Seeking Honest Home Values- Inflated Appraisals Remain A Problem
Delinquencies among holders of risky option ARMs are increasing as their minimum payments climb.
By E. Scott Reckard, Los Angeles Times Staff Writer
December 28, 2007
Thought the mortgage meltdown was just a sub-prime affair? Think again. There's another time bomb waiting to explode, experts say: risky loans made to people with good credit.
So-called pay-option adjustable-rate mortgages, or option ARMs, were the easiest and most profitable home loans for lenders and brokers to make for much of this decade. Last year, they accounted for about 9% of the volume of all mortgages made in the U.S. and were especially popular in California, Florida and Nevada -- states where home prices rose the most during the housing boom and are now falling most sharply.
An option ARM loan gives a borrower the option of paying less than the interest due, causing the loan balance to rise. If it rises too much -- say, by 10% or 15% -- the opportunity to make a low payment vanishes and the required payment skyrockets.
That scenario is becoming increasingly common. In fact, more than 75% of option ARM borrowers have been making only the minimum payments, analysts at Standard & Poor's Corp. said last week. As a result, the delinquency rate on option ARMs already is jumping and is likely to keep rising sharply, S&P said. Because option ARMS went only to "prime" borrowers, they aren't eligible for a much-publicized interest rate freeze that is part of a White House-backed plan to stem sub-prime foreclosures.
One upshot could be foreclosures growing more common in affluent neighborhoods.
"Whether it's a wealthy community or a sub-prime community, it all comes down to how much equity the borrower has and how much home prices fall," said Joshua Rosner, a managing director at investment research firm Graham Fisher & Co.
Option ARMs were originally offered in the 1980s by California savings and loans as a way to give some financial flexibility to self-employed people and others with variable incomes. But as homes became more expensive this decade, they became increasingly desirable simply because of the ability to make extraordinarily low payments for a good period of time.
"The only reason for taking [an option ARM] was to use the minimum payment to get more house or a bigger refi than you otherwise could afford," said Guy Cecala, editor of Inside Mortgage Finance.
Attractive payment option
Joan Olsen is an example of someone who took out a mortgage she couldn't afford. A retired welfare worker, she said she didn't fully understand the loan terms when she refinanced her San Diego condominium 15 months ago with an option ARM. Olsen, 73, had a top-tier credit score of 760 but said she could afford to make only the minimum payment on her loan, which initially was $788 a month and now is $847. Her loan balance is $289,000, up from an initial $272,000. If it hits $312,000, which it could do in 20 months, she'll be required to pay more than $2,000 a month. Meantime, home prices have tumbled: One condo in Olsen's building sold recently for $251,000, so refinancing isn't a viable possibility.
"I have no one but myself to blame," Olsen said, "for signing off on something I didn't understand."
Although option ARMs went to prime borrowers, they had many characteristics that made them riskier than standard fixed-rate mortgages.
For example, a borrower could make minimum payments as though the interest rate were 1% or 2%, when in reality interest was accruing at a much higher rate -- often 7.5% to 8% at a time -- in 2005 and 2006 -- when fixed-rate borrowers could get 30-year loans at 6.5%.
What's more, standards for making option ARMs were loosened starting in late 2004, when Wall Street firms began buying such loans in bulk to be converted into securities backed by the loan payments, Cecala said. Because lenders didn't have to keep the loans on their books, he said, they weren't too worried about the risk of losses.
As a result, loans of 90% or more of the home's value became the norm, up from a once-standard 80%. And many of the loans were made without verifying income or assets, even for borrowers who could easily have supplied that information -- an invitation for the borrower, loan officer or broker to fudge numbers, analysts say.
Olsen's loan required her only to state, not document, her retirement income from pensions and Social Security.
Her application says that income totaled $5,000 a month. In an interview, Olsen said she actually received well under $3,000 a month but left details of the application up to a saleswoman at the brokerage where she got the loan, and signed the stack of documents without reading them carefully.
A spokesman for the lender, the Homecomings Financial unit of GMAC Financial Services, said there was nothing in the application to trigger any alarms.
Despite such risks, the initial low payments on option ARMs have kept a lid on serious delinquencies -- 3.7% of all option ARMs, Standard & Poor's analysts said in a report last week. That's higher than before, but still low compared with the 6.3% delinquency rate on loans to good-credit borrowers with so-called hybrid ARMs, which have a low fixed rate for two to 10 years before becoming adjustable-rate loans.
At Calabasas-based Countrywide Financial Corp., which S&P said made about a quarter of all option ARMs last year, 3% of such loans held by the lender as investments were delinquent at least 90 days, up tenfold from 0.3% a year earlier. Delinquency rates were even higher on option ARMs from other lenders, including Pasadena-based IndyMac Bancorp and Seattle's Washington Mutual Inc., S&P said.
Countrywide and other lenders tightened their lending standards last summer to ensure borrowers could afford loans after the interest rates adjusted upward.
Had those guidelines been in effect previously, Countrywide recently said, it would have rejected 89% of the option ARM loans it made in 2006, amounting to $64 billion, and $74 billion, or 83%, of those it made in 2005.
Easy sell in better times
Before standards were tightened, several mortgage brokers and former and current Countrywide employees said, it was easy to sell option ARMs to borrowers by focusing on the low minimum payment.
As the housing market boomed, borrowers figured they could always sell the home at a higher price if they got in trouble -- and brokers pocketed big rebates for selling option ARMs, said John Diamond, a Chino broker with 39 years in the business.
Although a broker might earn $4,500 for selling a $300,000 fixed-rate loan, Diamond said, the commission could total $12,000 on an option ARM of the same size.
"These loans drove the whole industry from late 1999 through late 2006," Diamond said. "It was just about the only thing any broker wanted to sell."
Now the party is over.
At the San Francisco nonprofit Consumer Credit Counseling Service, which fields hundreds of calls a day from borrowers in trouble on their loans, about 25% involve option ARMs, said Erica Sandberg, a spokeswoman for the center.
"They've been paying less than the interest they owe, so the loan balance is going up," she said. "Refinancing such a loan is all but impossible. And in a lot of markets selling the home isn't an option now."
Homecomings, Olsen's lender, said it was negotiating with her, trying to modify her loan so she'll be able to stay in the condo, though she fears her retirement will have to end.
"I think there's no way around it," she said. "I'm going to have to work at least part time."
Tougher state rules for appraisers take effect today, but inflated appraisals will remain a problem, an expert says.
By E. Scott Reckard, Los Angeles Times Staff Writer
January 1, 2008
Starting today, the educational requirements for California home appraisers will be tougher, but a veteran property evaluator who teaches how to spot fraud says the rules won't alter how many appraisers do their jobs.
The new rules require 67% more hours of training before appraisers are certified at various levels, and define more precisely the curriculum to be used. The regulations are taking effect about two months after California enacted a law making it illegal to pressure an appraiser to inflate a valuation.
But master appraiser Steven R. Smith of Redlands says the changes won't fix what he described as the main problem: high-volume appraisal companies' relying too heavily on computers and trainees rather than legwork and interviews.
At a recent mortgage-fraud seminar in Orange County attended by scores of appraisers seeking to meet the new requirements, Smith said it was common for appraisers to seek comparative prices, or "comps," that match clients' price objectives rather than perform the objective analysis that they are required to do.
If sales in an immediate area don't support the desired price, appraisers look elsewhere, perhaps to a higher-end neighborhood not much farther away, he said.
"We have an army of appraisers that don't know they're wrong," Smith said in an interview. "If you are trained to search for comps based on price, that's what you will do."
That won't change much until appraisers are allowed to take the time necessary for a proper evaluation -- typically a day or two -- rather than rush through two or three appraisals a day as companies often require them to do, he said.
During the housing boom, inflated appraisals could remain undiscovered as rising home prices quickly caught up with puffed-up valuations. But flawed appraisals encouraged recklessness and in some cases fraud, experts say, exacerbating foreclosures and lenders' losses once prices began falling.
The issue isn't new. Inflated appraisals were blamed for enabling savings and loans in the 1980s to make rash investments that ultimately cost taxpayers hundreds of billion of dollars.
In an echo of that fiasco, bad appraisals have contributed to the current mortgage crisis by propping up loans made with little or no down payments and speculative home purchases, Smith said.
"We literally have millions and millions of inflated appraisals," he said.
Some may be more inflated than others. In a federal criminal case, two Orange County appraisers, Lila Rizk and L. Scott Robinson, are accused of fraudulently inflating appraisals on more than 20 homes in Beverly Hills and elsewhere on the Westside.
According to the indictment in Los Angeles federal court, Rizk and Robinson gave appraisals that were millions of dollars higher than the homes' list prices, used far-off and dissimilar properties as comps while ignoring similar properties near the homes, and used their own previously inflated appraisals as comps.
Rizk and Robinson allegedly profited by collecting hundreds of thousands of dollars in pumped-up appraisal fees, while other defendants allegedly pocketed proceeds from loans made for millions of dollars more than the true sales price of the homes.
Rizk and Robinson have pleaded not guilty. Rizk's attorney, Jan L. Handzlik, said Monday that the appraisers depended on phony comparable sales documents prepared by the ringleaders of the fraud and were fooled "just like the banks."
Robinson's lawyer, Errol H. Stambler, said the lenders "were as much at fault as anyone in this matter."
In a case with national reach, New York Atty. Gen Andrew Cuomo filed a fraud lawsuit Nov. 1 against First American Corp. of Santa Ana, accusing the real estate services firm of inflating appraisals across the country under pressure from Seattle lender Washington Mutual Inc.
Washington Mutual has said it is cooperating with investigations by federal regulators in the case and expects to be vindicated. First American said the suit was without merit and said Cuomo had "mischaracterized" a handful of e-mails.
But Cuomo, a former U.S. secretary of Housing and Urban Development, said the case was "symbolic of an industrywide problem."
Like credit scores and other data, appraisals limit how much lenders will lend. Low valuations can torpedo deals. In such cases, lenders lose fees and loan officers, mortgage brokers and real estate agents lose commissions.
Appraisers who deliver bad news can lose assignments.
"You can bring back an appraisal that's lower than the lender wanted," said Keefe, Bruyette & Woods bank analyst Fred Cannon. "But it will probably be the last time the bank calls you up offering work."
Current regulation of appraisers resulted from the mass failure of S&Ls in the 1980s. A congressional panel concluded that flawed and fraudulent appraisals were major contributors to the losses.
In the wake of the S&L crisis, a 1989 federal law required states to license or certify appraisers working for banks and thrifts insured by the Federal Deposit Insurance Corp. Appraisers could lose their licenses for skewing estimates to give clients the property values they sought. Lenders were supposed to erect "firewalls" between employees who order and evaluate appraisals and those who sign off on loan decisions.
In California, the Office of Real Estate Appraisers was created to license and oversee appraisers under the federal law. Each year, the office has revoked 12 to 15 licenses of fraudulent or grossly negligent appraisers, said Greg Harding, the office's chief of licensing and enforcement.
An additional 200 to 220 cases a year have been settled, mainly by imposing fines, rehabilitative education or license suspensions on negligent or incompetent appraisers, Harding said.
Last year, acting to fill a gap in federal law, California legislators passed a law making it a misdemeanor to improperly influence a real estate appraiser. Under the new state law, which took effect when it was signed Oct. 5 by Gov. Arnold Schwarzenegger, California appraisers who believe that they have been improperly pressured can file reports with state officials or federal regulators against licensed real estate brokers or agents, mortgage brokers or lenders. Several other states have passed similar laws.
Smith said he was skeptical that the new California law would make a difference. Calling state real estate regulators "impotent," he said that filing a complaint with them has been "like throwing it into a deep hole."
The new state appraiser education rules have been in the works for seven years, growing out of a February 2001 meeting between state regulators and a federal panel that sets standards for how states certify appraisers. At that meeting, authorities acknowledged that appraisal problems remained and decided that the states should beef up their rules, Harding said.
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