Peter J. Wallison, a codirector of AEI’s program on financial policy studies, researches banking, insurance, and securities regulation. As general counsel of the U.S. Treasury Department, he had a significant role in the development of the Reagan administration’s proposals for the deregulation of the financial services industry. He also served as White House counsel to President Ronald Reagan and is the author of Ronald Reagan: The Power of Conviction and the Success of His Presidency (Westview Press, 2002). His other books include Competitive Equity: A Better Way to Organize Mutual Funds (2007); Privatizing Fannie Mae, Freddie Mac, and the Federal Home Loan Banks (2004); The GAAP Gap: Corporate Disclosure in the Internet Age (2000); and Optional Federal Chartering and Regulation of Insurance Companies (2000). He also writes for AEI’s Financial Services Outlook series.
Buzz: Peter, I recently read your book, “Hidden in Plain Sight” and was so impressed, as an appraiser, to see such attention paid to the appraisal process. What went wrong?
Wallison: The appraisal process was integral to what happened in the crisis. The data in my book shows that the financial crisis was caused by the government’s housing policies, which caused a major deterioration in underwriting standards between 1992 (when these policies adopted) and 2008, when the financial crisis occurred. As underwriting standards are reduced—for example, when required downpayments go from 10 percent to 5 percent or less—homebuyers are able to take on more leverage and risk and buy larger homes with bigger mortgages. This process built an enormous housing bubble between 1997 and 2007. As the bubble grew and home prices increased at an unprecedented rate, valuation appraisals based solely on comparable sales prices also increased, fostering instead of restraining the growth of the bubble. Housing bubbles are by definition pro-cyclical, but they can be restrained and moderated by appraisal standards that rely on factors other than comparable sales. That did not happen in the years before the financial crisis.
Buzz: The subtitle of your book is “What Really Caused the World’s Worst Financial Crisis “. What did happen and how do we avoid a repeat?
Wallison: In 1992, Congress adopted a law that established “affordable housing goals” for Fannie Mae and Freddie Mac. Initially, the goals required that 30 percent of all mortgages Fannie and Freddie bought had to be made to borrowers at or below the median income where they lived. But HUD was given the authority to increase the goals, and over time, between 1993 and 2008, the goals were made substantially tighter. By 2000, they were 50 percent, and by 2008 they were 56 percent. In other words, by 2008, 56 percent of all mortgages Fannie and Freddie bought had to have been made to borrowers who were below the median income where they lived. In order to meet these quotas, Fannie and Freddie had to reduce their underwriting standards. Beginning in the early 1990s, they could no longer limit their purchases to prime mortgages, as they had in the past. They simply couldn’t find enough prime mortgages when half or more of the mortgages they bought were made to borrowers below median income.
Because they were the dominant players in the housing finance market, when Fannie and Freddie reduced their underwriting standards, others did too. By 2008, more than half of all mortgages in the US financial system—31 million mortgages—were subprime or Alt-A, and 76 percent of these mortgages were on the books of government agencies, primarily Fannie and Freddie. This shows without question that the government created the demand for these mortgages. The result was a massive housing bubble, and when the bubble deflated in 2007 these mortgages began to default in unprecedented numbers, causing a financial crisis.
Buzz: It has become quite apparent given the ability to do a “post mortem” that appraisal independence, or the lack thereof, played a pivotal role in the crisis. What policy and process changes can be made to remedy the sins of the past?
Wallison: Of course appraisers need to be independent. That’s a given. No housing finance system can survive without that. But appraisers also have to use valuation standards in addition to comparable sales. The purpose of an appraisal should be to tell a lender what amount can be safely lent against the collateral, which means determining the essential value of the property through the cycle. If that had been the standard for appraisers as underwriting standards deteriorated during the 1990s and 2000s, the frothy growth in housing prices would have been moderated and contained. Housing replacement cost and rental value are two examples of standards that can reduce the inherent pro-cyclicality of a housing bubble, and might have prevented the housing crisis if they had been used by appraisers during that period.
Buzz: Residential real estate and all of the derivative financial instruments represent the largest asset class in the world. One of the striking things you mentioned in your book is the dearth of data available to accurately analyze what actually did happen. In a world of big data isn’t that shocking?
Wallison: Yes, it is shocking, but I think can be attributed to the fact that the housing finance system has been dominated by the government for the last 60 years. When the government is in charge, it is very difficult to standardize definitions and neither the government nor market participants have an incentive to do so. For example, the definition of a subprime mortgage was not adopted until in 2001, when the bank regulators declared that any mortgage with a borrower’s FICO score of 660 or less was a subprime mortgage. But even then, the standard applied only to banks and not to Fannie Mae and Freddie Mac, which continued to use a standard that obscured their acquisition of these mortgages. In addition, when the government is in charge the definitions that determine how records are kept become political, with the most powerful groups influencing the government to avoid definitions and data collection where that is not in their interests. Finally, the government’s role reduced the interest of creditors in knowing the facts about the market that would allow them to estimate their risks; with the government in charge, creditors thought they were protected—and when Fannie and Freddie failed, they were. This is a cautionary tale for those who would change appraisal standards. As much as that might help to stabilize the housing market, it will not be in the interests of some groups, such as the realtors, who benefit—at least temporarily– from quickly rising prices.
Buzz: What has changed, if anything, to address transparency to the housing finance system and notably the appraisal process?
Wallison: Unfortunately, there has been very little change in the housing finance system since the financial crisis. That’s why the subtitle of my book is “What Caused the World’s Worst Financial Crisis and Why It Could Happen Again.” The government is still very much in charge of housing finance—in fact more so than ever—and is reducing underwriting standards, just as one would expect, in order to boost home sales. This can be changed, but it will require a major education of the public and a turn in government policies toward a non-government housing finance market. Both will be difficult. The political opposition to removing the government’s role in the housing finance system will be very strong–as it will also be against modifying appraisal standards in order to create a more stable market. Still, all homeowners should recognize that they are the losers when underwriting standards decline and homes are sold to borrowers who can’t meet their mortgage obligations. Then, when these homes are foreclosed, they are ultimately sold at a price well below market, and this—because appraisers use sales prices for valuations—drives down all housing values in the neighborhood. If American homeowners were to recognize this, they would support the political changes necessary to produce stable values in the housing market.
Buzz: Peter, thank you for your time today. And I look forward to seeing you at the Collateral Risk Network meeting in Baltimore on June 29th.
NOW AVAILABLE FROM ENCOUNTER BOOKS
Hidden in Plain Sight
What Really Caused the World’s Worst Financial Crisis And Why It Could Happen Again
By Peter Wallison
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Written by : Jim Morrison
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“Housing bubbles are by definition pro-cyclical, but they can be
restrained and moderated by appraisal standards that rely on factors
other than comparable sales. That did not happen in the years before the
financial crisis.”
FNMA told appraisers to base values on Pending Sales. If they had actually let us do our job and base it on actual sales and not make ridiculous upward time adjustments, everything would have been fine. What really needs to happen is to have 20% down on every loan and ban cash out refinances.
These two steps would solve everything, but of course it will never happen because it is too easy.
….”determining the essential value of the property throughout the cycle.” ??? Have you rewritten the definition of market value for us?
The banks and deregulation were at the center of the crises not the GSEs. The GSEs were used to swallow the toxic assets created by the bank frauds. Why else would all these banks be sued (successfully) by the GSEs? It’s publicly known the banks settled and paid back billions to the GSEs. The author is rewriting a known narrative to foist a political agenda on unsuspecting readers.
“The purpose of an appraisal should be to tell a lender what amount can be safely lent against the collateral, which means determining the essential value of the property through the cycle.”
The purpose of the appraisal is to provide the lender/client with an accurate, and adequately supported, opinion of market value of the subject property. Appraisers do not tell lenders what amount can be safely lent against the collateral… that is an underwriting decision.
I am unsure of what is meant by “determining the essential value of the property through the cycle”. Does this mean the appraiser is to provide some sort of ‘seasonally adjusted’ ‘cyclically adjusted’ market value?
The problems originated from one source… politicians who mandated loans be made to people who simply could not afford them.
Appraisers just provide market value; how lenders use those numbers is out of our control.
Amen!
I respect this man but it’s another opinion based solely on numbers. I was an agent and an appraiser during the boom. Appraisers were appraising at fair market values. Guess what? The competition was so fierce that houses would list for one number and then sell for 10% or more above that. People came to the table with ready cash to make up the sales price – appraisal deficit. I routinely had houses listed for, say, $150,000 and then the final sales price would be $172,000 as an example. The appraiser had zero to do with that. A perfect storm of buyers, too many of them, is what is the central cause of the inflated prices during the bubble. Again, he’s like a Monday morning quarterback.