The Moral Hazard of GSE Release and Appraisals

The proposed offering of shares in Fannie Mae and Freddie Mac has significant implications not just for housing finance generally, but for the appraisal profession specifically. How it manifests over the coming weeks and months, though, may be different than you would expect.

Let’s start with the most basic component of this, which is making shares in the GSEs available to investors in ways not seen since the conservatorship of Fannie and Freddie began. Under conservatorship, the federal government – and not shareholders – effects control over (and benefits financially from) the performance of the GSEs, through the policies set by the Federal Housing Finance Agency (FHFA).

Normally, companies that publicly offer shares have one central ethos: Returning value to shareholders in the form of profits through dividends. Profitability can be accomplished through two main avenues – increased revenue or decreased expenses. It’s why you can see a company have a great revenue quarter and still reduce headcount because the combination of both leads to better profits, ergo better shareholder returns.

However, public companies operate at their own peril, meaning investors also accept the risk of a company losing money, requiring bankruptcy, or failing entirely. This risk acts as the guardrails against imprudent behavior, preventing companies from engaging in moral hazards.

This is where the GSEs fundamentally differ, and why they possess every incentive imaginable to take on significant moral hazard as it relates to collateral risk policies.

One of the underlying assumptions is that the federal government, either explicitly or implicitly, would act as a guarantor of the GSEs should they suffer another significant exposure as they did in 2008. Essentially, the taxpayer remains as the backstop for private capital – an arrangement otherwise unseen in markets, and a major advantage for those looking to invest in the GSEs.

The reason current and prospective investors feel a guarantee will persist comes from the perceived impact on interest rates if no such guarantee exists. Without the backstop the GSEs, and the whole of the mortgage market, would have to price more risk into home loans than currently exists today and further exacerbate the affordability problem affecting borrowers.

(Worth noting here is that, while interest rates today are not far from historical averages, many potential borrowers enjoyed a run of historically low interest rates over the past several years. In a refinance context, it means rates would have to come down significantly for current borrowers to be “in the money” on a refinance and acts to lock in homeowners who might otherwise transact from leaving their current home.)

Not wanting to compound the pain of current rates, the continuance of an implicit guarantee is all but certain to be a component of the forthcoming public offering. So how might that affect GSE behavior as it seeks to drive profits and return value to shareholders?

Let’s start with the basic question of how the GSEs make money. They buy mortgage loans from originators, either depository or non-bank, and package them into pools of securities. They are the florist of housing finance, buying lots of different blooms and bundling them together to create an attractive bouquet for sale. Investors buy the mortgage-backed securities (MBS), and profit when the packages loans generally perform over time (read: people pay their mortgages).

Normally, competition in business would dictate that the GSEs need to either diversify their offerings or be aggressive in product pricing to create advantages. However, the market for MBS is essentially two players, Fannie and Freddie, who operate like fraternal twins: You can tell them apart easily, but they share a lot of common characteristics. This isn’t true competition, but two liquidity facilities operating in parallel without the common pressures that affect other businesses.

So where do the GSEs compete for market share? Time, specifically in the concept of velocity. With comparable requirements and pricing, velocity becomes the one true differentiator for the GSEs to try and influence selling decisions by mortgage originators. And nothing in the mortgage process can affect velocity more than the question of collateral value.

For decades the time involved in ordering, developing, and reporting of appraisal assignment results has been an impediment to the constant drumbeat to speed up the mortgage lending process. The appraisal process was never intended to be expedient, but instead to act as an impartial means of determining whether the home to be financed held enough value that, should the worst case happen, lenders could recover much of the loan loss incurred through a foreclosure.

The simple answer to this friction is simply to avoid the appraisal altogether. Through outright waivers of appraisal requirements, or by leveraging a property data report to support a waiver decision, both GSEs offer expedited answers to the question of collateral and afford originators certainty around the ability to sell their loans into the secondary market.

In fairness to the GSEs, there are circumstances where the total lending picture supports a waiver decision: A great credit risk borrower, a low LTV loan amount, and good data surrounding the subject property and its most likely comparables can make a compelling case for deciding not to require an appraisal. This avenue was intended to be an exception to the rule of requiring appraisals but instead is becoming the new normal at whatever speed markets and regulators can tolerate.

The introduction of property data reports into the waiver decision tree injects a layer of false confidence around how much is really known about the home collateralizing a loan. Sure, having a set of eyes following curated prompts to collect objective data points is better than nothing, but nothing offers an incredibly low bar to clear. The materiality of these reports, and their ability to truly inform lenders and the GSEs regarding the value of a home, is untested at best. (Maybe A/B test, learn, and disclose? Free idea.)

No matter how much is learned through the property data report, the outcome remains the same once the waiver is accepted: A home is mortgaged without a truly objective perspective providing insight as to the property’s worth.

And there is no incentive not to use this pathway as much as possible.

After all, should this process implode the risk of loss sits not with the GSEs or their investors, or even with those holding MBS notes, but with the taxpayer through the implicit guarantee afforded by the federal government.

Congress, in passing the Federal Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (and redoubling its efforts with the Dodd-Frank Act of 2010) has clearly espoused a strong preference for appraisals to underpin mortgage lending in the United States. Thanks to its own regulatory agencies, however, this clear intent has been effectively mooted since 1994 through carveouts and increases to the federal appraisal de minimus threshold.

The very government that wanted appraisals to be the norm, then allowed regulators to say “never mind”, is the same government now about to release the GSEs out of conservatorship while still backstopping their activities.

There is nothing stopping the GSEs from continuing their rapid expansion of appraisal alternatives to support loans sold to them, and no market pressure to stop this expansion since it happens in a nearly risk-free environment from their perspective. The very definition of moral hazard.

One last point on waivers: They have the effect, intended or otherwise, of juicing housing markets where they are in regular use. Phil Crawford, national appraisal podcaster, spent an episode breaking down how an accepted waiver in a transaction can lead to subsequent increases in the price per square foot of housing in a community, regardless of whether or not such an increase was previously supportable. One higher marker lifts subsequent sales, and leads to the double whammy of increased housing prices and higher property taxes.

It will take a marked downturn in the housing market to truly understand the damage done through the use of waivers and other alternatives, and it will come on the back of the taxpayers yet again. While history may not repeat, it is beginning to rhyme an awful lot these days.