STRUCTURED FINANCE SECTOR IN-DEPTH 15 February 2018 Contacts Lima Ekram +1.212.553.0335 AVP-Analyst [email protected]Jody Shenn +1.212.553.1612 VP-Senior Analyst [email protected]Yehudah Forster +1.212.553.7995 Senior Vice President/ Manager [email protected]CLIENT SERVICES Americas 1-212-553-1653 Asia Pacific 852-3551-3077 Japan 81-3-5408-4100 EMEA 44-20-7772-5454 RMBS – US Use of appraisal alternatives is likely to grow, posing new risks Summary Alternatives to traditional appraisals are drawing increasing interest among US mortgage market participants, signaling that increasing use of these alternatives is likely over the coming months or years. Such a shift would weaken the credit quality of new residential- mortgage-backed securities (RMBS) unless the transactions mitigate certain risks. » Property valuation alternatives draw interest, signaling potential risk. To reduce operational costs, increase efficiencies and/or respond to the shrinking and aging ranks of US appraisers, mortgage market participants are increasingly exploring the use of alternatives to traditional appraisals for property valuations and, in some cases, starting to use them more. » Risks vary across appraisal alternatives. The types of appraisal alternatives used will vary across RMBS products, with each valuation method presenting different strengths and challenges. Appraisal alternatives include: hybrid appraisals, broker price opinions (BPOs) and automated valuation models (AVMs). THIS REPORT WAS REPUBLISHED ON FEBRUARY 16, 2018 WITH A HEADLINE CORRECTED FOR GRAMMATICAL ISSUES. This document has been prepared for the use of Lima Ekram and is protected by law. It may not be copied, transferred or disseminated unless authorized under a contract with Moody's or otherwise authorized in writing by Moody's.
Use of appraisal alternatives is likely togrow, posing new risksSummaryAlternatives to traditional appraisals are drawing increasing interest among US mortgagemarket participants, signaling that increasing use of these alternatives is likely over thecoming months or years. Such a shift would weaken the credit quality of new residential-mortgage-backed securities (RMBS) unless the transactions mitigate certain risks.
» Property valuation alternatives draw interest, signaling potential risk. To reduceoperational costs, increase efficiencies and/or respond to the shrinking and aging ranksof US appraisers, mortgage market participants are increasingly exploring the use ofalternatives to traditional appraisals for property valuations and, in some cases, starting touse them more.
» Risks vary across appraisal alternatives. The types of appraisal alternatives used willvary across RMBS products, with each valuation method presenting different strengthsand challenges. Appraisal alternatives include: hybrid appraisals, broker price opinions(BPOs) and automated valuation models (AVMs).
THIS REPORT WAS REPUBLISHED ON FEBRUARY 16, 2018 WITH A HEADLINE CORRECTED FOR GRAMMATICAL ISSUES.
This document has been prepared for the use of Lima Ekram and is protected by law. It may not be copied, transferred or disseminated unlessauthorized under a contract with Moody's or otherwise authorized in writing by Moody's.
Property valuation alternatives draw interest, signaling potential riskBased on our conversations with mortgage market participants, they are exploring greater use of alternatives to traditional appraisalsfor property valuations and, in some cases, starting to use them more for tasks that play a role in the credit quality of RMBSsecuritization collateral. These alternatives include: hybrid appraisals, BPOs and AVMs. The reasons include a desire to reduceoperational costs, increase efficiencies and/or respond to the shrinking and aging ranks of US appraisers.
Although BPOs and AVMs have long been widely used in the mortgage market, the scope of their use has grown in recent years;meanwhile, market participants are more in the exploratory phase when it comes to hybrid appraisals. The current level of interestin expanding the use of such alternatives suggests that even greater utilization of some or all of those approaches is likely overthe coming years. Such a development would lead to increased risks in RMBS transactions unless mitigating factors are present.Among other things, the mitigants may stem from (1) use of products with stronger profiles, (2) the nature of their use, such as inquality control or as a primary valuation, (3) borrower or loan attributes that result in stronger and/or more predictable mortgageperformance, or (4) additional RMBS credit enhancement. On the other hand, in some situations greater use of the alternatives couldpotentially improve RMBS credit quality; for example, decisions to deploy cheaper valuation options could help preempt a shift towardsmaller sampling during quality control or due diligence.
Risks vary across appraisal alternativesAcross the different products, the items used to derive a valuation will vary, sometimes significantly, underscoring the potential fordiffering approaches to valuations to come to different conclusions, some of which may be less reliable. Exhibit 1 shows some ofthe differences between major valuation techniques. Field and desk reviews are used only to validate the soundness of traditionalappraisals, rather than as a primary source of valuation in originations or RMBS transactions, and we don't expect a shift in their use.
Exhibit 1
Valuation techniques vary, sometimes significantly
Traditional appraisal Hybrid appraisal Field review Desk review BPO AVM
Party providing valuation
Licensed appraiser,
typically with
experience in local
market
Report prepared by
licensed appraiser,
site visit completed by
third party
Licensed
appraiser
Licensed
appraiser
Real estate
broker/agent
No human
involvement
Valuation supported by written evidence Yes Yes Yes Yes Sometimes Sometimes
Use of standard forms and appraiser
attestations*Yes Sometimes Yes Sometimes No No
Visual inspection of the interior and
exterior areas of the subject property Typically both Interior and/or exterior Exterior-only No
Typically exterior-
only, but sometimes
both
No
Neighborhood inspection Yes Yes Yes No Yes No
Exterior review of properties used as
comps Yes Sometimes Yes No Sometimes No
Typical turnaround time 3 -30 days 3-7 days 2-3 days 3-5 days 3-5 days <1 day
*E.g. Fannie Mae/Freddie Mac Form 1004/2055Source: Moody's Investors Service
Some of these categories are less likely to gain traction in specific RMBS-related tasks or market segments, owing to regulatoryrestrictions or other issues. For instance, government-sponsored enterprises Fannie Mae and Freddie Mac have already begun to expand
This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page onwww.moodys.com for the most updated credit rating action information and rating history.
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when they will waive appraisal requirements based on the results of their own valuation technology. But banks generally must useappraisals for mortgages of more than $250,000, limiting their potential ability to use non-appraisal valuations in originations. For thisreason, hybrid appraisals, which are considered appraisal valuations, could be the most likely alternative product to gain traction in thenear future.
Below we offer additional details on a few of these products, and some of our views on their risks and benefits relative to traditionalappraisals and each other.
Hybrid appraisals
Exhibit 2
Licensed appraiser gets assistance from third party
Current Usage Typical cost Parties involved Typical Time Strengths Challenges
Not widely
used~$125-450
Licensed appraiser; real
estate professional3-6 days
Licensed appraisers have
skin-in-the game; typically
calculated and supported
using accepted standards
Appraiser may be less
familiar with local market
nuances; quality of
information from site visits
may be subpar
Source: Moody's Investors Service
Like traditional appraisals, hybrid appraisals are produced by licensed appraisers who provide a valuation based on information aboutthe subject properties and comparable sales. The appraiser follows the same approach to determining and supporting a valuation asthey would when conducting traditional appraisals and must comply with the Uniform Standards of Professional Appraisal Practice(USPAP, see Appendix A). However, unlike with a traditional appraisal, a hybrid appraisal relies on information from an on-siteexamination of a property conducted by a third party – often a real estate agent or broker. Rather than visiting the subject propertythemselves, the appraisers make use of information from the third party that's similar to what they would have gotten, such as photosshowing a specific set of property features. Because the appraiser does not need to travel to the property and can focus on analysisinstead, these valuations can offer reduced costs and/or increased efficiencies.
While variations of hybrid appraisals have long existed, we have noticed the product gaining more interest recently, though only limiteduse so far, as mentioned in Exhibit 2. To date, we have rated only one re-performing loan (RPL) RMBS transaction involving them; in thedeal, a small number of the valuations were used in the diligence process in lieu of BPOs.
StrengthsLicensed appraisers have 'skin-in-the game': Like with a traditional appraisal, with a hybrid appraisal, the appraiser is strongly motivatedto ensure that the valuation is correct. That's because errors could result in the appraiser losing future business or even potentially theirlicense, under certain circumstances.
Valuation typically calculated and supported using accepted standards: Although variations of the product are possible, hybrid appraisalsoften differ little from traditional appraisals aside from the use of third parties for property visits. That allows for greater comparabilityand consistency, and takes advantage of time-tested standards and requirements, such as the need for appraisers to be familiar with aparticular geography.
ChallengesAppraiser may be less familiar with local market nuances: An appraiser relying on public data and photographs taken by a third partylikely will be less able to capture nuances such as neighborhood or construction differences in choosing comparable sales. Qualitycontrol personnel, working off similar information, would be unlikely to catch such missteps.
Quality of information from site visits may be subpar: Without a licensed appraiser handling the property visits, the information gatheredduring it could be of lower quality owing to the individual conducting it lacking the appropriate expertise or incentives. The individual
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gathering the information could have less incentive because their work will only be an input into the appraiser's work, rather than astand-alone service that could affect their reputation.
Broker's price opinions
Exhibit 3
BPOs are already used widely
Current usage Typical cost Involved parties Typical timeline Strengths Challenges
Often used for main valuation and/or
in due diligence for secondary market
loan sales and RPL/SFR
securitizations; default servicing; REO
~$70-150Real estate
agent/broker3-5 days
Property visits provide
additional information;
market knowledge of
real estate professionals
Real estate brokers lack appraisers'
expertise and incentives; BPOs are
not formally valuations; BPOs do not
use the same documents or conform
to the same rules.
Source: Moody's Investors Service
A BPO represents a valuation in which a real estate broker or agent provides an estimated price or prices for a property if it were tobe sold in one or more scenarios (e.g. “as-is” vs. repaired or normal vs. faster timelines.) Often because of state law, these estimatescannot be not be a formal “opinion of value,” which defines an appraisal and thus requires a licensed appraiser to perform.1 However,they are often accepted as valuations. BPOs are provided together with short reports that include information on the subject property,comparable properties, recent sales and local/regional market information. They may also include information such as the type of workneeded to and estimated cost of bringing the property to “average” condition and how long repairs would take. BPOs typically rely ononly exterior property examinations, though some include reviews of home interiors.
The use of BPOs expanded greatly in the wake of the 2008 financial crisis, reflecting their traditional role mainly as a resource forservicing or liquidating defaulted mortgages. BPOs are also used for due diligence purposes during sales and securitizations of homeloans; for instance, we regularly see them used by third-party reviewers as an additional check on the valuations of certain propertiesserving as collateral for RMBS backed by newly issued loans. In addition, BPOs are commonly the main source of valuations forproperties securing loans in securitizations of re-performing/non-performing mortgages and single-family rental home collateral.
StrengthsProperty visits provide additional information: Unlike AVMs (see below), a BPO will usually include at least an exterior review of thesubject property. This can be used to assess a property's condition and that it continues to exist, and offers potential insight intoneighborhood quality. However, BPOs without interior reviews will take into account less information on property conditions andfeatures than traditional appraisals or hybrid appraisals with them.
Market knowledge of real estate professionals: Relative to appraisers, real estate agents and brokers may have additional sources ofknowledge about local market conditions and demand trends, such as via their experiences in attempting to sell similar homes.
ChallengesReal estate brokers lack appraisers' expertise and incentives: Unlike an appraiser, a broker does not specialize in valuing real estate.Furthermore, appraisers have more to lose than brokers if they conduct poor valuations; doing BPOs is generally a side business forbrokers, but appraisers can lose their licenses and livelihoods if their valuations are flawed. Additionally, individuals in real estate salesmay be biased toward higher valuations by the nature of their work.
BPOs do not use the same documents or conform to the same rules: Traditional appraisals are guided by forms and requirements thatrepresent best practices developed over time. For instance, comparable sales must meet specific criteria such as time of sale, distanceof the property from the subject property and guidelines of how to adjust values to take into account differences between thecomparable sales and subject property. Since these standards do not apply to BPOs, a BPO can be based on less reliable information oranalysis.
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Automated valuation models
Exhibit 4
No human involvement reduces adverse incentives
Current usage Typical cost Involved parties Typical timeline Strengths Challenges
Limited GSE use as valuation on new
originations; used as main valuation and/or
in due diligence in secondary market loan
sales; used in due diligence in some
securitizations and occasionally for main
valuation in RPL RMBS; quality control;
default servicing; REO
<$1-$25No human
involvement<1 day
Models lack the adverse
incentives of individuals;
sophisticated use of
technology and large
datasets may improve
accuracy
Valuations will depend on the
quality of the data and model used;
lack of property visits creates risk of
missed information; humans may
recognize changes in market trends
earlier
Source: Moody's Investors Service
AVMs provide valuations using models that assess public records and other data to provide an estimated market value for a property.AVMs often also offer estimates for the likely highest and lowest values, comparable sales and a confidence score. AVM “cascades”– in which two or more AVMs are run in succession – are often used to ensure that an AVM is offering the most reliable result for aparticular property or to find an AVM able to produce any valuation for the property. Certain AVMs will be unable to offer valuations oncertain properties and, if they can, may offer results with lower confidence.
AVMs started gaining wide interest in the 1990s when institutional investors started using them to evaluate collateral; by themid-2000s, they were often used in place of appraisals for originations of home equity loans and credit lines, among other things.Today, AVMs have a variety of uses including quality control, portfolio valuation and loss mitigation. Fannie Mae and Freddie Mac willoccasionally use AVMs/AVM-like tools to waive appraisal requirements for certain loans. AVMs are also used as both a due diligencetool and, occasionally, as a primary valuation source for securitizations backed by re-performing loans.
StrengthsModels lack the adverse incentives of individuals: AVMs are objective measurements because computer models lack self-interest; incontrast, both appraisers and real estate professionals may be tempted to provide valuations in line with the interests of the companieshiring them, in order to win future work.
Sophisticated use of technology and large datasets may improve accuracy: The ability of computers to analyze large sets of data hasbecome more sophisticated in recent years and new and more granular data has become available for use in AVMs. That could result inmore accurate valuations relative to human judgments.
ChallengesValuations will depend on the quality of the data and model used: Various AVM providers draw data from different sources and use theirown proprietary formulas. Certain datasets may be less accurate; for instance, by failing to reflect property renovations. Meanwhile,the models may be less accurate in markets with less homogenous properties, such as rural areas, or on “outlier” properties that haveunusual features.
Lack of property visits creates risk of missed information: AVMs typically assume all properties are in average condition and still exist.Thus, values cannot be adjusted up for upgrades or extensions or down for disrepair.
Humans may recognize changes in market trends earlier: Appraisers or real estate professionals familiar with local markets may bebetter positioned to identify the point at which a specific market is shifting from appreciation to depreciation, or vice versa. Unlike thecomputer models, those individuals will have access to information that is not captured by databases, such as verbal commentary frompotential home buyers or other anecdotal information. They may also develop an intuition for identifying when unusual factors, such asweakening school district reputations or unexpected developments with large local employers, will pose a headwind or are a source ofsupport for property prices.
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Other products
Field reviewA field review is typically requested to establish a “second opinion” on the accuracy and credibility of the original appraisal. A copyof the original appraisal is provided to a second appraiser who then reviews the appraisal to ensure accuracy, and will then physicallyinspect the property to verify the property condition and the comments in the original appraisal report. The field review report isUSPAP compliant as it is completed by a licensed appraiser.
Field reviews may be ordered as a second check on the original appraisal during the mortgage underwriting process owing to a largeloan amount or underwriter concern on the quality of the appraisal.
Desk reviewLike the field review, the desk review is also a second opinion product where a copy of the original appraisal is provided to a secondappraiser who checks to make sure that the appraisal is reasonable and adequately supported. The desk review appraiser also isrequired to provide an opinion of value of the subject property, identify any material deficiencies that might reduce the reliability ofthe appraisal and finally assess the riskiness of the appraisal. Unlike a field review, there is no visual inspection of the property. The deskreview is USPAP compliant as it completed by a licensed appraiser.
The desktop review is typically used as another check for loan funding due diligence, loan sale and securitization due diligence purposes.At its best, the desk review includes detailed commentary on the original appraisal including market conditions, subject property,transfer history of the subject and comparables, valuation, supporting valuation analysis and deficiencies.
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Appendix A: Uniform Standards of Professional Appraisal PracticeThe purpose of USPAP is to promote and maintain a high level of public trust in appraisal practice by establishing requirements forappraisers. USPAP, which are promulgated by the Appraisal Standards Board, embody the generally accepted ethical and performancestandards for appraisers in the United States. Compliance with USPAP is generally required when a person agrees to perform avaluation service as an appraiser, or when law, regulation, or agreement otherwise requires it.2 Current regulations require financialinstitutions regulated by the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation andthe Office of the Comptroller of the Currency to obtain an appraisal that complies with USPAP for any real estate-related financialtransaction, unless an exception applies. Exceptions include transactions where the loan amount is $250,000 or less and certainrenewals, refinances, or other transactions involving existing extensions of credit. In such cases, an appraisal is not required but an“evaluation,” which need not comply with USPAP, is required.3
Among other things, USPAP include standards for appraiser ethics and competence. USPAP’s Ethic’s Rule sets forth the requirementsfor integrity, impartiality, objectivity, independent judgment, and ethical conduct. Among other things, this includes restrictions onperforming an assignment with bias and on advocating the cause or interest of any party or issue. Regarding competency, USPAPrequires that the appraiser have the knowledge and experience to complete the assignment competently and that he or she be awareof, understand, and correctly employ those recognized methods and techniques that are necessary to produce a credible appraisal.
Appraisers who violate USPAP can receive disciplinary actions, such as fines and suspension and/or revocation of their license.4
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Endnotes1 See California rules.
2 USPAP 2016-2017
3 Interagency Advisory on Use of Evaluations in Real Estate-Related Financial Transactions
4 See, for example, Appraisal Foundation Voluntary Disciplinary Action Matrix
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