Monday, June 5, 2023 | The Latest Buzz for the Appraisal Industry

Lines of Defense in Real Estate Collateral Risk Management

As we all know, the home valuation is an integral part of the lending process that helps Americans in their journey to homeownership. It’s an honor to play such an important role, but it’s also important to remember that lending programs are required to follow strict practices to protect the lenders and their investors against collateral risk. This series of articles explores the role of appraisal review processes in the risk system in the format of mortgage lending for 1-4 family real estate. Throughout, I’ll address current practices and processes of appraisal review, measuring change through observations, and insight as to what is to come.

In practice, the mortgage lender and mortgage aggregator/investor place risk management focus on three lines of defense. The first includes development and use of processes to ensure regulatory and policy requirements are being upheld by the business unit originating mortgage products. This part of the program is focused on maintaining independence of appraisal processes and ensuring the appraisal obtained by the lender meets the requirements for the specific loan product. The second  is an internal oversight function, which owns risk policies and framework and advises on controls and implementations to ensure policy requirements and objectives are being upheld. The third is when parties outside of the lender’s business unit (e.g. auditor, investor, regulator)  review the effectiveness of controls and practices.

This three-part series will focus on the first two lines of defense in managing appraisal-related risk with a deeper focus on appraisal review processes.

The Appraisal Review

The Appraisal Institute’s Dictionary of Real Estate Appraisal 7th edition, defines appraisal review as “the act or process of developing an opinion about the quality of another appraiser’s work (i.e. report, part of a report, or some combination of these) that was performed as part of an appraisal or appraisal review assignment.” While this definition is offered in the context of the practice of Real Estate Appraisal, the question that comes to mind is: can an appraisal review be performed by a person or process that is not a part of an appraisal practice?

If you look at the current regulatory guidance and stakeholder policies, it is clear that an appraisal can be reviewed by an individual not holding an appraisal credential when it is an internal process and the result of the process does not create an opinion of Market Value for the purposes of extending credit. When the appraisal review provides an estimate of value, including a concurrence of value, most states will require an appraisal credential.

Many lenders and appraisal management companies have appraisers on staff to accommodate state requirements and to have a level of expertise to rely upon for complex issues. However, many lenders, particularly smaller lenders or non-bank lenders, will not have credentialed appraisers on staff to perform their review process and will rely on appraisers to provide appraisal review as a valuation service.

Appraisal review processes are necessary as the lender is required to have a complete understanding of the collateral being posted for a mortgage loan or a line of credit. While current risk of default remains at historic lows, lenders and investors need to remain steadfast in preparation for economic downturns and increasing defaults.

The goal of any appraisal review, whether developed internal or external to the business unit, is to ensure that the appraisal report obtained in association with an application for credit, contains sufficient information for the lender to move forward with a credit decision.

Most lending appraisal review policies and procedures are formulated to comply with two sources. The first source is the written appraisal requirements published for lending programs through stakeholders such as HUD/FHA, the Veterans Administration, and Fannie Mae and Feddie Mac. The second source is the Interagency Real Estate Appraisal and Evaluation Guidelines, the source for regulated banks and credit unions to follow to ensure their valuation programs, including appraisal review, are sufficient to uphold the lending regulation that applies to real estate lending.

 Quality Control and Quality Assurance  

Appraisal reviews are present in two distinctly different processes within an institution’s risk system –  Quality Control and Quality Assurance. Often the two terms are used interchangeably, but they are distinctly different processes.

While both terms speak to processes and activities, quality control is focused on analysis and inspection, and is in place to ensure that quality is at a specified level to uphold the manufactured product. Quality Assurance,  however, is focused on monitoring and evaluating the manufacturing process, to ensure standards of quality are being upheld and sustained. In essence, Quality Assurance is a testing program to gain confidence that the Quality Control processes are working as designed. Whether you are manufacturing an automobile or a mortgage, the manufacturer needs to exert control of the quality, and have assurances that quality is consistent.

In conclusion, the process of appraisal review is integral to a lender’s risk program in fulfilling the necessary level of due diligence to instill confidence that business practices meet the objectives of safety and soundness for the lender and related investors.  Without that confidence, the lender risks loss to the business, and the ability to participate in a system that is focused on managing systemic risk when it comes to real estate lending. The next article will focus on the steps a lender will use when developing their Quality Control and Quality Assurance programs.