The residential mortgage lending industry is changing due to the use of AVMs (automated valuation models). Although AVMs have their short-comings, lenders are being forced to make lending decisions faster than ever before, thus the undeniable dominance of AVMs in our lending environment today.
Before, affordable housing legislation banks lent on the purchase of a home strictly on a completely uninsured basis, thus, the bank had to underwrite their lending decision for a borrower to buy their home. This decision was based on a number of criteria that included the personal character of the borrower, his borrowing history, his capacity for obligation and the amount of capital he committed to the home purchase. This included most lending underwriting for most loans for credit cards, car loans, lines of credit or business loans. In the case of a mortgage, a home is used for collateral for which a value had to be appraised.
This appraised value had been traditionally assigned to a licensed appraiser to evaluate. This person would be licensed by a national body with a code of ethics, like the Appraisal Institute of Canada, and he would follow a local apprenticeship managed through a local body like the Ontario Association of the Appraisal Institute. The appraisal engagement began with the bank hiring the appraiser with a demonstrated knowledge of the neighbourhood with a proven track record of doing appraisals for the bank. This report was a complete report written by the appraiser with complete details including comparables. This report included pictures, analysis of how the subject compared to the comparables, plus local area influencers on value. The appraiser would typically meet the seller to do the walk through and interview the owner if she had questions.
Today, the lending environment has changed dramatically and so has the appraisal environment changed with it. CMHC and Genworth, mortgage insurers in Canada, have changed the landscape of home ownership in Canada along with Fannie Mae and Freddie Mac, in the USA. The USA real estate market meltdown triggered by the Bears and Sterns fallout lead to the greatest erasing of American household value in its history of a nation. As a result, all stakeholders in the mortgage industry and their roles were scrutinized. A major player in the USA was AVMs for their Fannie Mae and Freddie Mac mortgages.
AVMs are computer systems that use real estate data to estimate the “value” of a property at a given time. This “value” is used in lending to asses loan-to-value criteria in mortgage loan underwriting. In the case of the USA, this value is used for purchases and refinances to high loan-to-values exceeding 75 percent. These high-ratio loans were insured by Fannie Mae and Freddie Mac and these home insurance providers set rules on their insurance criteria which allowed for AVM valuations. Since the market meltdown, AVMs are being scrutinized more than ever as American’s have witnessed more than half of their home values erased and lenders have lost their security.
How are AVMs at fault here? AVMs use local sales data with quantitative data of the subject property compared to sales data in the neighbourhood and come up with a valuation. These sophisticated systems use statistics and warehoused data from real estate boards, and municipal and state records, to come up with a value. A mathematician would have a strong argument that AVM values are undeniably the true value, but what is true value? From a lender’s point of view, the value that matters is the market value if the property is sold in the open market under a foreclosure or power of sale. This “liquidation” value is only determined in a true selling environment where there may be many buyers that are seeking a deep discount from a power of sale property. Or, on the day of sale may have seen an interest rate hike that has forced many buyers to wait and see where prices are going. Another factor may be the local news of a plant closing nearby and there are ten more listings coming onto the market for a similar property in better condition at the same price. These economic, time-sensitive and location-specific factors are not well documented in an AVM’s historical data as a live person doing an appraisal.
Although AVM values have their short-comings, lenders use AVMs because of their quick availability, their relative accuracy and competitive pricing which all fit into the lender’s risk management. Banks today have allowed borrowers to use their equity in their homes almost like revolving credit. Canadian banks have seen a steady consistent growth in Canadian home values over several years; accordingly the banks have allowed Canadian’s to borrow against that equity more and more. With the collateralized mortgage allowing lenders to register a charge greater than the mortgage initially advanced, banks have created a future channel to allow borrows to ask for more in the future. Collateralized and standard mortgage charges today over 80 percent of the value of the home are now insured by CMHC and Genworth, so lenders are aggressively seeking lending channels as long as these insurers will insure. CMHC uses EMILI as their AVM to come up with home values. As long as EMILI provides a value that is required by the lender and the borrow meets the minimum credit-granting criteria set by CMHC, the bank’s risk is mitigated by the CMHC insurance in case of default.
How can AVMs be vulnerable to fraud or manipulation? Neighbourhood values can be unusually high due to builder sales incentives which may skew true market value, which a qualified appraiser would catch. Also, sales where buyer and seller are represented by the same agent or firm, dual agency, where values can be manipulated to accommodate for a cash back or seller incentive, CMHC has mitigated that risk by requiring a mandatory, full appraisal. These “red flag” scenarios are a few ways insurers mitigated risk of fraud or manipulation.
Finally, AVMs are supplying a much needed demand by consumers to tap the equity of their home. Spending beyond household annual income is a major problem in North America and debt consolidation through home refinancing has helped families to stay afloat. In turn, the mortgage industry is very busy providing to this lucrative market. As a result, lenders have competitive pressures to lower interest rates, lower fees and underwrite loans faster. Lenders have a competitive advantage in the consumers eyes when they can approve a loan at the first meeting and get the client to sign rather than wait on an appraisal where the borrow has to fork out an additional fee to have it completed. AVM allows lenders to do exactly that thus why AVMs are the undeniable market leader in appraisals.
In conclusion, computer valuations based on numerous complex calculations by an AVM tempered with red-flag scenarios for human appraisals appear to be solution to the fast-paced lending environment, however, more forward looking models and industry over-sight are important to protect borrowers from borrowing too much. The qualified human appraiser is now a consultant more than ever for those special cases that where data is not readily available and where data can be manipulated by market players.