Two Unknown Drivers of the Housing Boom

http://www.marketwatch.com/news/story/credit-rating-agencies-return-crosshairs/story.aspx?guid=%7BAFB9C89A%2D9AE3%2D4718%2D8817%2D39918E371C23%7D

The article above investigates the role that Fitch, Standard & Poors, and Moody's played in the recent housing boom and the current credit market meltdown.

These agencies are not significantly known by the average American but they played a vital role in the recent housing boom by continually rating Debt Obligations attached to housing higher and higher, with little scrutiny of the actually obligation's credit worthiness. And why would they? These agencies are also publicly traded companies whose sole purpose is to maximize profits: if they didn't go along with the bankers, one of the other agencies would receive the business.

Similarly, appraisers are equally to blame: without them, neighborhood's per-square-foot-averages would not have budged!! The common practices for appraising a home are to judge a) what the costs of replacing the home would be or b) what did similar homes within a one mile radius sell for within the previous six months. It isn't hard to guess that option B is most often embraced by the appraisers. But here's the rub, appraisers can only put dinner on the table if banks keep calling them specifically to go appraise a potential lending opportunity for the bank. In the frenzy of the past five years, banks were handing out mortgages to everyone and their kitty cat, desperate to give each potential borrower as much debt as possible.

In previous writings, I have noted that the banking industry created numerous new mortgage products to allow more and more borrowers to be eligible for higher amounts of debt (interest only, adjustable rate, subprime, Alt-A, document-less). But part of that cycle is by law the home must be appraised. So what happens to appraiser A if he regularly appraises home lower than appraiser B in this past market frenzy? A doesn't ever get called again by the bank while B can't appraise enough of the bank's new borrowers' potential properties. B then continually raises the values for homes in a given area, and those higher values are then used by other appraisers to raise the value of the homes they are appraising.

In both cases, the appraisers and debt-credit ratings agencies were responsible for the extreme national bloat in values of either homes themselves or the underlying debt obligations the banks created out of those vary mortgages.

To explain that, I need to explore with you what is a CDO or collateralized debt obligation: During this real estate boom, bankers realized that could turn mortgages into sellable securities (otherwise known as stocks). Given mortgage holders were paying a consistent ~6% on their household mortgages, the bankers pooled those loans together, sliced them up, and sold these bundles off to investors. But what happens when it turns out that the actual mortgage holders CAN'T pay that 6% mortgage payment and then default? The value of the CDO plummets!

But did Moody's or Fitch or Standard & Poor's wave any red flags about these products? No. Instead they did the opposite and continued to tout these products' credit worthiness.

Without these two darkhorses in the real estate world, this recent boom could not have occurred! Yes, there were other major factors like historically low interest rates, change in tax laws to allow sellers to avoid capital gains every two years as opposed to once in a lifetime, and new shady mortgage products. But none of that would have meant a thing if the national army of appraisers hadn't gotten on board and helped skyrocket homes' values.

It is clear that both the credit/debt ratings systems and appraisers systems are in need of overhaul. Let's start by making these ratings agencies actually have to do due diligence on the mechanisms they are rating: currently they all openly admit that there may be NO DUE DILIGENCE behind their actual ratings! This is absurd that the markets actually use their services at all.

-Alok Appadurai