As a first-time homebuyer a few years back, I am now working on becoming a first time homeseller. I was told by our realtrix that she recently had a closing that was held up by a house that failed to appraise at the selling price. Since she specializes in old houses (and ours is pushing 95) she told us that it was unlikely but possible that a sale of our house could be held up for the same reason, depending on how much we were able to get for it.

I nodded my head at the time, but thinking on it later in the day, I was more and more baffled the more I considered it. In the financial markets, if you value infrequently traded securities, then you know that the absolute holy grail of a security's valuation is an arms length trade, in size, viewable on the "tape" (stock exchange, TRACE, MSRB, etc.). Even if you have no trade, an appropriately sized offering on the security sets a ceiling on the price, while a live, executable bid sets a floor price beneath which there's no justification to value the piece. The terminology varies from sector to sector, but fair valuing, marking to model, etc., should be avoided whenever possible.

I guess people for a while have been saying the appraisal system for houses was a contributor to the housing crisis, but most claim it was improperly performed appraisals which led to the problem. To me, the whole structure of the system is wrong. Right now, it works like this: customer pulls a price less than selling price out of the air, and probably after some negotiations, a price is settled upon by the buyer and seller. At this point, it is probably a written, binding offer, contingent upon inspection and appraisal at or above selling price . THEN, an appraiser is brought in to determine "market value." But the market price has already been set! If the appraiser can't take the live, accepted bid on the very property in question as the house's value, then what can he possibly go on?

The answer, incredibly, is that the appraiser is marking to market. He is marking to a model, based on comps, accouterments, neighborhood, lot size, rebuild cost, etc., but it is undeniably a model. If the system made any sense, it wouldn't go offer -> negotiate -> agree -> appraise -> close. The appraisal would be conducted prior to the offer and negotiation as a bidding tool to the buyer… or even as justification by the seller for the offering price. As it is, the appraisal serves two purposes. One, it gives the buyer a false sense of security that he paid the right price, and it gives the bank a false sense of security that sufficient equity will be coupled with the down payment to motivate the mortgagor to perform, and/or that a sale under duress could make the bank sufficiently whole to take the loan risk. I know that theoretically appraisers don't try to "hit the number" but it seems like the knobs on the appraisal are probably turned a little bit at least to get in the right ballpark. I know that it's supposedly a science and they are professionals, etc., but still…

The structural problem, of course, is that the buyer and the lender are trusting an appraiser's mark-to-model to protect their long-term interests. It allows lenders to be more impersonal and buyers the sense they are delegating responsibility. To me, it's yet another example of unintended consequences of regulation: a process that was intended well but ultimately creates an environment where a buyer's biggest purchase in a lifetime and the financier facilitating the trade are entrusting huge sums of money to the model and signature of an interested (but probably not interested enough) third party. A signature counts more today than it ever, in a time when it probably means less than ever.

But I sure hope my house appraises right when I accept an offer!

Jim Sogi comments:

The appraisers' methods have been well tested in the courts, and recently not so well in the markets. There are 3 ways to value property:

1. Comparable Sales

2. Income

3. Replacement Cost.

Marginal price in liquid markets are set by comparable sales of that security. But we know that they can be wrong also. Comparing the appraisal methods to see if there is undue variance give some back up to each method. If one or more are way off, perhaps something is not right. Chair's Fed Model looks at the income for stocks. Replacement cost is rarely used and does not account for things like location or in the stock market, goodwill. Over reliance on comparable sales, which are set at the margin, resulted in the boom and crash of real estate and derivatives of the mortgages.There is quite a bit of play in the range of price that an appraiser can defend, and it plays out regularly in court with the IRS in estate tax cases so the method has been well tested.
They key is getting a good appraiser.

Sam Humbert explains:

The prospective buyer of your home isn’t the young couple with the cute kids and Labrador retriever you’ve been “negotiating” with. It’s their bank. The bank takes all the risk, aside from the small haircut the down payment represents. And appraisals are how banks roll. If you don’t like it, sell to an all-cash buyer instead, so there’s no bank in the picture.

Jonathan Bower writes:

Appraisers are part of the vig in a real estate transaction. As recent first time homesellers (about a year ago) who "scratched" the house, we discovered the long line of people with their hands out to help facilitate my transaction…

City (Sales and Stamp Tax)

County (Sales and Stamp Tax)


2 Brokers (on the market less than 2 weeks…)






Municipal Service Fee

Document Preparation Fee

Closing Fee

Wire Fee

Overnight Fee et al

This is when I realized why the gov't is so interested in stimulating the housing market…

Ken Drees writes:

In general, during the housing boom there was no restraint on the appraisal part of the transaction. The appraisal price was matched to or above the agreed upon sale price in order for the loan to go through. The appraisal person often asked the real estate agent what number they needed. Once again, this is not true in all cases–but obviously lax rules and lax ethics swirled around this function during the boom. Now there is a lot of heat and scrutiny on the appraisal part of the process. These people can and will be held liable and responsible for any questionable values. So naturally they are over reacting and sharpening their pencils to the point of overkill on the low end of ranges. It really is a buyers market–and only now the appraisal needs to be at or below the selling price for the loan to go through.

No wonder that money supply is high at the base level and crashing in terms of reaching the people. Where is the lending?

Rocky Humbert comments:

If a lender isn't involved, there's no need for an appraiser, and there's no bank closing fees. If one has engineering expertise, an inspector is optional. A knowledgeable buyer can also conduct his own title search from public records and (bravely) skip the Title insurance, and can also (in most states) represent themselves "Pro Se," and not retain an attorney. You can also buy and sell without a broker. All of these people are providing risk-reduction or other services for the parties.

The real "vig" in a real estate transaction is not only the stamp tax and bid/ask spread, but also new drapes for all of the windows, and the discovery that there's no way to fit your 9-foot Steinway Concert Grand Piano through the front door.

Real estate markets have one unique peculiarity: In what other market is the seller's identity and cost-basis a matter of public legal record, but the buyer can remain anonymous prior to the closing?

Phil McDonnell adds:

In a market with fungible items the fair market value is the gold standard. The reason is that the previous transaction is a good measure of value given that all items traded are identical. But in Real Estate every property is unique. Even in cookie cutter developments the locations are unique.

Real Estate also differs in financing because the margins are only about 10% or so. Your broker can and will sell you out if your stock falls in value below maintenance margin even momentarily. The bank cannot do that to a homeowner. In effect a mortgage is a loan and a put option. This is because the homeowner can put the house back to the bank if it falls underwater via a foreclosure or short sale.

In California during the boom an immigrant gardener was able to buy something like 10 houses from his friend for inflated prices because of lax mortgage appraisal standards. In scams like that the friend walks away with fast cash from the overpayment. Appraisals are really designed to weed out the risk of less than arms length transactions for the banks.

Stefan Jovanovich writes:

Around here (Contra Costa, Alameda Counties) in California the appraisers were usually in on the deal and their justification for the absurd valuations was the "fair market value" of the lots on which the houses were built. The primary fallacy was– and is– the idea that the dirt itself could be adequate security for the loan. That has been a recurring delusion throughout American history– that land alone could support debt. In the bad old days when money was itself the gold standard, bankers refused to lend against land; they limited their risk to the earnings power of the improvements - i.e. the buildings or the prepared soil. Rents and reliable crop yields were seen as the only reasonable estimate for comparable value; and, since those were expressed in dollars, properties were not considered unique. That was, of course, one of the limits of the gold standard that the newer, more flexible currency was going to solve. And it did in one sense; imagine what dirt prices would be without FHLBs, FNM, FRE and the AAA of 1938.

Rock Humbert replies:

Maslow's hierarchy of needsOuch. Maslow's Hammer just came down on my head, as Stefan once again suggests that society's ills would be cured by the gold standard.There is an important difference between saying "appraisers were usually in on the deal" (which suggests fraudulent intent), and saying the justification was "fair market value.""Fair Market Value" (FMV) is a defined term: the "price" where a willing buyer and a willing seller complete a transaction. This concept is applicable to all assets (including land, copper, gold, horses, equities, etc.), and the price can be stated in any agreed medium of exchange (dollars, gold, salt, seashells). Although it wasn't called FMV, the FMV concept dates back to at least King Solomon and the Talmud.

If a third party (e.g. a bank) provides capital for an asset purchase/investment (debt, equity or barter), and the third party is falsely induced to provide capital, this is fraud. And the existence of fraud also pre-dates modern history. Hardly an argument for the gold standard.

If the third party provides capital based on assumptions (including FMV) regarding the asset purchase that turn out to be wrong, this can be called a bad business decision. And bad business decisions are not a recent development either. Again, hardly an argument for the gold standard.

However, if the bank makes an investment because it plans to flip the loan to Fannie & Freddie– that's a completely different story. And much of the recent mess can be attributed to this phenomenon.(Yet I don't understand why a gold standard and the existence of a gold-rich Fannie & Freddie are necessarily mutually exclusive.

Perhaps Stefan will explain…. 

Stefan Jovanovich explains:

No Fannie or Freddie could possibly be or want to be "gold-rich"; if you can exchange your paper with the central bank why would you want to endure the vicious discounts that 19th century merchants imposed because they insisted on valuing their inventory by what it would sell for in cash, not what it could be appraised for or securitized into? No one here has disagreed that the state has a monopoly of legal tender. What the medium of exchange folks have said is that the government monopoly (and the potential for abuse inherent in any legal monopoly) does not matter because you can always trade your horses, copper, land for money whenever you want and the government's self-regulation will prevent abuse. Or, as Rocky put it, the tax man will take property instead of cash in payment of taxes. Alas that part is simply not true: the tax liability remains even after the taxpayer's property is seized; it is only discharged when and if the property is sold. (One of the interesting interactions of the present tyranny is how the drug laws have revived debtors prison.) Perfect liquidity, like FMV, is a notion that works better on paper than it ever does on the barrel head where - even now - legal tender (Fed reserve balances and notes) remains in limited supply. Because legal tender is in limited supply, there is the unavoidable temptation for the holders of the government to make more money available whenever Congress and the President want a war - whether against poverty or Iraq. That was what the Founders properly feared. They wanted the unavoidable monopolies of our central government - the powers to make Money and War - to be constrained by the requirement that both be approved by an actual vote of the Congress. Since they knew that no unpopular war could be waged without a debasement of the currency, they imposed the further restraint of insisting in our Constitution that the Money be Coined to a Standard Weight and Measure. Credit would regulate itself, even in a world of mark to model and foreign military/aid adventures, as long as the government monopoly could not create legal tender as needed. Money exchangeable on demand into specie was the ballast for republic itself; it might seem useless to waste all that precious cargo space carrying heavy weights that were only hoarded– until you found yourself caught in a storm– and then the ballast would be the only thing that would give the ship of state's righting arms the weight with which to do their work.

David Hillman writes:

Speaking of real estate, more particularly of having the ranch foreclosed upon, TCM [Turner Classic Movies] will air this evening at 10 EDT/9 CDT, a chair and list favorite, the original 1970 version of the classic 'demise of the old west' tale, "Monte Walsh" starring Lee Marvin. Thought some might like a heads up. Enjoy. 

Stefan Jovanovich adds:

And now for a brief jab at Maslow: anyone who would compare being the lonely Jew in a New York school full of gentiles in 1920 to being "the first Negro enrolled in an all-white children" had a sense of self-importance that would have made even our country's original hammer head (aka George Washington) blush. Talk about a hierarchy of needs!





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