A question of values

Each day brings news of more fallout from the sub-prime mortgage lending disaster. Consumers are losing their homes, home prices are plummeting to unusual lows, lending institutions are struggling, appraisers are under fire for their processes and investment portfolios are rapidly losing value. As more foreclosures occur, homeowners insurers are also exposed to increased risk of vandalism, arson and fraud claims, pitting them against the other insured on the policy – the lender.

At the center of this financial turmoil is the “American Dream,” or the desire of most citizens to purchase and own a house. The explosion of home ownership after WWII has not slowed measurably until now when unstable home prices, lack of funding sources and general confusion are limiting development and access.

Having said this, there is one fundamental concept that seems to have been lost since 1996 that may provide an essential ingredient to a stabilizing solution. This concept, essential to the lending process since the depression, works to set boundaries on home values, especially when markets are in serious decline. This concept, the cost approach method of appraisal holds the key to stopping and reversing this downward economic spiral.

A Question of Values
Core to the lending process is the ultimate value placed on a home. This amount serves as the foundation for the amount lenders are willing to lend to qualified consumers. However, the value established for homes in the lending process has come into question like never before. Actually, these values are in free-fall in most markets, making the amount of mortgage consumers can now qualify for uncertain. Often times this amount is too low for refinancing earlier ARM loans to more traditional financial instruments.

Because market values,  the current mode of assessing the amount of mortgage money available per-property, are the most widely employed medium of exchange, market value analysis alone is too often dramatically lower today than it was a mere 6 months ago, and vastly different, if not lower than the actual cost to construct the property or assess its land. Mortgage brokers and lenders are under scrutiny for relying on home comparable values solely for assessing mortgage rates. This, coupled with the fact that prior lent ARM loans are coming due at values much higher than currently shown, is bringing entire loan appraisal process under fire.

Since the introduction of comparables, the pure market value approach for residential markets, a process recommended and launched when home prices were skyrocketing, those lenders and consumers with then-high market valuations cannot come close to the original values in too many instances. In a recent case in Milwaukee, WI, an appraisal performed six months ago showed a $400,000 loss in market value when the homeowner went to refinance today, leaving a serious shortfall the consumer must make up.

Coincidentally, the actual replacement cost of the property remained constant or gradually increased at the pre-crisis value. This suggests that the process employed in the pre-market value appraisal time using what has often been referred to as the “cost approach” accurately stated the tangible asset that remains for the lender and their customer.

“A tangible and very measurable asset remains and can be measured: It is the home. It was common practice to employ the cost approach, a replacement cost estimate of the home, as an integral part of every appraisal performed. Now, lacking that insight, there is no stabilizing value for falling costs, states Peter Wells, President of Marshall & Swift, the appraisal division of MSB and the nation’s largest provider of appraisal information.

Wells and the editors at Marshall & Swift recommend that the cost approach be revisited as part of the long-standing appraisal process. This is beneficial because each home’s replacement cost can be tabulated quickly and accurately and the amount of valuation free-fall can stop at the replacement cost. The fact is that there is a property and it has intrinsic worth. It will be many months before the investment community will have confidence in the security or quality of the property assets that make up mortgage loan portfolios and the CDOs (Collateralized Debt Obligations) they supported. The hard truth is that relying solely on Market Value comparables to determine real property asset value has been seriously short-sighted, if not a leading cause of the current dilemma.

Taking the example of the Milwaukee home cited earlier, we discover that the replacement cost for the home represented in the cost approach is more consistent with comparable values of several years earlier before the instability of markets set in. That replacement cost value has remained relatively constant in a time of extreme turmoil, only increasing slightly while the market value shot up to nearly $400,000 higher than the replacement cost, before plummeting nearly $600,000 below replacement cost. The valuation effort is quite volatile from month to month when valuations are based solely on market value appraisal. Of course, this concern further fuels seeming consumer panic in the home sales arena, and pushes more consumers in need of refinancing into foreclosure.

The free-falling spirals in local markets due to the apparent panic caused by the market value only approach to appraisal would certainly be mitigated if the more measurable and real cost of construction for individual homes were made once again integral to the appraisal process. It is the belief at Marshall & Swift that if the costing data, which courts and the construction industry view as accurate, were used to help underwriters and reviewers balance the downward valuation spiral, the floor would be understood, essentially within reasonable distance to the tangible asset value of the house.

Other benefits accrue from reinstating the cost approach to appraisal. Essentially, insurance companies insure homes to their replacement cost value, mandating this element of valuation as the benchmark for this side of the financial equation. Banks and lenders are concerned to have properties adequately insured to protect their investment. When a total loss occurs and properties cannot be replaced, often times the lender ends with simply a vacant lot that is undeveloped. Likewise, having an adequate insurance policy helps protect banks should the property go into foreclosure.

A recent example where verified costing data would have potentially uncovered a major fraud case was with Bear Sterns and BankFirst. Both were affected by a fraud case in Atlanta involving $6.8 million by a relatively unsophisticated crime ring. As a December 21, 2007 the article in The Wall Street Journal commented, “Of course, the Atlanta scheme wouldn’t have worked if not for appraisers willing to approve values far in excess of what builders were charging for new homes.” 

The cost approach is simply an estimate of the replacement value of a property calculated from the cost to build, less deprecation, plus the value of the land. The concept was pioneered and perfected by Marshall & Swift in the 1930s. Appraisers have long known the value of the cost approach, which is especially valuable in economies marked by price surges when property value vastly exceeds its replacement cost. Mortgage loans and financial investments were made based on these inflated, market-bubble values, and the value of portfolio assets rapidly deflated.

Recent research reveals two pertinent points:

• Subprime and ARM loans accounted for most of the defaults and foreclosures in the marketplace
• An estimated 13 percent of the ARMs originated between 2004 and 2006, (approximately 1.1 million loans) will foreclose over the next six to seven years because of interest rate changes

Although the time proven cost approach method has been readily available via flexible and efficient Web-based technologies to serve as a check against ballooning market values, the parties to the lending process did not continue to include it in their loan processes. The undisciplined nature of the sub-prime loan environment has now led to a situation that may require a bailout by U.S. taxpayers. Only by returning to disciplined loan underwriting, which must include the cost approach, can the mortgage sector return to stability and move to credibility and profitability.

Effect on Property Insurers
Not surprisingly, homeowners insurers have been affected by the chaos in the home real-estate market. According to the National Coalition Against Insurance Fraud, an increase in suspected cases of arson is anticipated as another result of the sub-prime lending crisis. Already, arson is the major cause of structural fire dollar losses and accounts for $2 billion in direct property damage each year. Any increase in arson would be a devastating blow to property insurers and their investors.

The potential for arson is substantial: Nearly one in every 557 homes received a foreclosure filing in February. In the same month, foreclosure filings consisting of default notices, auction sale notices, and bank repossessions were reported on nearly 224,000 properties nation-wide, a 60 percent increase compared to the same month one year ago.

Generally, insurance carriers first learn about their policyholders’ financial difficulties when notified of the foreclosure of the property. However, by that time, many homeowners may have abandoned the property or may have been motivated by anger and frustration to damage or destroy it.

What insurance carriers and their investors need to understand is that notification of default, auction sale and foreclosure is available for insurers. Insurance underwriters can readily receive notices of default or trustee sale as many as 180 days earlier than receipt of the final change of title or request for policy cancellation. This reliable data gives insurers greater transparency into their books of business and enables them to take decisive action to minimize the potential for moral hazard claims. In the claims area, predictive analytics services can give more insights to quantify the potential for arson or vandalism or fight fraudulent claims.

Insurers are required by law to set aside sufficient funds, “policyholders’ surplus,” to cover potential claims. Because of the financial obligations to their policyholders, most insurance carriers are conservative investors and unlikely to invest policyholders’ surplus in sub-prime investments or CDOs. For example, at the end of 2006, Allstate Corporation had less than 8% of its fixed-income investments in mortgage-backed securities.

Although insurers’ investment portfolios are expected to be relatively unscathed, the mortgage crisis is flattening the insurance market and making it unattractive to investors. The tighter mortgage market has dried up new housing starts, stalled sales of existing homes, and reduced predicted demand for home improvements. Essentially, the crisis has created a flat market for new policy sales that drive growth.

However, what experienced observers of both the real estate and property insurance arenas know is that there are other ways to grow premium and increase share value. As mentioned, the key is found in the value of the American home, and in this case, the homes already insured by carriers. The time is right for insurers to restart growth by taking a closer look at the replacement cost values of the homes in their existing books of business.

Research shows that in 2007, an estimated 66 percent of typical American homes were undervalued for the purpose of insurance by an average of 18 percent. This represents a potential for underinsurance for 2/3 of American homes, a frightening proposition in today’s catastrophe-prone environment. Nevertheless, it also represents an opportunity for insurance carriers to grow their written premiums by increasing their focus on the insurance-to-value statistics in their own existing books of business. A further benefit will be the good will generated by proactively contacting and working with homeowners to improve the protection of what is often their most valuable assets. Turnkey solutions already exist to accomplish this important objective.

With decisive application of the disciplined, predictive home valuation strategies mentioned above, lenders, insurers, investors, and homeowners can begin to retrench and regain a solid financial condition.