Mortgage lenders employing automated valuation models for home appraisals need to ensure they are conducting proper due diligence and have adequate risk management practices in place. Valuations require objectivity, market-specific knowledge, industry expertise and most importantly, a brain. While many tout the cost-effectiveness of "all-encompassing" software, the industry needs systems that combine the efficiency of these advanced technologies with the accuracy of human expertise.
There are more homes today in a positive equity position than there were during the financial crisis, rising interest rates have driven down refinance demand and a wave of maturing home equity lines now exist.
Modest repayment requirements and more relaxed structures have led to a decrease in delinquencies and loss rates for home equity loans, but many lenders' risk management practices have not kept pace with the increased demand and eased underwriting standards for these products. Increased adoption of limited-scope automated valuation models combined with an inherent vulnerability to fluctuating interest rates have made today's lenders more susceptible to home equity lending risks.
While AVMs do hold value — they are a cost-effective, fast tool to produce appraisals — the popularity of AVM usage among home equity lenders has been a large contributor to loss mitigation and defaulted loans. These valuation products may be more cost-effective than traditional appraisals — costing $12 to $15 per address versus upwards of $500 — but they often lead to discrepancies because they lack the precision of an inspection-assisted valuation report. It is not uncommon for AVMs to produce unconfirmed, arbitrary values and information.
Some lenders are opting to "enhance" their valuations with broker price opinions to eliminate these discrepancies (which average less than $100), but BPOs are not intended to determine the recommended sales price — they are for determining the market value of the property, and there is a significant difference between those two values. Not to mention the majority of brokers do not have proper liability coverage to use their reports for home equity loans, further increasing risks.
The good news is that several governing agencies (such as the Office of the Comptroller of the Currency and Federal Deposit Insurance Corp.) are beginning to see the heightened risks surrounding the appraisal process, so they are stepping in and developing standardized valuation guidelines that will help lenders develop stronger risk management infrastructures within the home equity lending channel.
Some of these new policies include requiring lenders to adopt risk management processes commensurate with the level of risk and complexity of its third-party relationships; having policies and procedures in place to effectively manage the credit risks associated with home equity loan products; and establishing reviewer qualification criteria to help ensure reviewers have the requisite education and experience to perform the level of review needed for the type, risk and complexity of the transaction — among others.
Once passed, these standardized policies will require lenders to implement specific valuation tools and loss mitigation practices. This is certainly a step in the right direction, as it enables the appraisal industry to collectively develop more credible results and drive more informed decision making within the home equity market. However, even with these policies in place, it is to be expected that many lenders will seek the most cost-effective valuation tools.
This presents an opportunity for the industry to develop more advanced, hybrid valuation technologies that are customized specifically to meet these new demands. For example, in a hybrid valuation approach, the appraiser could conduct a comprehensive desktop appraisal leveraging data extracted in real time from an inspection report completed by a local real estate broker or agent. Segmenting the inspection process significantly reduces the costs associated with developing a full Form 2055 Exterior Appraisal Report, but still contains the in-depth analyses needed to determine the appropriate value.
This type of innovation is the key to bringing more adequate and compliant valuation tools into the marketplace in conjunction with the agencies' new rules, while keeping profits and losses at a reasonable level. It is important to not lose sight of the value of human involvement in a world where technology is often preferred over bodies. The home equity lending market has historically had minimal risks, but this $7.6 trillion market — like many things in the industry — has changed. The past just goes to show how important it is for an industry built on risk and reward to be more proactive in embracing precision and innovation.
Joshua Fuchs is chief appraiser for ISGN.