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Rural credit markets and proposed changes in appraisal standards.

Real estate appraisal reform is an important component of the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA). Title XI of the act requires that by 1992 real estate transactions that involve financing by a federally insured institution be appraised by a state certified or licensed appraiser.

Recently, bank regulatory agencies, including the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), and the Resolution Trust Corporation (RTC), proposed to increase the de minimus threshold above which the services of a certified or licensed appraiser would be required. They suggest the threshold be raised from $50,000 to $100,000.

An amendment to the Senate banking bill would have set a de minimus threshold of $100,000 on residential transactions and $250,000 for commercial sales.(1) It would have also exempted rural areas from the appraisal requirements of FIRREA. While the de minimus threshold and rural exclusion were subsequently deleted from the Senate banking bill, ultimately the de minimus issue may be resolved in the courts.(2)

This article's objective is to examine the public policy implications of the proposed changes as they pertain to residential property in rural areas. The fact that many public policy programs intended to benefit rural economies have actually been counterproductive has been well documented by agricultural economists. Because of developments in the residential mortgage market, the proposed changes may have a detrimental impact on the provision of housing financing to less-developed rural communities. This negative effect could manifest itself in a variety of ways, including:

* Higher equity-to-value ratios for rural home buyers

* Loss of private mortgage insurance and greater reliance on public sector insurance programs

* Rural mortgage credit rationing and the potential upstreaming of mortgage funds to urban centers

* Higher cost of rural mortgage credit caused by greater default risk associated with unappraised mortgage portfolios


A question frequently posed in the financial press is: Why is a decline in long-term interest rates not immediately followed by a decrease in mortgage rates? Brokers, builders, and buyers often complain about the "stickiness" of the mortgage market.

In the past, the failure of mortgage rates to follow other long-term rates has been attributed to the localized nature of the market. Mortgage rates tended to reflect the supply and demand of mortgage credit within a region and did not respond completely to changes in national capital markets. During tight money periods, many lenders chose not to increase mortgage rates sufficiently to reduce the number of loan applications and instead developed procedures for rationing the available supply of funds.(3)

The Depository Deregulation and Monetary Control Act of 1980 and the Garn--St. Germain Depository Institution Act of 1982 significantly altered the mortgage market environment. This legislation coincided with new pass-through programs initiated by the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Corporation (Fannie Mae). From 1981 to 1986, pass-through securities issued by the Government National Mortgage Association (Ginnie Mae), Fannie Mae, and Freddie Mac increased from less than $25 billion to $250 billion. By the end of 1988, the outstanding balance of pass-through securities accounted for almost 25% of total mortgage debt in the United States.(4)

Financial institutions prefer to make loans on assets that can be easily securitized to maintain balance sheet flexibility and control risk. Therefore, loan terms in the primary market are influenced by investors in the secondary market. If mortgage originators expect to maintain their secondary mortgage market investor clientele, yields must be competitive with alternative securities of similar risk--a concept known as the "substitution principle."

Recent evidence supports the assertion that the co-movement between mortgage and capital market rates has increased significantly over the last decade. In "Volatile Mortgage Rates: A New Fact of Life," H. Roth found a much higher correlation between mortgage and capital markets in the 1980s than in the 1970s.(5) Devaney et al. found in "Cointegration and Causal Relations in Mortgage and Capital Markets" that during the 1970s, mortgage and treasury rates were not cointegrated, while in the 1980s they were cointegrated. Two time series that are cointegrated are said to share a "long-run, equilibrium relationship." Both studies conclude that by the late 1980s, mortgage rates adjusted more quickly to a change in interest rates than they had done earlier in the decade.(6)

During the 1980s, mortgage markets changed from being an assortment of highly localized, personal lending markets to an impersonal, national market. This change occurred as a consequence of depository institution deregulation, mortgage standardization, and the emergence of the secondary mortgage market. While the integration of mortgage and capital markets may have increased mortgage rate volatility, it resulted in a more efficient allocation of mortgage funds based on price rather than credit-rationing standards. The data show that the proportionate spread between mortgage and treasury yields declined during the 1980s, suggesting that mortgage rates were lower in the post-deregulation environment than they would have been had these changes not occurred.

In spite of these developments, differences in mortgage rates may still persist. If there is an absence of competition in a local credit market, mortgage rates will be higher than they are in other more competitive markets. In addition, residential mortgages in regions more vulnerable to economic cycles are subject to greater default risk. If secondary mortgage market investors price risk correctly, they will require a higher return in the riskier regions. Regional differences in mortgage rates thus may persist even if the local lending market is competitive. In the absence of government guarantees, regional differences in mortgage risk would be reflected in the pricing of securitized mortgage instruments.


If real estate appraisals are cost efficient, the benefits of the information provided to lenders exceed the costs. The greatest benefit of real estate appraisals is a reduction in the variance of expected market value of appraised versus unappraised properties. When the market value of a property falls below the outstanding balance of the loan, borrowers have an economic incentive to "put" the property back to the lender (i.e., default). Because most mortgage defaults occur in the first three years when loan-to-value ratios are relatively high, a lender can mitigate the higher default risk on unappraised property by increasing equity-to-value ratios, particularly for borrowers with high credit risk.

This strategy shifts the burden of risk to lower income, first-time home buyers and conflicts with public policy objectives outlined by HUD. As an alternative to a higher equity-to-value ratio, a lender could require a "default risk premium." Finance theory predicts that if the expected default risk on unappraised property is greater, the lender will require a higher rate of return than on property that is appraised.

Even if local lenders do not require a risk premium or a higher equity-to-value ratio on unappraised residential property, secondary mortgage market participants may be less inclined to accept a subjective opinion of market value. Given a choice of two mortgage pools alike in every respect except that one is composed of appraised properties while the other is not, most investors would choose the appraised pool. In practice, mortgage pools usually require private mortgage insurance on high loan-to-value loans. Failure to obtain an independent appraisal would preclude private mortgage insurance and may shift more of the insurance burden to the public sector--a result also inconsistent with stated public policy objectives.

Because secondary mortgage market participants will continue to require appraisals and mortgage insurance, originators who intend to sell their mortgages may have little choice but to require appraisals on loans that fall below the de minimus threshold. If there is not a sufficient number of qualified appraisers in rural areas, licensed appraisers from the nearest urban area may be brought in at a higher cost. Perhaps the worst-case scenario is that at some point the secondary market would simply refrain from securitizing mortgages below the de minimus threshold.

Because rural residential property is more likely to fall below the threshold, if the de minimus standard is increased or eliminated altogether rural communities could find themselves paying higher mortgage rates with fewer financing alternatives. Many small rural banks already offer a limited menu of mortgage terms compared with their urban counterparts. The inability to sell mortgages in the secondary market not only may limit the variety of mortgage financing further but could even cause a credit crunch if the standards result in a segmented market of appraised and unappraised mortgages.

The potential for a credit crunch is more acute in rural communities with a less than competitive credit market. Some rural mortgage borrowers may be excluded from the market if local lenders are branches of money center banks with highly centralized lending policies predicated on serving an urban customer base. Currently, a rural financing gap and bank deposit upstreaming away from local communities is considered a major developmental problem in less developed rural regions.(7) If rural mortgage lending becomes riskier this problem could accelerate.

By providing a lender with information to help control default risk, a real estate appraisal serves a function similar to that of a bond rating agent. Lending money on unappraised property is not unlike the purchase of low-quality, unrated debt, frequently referred to as "junk bonds." The purchase of unrated debt, like the mortgages of unappraised property, is a private investment decision unless taxpayers are ultimately held responsible as guarantors. In light of taxpayer subsidies to the federal deposit insurance fund, policies that increase the default risk of bank assets should be accompanied by a higher deposit insurance premium. Regulators should ensure that stockholders and depositors rather than taxpayers bear any incremental risk resulting from unappraised mortgage portfolios.


During the 1980s, financial deregulation and the growth in securitized mortgage instruments contributed to a highly efficient national mortgage market. A system of mortgage credit rationing that discriminated against new home buyers and the less affluent was replaced with a system based on price allocation. The proposal to exempt rural property from appraisal and increase the de minimus threshold to $100,000 could create a segmented market of appraised and unappraised mortgages.

If unappraised property has a greater probability of default, finance theory predicts that these mortgages must yield a default risk premium not unlike the yield differential on low-quality BBB corporates versus high-quality AAA bonds. An alternative to higher mortgage rates on unappraised property would be higher equity-to-value ratios. Secondary mortgage market participants will continue to require appraisals on loans below the threshold. In this case, lenders in the smaller rural markets may limit choice of mortgage terms and develop niches that specialize in the origination of appraised mortgages to be carried by an institution.

One reason home purchase can be highly leveraged is because of the relatively low default risk in the post-World War II era. A prolonged period of rising home prices tended to mitigate defaults and camouflage even bad lending decisions. Of course, what goes up can also come down. In the 1980s, real estate proved that it was not immune to economic reality.

Ironically, in this kind of economic environment price discovery through appraisals becomes more important than ever, especially when a stated public policy objective is to provide opportunities for home ownership. Between 1982 and 1989, the Census Bureau reported that the percentage of Americans under 35 years who own their homes declined from 41.2% to 39.1%. If equity-to-value ratios increase and construction costs continue to rise, this percentage will probably continue to decline.

The proposed change in standards presumes that rural credit markets continue to operate in the folksy, personal style of years past when, in fact, a local bank is likely to be a branch or subsidiary of a bank holding company headquartered in a major metropolitan area. Even small loans may be reviewed at the head office, and credit policies are highly centralized. The proposal implies that rural lenders have superior market knowledge even though rural markets tend to be less liquid than urban areas. Price theory would predict that the opposite is true.

In sum, the potential problems and confusion caused by the proposed changes would appear to offset any advantages. Even though the intent may be to ease the burden of appraisal reform on rural credit markets and lower income home buyers, the ultimate result may have the opposite effect. The proposal appears to have more to do with political expediency than with good public policy.

Mike Devaney, PhD, is an associate professor of finance at Southeast Missouri State University. He received a PhD from the University of Arkansas, and is a Chartered Financial Analyst (CFA) and an MAI candidate. He has published numerous articles in real estate-related publications.

William Weber, PhD, is an associate professor of economics at Southeast Missouri State University and received PhD from Southern Illinois University. Mr. Weber's research interest is public finance. The authors are currently examining the role of rural credit markets in the development of rural economies.

1. "Proposed Changes to FIRREA's Intent Threaten Reform," Appraiser News (November 15, 1991): 1.

2. "Appraisal Institute to Sue FDIC Over $100,000 De Minimus Decision," Appraiser News (April 1, 1992): 1.

3. P. Anderson and J.R. Ostas, "Private Credit Rationing," Financial Markets, Instruments, and Concepts, John Brick and Robert Dame, Inc., ed. (Richmond, Virginia: John Brick and Robert Dame, Inc., 1982), 497-514.

4. M. Devaney, K. Pickerill, and F. Krause, "Cointegration and Causal Relations in Mortgage and Capital Markets," Journal of Financial Services Research, v. 5 (1992): 341-353; M. Devaney and K. Pickerill, "The Integration of Mortgage and Capital Markets," The Appraisal Journal (January 1990): 109.

5. H. Roth, "Volatile Mortgage Rates: A New Fact of Life," Economic Review (March 1988): 16-28.

6. Devaney, Pickerill, and Krause, 341-353.

7. Lower Mississippi Delta Development Commission, The Delta Initiatives (Memphis, Tennessee: Lower Mississippi Delta Development Commission, 1990). 110-111.
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Author:Devaney, Mike; Weber, William
Publication:Appraisal Journal
Date:Jan 1, 1993
Previous Article:Uniform standards of professional appraisal practice: implications for the financial community.
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