Suggested Reform: Congress should amend the National Bank Act to mandate that all FDIC insured institutions must average at least two of three separate residential appraisal methods in determining a homes value, if a home will serve as security for a bank loan.

Importance: The appraisal process establishes the value of the security that will back a mortgage loan; here the value of the security is the appraised value of a home. If the security backing a loan is significantly over-valued, then the mortgage bank carries a much greater risk than is apparent on the face of a loan. Where a group of national banks convey tens of thousands of mortgage loans annually, the undisclosed risk will permeate the entire national banking system.

The Appraisal Methods
According to accepted real estate and banking practice, state-licensed home appraisers provide valuation reports to lending institutions; the mortgage lenders then use those reports to establish the value of the security. As it stands, in many U.S. states the comparative sales appraisal method is the only one used in valuing the security that backs a mortgage loan, even though three appraisal methods exist. Among the three appraisal methods, only that of comparative sales prices has the potential to completely detach home values from economic reality. Here is a short synopsis of three real estate appraisal methods, only the first of which is generally used for establishing the value of owner-occupied homes.

1) The Comparative Sales Method (CSM)
Values are determined on a relative basis; that is, the sales price of homes sold within the previous six months and located within one-half mile of the subject property are used to determine the current value of the home under consideration. If home size, age, amenities (number of bathrooms, type of fixtures, etc.), and similar considerations comport with one another, then the reasoning of this method provides that Subject Property X has a value approximately average of Homes A, B, and C. The reasoning is sound, so long as the value established for A, B, and C is accurate.

2) The Replacement Value Method (RVM)
This method is used to determine what amount of money would be necessary to completely replace a home that was destroyed by fire, tornado, etc. Insurance companies routinely evaluate the value of homes in determining the premiums to charge for hazard insurance policies. The higher the cost to completely rebuild a destroyed home, the higher the premiums that must be paid by homeowners. The RVM has the distinct advantage of using empirical data: lumber will cost X, a new concrete foundation will cost Y, and a new roof will cost Z. Unless there is an actual increase in the cost of materials and labor (reflecting economic reality), the purported value of a home cannot rise.

3) The Income Method (IM)
The income method is used for residential properties, but typically this method is only used for multi-family, investment (duplex, triplex, etc.) properties. This valuation method relies on the question of how much income a residential property will generate. This appraisal method is firmly grounded in economic reality; the value derived for a home is directly limited by the rents that can be received from families that occupy it. The amount of rent that can be paid each and every month is directly linked to family income; and unless aggregate family income rises, rents cannot rise for long. Without significantly rising rents, home values cannot rise very far under this approach.

The Problem with the Comparative Sales Method
Returning to the comparative sales approach, we must recognize that several implicit assumptions are built into the derived prices for homes A, B, and C.?? For example, under traditional lending standards, no prudent banker would typically allow a borrower (even with good credit) to commit more than approximately 30% of household income to a proposed monthly mortgage payment. That traditional truism automatically helped moderate the growth of home prices. Fewer buyers qualifying for a particular range of mortgage loans meant prices could not go into runaway mode, as there would be less overall demand at a given price. However, consider what could happen to prices if the implicit assumption of the prudent banker were dead wrong? What if prudence gave way to a five-year flight to Fairyland, a land where borrowers were granted loans without regard to their incomes??? Additionally, under traditional mortgage lending standards, homes could not be purchased (without special Government-backed programs), unless the buyer gave at least 5% (and typically 10 to 20%) of the purchase price as a down-payment. The most prudent lending standards call for borrowers to give at least 20%, so that the bank is comfortable that its loan amount can be recovered, even under a duress sale.?? However, what might happen to sales prices in a highly competitive market, a market flooded with buyers specifically because homes could be purchased without any down-payment??? The combination of ignoring borrower income levels and dispensing with downpayments directly fuels a massive, but artificial, demand for housing.?? Upwardly spiraling demand causes people to try and outbid one another; the overbidding process leads to grossly over-inflated home values.?? And those artifically inflated values (because the demand was artificially created) are then used for the comparative sales figures to value the next set of loans for the bank.?? With a systemic cause in place for over-inflated loan security (one greatly exacerbated by lax credit standards), the banks cannot help but get into trouble.

Conclusion:
In the final analysis, there is a systemic flaw in the current practice of using only the comparative sales method for valuing owner-occupied homes in the United States. Compelling FDIC-insured banks to use one or both of the two additional appraisal methods that are standard in the commercial and investment segments of the real estate industry would most likely circumvent another housing bubble from developing when the next generation forgets this one.