercion of appraisers. Examples of recently issued policies that address appraiser independence include HVCC, which took effect in May 2009; the enterprises' new appraiser independence requirements that replaced HVCC in October 2010; and revised Interagency Appraisal and Evaluation Guidelines from the federal banking regulators, which were issued in December 2010. Provisions of these and other policies address (1) prohibitions against loan production staff involvement in appraiser selection and supervision; (2) prohibitions against third parties with an interest in the mortgage transaction, such as real estate agents or mortgage brokers, selecting appraisers; (3) limits on communications with appraisers; and (4) prohibitions against coercive behaviors.

section_title: Letter
paragraphs: I am pleased to be here today to discuss our work on residential real  estate valuations. Real estate valuations, which encompass appraisals  and other value estimation methods, play a critical role in mortgage  underwriting by providing evidence that the market value of a property is  sufficient to help mitigate losses if the borrower is unable to repay the  loan. However, recent turmoil in the mortgage market has raised  questions about mortgage underwriting practices, including the quality  and credibility of some valuations. An investigation into industry appraisal  practices by the New York State Attorney General led to an agreement in  2008 between the Attorney General; Fannie Mae and Freddie Mac (the  enterprises); and the Federal Housing Finance Agency (FHFA), which  regulates the enterprises. This agreement included the Home Valuation  Code of Conduct (HVCC), which set forth certain appraiser independence  requirements for loans sold to the enterprises and took effect in 2009.  The Dodd-Frank Wall Street Reform and Consumer Protection Act (Pub.  L. No. 111-203) (the Dodd-Frank Act) directed us to study the  effectiveness and impact of various valuation methods and the options  available for selecting appraisers, as well as the impact of HVCC.
My statement summarizes the report we are releasing today, which  responds to the mandate in the Dodd-Frank Act. Our work focused on  valuations of single-family residential properties for first-lien purchase and  refinance mortgages. The report discusses (1) the use of different  valuation methods and their advantages and disadvantages, (2) policies  and other factors that affect consumer appraisal costs and requirements  for lenders to disclose appraisal costs and valuation reports to  consumers, and (3) conflict-of-interest and appraiser selection policies  and views on the impact of these policies on industry stakeholders and  appraisal quality. We consider the impact of HVCC throughout the report.  To do this work, we analyzed proprietary data we obtained from the  enterprises, lenders, and a mortgage technology company on the use of  different valuation methods and appraisal approaches. We reviewed  academic and industry literature and examined federal regulations and  policies, as well as internal policies and procedures of lenders. Finally, we  interviewed a broad range of appraisal and mortgage industry participants  and observers and discussed these issues with officials from the  enterprises, FHFA, the federal banking regulatory agencies, and other  federal agencies. The work that this statement is based on was  performed from July 2010 to July 2011 in accordance with generally  accepted government auditing standards. Those standards require that  we plan and perform the audit to obtain sufficient, appropriate evidence to  provide a reasonable basis for our findings and conclusions based on our  audit objectives. We believe that the evidence obtained provides a  reasonable basis for our findings and conclusions based on our audit  objectives.
subsections: section_title: The Widespread Use of Appraisals for Mortgage Originations Reflects Their Advantages Relative to Other Valuation Methods
paragraphs: Available data and interviews with lenders and other mortgage industry  participants indicate that appraisals are the most frequently used  valuation method for home purchase and refinance mortgage  originations. Appraisals provide an opinion of market value at a point in  time and reflect prevailing economic and housing market conditions.  Data provided to us by the five largest lenders (measured by dollar  volume of mortgage originations in 2010) show that, for the first-lien  residential mortgages for which data were available, these lenders  obtained appraisals for about 90 percent of the mortgages they made in  2009 and 2010, including 98 percent of home purchase mortgages. The  data we obtained from lenders include mortgages sold to the enterprises  and mortgages insured by the Federal Housing Administration (FHA),  which together accounted for the bulk of the mortgages originated in 2009  and 2010. The enterprises and FHA require appraisals to be performed  for a large majority of the mortgages they purchase or insure. For  mortgages for which an appraisal was not done, the lenders we spoke  with reported that they generally relied on validation of the sales price (or  loan amount in the case of a refinance) against a value generated by an  automated valuation model (AVM), in accordance with enterprise policies  that permit this practice for some mortgages with characteristics  associated with a lower default risk.
The enterprises, FHA, and lenders require and obtain appraisals for most  mortgages because appraising is considered by mortgage industry  participants to be the most credible and reliable valuation method for a  number of reasons. Most notably, appraisals and appraisers are subject  to specific requirements and standards. In particular, the Uniform  Standards of Professional Appraisal Practice (USPAP) outlines the steps  appraisers must take in developing appraisals and the information  appraisal reports must contain. USPAP also requires that appraisers  follow standards for ethical conduct and have the competence needed for  a particular assignment. Furthermore, state licensing and certification  requirements for appraisers include minimum education and experience  criteria, and standardized report forms provide a way to report relevant  appraisal information in a consistent format.
In contrast, other valuation methods, such as broker price opinions (BPO)  and AVMs, are not permitted for most purchase and refinance mortgage  originations. The enterprises do not permit lenders to use BPOs for  mortgage originations and only permit lenders to use AVMs for a modest  percentage of mortgages they purchase. Additionally, the federal banking  regulators’ guidelines state that BPOs and AVMs cannot be used as the  primary basis for determining property values for mortgages originated by  regulated institutions. However, the enterprises and lenders use BPOs  and AVMs in a number of circumstances other than purchase and  refinance mortgage originations because these methods can provide  quicker, less expensive means of valuing properties in active markets.
When performing appraisals, appraisers can use one or more of three  approaches to value—sales comparison, cost, and income. The sales  comparison approach compares and contrasts the property under  appraisal with recent offerings and sales of similar properties. The cost  approach is based on an estimate of the value of the land plus what it  would cost to replace or reproduce the improvements minus depreciation.  The income approach is an estimate of what a prudent investor would pay  based upon the net income the property produces. USPAP requires  appraisers to consider which approaches to value are applicable and  necessary to perform a credible appraisal and provide an opinion of the  market value of a particular property. Appraisers must then reconcile  values produced by the different approaches they use to reach a value  conclusion.
The enterprises and FHA require that, at a minimum, appraisers use the  sales comparison approach for all appraisals because it is considered  most applicable for estimating market value in typical mortgage  transactions. Consistent with these policies, our review of valuation data  that we obtained from a mortgage technology company—representing  about 20 percent of mortgage originations in 2010—indicates that  appraisers used the sales comparison approach for nearly all (more than  99 percent) of the mortgages covered by these data. The cost approach,  which was generally used in conjunction with the sales comparison  approach, was used somewhat less often—in approximately two-thirds of  the transactions in 2009 and 2010, according to these data. The income  approach was rarely used. Some mortgage industry stakeholders have  argued that wider use of the cost approach in particular could help  mitigate what they view as a limitation of the sales comparison approach.  They told us that reliance on the sales comparison approach alone can  lead to market values rising to unsustainable levels and that using the  cost approach as a check on the sales comparison approach could help  lenders and appraisers identify when this is happening. For example,  these stakeholders pointed to a growing gap between average market  values and average replacement costs of properties as the housing  bubble developed in the early to mid-2000s. However, other mortgage  industry participants noted that a rigorous application of the cost  approach may not generate values much different from those generated  using the sales comparison approach. They indicated, for example, that  components of the cost approach—such as land value or profit margins of  real estate developers—can grow rapidly in housing markets where sales  prices are increasing. The data we obtained did not allow us to analyze  the differences between the values appraisers generated using the  different approaches.
section_title: Recent Policy Changes May Affect Consumer Costs for Appraisals, while Other Policy Changes Have Enhanced Disclosures to Consumers
paragraphs: Factors such as the location and complexity of the property affect  consumer costs for appraisals. For example, a property may have unique  characteristics that are more difficult to value, such as being much larger  than nearby properties or being an oceanfront property, which may  require the appraiser to take more time to gather and analyze data to  produce a credible appraisal. Mortgage industry participants we spoke  with told us that the amount a consumer pays for an appraisal is generally  not affected by whether the lender engages an appraiser directly or uses  an appraisal management company (AMC)—which manages the  appraisal process on lenders’ behalf—to select an appraiser. They said  that AMCs typically charge lenders about the same amount that  independent fee appraisers would charge lenders directly, and lenders  generally pass on these charges to consumers. In general, lenders, AMC  officials, appraisers, and other industry participants noted that consumer  costs for appraisals have remained relatively stable in the past several  years. However, appraisers have reported receiving lower fees when  working with AMCs compared with working directly with lenders because  AMCs keep a portion of the total fee.
A provision in the Dodd-Frank Act that requires lenders to pay appraisers  a customary and reasonable fee could affect consumer costs and  appraisal quality, depending on interpretation and implementation of  federal rules. The effect of this change on consumer costs may depend  on the approach lenders and AMCs take in order to demonstrate  compliance. For example, some lenders and industry groups are having  fee studies done to determine what constitutes customary and reasonable  fees. According to the Dodd-Frank Act, these studies cannot include the  fees AMCs pay to appraisers. As a result, some industry participants,  including some AMC officials, expect these studies to demonstrate that  appraiser fees should be higher than what AMCs are currently paying. If  that is the case, these lenders would require AMCs to increase the fees  they pay to appraisers to a rate consistent with the findings of those  studies, which in turn could increase appraisal costs for consumers.  However, some lenders are evaluating the possibility of no longer using  AMCs and engaging appraisers directly, which would eliminate the AMC  administration fee from the appraisal fee that consumers pay.
Other recent policy changes that took effect in 2010 aim to provide  lenders with a greater incentive to estimate costs accurately when  providing consumers with an estimated price for third-party settlement  services, including appraisals. If actual costs exceed estimated costs by  more than 10 percent, the lender is responsible for making up the  difference. The Dodd-Frank Act permits, but does not require, lenders to  separately disclose to consumers the fee paid to the appraiser by an  AMC and the administration fee charged by the AMC. Another policy  change enhances disclosures by requiring lenders to provide consumers  with a copy of the valuation report prior to closing.
section_title: Conflict-of-Interest Policies Have Changed Appraiser Selection Processes, with Implications for Appraisal Oversight
paragraphs: Recently issued policies reinforce long-standing requirements and  guidance designed to address conflicts of interest that may arise when  direct or indirect personal interests bias appraisers from exercising their  independent professional judgment. In order to prevent appraisers from  being pressured, the federal banking regulators, the enterprises, FHA,  and other agencies have regulations and policies governing the selection  of, communications with, and coercion of appraisers. Examples of  recently issued policies that address appraiser independence include  HVCC, which took effect in May 2009; the enterprises’ new appraiser  independence requirements that replaced HVCC in October 2010; and  revised Interagency Appraisal and Evaluation Guidelines from the federal  banking regulators, which were issued in December 2010. Provisions of  these and other policies address (1) prohibitions against loan production  staff involvement in appraiser selection and supervision; (2) prohibitions  against third parties with an interest in the mortgage transaction, such as  real estate agents or mortgage brokers, selecting appraisers; (3) limits on  communications with appraisers; and (4) prohibitions against coercive  behaviors.
According to mortgage industry participants, HVCC and other factors  have contributed to changes in appraiser selection processes—in  particular, lenders’ more frequent use of AMCs to select appraisers.  Some appraisal industry participants said that HVCC, which required  additional layers of separation between loan production staff and  appraisers for mortgages sold to the enterprises, led some lenders to  outsource appraisal functions to AMCs because they thought using AMCs  would allow them to easily demonstrate compliance with these  requirements. In addition, lenders and other mortgage industry  participants told us that market conditions, including an increase in the  number of mortgages originated during the mid-2000s, and lenders’  geographic expansion over the years, put pressure on lenders’ capacity  to manage appraisers and led to their reliance on AMCs.
Greater use of AMCs has raised questions about oversight of these firms  and their impact on appraisal quality. Direct federal oversight of AMCs is  limited. Federal banking regulators’ guidelines for lenders’ own appraisal  functions list standards for appraiser selection, appraisal review, and  reviewer qualifications. The guidelines also require lenders to establish  processes to help ensure these standards are met when lenders  outsource appraisal functions to third parties, such as AMCs. Officials  from the federal banking regulators told us they review lenders’ policies  and controls for overseeing AMCs, including the due diligence they  perform when selecting AMCs. However, they told us they generally do  not review an AMC’s operations directly unless they have serious  concerns about the AMC and the lender is unable to address those  concerns. In addition, a number of states began regulating AMCs in 2009,  but the regulatory requirements vary and provide somewhat differing  levels of oversight, according to officials from several state appraiser  regulatory boards.
Some appraiser groups and other appraisal industry participants have  expressed concern that existing oversight may not provide adequate  assurance that AMCs are complying with industry standards. These  participants suggested that the practices of some AMCs for selecting  appraisers, reviewing appraisal reports, and establishing qualifications for  appraisal reviewers—key areas addressed in federal guidelines for  lenders’ appraisal functions—may have led to a decline in appraisal  quality. For example, appraiser groups said that some AMCs select  appraisers based on who will accept the lowest fee and complete the  appraisal report the fastest rather than on who is the most qualified, has  the appropriate experience, and is familiar with the relevant  neighborhood. AMC officials we spoke with said that they have processes  that address these areas of concern—for example, using an automated  system that identifies the most qualified appraiser based on the  requirements for the assignment, the appraiser’s proximity to the subject  property, and performance metrics such as the timeliness and quality of  the appraiser’s work.
While the impact of the increased use of AMCs on appraisal quality is  unclear, Congress recognized the importance of additional AMC oversight  in enacting the Dodd-Frank Act by placing the supervision of AMCs with  state appraiser regulatory boards. The Dodd-Frank Act requires the  federal banking regulators, FHFA, and the Bureau of Consumer Financial  Protection to establish minimum standards for states to apply in  registering AMCs, including requirements that appraisals coordinated by  an AMC comply with USPAP and be conducted independently and free  from inappropriate influence and coercion. This rulemaking provides a  potential avenue for reinforcing existing federal requirements for key  functions that may impact appraisal quality, such as selecting appraisers,  reviewing appraisals, and establishing qualifications for appraisal  reviewers. Such reinforcement could help to provide greater assurance to  lenders, the enterprises, and federal agencies of the quality of the  appraisals provided by AMCs.
To help ensure more consistent and effective oversight of the appraisal  industry, the report we are issuing today recommends that the heads of  the federal banking regulators (FDIC, the Federal Reserve, NCUA, and  OCC), FHFA, and the Bureau of Consumer Financial Protection—as part  of their joint rulemaking required under the Dodd-Frank Act—consider  including criteria for the selection of appraisers for appraisal orders,  review of completed appraisals, and qualifications for appraisal reviewers  when developing minimum standards for state registration of AMCs. In  written comments on a draft of our report, the federal banking regulators  and FHFA agreed with or indicated they will consider this  recommendation. The Bureau of Consumer Financial Protection did not  receive the draft report in time to provide comments.
Chairman Biggert, Ranking Member Gutierrez, and Members of the  Subcommittee, this concludes my prepared statement. I am happy to  respond to any questions you may have at this time.
section_title: GAO Contact and Staff Acknowledgments
paragraphs: For further information on this testimony, please contact me at (202) 512- 8678 or shearw@gao.gov. Contact points for our Offices of  Congressional Relations and Public Affairs may be found on the last page  of this statement. Key contributors to this testimony include Steve  Westley, Assistant Director; Don Brown; Marquita Campbell; Anar  Ladhani; John McGrail; Erika Navarro; Jennifer Schwartz; and Andrew  Stavisky.
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