One noteworthy feature of the financial crisis a decade ago was the search for scapegoats.
At various times and places, the financial system’s near-collapse was the fault of greedy Wall Street financiers, careless or criminal bankers, deluded developers and, not least of all, appraisers who “lied” about the value of properties they assessed. Only rarely did anyone place blame on people who borrowed more money than they could realistically afford to repay in order to buy houses that were too big, too remote or just too costly for their circumstances.
Lessons learned from such circumstances are fleeting. Once again, mortgages are available with single-digit percentage down payments. And once again, where stresses are beginning to show in the mortgage markets, appraisers are catching blame for supposedly being eager to justify too-high valuations – even though this has been the opposite of my personal experience in numerous transactions with appraisers during the past decade.
Case in point: The Federal Housing Administration now blames appraisers for the increasing losses on insurance it issued for reverse mortgages.
In November, the FHA said it expected a $14.4 billion shortfall in its mortgage insurance fund in coming years, principally due to losses it sustained on reverse mortgage insurance. FHA Commissioner Brian Montgomery identified inflated appraisals as the culprit. He added that he feared inflated appraisals may also lurk in the agency’s traditional mortgage insurance portfolio, despite the fact that the FHA’s most recent report says that all of the mortgage insurance fund’s expected future losses are due to reverse mortgages.
As of Oct. 1, the FHA requires lenders to submit two appraisals on certain reverse mortgage loans, and to use the lower of the two valuations. In late November, Montgomery said the FHA system flagged about 22 percent of reverse mortgages for a second look. This new rule is the FHA’s answer to alleged appraisal inflation.
Yet it is worth noting that any losses the FHA is recording today are actually the result of transactions made years earlier, and in some cases many years earlier. In a reverse mortgage, homeowners borrow against the value of their house, and the lender is repaid when the house is sold. This means that many reverse mortgages only come due when the borrower dies. It is then, often long after the loan originated, that it becomes clear whether there is enough equity in the home to pay off the principal and accrued interest on the “home equity conversion mortgage,” or HECM, as the FHA routinely calls reverse mortgages.
When the equity is not sufficient to pay the lender what it is due, the insurer – that is, the FHA – must make up the difference. So it is easy to see why FHA officials are tempted to blame inflated appraisals when the agency must pay out more than it expects.
But reverse mortgages are complicated instruments, which carry a variety of risks beyond the question of what a house is worth when the mortgage is issued. One unknown is the length of time the mortgage will be outstanding. The longer the borrower stays in place, the greater the amount owed. This first risk factor interacts with the second, which is investment and market risk. How fast will the particular home’s value appreciate compared to the interest rate on the loan? At 6 percent annual interest, compounded, the amount due on a loan will double in 12 years. That means a loan issued at a 50 percent loan-to-value ratio will have no cushion beyond the home’s appreciation in 12 years’ time. Sometimes, in some markets, homes don’t appreciate at all in a dozen years. And if this loan extends beyond 12 years, the lender will likely face a loss on the reverse mortgage, regardless of the initial appraisal’s accuracy.
Of course, the FHA has collected insurance premiums in return for taking on the risks of insuring mortgages, including reverse mortgages. Those premiums are invested in Treasury securities at market interest rates, which have been historically low since the financial crisis, although they are rising now. But the FHA is part of the Department of Housing and Urban Development, a federal agency. So its investment “returns” are really just an accounting entry. By lending its premiums to the Treasury, the government is basically lending money to itself and then crediting the FHA with interest it never received from any third party.
The way to avoid losses, then, is to price FHA insurance at rates high enough to cover all the risks that the government actually assumes when it backs mortgages, of any type. The FHA currently charges a 2 percent initial premium on a reverse mortgage, up to the maximum coverage of $679,500, and then 0.5 percent per year. But the FHA collects only the 2 percent initial fee at inception, and that fee is actually deducted from the amount issued to the borrower at closing. The rest is simply added to the amount due when the home is sold, typically at the borrower’s death. So the FHA is essentially in the business of lending the premiums it is paid for insuring reverse mortgages, and then guaranteeing its own payments.
If this doesn’t make much sense to you as a business model, well, you are not alone. It doesn’t make much sense to me, either. It also doesn’t make a lot of sense as public policy. The FHA was established primarily to encourage homeownership; it will not accomplish this goal by insuring money lent to people who already own homes and are merely borrowing against them.
As a matter of public policy, it would be more logical to expect people to get private insurance for reverse mortgages (if they get insurance at all). Private insurance would then be priced according to market factors, and entities hoping to profit from making or insuring these loans could bear the risks involved. Or, more simply, we should just expect people who need to cash out of their homes to sell them. They would pay whatever tax is due and then buy something cheaper, or rent if necessary, for the remainder of their lives. An actual sale takes all the guesswork out of the question of what a home is worth when the homeowner wants to pull cash from it.
Blaming appraisers for losses on reverse mortgages is just another exercise in scapegoating. The appraisal industry’s collective role in any losses connected to these transactions is minimal compared to all the other risks involved. The FHA’s proclivity to blame the appraisers is an exercise in self-deception, or misdirection, or both.