Banking on unreal estate - the appraisal scam

Washington Monthly, Feb, 1986 by Kenneth Weiss

Incredibly, of the four federal banking agencies in a position tostop the appraisal abuses, only the Federal Home Loan Bank Board has taken the minimal step of even requiring an appraisal for real estate loans. The Bank Board, which supervises federally insured S&Ls, does require lenders to have an appraisal for each real estate loan and reviews appraisals during routine examinations. The policy has had an uphill battle, though. A real estate developer who has been turned down for a loan by a conscientious S&L officer demanding an accurate appraisal can go across the street to a commercial bank that doesn't require an appraisal at all. To avoid losing out, S&Ls will often tolerate exaggerated appraisals.

A first step toward solving the appraisal problem therefore wouldbe for all the regulatory agencies at least to require independent appraisals by people who are not beholden to the parties to the transaction. Mandating this for all lenders-no matter who they're regulated by would dampen the incentive to continue these unethical and risky practices. In addition, as a regular part of their oversight, all federal examiners should audit real estate loans to check for appraisals. We don't need a vast army of special bank police to make it work. If checks were random so all parties knew they might be examined at any time, if penalties were stiff, and if those involved knew the examiner might actually drive out and see that expensive dream condo is near a noisy intersection, then the fear of detection would be instilled in the hearts of all the players. After all, the IRS, in its prouder days, didn't have to audit everyone to make us fear that we might be next.

Finally, we need to make sure that the regulators themselves don't have an incentive to hush up the real estate scandals. In the Maryland S&L crisis, a top official of the regulatory office had been presented with extensive evidence of wrongdoing but was paralyzed by fear that exposing and punishing the misconduct would cause a run on the banks and consequently a run on the state S&L insurance agency. To prevent regulators from treading lightly, we should require that results of federal examinations of real estate loans be made public within three months. This would guarantee that the regulators, however much they might be tempted to cover up, could not do so. Everyone involved in the transaction, from the appraiser to the regulator, would know that phony appraisals should not be used and real estate loans should not be based on them.

If lenders become convinced they are playing on an even field andthat cheaters are likely to be caught and punished, they might come to see that it's in their own economic interests to weed out bogus appraisals. Lending institutions would avoid millions of dollars in potential losses if they hired a few staff experts or outside consultants to review all appraisals used for loans. For banks with a history of questionable real estate loans, the regulatory agencies could require that the banks hire an appraisal reviewer as a condition for federal insurance "As a practical matter, any of the surviving S&Ls are going to have to have an in-house review. . . .It is a blueprint for disaster where you rely on an appraisal that comes in at the door," said Hewitt, who now reviews appraisals as a banking consultant in Ft. Lauderdale, Florida.