Magazine article Mortgage Banking

Evaluating AVMs

Magazine article Mortgage Banking

Evaluating AVMs

Article excerpt

I recently participated in a panel discussion while attending a conference on subprime lending. I noticed one of the hot topics for the industry is the use of automated valuation models (AVMs). These models are becoming increasingly important to the mortgage industry, given the need to reduce the cost of originations and speed up the origination process in order to be competitive in today's environment.

A number of the panel discussions made mention of the significant number of companies whose cost of origination exceeded the value of the loans being created. Despite incentives, lenders appeared hesitant to migrate from traditional valuation practices, given perceived risks related to AVMs.

As a result, I returned from the conference and decided to investigate just how prudent it is to use AVMs and what steps can be taken to enhance a mortgage lender's confidence in using an AVM. The following is a synopsis of what I learned from my Deloitte & Touche USA LLP colleagues.

Collateral valuation is a crucial component in the mortgage underwriting process. It provides support in determining if the collateral value is sufficient to cover the amount of the loan in case the borrower defaults. Regulatory agencies require lending institutions to adhere to "safe and sound" operating practices by implementing an adequate appraisal program. While traditional collateral valuations involved appraisers conducting in-person and on-site estimates, AVMs have increasingly been used in the collateral valuation process.

Developed in the late 1990s, AVMs are computer-generated property valuations that use real estate information such as property characteristics, market demographics, sales prices and regional trends to estimate the value of a property and eliminate the need for an on-site inspection. Today AVMs are widely used in the refinance and home-equity lending arena and are increasingly being used for home-purchase loans, often replacing drive-by and full appraisals.

According to an April 2006 report by Atlanta-based Bench Mark Consulting International's Brian King, entitled Property Valuation, Title, Flood, and Closings--the Past, the Present, and the Future, in 2005 Bench Mark released the results of its Consumer Bankers Association's Home Equity Lending Study, which revealed that the percentage of valuations performed using AVMs increased from 50 percent in 2003 to 66 percent in 2005. Although estimates vary, according to an article by Nima Nattagh and Dave Ross in the August 2005 issue of Mortgage Banking, "Refining Valuation Models," other studies report that as much as 50 percent of all originations (purchase, home-equity or refinances) involved the use of valuation models as instruments in the underwriting process.

AVMs were not always accepted by the mortgage industry. When first introduced, they received criticism from both appraisers and the risk-rating agencies. Inaccurate property value estimations due to the simplicity of models, and the lack of long-term real estate data hindered AVMs' credibility.

In the spring of 2004, New York--based Fitch Ratings proposed a 10 percent to 15 percent devaluation for bond pools backed by homes that did not receive a traditional appraisal and were in a soft real estate market. New York--based Standard & Poor's (S & P) soon followed suit, applying restrictions to situations where AVMs could be used. Nevertheless, because of the cost-effectiveness of AVMs, mortgage lenders still included them as a supplementary tool in the appraisal process.

As AVMs become more sophisticated and real estate data become more readily available, the accuracy of automated valuations is improving, and there are signs that the mortgage industry has reversed its opinion on AVMs. In March 2006, both Fitch and S & P eased their restrictions on the use of AVMs, thereby boosting the confidence in them by mortgage lenders. Meanwhile, Fannie Mae and Freddie Mac continue to legitimize the use of AVMs by waiving independent valuation requirements based on the use of their own internal AVMs. …

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