Banking on unreal estate - the appraisal scam.

When Richard Hewitt was poring over financial records of the ailing Community Savings & Loan in Bethesda, Maryland, his eyes fell upon a troubling list of approved real estate appraisers. As a federal banking investigator, Hewitt knew some of the listed appraisers had "very fine reputations:' But strangely, each of the reputable names was crossed out. Scribbled in the margin next to them were the words, "Do not use."

One of the blacklisted appraisers later told Hewitt that Community's subsidiary, Equity Programs Investment Corporation (EPIC), had asked him to use an unethical method to establish the value of a 200-unit condominium complex. EPIC wanted him to ignore the fact that the condos were both vacant and located in an area notorious for its vast number of unoccupied condominium projects-two characteristics that can greatly diminish property value. When the appraiser declined to set market value "out of context," EPIC officials struck him from the list and turned to someone else.

Hewitt stumbled on the list while investigating a wide-reaching scandal involving shaky EPIC property loans and the downfall of Community Savings. This peculiar list shows more than just

' another element of the EPIC collapse, which has forced 20,000 homes into foreclosure, rattled the mortgage industry, and threatens investors with hundreds of millions of dollars in losses. It provides a rare glimpse inside perhaps the biggest con in the real estate industry: grossly exaggerated appraisals. Although previously tolerated as an improper but innocuous part of the real estate game, it is now becoming clear that bogus appraisals were a major cause of the collapse of EPIC, as well as hundreds of savings and loans and banks such as Continental Illinois, the largest failure of all. In the past three years, 322 savings and loans have failed or had serious financial troubles because of faulty or fraudulent appraisals, according to the Federal Home Loan Bank Board. And, incredibly, even though massive over-appraisals have contributed to case after case of bank and S&L failures, most federal regulators are turning their heads, insisting it is only a minor part of the banking crisis. Setting up the con

An unbiased, accurate appraisal is the cornerstone of a good realestate loan. Lending institutions rely on professional appraisers to determine the market value of property and hence the true value of the collateral being offered for the loan. If the appraiser is on target, bankers know the value of the property will be enough to cover the loan in the event the borrower stops paying.

But the nation's 150,000 to 250,000 appraisers aren't always on target. Not surprisingly, most of the inaccuracies fall on the side of inflating the value of property rather than diminishing it. Some of it is simply sloppy work. But more often than not, over-appraisals are deliberate schemes that benefit the real estate investor, the developer, the appraiser, and sometimes the lender but end up hurting the rest of us when the plan unravels.

Here's how it works. Let's say a Houston developer has built 100condominiums in a particular neighborhood. He sells 90 of them for $100,000 apiece before the local real estate market takes a steep downturn. Prices plummet and for six months the panicked developer is unable to sell the last ten units, which are uncomfortably close to a noisy intersection. As an inducement to potential investors, the developer agrees to chop $10,000 off the cost of each of the remaining condos through some financial gymnastics that effectively lower the interest rate on the loan. He does this by paying $10,000 to a lender, who in turn lowers the interest rate for a real estate loan. With those incentives in place, a real estate speculator pledges to buy the last ten units.

The speculator and the developer then work together to turn the decline in real estate value to their advantage. They call in an appraiser, an independent consultant who is supposed to examine the property, its surrounding area, and its financial history to determine the property's market value. Most likely the appraiser has worked with them before and knows what's expected. The appraiser sets the value of each condo at $100,000, ignoring the market decline and the fact that the units are being sold, in effect, for $90,000.

With that appraisal in hand, the condo buyer goes to the local savings and loan. For collateral he offers property valued at $100,000, even though its actual worth is $90,000. Eager to lend money and perhaps even complicitous in the planning of this deal, the S&L officer accepts the $100,000 figure. Because the $10,000 reduction to the buyer comes in the form of an interest discount, not an out-and-out price cut, the lender can pretend that the value is $100,000 and use the inflated appraisal to validate the fiction. The S&L officer also knows that if he plays too strictly by the rules, the speculator will take his business elsewhere. Since this real estate speculator is considered a good risk, he is able to get a loan covering 95 percent of the listed purchase price for each condo. So he now has $950,000 in loans even though he is paying only $900,000 for the condos. He uses that extra $50,000 to invest in other high-yield enterprises and pockets the profits.

In an ideal world, it is a con without a victim. In this case, the developer was able to unload unwanted property and walk away from the whole housing development with a profit. The speculator was able to secure loans larger than needed and purchase ten condominiums without spending a dollar of his own money. The appraiser took home a fee and a promise for future business. He was not likely to have been one of the appraisers with "Do Not Use" scribbled next to his name. The local savings and loan, probably plagued by an anemic cash flow, was able to draw in new loans and new loan fees. If the property appreciates quickly and the investor continues to make his monthly mortgage payments, no one should ever know the difference.

But today's property market is far from ideal. Real estate players can no longer rely on double-digit inflation to boost property values automatically. (In the 1970s, inflation fueled such rapid real estate appreciation that in a short time real property values often caught up with bloated appraisals.) Worst of all, more and more investors and homeowners are defaulting on their loans, leaving banks and S&Ls with large, outstanding loans and forcing them to cash in the collateral. At that point, faulty appraisals become noticeable.

If, for example, that Houston condominium owner, for whatever reason, defaults on his loan, the S&L seizes the property and sells it to pay off the loan. But when the S&L tries to sell the ten condos, it discovers they are worth only $900,000 or even less. The S&L then swallows a $50,000 loss and probably more because banks often have to sell low to get rid of property quickly. Ultimately, if the S&L goes under or requires a government bailout, the taxpayer wind up picking up the bill. This example is on a tiny scale compared to the over-appraisals involved in companies like EPIC or Continental Illinois, in which hundreds of millions of dollars in losses are projected.

In addition to the 322 savings and loans that have failed or floundered since 1983 because of faulty appraisals, federal regulators are discovering that many ostensibly healthy lending institutions hold loans based on bloated property values. In 1984 alone, the Federal Home Loan Banks Board found "serious appraisal problems" in 359 S&Ls with property values boosted $1.8 billion over their actual worth. Also, some of the large commercial banks on the federal government's financial worry list have badly mis-appraised real estate holdings. A six-month study by the House Government Operations subcommittee on commerce, consumer and monetary affairs concluded that "real estate appraisal abuses seem to be a serious problem of national proportions ." EPIC proportions

The most infamous example is EPIC itself. EPIC's 20,000 homes are now worth about 25 percent less than their appraised value, according to federal banking regulators. And the list of friendly and unfriendly appraisers stumbled on by federal investigators would seem to indicate the exaggerated estimates did not materialize accidentally, although EPIC officials could not be reached for comment. With its dramatic collapse last fall, EPIC stopped making payments on $1.3 billion in mortgages, forcing the homes into foreclosure.

A key to EPIC's initial success, according to real estate experts, was its ability to buy homes at below-market prices while borrowing money based on full-market appraisals. Generally, EPIC purchased houses that big builders had trouble selling, such as the dregs of large housing projects. Many of EPIC's homes were also in areas with weak housing markets, including Houston, Dallas, Washington state, and Colorado. In return for picking up the unwanted housing, builders gave EPIC discounts of up to 25 percent off the purchase price. Since the loans were based on full market price, EPIC was awash in extra loan money, enabling the company's officials to make money off each home purchase. Yet the EPIC investment deals were structured so they didn't generate enough rent or other income to keep up with the mortgage payments. EPIC officials had to make up the shortfall by constantly bringing in new investors or borrowing money from Community Savings. They knew that if the stream stopped, EPIC would collapse.

That's exactly what happened last August when federal regulators told Community Savings that if it wanted federal insurance, it would have to dump EPIC. This left EPIC officials with no choice but to stop borrowing money from the S&L and quit bringing in new partners. Now the losses are being counted. Community Savings could lose as much as $100 million it sank into EPIC property deals. But ultimately the taxpayers will end up paying a big chunk of the costs. The collapse of Community and several other Maryland S&Ls has bankrupted the states private insurance system. Faced with pressure from angry depositors, Maryland guaranteed the S&Ls deposits. The legislature is now considering a plan to spend $70 million this year and could eventually pay more than $100 million on top of that. Federal officials estimate that at least 5,800 private investors, many of whom bought the homes as tax shelters, will have to absorb $300 million in losses. Maryland officials, who have taken over Community and EPIC and tossed out the former owners, hope the figure is exaggerated. But the ultimate loss will be determined when creditors try to sell the homes for whatever they can get. Congressional investigators looking into fraudulent appraisals say they have collected "numerous examples" of EPIC properties that were appraised 50 percent to 100 percent over their real value.

EPIC's collapse has shaken the entire $20 billion private mortgage securities industry as well as the mortgage insurance industry. At least ten U.S. mortgage insurers and another ten companies in Europe and the U.S. that insure the insurers face claims totaling $400 million. Nearly 100 S&Ls hold EPIC mortgages backed by over-valued properties. In addition, major Wall Street investment houses that buy mortgages from S&Ls and trade them on the securities market are afraid the EPIC collapse will scare away investors. Salomon Brothers, the largest trader in the mortgage-backed securities market, has even tried to put together an industry plan to bail out or buy out EPIC to prevent a crisis of confidence in the secondary mortgage market-once thought to be one of the safest investments around. Fictional golf courses

Other banks and S&Ls around the country have encountered massive real estate over-appraisals. Federal banking examiners found 411 instances of faulty or fraudulent property appraisals when they examined the records of the failed Empire Savings and Loan in Mesquite, Texas. The case is a classic example of "land flips," a lucrative scam in which a group of collaborators sell land among themselves, each time artificially raising the property's value with new, bloated appraisals. In some cases the property's value triples in a day or two. Independent auditors discovered that Empire's $59.3 million in real estate collateral was actually worth $7.9 million.

Federal regulators last July seized Sunrise Savings & Loan in Boynton Beach, Florida. The troubled S&L may sustain as much as $200 million in losses, mostly from over-appraised real estate. In one instance, an appraiser valued undeveloped land at $29,000 an acre even though nearby property went for no more than $5,000 an acre. The appraiser based his assessment on what the land would be worth if surrounded by a luxurious country club and golf course--neither of which was in the works.

Lest you think the appraisal racket is stinging only smaller S&Ls, Bank of America of San Francisco lost $95 million in 1984 because property loans it handled were based on fraudulent appraisals. And over-appraisals played a role in the biggest blowout of all, the near-collapse of Continental Illinois Bank and Trust Company. The Federal Deposit Insurance Corporation (FDIC) has testified that it will have to absorb at least a $200-million loss from overvalued real estate in the bailout of Continental. After purchasing real estate appraised at $400 million on Continental's books, the FDIC discovered the land was worth only half that amount.

Failures to notice

Despite the growing number of government bailouts and mounting losses, most bank regulators treat the over-appraisal problem as if it were little more than a bounced check to the corner grocery. Take, for example, the Federal Deposit Insurance Corporation, which insures all U.S. commercial banks and regulates state-chartered banks that are not members of the Federal Reserve system. Even though the FDIC will have to pay $200 million just to cover overvalued real estate holdings of Continental Illinois, the agency insists that it need not pursue tighter restrictions on appraisals. "We feel that the ones we have in place now are adequate," says George J. Masa, assistant director of the FDIC's division of bank supervision.

The Office of the Comptroller of the Currency, which regulates the country's 5,000 national banks, including Continental, didn't seem to mind Continental's inflated appraisals either In a letter to Rep. Doug Barnard, chairman of the monetary affairs subcommittee, a representative of the Comptroller's office said that its examiners, in viewing Continental's records, "did not disclose any real estate appraisal abuses warranting disciplinary action or criminal referral."

The Comptroller's office, the FDIC, and the Federal Reserve System all believe that poor assessment of a loan applicant's ability, or rather inability, to repay is the main problem with troubled banks and therefore federal supervisors need not focus on appraisal abuses. In other words, provided the borrower is worthy of credit, the regulators contend, the value placed on real estate collateral shouldn't matter

This view is naive. No matter how closely lending institutions screen their loan applicants, a certain number of loans fail, about 3 percent on average for property loans. Even borrowers with impeccable credit records fail on their loan payments from time to time. If the underlying property is overvalued, then banks and S&Ls will lose money when the property is sold at foreclosure. Moreover, failing to deal with over-appraisals on the grounds that "bad bank loans" are the real problem simply ignores an important part of the bank crisis. A loan based on an over-appraisal is a bad bank loan." The fact remains that a risky loan is easier, and in some cases, possible to make only when it is buttressed by an appraisal that falsely overvalued the collateral," Rep. Barnard points out.

"The only way that the FDIC or Comptroller's arguments make senseis if they had only one bank failure a year," said a congressional investigator who spent six months probing appraisal problems. "But they are hiring scores of attorneys for their liquidation staffs. Their attitudes border on gross irresponsibility."

Just last year the Federal Home Loan Bank Board, which runs the Federal Savings and Loan Insurance Corporation, closed ten S&Ls, seized another 25 S&Ls to install new boards of directors and managers, and assisted 22 others in merging with healthier institutions. A recent General Accounting Office study estimated that 42 percent of the nation's S&Ls either are already broke or have dangerously low net worths. The FDIC, meanwhile, has counted 120 bank failures for 1985, with another 1,100 of the nation's 15,000 banks on the agency's problem list. There have been so many S&L failures and bailouts that, according to The Washington Post's Hobart Rowen, "the FSLIC is running out of money." If the FSLIC or FDIC do run out of money, who is going to pick up the tab? For the answer to that question, take a look at what happened in Maryland when the collapse of the S&Ls caused a run on the Maryland Savings and Loan Insurance Corporation, producing tremendous pressure on state officials to have the taxpayers finance a bailout.

Call in the feds

Although property over-appraisals are by no means the only cause of bank failures, they are dramatically magnifying the effects of loan defaults in S&Ls and banks throughout the country. It is not necessary to screen old newsreels of bank failures during the Depression to realize that a financial system collapse is something worth avoiding. Fortunately, there are common sense steps that can be taken to help defuse the problem. Ideally, the banks themselves would take responsibility for screening the fraudulent and faulty appraisals. But the lending institutions are in no position to be diligent. The realities of the market virtually force them to accept shady appraisals. They know that if they question the veracity of an evaluation the developer will take the business elsewhere. "Builders and developers always go the course of least resistance," said Hewitt, a former examiner with the Bank Board. It is just too easy to shop around for a bank or S&L that is willing to look the other way "The poor S&L is caught between a rock and a hard place," he said. If it strictly follows the rules, it loses business. If it doesn't, it puts its financial well-being in jeopardy. In today's lackluster banking economy, there are too many eager lenders chasing too few qualified borrowers. This type of borrowers' market means there is little chance lenders will do anything-unless compelled by government action. Only government intervention with a common set of rules can convince the players in the real estate game that they don't have to cheat to keep ahead of the competition.

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.

Guy Reese is a living example of how the system should work. Reese, who used to review appraisals for the Bank Board, now provides the same service for a Dallas-based S&L, Sunbelt Savings Association. In the past year, Reese and his staff have reviewed about 500 applications for property loans and sent back 90 percent of the appraisals for corrections or modifications. The great majority of the serious deficiencies, Reese said, resulted from "a failure of the appraiser to provide an unbiased, objective estimate of market value." If Reese doesn't accept the appraisal, the loan isn't made Jack Sommerfield, vice chairman of Sunbelt Savings, said his board is pleased with Reese's results so far. "We are confident that it is going to save us some money. We know day in and day out that this is a better way to go'" Sunbelt, a large S&L with $3 billion in assets, is one of a handful of lenders that have taken positive steps to protect themselves against faulty or fraudulent appraisals and the havoc they can wreak.

The trend will have to growif the nation's lenders are to survive.