Nov172008

A Free-Market Solution to Prevent Housing Bubbles

Our new President will need help to address the problems in the residential real estate financing system that resulted in The Great Housing Bubble. My full proposal is here: Preventing the Next Housing Bubble.pdf. The following is an exerpt from this proposal:

bernanke_forever_blowing_bubblesThe secondary mortgage market was created in the 1970s by the government sponsored entities, Freddie Mac, Fannie Mae, and Ginnie Mae. This market was expanded by the creation of asset-backed securities where mortgage loans are packed together into collateralized debt obligations (CDOs). This flow of capital into the mortgage market is a necessary and efficient tool for delivering money to borrowers for home mortgages. This market must remain viable for the continued health of residential real estate markets. The problem during the Great Housing Bubble was that the buyers of CDOs did not properly evaluate the risk of loss through default on the underlying mortgage notes that were pooled. The reason these risks were not evaluated properly is due to the appraisal methods used to value real estate serving as collateral backing up these loans.

There is one potential market-based solution that would require no government regulation or intervention that would prevent future bubbles from being created with borrowed capital: change the method of appraisal for residential real estate from valuations based exclusively on the comparative-sales approach to a valuation derived from the lesser of the income approach and the comparative-sales approach. Both approaches are already part of a standard appraisal, so little additional work is necessary – other than appraisers will have to focus on doing the income approach properly. In the current lending system, the income approach is widely ignored. This change of emphasis in valuation methods could come from the investors in CDOs themselves. When the fallout from the Great Housing Bubble is evaluated, it is clear that the comparative-sales approach simply enables irrational exuberance because the past foolish behavior of buyers becomes the basis for future valuations allowing other buyers to continue bidding up prices with lender and investor money. Prices collapsed in the Great Housing Bubble because prices became greatly detached from their fundamental valuation of income and rent. This occurred because the comparative-sales approach enables prices to rise based on the irrational exuberance of buyers. If lenders would have limited their lending based on the income approach, and if they would not have loaned money beyond what the rental cashflow from the property could have produced, any price bubble would have to have been built with buyer equity, and lender and investor funds would not have been put at risk. There is no way to prevent future bubbles, and the commensurate imperilment of our financial system, as long as the comparative-sales approach is the exclusive basis of appraisals for residential real estate.

Investor confidence in the market for CDOs and all mortgages was shaken during the decline of the Great Housing Bubble – and rightly so. Investors were losing huge sums, and nobody clearly understood why. There was a widespread belief these losses were caused by some outside factor rather than a systemic problem enabled by the lenders and investors themselves.   For investor confidence to return to this market, investors must first ascertain a more accurate evaluation of potential losses due to mortgage default. This requires an accurate appraisal of the fundamental value of the residential real estate serving as colla-teral for the mortgage loans that comprise the CDOs. Since the fundamental value of residential real estate, the value to which prices ultimately fall during a price decline, is determined by the potential for rental income from the property, revaluing properties using the income approach would provide a more accurate measure the value of the mortgage note and thereby the CDO.

The ratings agencies who rate the various tranches of CDOs must adopt the method of valuation utilizing the lesser value of the income approach and the comparative-sales approach. The ratings agency’s recommendations and ratings carry significant weight with investors, and the ratings agencies clearly made a tragic error in their ratings of CDOs during the Great Housing Bubble. If the ratings agencies properly evaluate the underlying collateral backing up the mortgages that are pooled together in a CDO, investors will regain confidence in the ratings, and money will return to the secondary market. If investors in CDOs recognize the chain of valuation as described, they would be unwilling to purchase CDOs valued by other methods. If investors are unwilling to purchase CDOs where the underlying collateral value is measured using the comparative-sales approach and instead demand a valuation based on the income approach, the syndicators of CDOs will be forced to respond to investor demands or they will not be able to sell their syndications. Investors and the ratings agencies can mandate a new valuation method for residential home mortgages.

In September of 2008, the Federal Government took “conservatorship” of the GSEs responsible for maintaining the secondary mortgage market. With the collapse of the asset-backed securities markets and CDOs, the GSE swaps were the only viable market for mortgage paper. This provides a unique opportunity for changing the market dynamics with limited government intervention. If the government in its role as conservator were to decide to mandate a change in appraisal methods, the secondary market would be forced to accept this change. Like any sweeping change in methodology, it could be phased in over time to properly train appraisers and work out the details of implementation. If the GSEs lead, the rest of the market will follow.

The main objection with the income approach is the difficulty of evaluating market rents, particularly in markets where there may not be many (or any) comparative properties for rent in the market. This is an old problem, one that has been studied in great detail by the Department of Labor Bureau of Labor Statistics.   Comparative rents have been collected by the DOL since the early 1980s as part of their calculation of the Consumer Price Index. The problem of irrational exuberance in the late 1970s in coastal markets, particularly California, caused the consumer price index to rise rapidly. Since the CPI is widely used as an index for cost-of-living adjustments, volatility in this measure caused by the resale housing market needed to be urgently addressed. After over a decade of study, the DOL decided to value the change in housing costs by a comparative rental approach rather than a change in sales price approach used previously. This smoothed the index and reduced volatility because the consumptive aspect of housing services were tethered to rents and incomes rather than being subject to the volatility caused by irrational exuberance in the housing market.

The Department of Labor Bureau of Labor Statistics measures the market rental rate in markets across the United States. It breaks down the market into subcategories based on the number of bedrooms, and it does a good job of estimating market rents in the various subcategories. These numbers are updated each year. The figures from the DOL would serve as a basis for evaluation of market rents, and it may be the only basis in areas where there are few rentals. In submarkets where there is sufficient rental activity, the income approach can use real comparables to make a more accurate evaluation. Appraisers will decry the lack of available data on rentals as many rentals, particularly for single-family detached homes are done by private landlords who do not report these transactions; however, if this method of appraisal were the standard, private companies would spring up to track these transactions and maintain an up-to-date database. Valuing properties based on the income approach may be more difficult than the comparative-sales approach, but when the latter method is fundamentally flawed, ease-of-use is not a compelling reason to continue to rely on it.

There is also the objection that the income approach method of valuing residential real estate has the same problems as the comparative-sales approach because both approaches rely on finding similar properties and making an estimation of market value by adjusting the values of comparative properties. In both approaches the appraiser must explain their reasons for the adjustments to justify the appraised value of the subject property, and this is a potential source of abuse of the system. No system is perfect, but the potential to inflate prices though manipulating appraisals based on the income approach is far less than the potential problems emanating from the comparative-sales approach because the basis of adjustment in the income approach is a properties fundamental value whereas the basis of adjustment in the comparative-sales approach is the prices paid by buyers subject to bouts with irrational exuberance. If lenders start accepting appraisals where the income approach contains adjustments to value that increase the appraised amount 100% – something that would have been required to justify pricing seen during the Great Housing bubble – then the system is hopelessly broken. The main argument for using the income approach is that its basis is the fundamental value whereas the basis for the comparative-sales approach is whatever price the market will currently bear. Prices are not likely to decline below a properties fundamental value where as a property may decline significantly from a point-in-time estimate of market value. Using the income approach lessens the risk to lenders and investors and ensures the smooth operation of the secondary mortgage market. Using the comparative-sales approach exclusively results in the turmoil witnessed during the price decline of the Great Housing Bubble.