Weak rules cripple appraiser oversight

By Mitch Weiss, Associated Press Writer

CHARLOTTE, N.C. (AP) -- As soaring home prices set the stage for America's great housing meltdown, a critical step in making sure those home sales were a fair deal -- the real estate appraisal -- was undermined from within.

After the nation's last major banking disaster, Congress set up a system to catch rogue appraisers. Their game: inflating the value of homes at the direction of equally unscrupulous real estate agents and mortgage brokers, whose commissions are determined by the size of the deals.

But a six-month Associated Press investigation found that the system is crippled by both the bumbling of its policemen and their inability to effectively punish those caught committing fraud.
And despite ample evidence appraisers are pressured into inflating home values -- sometimes to prices in support of loans that are more than buyers can afford -- the federal regulators charged with protecting consumers have thus far made a conscious choice not to act.

"The system is completely broken," Marc Weinberg, the former acting director at the federal agency charged with monitoring the appraisal industry, told the AP before he retired earlier this year. "It's amazing that the system ever worked at all."

The AP conducted dozens of interviews and reviewed thousands of state and federal documents, and found:

-- Since 2005, at the height of the housing boom, more than two dozen states and U.S. territories have violated federal rules by failing to investigate and resolve complaints about appraisers within a year. Some complaints sat uninvestigated for as long as four years. As a result, hundreds of appraisers accused of wrongdoing remained in business.

-- The only tool federal regulators have to force states into compliance is so draconian -- it would effectively halt all mortgage lending in a state -- that it has never been used.

-- Both state appraisal boards and the federal agency charged with overseeing them are chronically understaffed, many with only one full-time investigator to handle the hundreds of complaints that arrive each year. Some don't even have an investigator.

"The appraisal reforms of the late 1980s were good reforms," said Susan Wachter, a real estate professor at the University of Pennsylvania's Wharton School of Business. "But they were not sufficient to prevent what we have seen ... because regulation without teeth is not regulation."

To be sure, there are many causes of the housing crisis -- lenders who allowed people with spotty credit to buy homes with little or no money down, mortgage brokers who focused on selling loans without regard to the borrowers' ability to repay, investment bankers who bought and sold risky mortgage-backed securities. A few of the worst offenders -- appraisers included -- have been put behind bars.

But experts and industry insiders, including appraisers who feel betrayed by colleagues who don't follow the rules, believe the failure to effectively monitor the real estate appraisal industry contributed to housing's collapse.

There is no doubt, Wachter said, "that fraud has increased and appraisal fraud has increased in a way to exacerbate the problems."

This is the way the system is supposed to work:

Typically, an appraiser receives an order from a real estate agent, lender or mortgage broker to inspect a property. Based on a physical inspection of the home and comparable sales in the area, they develop an estimated value for the property. That figure is used by banks to set the home's value as collateral for the mortgage loan.

Appraisers are supposed to come up with a value free of any outside pressure. But more than three dozen appraisers nationwide interviewed by the AP said they often felt pushed by a real estate agent or mortgage broker to fraudulently inflate a property's value. They supplied the AP with documents from lenders asking them to "hit a number."

"The higher the loan amount, the more money brokers and lenders make in the deal," said Ray Haynes, an appraiser from Cherryville, N.C. "And they threaten you. They say, 'If you don't play ball with us, we'll go somewhere else.' And they do. I've seen my business shrink. They're all doing it. It's hard to stay honest."

Documents obtained by the AP also show that hundreds of appraisers complained to federal and state agencies about such fraudulent inflation of property values.

The appraisal system has broken down before. In 1989, Congress concluded that "faulty and fraudulent appraisals were an important contributor to the losses that the federal government suffered during the saving and loan crisis." And it passed the Financial Institutions Reform, Recovery and Enforcement Act.

Under the law's reforms, a private group known as the Appraisal Foundation wrote the rules governing appraisers. The law also recommended that states begin licensing appraisers and disciplining those who break the rules.

A federal agency called the Appraisal Subcommittee, an independent federal agency that answers to Congress, would conduct field reviews and audits, and maintain a national registry of appraisers -- including dossiers on those who break the rules.

But problems plagued the system from the start. It took years for some states to set up the independent review boards to supervise appraisers or hire personnel to investigate complaints. Even today, eight states still do not require appraisers to obtain a license or certification.

"We got to this point by a lack of enforcement. ... The public has the right to expect the appraisal boards are taking care of that problem," said Bob Ipock, an appraiser from Gastonia, N.C., who is a critic of the current system. "And they are not. They're looking the other way."

The Appraisal Subcommittee is supposed to help states remove from the system those appraisers who agree to "hit a number." But it has only four employees to conduct field reviews and audits of 50 states and four U.S. territories, and hasn't even had a permanent director since the agency's former chief retired at the end of last year.

Following Weinberg's subsequent departure in February as acting director, none of the agency's current employees -- including interim director Vicki Ledbetter -- returned more than a dozen messages left by the AP over a period of several months seeking comment.

When the agency does find a state failing to follow the law, the only tool available to force compliance is a death sentence known as "non-recognition" -- a penalty that would ban all appraisers in that state from handling deals involving a federal agency.

"Do you know what that would have meant? The net effect is it would have effectively shut down mortgage lending in that state," former subcommittee director Ben Henson, who retired in December, told the AP. "To take that action would have been an unbelievable disruption to the economy. I wasn't going to do that."

When field reviews began in the 1990s, states were repeatedly warned they were failing to comply with the law -- warnings that continue to this day. But without the ability to issue fines or impose a less destructive punishment, the Appraisal Subcommittee is powerless. It has never taken any action against a state for not obeying the law.

"Either you shut it off completely in a state, or you just send letters," said Gary Taylor, an appraiser from New York who sits on the Appraisal Foundation board that writes qualification guidelines. "The threat of the atomic bomb is the only thing."

And so, the violations stack up year after year, largely without consequence.

In the last three years alone, as the nation's housing market went from boom to bust, 27 states or territories failed to investigate and resolve complaints within a year. In Washington, D.C., the agency found last August that 32 of the district's 35 pending cases were older than two years. In Florida, almost 50 percent of 169 cases older than a year concerned appraisers involved in "fraud and flipping."

Faced with such backlogs, some states just give up. In New Hampshire, the state appraisal board decided in July 2006 to close all outstanding files dating to 2002 -- some of which included allegation of fraud -- because they "were too old to investigate."

In Ohio, the Appraisal Subcommittee found in 2005 that 40 percent of the state's 199 outstanding cases were older than a year, many older than two. To help clear the backlog, Ohio began allowing appraisers to sign consent orders -- a deal similar to a plea bargain in which an appraiser agrees to the facts of a case in exchange for a reduced punishment. That could be a short-term suspension, for example, instead of a license revocation.

In 2006, 11 appraisers signed such consent orders in Ohio. That figure swelled to 148 the following year.

"They know they can keep doing what they're doing because they can get away with it," said Carl Schneider, an appraiser who serves on the Oklahoma appraisal board's disciplinary procedures committee. "They're not getting punished. And states aren't doing more because they know regulators won't do a thing."

By law, the Appraisal Subcommittee must maintain a registry of appraisers that includes a disciplinary history. But a disciplinary action stays on the Web site only as long as it's current -- once the suspension is over, the action is removed, making it appear as if the appraiser has never been in trouble.

The flaws in the system also allow appraisers to stay in business while complaints against them are under investigation. North Carolina appraiser Jerry Gooden had eight complaints filed against him between 2001 and 2003, all related to a trainee who performed dozens of appraisals under his supervision and later pleaded guilty to mortgage fraud.

All the while, Gooden remained listed in good standing on the Appraisal Subcommittee's Web registry of appraisers. His license was suspended in 2005 for nine months because of the complaints. But even today, his entry shows he's never been disciplined. When contacted recently by telephone, Gooden said he was busy and didn't have time to talk.

When Illinois appraiser Donald Martin wrote to the Appraisal Subcommittee in December 2000, he told of how lenders, mortgage brokers and real estate agents withheld business from appraisers who refused to inflate values, guarantee a predetermined value or ignore deficiencies in a property.

Honest appraisers, he wrote, were blacklisted in favor of those with a "rubber stamp." He begged the agency to take action.

But as it would say in response to nearly a dozen such letters, the subcommittee answered that it didn't have the statutory authority to investigate such complaints. It promised to forward the complaint to the appropriate federal agencies, such as the Federal Reserve, which could have acted out of concerns for the health of the appraisal industry.
There is no evidence that ever happened.

"They just blew me off," Martin said. "I wasn't alone. We had appraisers from all over the nation writing in and urging them to take action."

That same month, subcommittee board member Thomas Watson Jr. -- then the national bank examiner at the federal Office of the Comptroller of the Currency -- did propose action. In a letter to appraiser groups and banking regulators, he called a meeting to discuss concerns "resulting from inappropriate pressure being placed on real estate property appraisers to 'hit a certain value.'"

Henson, the subcommittee's director at the time, attended the meeting and remembers hearing story after story about appraisers being pressured. But he called the information "mostly anecdotal," never forwarded the information to the full board and never followed up to see if any federal regulator looked into the complaints.

"People who say we should have done more don't understand how the system works," Henson said. "Agencies just don't lobby to change things. We had no interest in doing anything like that. It just wasn't our area."

The American Society of Appraisers formally asked the Appraisal Subcommittee to act in January 2001, noting the agency was in a "good position to work with bank regulators and others on the problem." Again, the agency responded by saying it did not have the authority to examine the issue.

"It didn't surprise me they didn't do anything," said Richard Amoling, the society's former president. "Everything related to the issue went into a black hole. Why, I just don't know."
Weinberg, who worked at the Securities and Exchange Commission before he was hired as the Appraisal Subcommittee's attorney in 1991, said the agency could have pushed more.
"I tried to push, but nobody wanted to hear what I was saying," he said.

That included Congress. When serving as president of a national appraisers trade association in June 2004, Taylor -- the Appraisal Foundation committee member -- told a House subcommittee field hearing that "problem appraisals are being allowed, and in some ways even encouraged, by a regulatory structure that promotes lax enforcement and ineffective oversight."
Taylor, president of Rogers & Taylor Appraisers Inc. in Hauppauge, N.Y., pleaded for help: "We are here to alert Congress that the licensing system it created for appraisers is broken ... and needs to be fixed." It wasn't.

Records obtained by the AP also show that complaints about individual appraisers filed at the state level are left unresolved for months -- and often for years -- but for a different reason: Many states have only one full-time inspector. Some appraisal boards also are rolled into bigger regulatory agencies, where inspectors with little or no experience are assigned to investigate complaints.

"I think the design of the system is excellent," said Philip Humphries, the current director of the North Carolina Appraisal Board. "But states don't have the money to hire personnel to carry out what the system was designed to do."

Henson said most of the complaints are frivolous, involving consumers upset because an appraiser "may have been rude or said my house wasn't worth as much as I thought." He said few of the complaints have anything to do with inflated appraisals. "That was just not a problem," he said.

Filed complaints are considered private and are not open to public inspection. But consent orders are public, and the AP's investigation found that Henson's assessment that most complaints are frivolous is simply wrong. In North Carolina, for example, of the more than 300 consent orders filed since 1994, 65 percent involved mistakes that inflated a home's value.

Even when states do investigate and find problems, rogue appraisers are rarely disciplined. Since 1994, only 13 appraisers -- there are currently about 3,500 licenesed appraisers in the state -- have had their licenses taken away by North Carolina's appraisal board. During the same period, California, the nation's most populous state, revoked 89 licenses; Tennessee, West Virginia and Wyoming did not revoke any, according to Appraisal Subcommittee records.
Violators are usually only reprimanded or, if their licenses are suspended, the suspension often is reduced if they agree to take remedial education classes.

Since 1994, consumers have filed 23 complaints against Richard Chapman, an appraiser from Emerald Isle, N.C. His license was suspended for five years in a case in which he was accused of submitting appraisals with "misleading information" and "inaccurate data." Since his license was reinstated in 2000, 11 new complaints have arrived.

"Just because you're disciplined, that doesn't make you a bad appraiser," said Chapman, who estimated he's been involved in 80,000 appraisals since 1980 and trained about 60 appraisers. "I may have done some technical things wrong, but I've done a good job. I'm proud of my work."
The North Carolina board dismissed two of the 11 recent complaints outright, while two others were dismissed with warnings to be more careful. Six were dismissed on the condition that Chapman complete appraiser education classes, and he was reprimanded for one complaint.
"There no habitual felon law for appraisers," said board attorney Roberta Ouellette, defending the agency's action. "Why should he get super-zapped for doing a lot of little things that a lot of other appraisers are doing every day but haven't had complaints turned in on them?"

The failings of the appraisal regulatory system and its impact on the nation's housing market led Andrew Cuomo, the New York attorney general, to reach a deal in March with Fannie Mae and Freddie Mac, which purchase mortgages from other financial institutions.

Cuomo's deal requires Fannie Mae and Freddie Mac to buy mortgages only from lenders who use independent appraisers. The new rules also prevent lenders who want to sell loans to Fannie Mae or Freddie Mac from using in-house appraisers to do the first evaluation.

The agreement, which will take effect in 2009, will create a watchdog to monitor the appraisal business: Fannie Mae and Freddie Mac will spend $24 million to create the Independent Valuation Protection Institute, which will accept complaints from consumers and appraisers. It will also monitor the enforcement and report to Cuomo's office.

But such a system duplicates the regulations already in place, including the same lack of enforcement tools that led the existing system to failure. And it's already under fire. John Dugan, the U.S. comptroller of the currency, wants the deal scrapped, arguing it would increase the cost of home loans for borrowers without strengthening consumer protections.

Cuomo didn't return repeated requests for comment. But Taylor, the Appraiser Foundation board member who asked Congress for action in 2004, doesn't see much hope for his success.
"There has to be effective enforcement of some sort. There has to be reality to it," Taylor said.

"What are you going to do if there is pressure on appraisers? How are you going to penalize someone who puts that pressure on appraisers? Who's going to do it? Who's going to enforce it? They need to have that or it won't work."

Senate Approves Housing Bill, New Regulations Discussed by the Administration

After parliamentary maneuvers delayed passage for weeks, the Senate late last week sent its approved version of the housing bill to the House of Representatives. This sets up the next round of negotiations on the measure, which is expected to be approved by both bodies by the end of the month. While President Bush has suggested he will veto such a measure, legislators in the House and the Senate are pressing to craft a bill acceptable to all.

Housing stimulus and foreclosure relief are the focus of the bill and it is clear that official Washington is paying attention to the calls from constituents, consumers and industry to address the worst housing and finance crisis in decades. The Senate bill, H.R. 3221, contains provisions for foreclosure relief designed to rescue up to 400,000 families by allowing them to refinance into more affordable loans. The Federal Housing Administration would be given authority to insure up to $300 billion in new loans, a part of the measure considered controversial by many as too expensive. This is one of the measures that postponed passage until after the Independence Day break.

Other provisions contain housing related tax breaks and credits for first-time homebuyers, clearly an effort to stimulate the sagging housing market. There is also funding for local communities to purchase foreclosed properties to stem blighted areas. Fannie Mae and Freddie Mac are given higher loans limits to $625,000, although the House is pushing for higher limits in its version of the bill up to $730,000.

All of this comes as home values and confidence continue to slip and the nation’s economy sputters along with rising fuel and commodities prices causing real concern. As I have said before in this column, consumer and investor confidence is a central key to resolving this mortgage and financial crisis. Last week there were signs that restoring confidence may finally be getting more attention.

Policy makers in Washington have begun to talk in terms of needing to know a true, independently derived appraisal documenting the collateral value and making sure the regulatory process is in place to do what is necessary in today’s complicated financial marketplace. At a Congressional hearing both Treasury secretary Henry Paulson and Federal Reserve chairman Ben Bernanke called for legislation and regulatory reform to prevent a future financial crisis. Their suggestions include authority in a new regulator to fill in the gap created by today’s complicated and exotic financing. And while it will be up to the next president and the next Congress to address this in full, the discussion has begun in earnest. Also in Washington last week, the FDIC held a conference on low-and moderate-income lending issues and panelists attested to the need for an appraisal process that is accountable with quality, independent appraisals being a high priority.

Music to my ears, as I have worked through the kind of financial institution crisis we face in the past and I know that re-valuing the collateral to today’s market value, and strengthening appraisal policies are required and important steps toward restoring consumer and investor confidence. Sheila Bair, chairman of the FDIC, is a believer in quality appraisals and knows the necessity of knowing the true value of the underlying collateral for a loan. Her office sponsored the FDIC forum and we are likely to hear more from her as the discussions for additional regulatory authority unfold in the coming months.

Stay tuned as we continue to work though these trying times.

Thomas J. Inserra is the CEO of Zaio Corp

Market's down, but you wouldn't know it from property taxes

By James Thorner, St. Petersburg Times Staff Writer

When home sales were blazing three years ago, property values soared on the blast of hot air. These days, with sales as cool as Dick Cheney at an Osama bin Laden rally, values are thunking back to earth.

Unless you're Juan Lopez, resident of St. Petersburg's Allendale Terrace neighborhood.
At the height of the housing boom in December 2005, Lopez and his wife, Joyce, paid $250,000 for a rough-around-the-edges 904-square-foot house near 36th Avenue N and Seventh Street. It was built in 1941 and suffered from renter's rot. A new appraisal values the home at $237,000.

Try telling that to Pinellas County. The property appraiser's office values the house at nearly $300,000 and taxed the Lopezes $5,600. Here's the twist: The county admits his house is nearly worthless, but claims his land alone would sell for $300,000.
Granted, the Lopez home squats on the edge of an attractively leafy enclave of brick streets. But facts are stubborn things: Lopez paid $250,000 at market peak for the house and lot. Pinellas property values have since dipped 10 to 20 percent. And the county's acting as if Lopez sleeps atop Saudi oil.

Eager to save money with a baby on the way, Lopez investigated. He was stunned to learn the county raised his 2007 property values by cherry-picking two lot sales during white-hot 2005. Most aggravating is a sale on 25th Avenue, 11 blocks away in Crescent Park Heights.
That lot sold for $200,000, but it turned out to be a speculative purchase by a builder who went bankrupt. He built a luxury home there. It's in foreclosure. Yet this is what passes in Lopez's case for a "comparable sale."

A cursory look at the tax rolls suggests the problem goes well beyond Lopez. How does government justify muscular appraisals when the market's a 95-pound weakling?

ZAIO Chief Speaks - History Lesson is Relevant

RESOLVING THE SUB PRIME DILEMMA
Applying lessons from the S&L crisis will restore stability and market confidence

By Thomas Inserra, MAI, SRA, CEO, Zaio Inc.

History is repeating itself.
The conditions surrounding the current sub prime mortgage crisis and the 1980-95 savings and loan crisis are eerily similar: An oversupply of property for sale. A sharp drop in new home construction and mortgage lending volumes. Huge loan losses. Heightened foreclosure rates. Lenders going out of business. Turmoil in security markets, with global implications. Action from the Fed to stimulate the economy. Congressional hearings to assign blame and write new regulations.

During the S&L crisis, federally insured financial institutions with combined assets of $924 billion failed over a 15-year period. Like today’s sub prime mortgage problem, the root cause was a breakdown in credit and appraisal processes. To address the S&L issue, a government-funded corporation called the Resolution Trust Corp. (RTC) was created in 1989. The RTC managed 747 financial institutions with $402.6 billion in assets, making it one of the largest corporations in the world.

The RTC succeeded in resolving the S&L dilemma by revamping credit and appraisal processes, improving investor access to appraisal data, and revaluing mortgage assets to reflect current market values. Over time, restored confidence in credit and appraisal processes led to improved marketability and liquidity of mortgage assets.
Ironically, in 1994, at a time when the S&L crisis was still underway, lenders successfully lobbied for new regulatory loopholes, including an exemption from appraisal regulations for loans under $250,000. The $250,000 loophole, along with the failure to extend appraisal regulations to sub prime lenders, mortgage brokers and state-regulated institutions, sowed the seeds for the current sub prime crisis.

In some of the worst losses in the S&L breakdown, lenders bribed or coerced appraisers, partnerships flipped property back and forth to artificially increase value, and appraisers inflated values to help make more loans. It’s alarming to note that 90 percent of today’s appraisers have reported that lenders have attempted to influence their “independent” conclusions.

Lenders have also migrated away from appraisal reports. Some found that, instead of encouraging an appraiser to inflate values, they could avoid the appraiser altogether, and use less expensive broker price opinions (BPOs) from real estate agents or computer-generated AVMs (automated valuation models). The widespread use of BPOs and AVMs significantly increased sub prime loan losses, and represents yet another breakdown in the appraisal process.

Clearly, current issues will not be resolved until regulatory loopholes are closed and lenders take measures to improve credit and appraisal processes – essential steps in restoring market confidence, and preventing a future crisis.

Lenders and regulators need to re-engineer the appraisal process so that values cannot be manipulated, and so that pressure exerted by loan officers on appraisers is eliminated.
A very promising example of appraisal reform is a nationwide group of licensed appraisers who are beginning to draft reports in advance, prior to any transaction, and storing them in a secure database. Lenders are already benefiting from this approach, and are better able to meet the needs of borrowers because they can retrieve their pre-manufactured appraisals in seconds, instead of days or weeks.

Although regulatory loopholes have not yet been closed, many lenders have already strengthened their own credit and appraisal policies. Some have eliminated BPOs and AVMs, and reinstated mandatory appraisals on all mortgage loans. Lenders are also implementing new accounting regulations requiring assets to be based on current market value rather than historic costs. In addition, many lenders are now revaluing assets on a quarterly or even monthly basis. This improves transparency, while allowing lenders to react quickly to changing market conditions, establish appropriate loan loss reserves, and improve investor confidence.
Eventually, this mortgage dilemma, like the last one, will pass, and it will be resolved in the same manner: by restoring proven credit and appraisal procedures, by revaluating all mortgage assets to reflect realistic, current market values, and by restoring confidence.

Investors – then and now – demand proof of underlying market value before they will act. And it’s the investors, lenders and portfolio owners who have learned the lessons of the past who will lead the market recovery.

How the Residential Subprime Meltdown is Effecting the Commercial Market

State of CRE Financing Part I: Beyond What Was Expected CoStar.com

Written by Mark Heschmeyer

Residential Depression -- Not CRE Market Conditions -- Is the Main Force Constraining "Commercial Real Estate Lending"

"Beyond what we expected." That was how U.S. banks portrayed the first quarter in regards to their real estate lending - and they weren't being positive.

The amount of residential asset writedowns, the amount of reserves they have needed to set aside and the spillover of residential downturn into commercial real estate are going beyond what they expected just late last year.

For clarification purposes, the vast majority of banks treat residential construction loans as commercial real estate lending because that is how such loans are categorized by federal banking regulators. What's clear is that the vast majority of writedowns, reappraisals and delinquencies in the asset portfolios of U.S. banks are tied to residential construction. And without exception, the outlook for that segment of their business is still dismal.

While the owner- and non-owner-occupied commercial building loans segment of their portfolios remain stable, the chain reaction effect from the housing market collapse is beginning to show signs of creeping into these assets, according to banks' first-quarter results.

And, partly because of all the intermingled nature of loans and different real estate types, the outlook for lenders, the U.S. economy and commercial real estate is - in bankers' words - hard to predict, but is clearly going to be less robust for the time being.

John Allison, chairman and CEO of BB&T Corp. in Baltimore, MD, summed it up residential and commercial markets best in his quarterly conference call: "We expect real estate markets to remain slow and for prices to continue to fall, maybe another 5% to 10%, but it will vary a lot by market. We do think real estate will bottom this fall and be recovering in spring of 2009. Real estate price cycles typically run three years and in the spring of 2009, it will be three years."

"I think we're two-thirds [of the way through] recognizing the non-performers and maybe two-thirds, or probably more like a half, [the way through] recognizing the losses because we really didn't turn into losses until the fall. If you look at prices, [they] peaked two years ago in the spring of 2006, but because we've been on such a long run, it was really [the last part of] 2007 before we started really turning into losses. This is just a wild guess, I'm guessing we're probably halfway through the loss process as an industry."

(Editor's Note: This is the first of a two-part story examining the state of commercial real estate finance. CoStar Advisor has reviewed the first quarter results of more than 75 bank and bank holding companies, read through more than a 300,000 words in earnings call transcripts (the equivalent of more than 225 CoStar Advisor news stories) and culled through several federal regulatory surveys and banking reports. Part I looks at the current state of commercial real estate markets from the lenders' viewpoint. Part II of the story to be published next week looks at how lenders are and will be responding to market conditions and their outlooks for the coming year.)

It All Starts with Housing

To understand current commercial real estate market conditions, the housing market deflation cannot be ignored. It all started with the unexpected rapid implosion of the subprime mortgage market in February of last year. That was the event that wiped out an entire support base on which housing sales were based: the first-time and low-income homebuyer.

When that support cracked, so did a second column of support: the speculative investor that hoped to flip a property in a year or two. Then the whole housing market came tumbling down.

It triggered an immediate drop in value of hundreds of billions of dollars of mortgage-backed securities, which triggered the substantial write-off in values of assets at financial houses, closed the spigot on the issuance of new mortgage-backed securities and eventually shut down additional real estate lending. It was the proverbial house of cards collapse.

The chain reaction effect is important to understand because it explains in a lot of ways why banks, lenders and Wall Street have so far seemed to be caught off guard.

"The real problem today is what's happening 'around' our loans not so much what's happening 'with' our loans," said George L. Engelke, Jr., chairman and CEO of Astoria Financial Corp.

If you've got a community that's got 50 houses for sale and they are all in foreclosures or financial trouble, Engelke noted, "People can't get a transaction done."

No matter how well banks monitored the individual loans in their portfolio or the performance of their customers, it was not enough to see how they would be impacted from the chain reaction. Likewise, no matter how good customers' credit condition looks on paper, it is still hard to get a loan.

Because of that, it is not unusual now to see banks writing down the value of loans that they normally would not have and not making loans that normally would have. Bryan Jordan, CFO of First Horizon National Corp. gave this account of one loan that was current and in good standing.

"We observed the draw inactivity on construction projects in California City [in Kern County east of Bakersfield, CA]," Jordan said. "Our investigation identified that the local city had placed a stock order on construction by this customer due to past due real estate pattern and additional lengths placed on the property. Although the loan remained current due to interest reserves, the credit was classified substandard in a new appraisal order. Following receipt and review of the appraisal, the loan was charged down to the estimated current realizable value."

"Given the deteriorating market condition," Jordan said, "we continue to be proactive in identifying problem loans and in writing them down to realizable value, which includes disposition costs and adjustments for market declines since the last appraisal."

According to bankers, appraisers are also becoming more aggressive in writing down the value of real estate assets.

"What happened is that we are going through a very challenging time that when you have major developers like KB Homes and all of the big ones who are suddenly walking away from big developments in this kind of environment, appraisers are turning to extremely, extremely pessimistic views," said Dominic Ng, chairman, president and CEO of East West Bancorp.

Trickle Down into CRE

John D. Schwab, executive vice president and chief credit officer of Citizens Republic Bancorp Inc. said his bank saw 36 commercial real estate loans slip into the non-performing category.

"About half of them were what I’m going to call much smaller income producing properties where these are retail strips where there is vacancies where the cash flows are no longer supporting the currency of loans," Schwab said. "The chunkier ones happen to be, as I mentioned, both land development and income producing."

Harris H. Simmons, chairman, president and CEO of Zions Bancorporation, said his staff is seeing anecdotal evidence of a little bit of commercial deterioration in trades and businesses that are related to that market, for example, firms such as plumbers, electricians and so forth.

John Allison of BB&T said his banks are seeing the housing impact trickle into a host of other commercial businesses. "I think the impact in the automobiles business is pretty dramatic," Allison said. "I think the fact that people have less comfort in the equity in their homes, [and that lack of] security makes them less willing to do bigger purchases. It's impacting the furniture business pretty significantly. Obviously people buy furniture when they buy new homes and that's a deferrable purchase and so you have furniture retailers struggling."

Nonetheless, bankers are still generally comfortable with most aspects of their office, industrial and retail real estate portfolios and clients.

Whether you could translate auto dealer and furniture retailers' problems into shopping centers problems is an unknown, Allison said.

"I am in the process and every spring I get to visit all 33 of our community banks and I am having the opportunity to talk to lots of our small business, middle-sized business clients," he said. "And the story if you are in the residential construction development business is that you aren't having any fun."

That pessimism hasn't hit the commercial market yet, Allison added.

"If you are in the commercial end of the market, most everybody says things are fine, although they may not be fine going forward. I am not getting anybody on the commercial side that's not pretty optimistic," he said.

"One thing is that in the early '90s a lot of the downturn was commercial, not residential, because you had so much excess buildings," Allison said. "And this time around, you probably have some excess buildings, but it's nothing like the early '90s, where you had so much excess lot development in retrospect on the residential side. I think that's why you are having a much more serious correction on the residential versus commercial."

Gregory Smith, CFO and senior vice president of Marshall & Ilsley Corp., said, "fundamentals in the apartment, medical office, and warehousing segments are positive. Fundamentals in hospitality are currently good, however, we anticipate softening reflecting the economy in general and high gas prices. Retail and office demonstrates softening."

Dominic Ng of East West Bancorp, said the occupancy rates of shopping centers, hotels, industrial warehouses and office buildings in his Inland Empire market in Southern California are still holding up.

"Despite all of the concern about recession and so forth, we have not seen any kind of increase in vacancy rate in any substantial manner," Ng said. "There's a huge relief because interest rates have come down so much due to the Fed fund reduction. Now our customers used to pay about 7.5%, 8% to us and now they're paying, about 5.5%, 6% and they may be even lower but the rents are not dropping, so they're picking up even more cash flow."

On top of that, Ng said, unlike in the residential sector in which there is a huge glut of inventory, there is very little supply of commercial properties.

Fed Rate Cuts Have Produced Mixed Results

Not all banks agree that the rate cut has been a good thing or a stimulus. The escalating drop in interest rates over the winter occurred faster than the banks' could reprice their deposits. That prompted drops in net interest incomes for many banks.

Charles T. Canaday, Jr., president and CEO of MidCarolina Financial Corp., said, "The dramatic and rapid decreases in short-term interest rates during the first quarter, caused by the Federal Reserve's initiatives to stimulate our nation's economy which has been hampered by real estate related concerns, have negatively impacted our interest margin."

Hugh Potts, Jr., chairman and CEO First M&F Corp. also said, "First-quarter results are below last year's results and early expectations. The primary influence was the effect on the net interest margin brought about by the actions of the Federal Reserve in January and March to lower short-term rates," said. Potts added, "The Fed actions precipitated cuts in prime, which had an immediate negative impact on the margin. While we expect to recover margin as the year unfolds, its effect is evident."

That problem was particularly hard on banks that do a lot of commercial lending, said Ted Thomas Cecala, chairman and CEO of Wilmington Trust Corp. "Because we originate a larger number of commercial loans than any other type of loan, we tend to be access sensitive," Cecala said. "This means that when interest rates move, yields on our loan portfolio will adjust faster than our costs of deposits and national market funding. When the Fed moves interest rates, the effect on our floating rate assets is seen very quickly."

The Banker's Eye View of the Country

The Federal Reserve's latest monthly Beige Book lender survey issued in the past week concurs with what CoStar Advisor found in banks' first-quarter reports and comments.

Housing markets and home construction remained sluggish throughout most of the nation, but neither were there signs of any quickening in the pace of deterioration. New residential construction was reported to have remained at depressed levels, and none of the Federal Reserve districts reported any pickup since March.

Declines or downward pressures in residential selling prices were specifically reported in the Boston, New York, Philadelphia, Richmond, Atlanta, Chicago, Minneapolis, Kansas City, and San Francisco regions.

In particular, New York and San Francisco noted some incipient price declines in areas that had previously shown resilience - respectively, New York City and the Pacific Northwest, as well as Utah.

On the other hand, the Cleveland region noted some stabilization in home prices.

Commercial real estate markets were generally reported to be steady or softening in most areas. Weaker conditions in the rental market were reported in eight regions: New York, Philadelphia, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, and San Francisco.

On the other hand, the leasing markets were said to be steady in the Boston, Kansas City and Dallas areas.

Reports on commercial development were mixed with activity having weakened in the Philadelphia, Atlanta, and San Francisco regions, but having increased in the Cleveland, Chicago, and Kansas City Districts. St. Louis characterized commercial construction as strong.

Sales of commercial properties were generally indicated to be sluggish, while prices were said to be under downward pressure. The Boston, Philadelphia, Minneapolis, Kansas City, Dallas, and San Francisco regions all reported weakness in commercial real estate sales and prices.

Banks reported mixed trends in lending activity, with fairly widespread slowing in the consumer segment but some stabilization, at low levels, in residential mortgage activity.

Overall lending activity was reported to have increased in the Philadelphia, Richmond and St. Louis regions, but to have declined in the New York, Chicago, Kansas City and San Francisco regions.

The Dallas region described lending activity as steady but soft.

Lending activity for new home mortgages, though generally characterized as sluggish, was reported to have stabilized in the New York, Cleveland, Chicago, and San Francisco areas.

Consumer loan demand, however, weakened in a number of areas: New York, Atlanta, Chicago and Kansas City. Credit quality was reported to have deteriorated, on balance, since March. Increased delinquency rates were noted by New York, Philadelphia, and Cleveland, while Kansas City reported that loan quality remained lower than a year ago.

Widespread tightening in credit standards was reported, especially on residential and commercial real estate loans. In general, banks were reported to be tightening credit standards in the New York, Cleveland, Atlanta, Chicago, Kansas City, Dallas and San Francisco regions.

In addition, Boston noted that standards remain tight on commercial mortgages, while Philadelphia indicated that banks are limiting lending in this category. Richmond indicated tighter standards on residential mortgages.

Pop the Champaigne and Savor This

The Housing Crisis Is Over
The Wall Street Journal

By CYRIL MOULLE-BERTEAUX
May 6, 2008; Page A23

The dire headlines coming fast and furious in the financial and popular press suggest that the housing crisis is intensifying. Yet it is very likely that April 2008 will mark the bottom of the U.S. housing market. Yes, the housing market is bottoming right now.
How can this be? For starters, a bottom does not mean that prices are about to return to the heady days of 2005. That probably won't happen for another 15 years. It just means that the trend is no longer getting worse, which is the critical factor.
Most people forget that the current housing bust is nearly three years old. Home sales peaked in July 2005. New home sales are down a staggering 63% from peak levels of 1.4 million. Housing starts have fallen more than 50% and, adjusted for population growth, are back to the trough levels of 1982.
Furthermore, residential construction is close to 15-year lows at 3.8% of GDP; by the fourth quarter of this year, it will probably hit the lowest level ever. So what's going to stop the housing decline? Very simply, the same thing that caused the bust: affordability.
The boom made housing unaffordable for many American families, especially first-time home buyers. During the 1990s and early 2000s, it took 19% of average monthly income to service a conforming mortgage on the average home purchased. By 2005 and 2006, it was absorbing 25% of monthly income. For first time buyers, it went from 29% of income to 37%. That just proved to be too much.
Prices got so high that people who intended to actually live in the houses they purchased (as opposed to speculators) stopped buying. This caused the bubble to burst.
Since then, house prices have fallen 10%-15%, while incomes have kept growing (albeit more slowly recently) and mortgage rates have come down 70 basis points from their highs. As a result, it now takes 19% of monthly income for the average home buyer, and 31% of monthly income for the first-time home buyer, to purchase a house. In other words, homes on average are back to being as affordable as during the best of times in the 1990s. Numerous households that had been priced out of the market can now afford to get in.
The next question is: Even if home sales pick up, how can home prices stop falling with so many houses vacant and unsold? The flip but true answer: because they always do.
In the past five major housing market corrections (and there were some big ones, such as in the early 1980s when home sales also fell by 50%-60% and prices fell 12%-15% in real terms), every time home sales bottomed, the pace of house-price declines halved within one or two months.
The explanation is that by the time home sales stop declining, inventories of unsold homes have usually already started falling in absolute terms and begin to peak out in "months of supply" terms. That's the case right now: New home inventories peaked at 598,000 homes in July 2006, and stand at 482,000 homes as of the end of March. This inventory is equivalent to 11 months of supply, a 25-year high – but it is similar to 1974, 1982 and 1991 levels, which saw a subsequent slowing in home-price declines within the next six months.
Inventories are declining because construction activity has been falling for such a long time that home completions are now just about undershooting new home sales. In a few months, completions of new homes for sale could be undershooting new home sales by 50,000-100,000 annually.
Inventories will drop even faster to 400,000 – or seven months of supply – by the end of 2008. This shift in inventories will have a significant impact on prices, although house prices won't stop falling entirely until inventories reach five months of supply sometime in 2009. A five-month supply has historically signaled tightness in the housing market.
Many pundits claim that house prices need to fall another 30% to bring them back in line with where they've been historically. This is usually based on an analysis of house prices adjusted for inflation: Real house prices are 30% above their 40-year, inflation-adjusted average, so they must fall 30%. This simplistic analysis is appealing on the surface, but is flawed for a variety of reasons.
Most importantly, it neglects the fact that a great majority of Americans buy their houses with mortgages. And if one buys a house with a mortgage, the most important factor in deciding what to pay for the house is how much of one's income is required to be able to make the mortgage payments on the house. Today the rate on a 30-year, fixed-rate mortgage is 5.7%. Back in 1981, the rate hit 18.5%. Comparing today's house prices to the 1970s or 1980s, when mortgage rates were stratospheric, is misguided and misleading.
This is all good news for the broader economy. The housing bust has been subtracting a full percentage point from GDP for almost two years now, which is very large for a sector that represents less than 5% of economic activity.
When the rate of house-price declines halves, there will be a wholesale shift in markets' perceptions. All of a sudden, the expected value of the collateral (i.e. houses) for much of the lending that went on for the past decade will change. Right now, when valuing the collateral, market participants including banks are extrapolating the current pace of house price declines for another two to three years; this has a significant impact on the amount of delinquencies, foreclosures and credit losses that lenders are expected to face.
More home sales and smaller price declines means fewer homeowners will be underwater on their mortgages. They will thus have less incentive to walk away and opt for foreclosure.
A milder house-price decline scenario could lead to increases in the market value of a lot of the securitized mortgages that have been responsible for $300 billion of write-downs in the past year. Even if write-backs do not occur, stabilizing collateral values will have a huge impact on the markets' perception of risk related to housing, the financial system, and the economy.
We are of course experiencing a serious housing bust, with serious economic consequences that are still unfolding. The odds are that the reverberations will lead to subtrend growth for a couple of years. Nonetheless, housing led us into this credit crisis and this recession. It is likely to lead us out. And that process is underway, right now.

Mr. Moulle-Berteaux is managing partner of Traxis Partners LP, a hedge fund firm based in New York.

Do Banks have the money to lend?

This is an article from Bloomberg News, Tuesday, April 8, 2008 which explains in laymen's terms the situation that the major lenders find themselves dealing with. It's a quick read.

Citigroup, Wells Fargo May Fuel Recession by Curtailing Lending
By Mark Pittman, Alan Katz and David Mildenberg

April 8 (Bloomberg) -- Bank holding companies including Citigroup Inc., Bank of America Corp. and Wells Fargo & Co. have the thinnest safety cushion against losses in seven years.
The margin may erode further in coming weeks. Credit ratings on $704 billion of bonds have been cut this year following the collapse of the U.S. housing market. Sheila Bair, chairman of the Federal Deposit Insurance Corp., said last week that the downgrades may compromise bank capital ratios enough that some of the largest institutions will no longer be considered well capitalized.
Falling below a regulatory benchmark that is intended to maintain a minimum level of capital to protect depositors against losses would subject banks to more scrutiny from regulators than they have ever experienced.
``This is a nightmare for the country,'' said William Isaac, who was chairman of the FDIC from 1981 to 1985. Banks will ``raise what capital they can, then they'll slow down their growth and stop lending, and what should be a mild recession becomes a much more serious one.''
The biggest danger to the economy is that to preserve their ratios, banks will cut off the flow of credit, causing a decline in loans to companies and consumers. Banks have already raised $136 billion in capital, based on data compiled by Bloomberg, and cut dividends. More stock sales and payout reductions are likely to follow, says analyst Meredith Whitney at Oppenheimer & Co.
`Institutional Panic'
The credit crunch has already cost the world's biggest financial companies about $232 billion and forced a government bailout of New York-based Bear Stearns Cos., the fifth-largest U.S. investment bank. The International Monetary Fund said last week that banks were in the worst financial crisis since the Great Depression.
``Banks have to maintain their ratios,'' said Dennis Santiago, chief executive officer of Institutional Risk Analytics, a Torrance, California-based research firm that monitors banking statistics. ``This is an institutional panic. At what point will consumers feel the panic? I don't know.''
The banks need to shore up the ratio of the value of their common stock, preferred shares, retained earnings and loss reserves to the total of risk-adjusted assets, which are affected by credit ratings. To be considered a ``well capitalized bank'' by U.S. regulators, an institution can't have more than 10 times its capital in risk-weighted assets. More than 99 percent of American banks qualify as well capitalized.
As a group, regulated banks had a total risk-based capital ratio of 12.79 percent at the end of last year, according to data compiled by Bloomberg. The figure was the lowest since 2000, before the last U.S. recession.
Citi's Ratio
Pittsburgh-based PNC Financial Services Group Inc.'s banking unit had a 10.24 percent total risk-capital ratio at the end of 2007, according to the FDIC. Cleveland-based National City Corp.'s banking unit had a ratio of 10.31 percent.
The holding companies for Citigroup, Bank of America and Wells Fargo have the lowest ratios in at least the five years that the Federal Reserve has been tracking the data.
Citigroup, based in New York, had stock, retained earnings and preferred shares in 2007 equal to 10.7 percent of its risk- weighted assets. That's down from 12.02 percent in 2005. Wells Fargo, based in San Francisco, was at 10.68 percent, down from 11.76 percent, and Charlotte, North Carolina-based Bank of America, 11.02 percent, down from 11.08.
By contrast, the average ratio for the nation's 66 biggest bank-holding companies was 11.63 percent. New York-based JPMorgan Chase & Co., the third-biggest U.S. bank holding company, had a ratio of 12.57 percent, up from 12.04 percent. The measurements are so important that JPMorgan obtained an exemption from the Fed last week so it could exclude from risk- weighted assets certain securities in the planned takeover of Bear Stearns.
`Big Concern'
Spokesmen for the 10 biggest bank holding companies, including Citigroup, Bank of America and Wells Fargo, declined to comment for this story, some citing rules restricting what they can say in the days leading up to financial reports. One factor affecting Bank of America's capital ratio was its October purchase of LaSalle Bank for $21 billion.
The FDIC's Bair said last week that ratings changes will probably lower bank capital ratios for some U.S. banks.
``It's a big concern,'' Blair said in an interview April 3. ``We are dealing with an unprecedented situation.''
How much commercial banks have already cut back on lending will be known in mid-April when most report earnings.
``All I know is the first-quarter reports are going to be pretty bad, and there's a lot more to come,'' said L. William Seidman, who was chairman of the FDIC from 1985 to 1991. ``Our experience was that if the economy got in trouble, it took at least a year for the banks to get into trouble.''
`When Tide Goes Out'
Fed Chairman Ben Bernanke described bank capital requirements in congressional testimony April 2 as ``the nub of the problem'' and said U.S. institutions had ``hunkered down'' and were lending less.
Falling below the required capital levels would also hinder banks' ability to take over other banks and raise deposit insurance rates, according to the FDIC and the Office of the Comptroller of the Currency.
``The important thing to remember about capital ratios is that they are minimums,'' said Ralph Sharpe, a lawyer at Venable LLP in Washington, who was director of the OCC's enforcement and compliance division from 1984 to 1994. ``In good times everybody looks good, but when the tide goes out, you see who is not wearing their bathing suit.''
Moody's Investors Service, Standard & Poor's and Fitch Ratings have lowered investment-grade ratings on more than 28,000 mortgage- and asset-backed securities since the first of the year. In March alone, more than $134 billion in such securities were downgraded enough to change risk weightings on bank balance sheets, according to data compiled by Bloomberg.
AAA Weighting
Banks are required to put different risk weightings on assets ranging from government notes to mortgage securities to corporate bonds and cash. A $100 million mortgage-backed security with an AAA or AA rating counts as $20 million for the bank's risk-adjusted asset total. Securities with top credit ratings are considered most likely to be repaid and count for less risk.
If the same security's rating fell to BBB+ on Fitch's or S&P's scale, the risk weighting would rise to 100 percent, or the full $100 million, because of an increased likelihood of default. When ratings companies differ on the grade given to a mortgage-or asset-backed security, regulators use the lowest one.
All corporate bonds have a risk weighting of 100 percent, no matter what their rating, because of their perceived risks, while cash and government securities carry no weight.
Maintain Ratio
At the end of last year, Citigroup, for instance, owned $552 billion of securities weighted at zero risk and $523 billion at 20 percent. It also held $320 billion with risk weightings of 50 percent and $881 billion at 100 percent, according to data filed with the Federal Reserve.
To maintain the ratio of 10 percent when a $100 million AAA security is dropped to BBB, a bank's needed capital would rise to $10 million from $2 million. An institution can raise the $8 million by selling stock or preferred shares. The bank can also compensate by selling the security, or cutting back on other lending.
Regulators focus on two more measures in gauging the health of financial institutions. Well-capitalized banks must have Tier One capital, which excludes subordinated debt and some preferred shares, of at least 6 percent of risk-weighted assets. Additionally, Tier One capital can't fall below 5 percent of total tangible assets, not adjusted for risk and excluding goodwill, or the extra value of acquired assets.
Investment banks, such as Goldman Sachs and Morgan Stanley, both based in New York, have different regulatory requirements and aren't subject to the same minimums.
`Potential Shortfall'
To bolster their capital ratios, banks have been raising money for months, including a $19 billion initial public offering of Visa credit cards, which was owned by a bank group.
Citigroup has so far been the biggest seeker of capital, generating $30.4 billion through the sale of shares, preferred stock and bonds convertible into equity. Chief Financial Officer Gary Crittenden said in January that the program ``addresses this potential shortfall under multiple scenarios.''
A risk-based capital ratio lower than 10 percent automatically pulls a bank into a lower regulatory category, called ``adequately capitalized.'' By itself, that wouldn't set off runs on teller windows, said Isaac, the former FDIC chairman. Individual depositors will rely on FDIC insurance to protect their savings while larger business clients will examine the overall health of the bank, Isaac said.
``It does affect bragging rights,'' Isaac said. ``A lot of banks want to be able to say `we're well-capitalized by regulatory standards.''
Fremont General, National City
Smaller banks, which own fewer mortgage-backed securities and do more direct real-estate lending, are already feeling the pain. Fremont General Corp., a former subprime mortgage lender, has until May 26 to generate new funds or find a buyer after it was deemed undercapitalized by regulators. Its total capital risk ratio was 9.21 percent.
National City is in talks to sell itself to KeyCorp, a rival bank that's also based in Cleveland.
The number of lenders on the FDIC's ``problem'' bank list rose to 76 on Dec. 31 from 50 a year earlier. In 1990, the total reached 1,500. Three FDIC-insured banks failed in 2007, the first since June 2004. The agency hired as many as 138 examiners for a division that manages shutdowns and liquidations of failed banks, agency spokesman Andrew Gray said.
To contact the reporters on this story: Mark Pittman in New York at mpittman@bloomberg.net; Alan Katz in Paris at akatz5@bloomberg.net; David Mildenberg in Charlotte, North Carolina, at 6587 or dmildenberg@bloomberg.net. Last Updated: April 8, 2008 00:01 EDT