Thursday, August 14, 2014

Why Specialized AVMs are Needed for Foreclosure Markets

Most banks and mortgage houses have been buying AVM values from the leading vendors to cater to their needs in the front-end (origination) and mid-end (portfolio management). However, since the recent housing bust, their back-end (collections, foreclosures, short sale, REO sales, etc.) needs have exploded. Obviously, the AVM values that are meaningful for the front-end and mid-end are practically useless in the back-end. 

While some traditional AVM houses and private consultants will still try make a case in favor of a market-appropriate discounting factor to continue to recycle their current model, that concept is virtually untenable considering the fast-moving nature of the back-end market. Here are some of the reasons why specialized REO and foreclosure (“foreclosure”) AVMs would be needed to address the fast-growing needs of this particular market segment:

1. An Overall Discounting Factor is Only a Surface Correction: Let’s say, for argument’s sake, in major market X, the market differential between the primary market and the foreclosure market is 30%. On the heels of this market statistic, if a bank buys current AVM values from a vendor and tries to fit a 30% haircut to its foreclosure portfolio, it would make a serious mistake by only emphasizing surface corrections, thereby distorting the sub-markets (a.k.a. pockets) that tend to deviate from the norm.Even a local housing market consists of many diverse sub-markets that tend to be econometrically different from the smooth median corridor. Therefore, those deviating sub-markets would be grossly mispriced should a generic haircut is applied; in fact, some would be grossly overvalued while others would be significantly undervalued, thereby lowering the market reliability of the portfolio.

2. Foreclosures are Often Disproportionately Clustered in Sub-markets: Since foreclosures are often disproportionately higher or clustered in certain sub-markets, using generally discounted AVM values as described above would be irrational, particularly when large portfolios are negotiated, causing more trouble for the retail brokers and small homebuilders who are trying to rationally work through their inventories. Of course, today, foreclosures are more wide-spread, extending from the sub-prime and Alt-A into the prime portfolios. Therefore, they require more specialized valuation, including specialized foreclosure AVMs. The high-end trophy properties (mansions, waterfronts, etc.) should not be subjected to any AVM’s – always professionally hand-worked, instead.

3. Foreclosures will Continue to Plague Prime Portfolios for Several More Years: Given the continued squeeze in the Jumbo mortgage market, foreclosures will continue to plague the prime portfolios for several more years. In fact, prime foreclosures and charge-offs are expected to stay elevated due to the continued high incidence of short sales and the highly probable tsunami of HELOC defaults hitting the market in early 2015. If the HELOC hypothesis comes to pass, a new generation of specialized AVMs geared exclusively toward that segment would be mandatory. In fact, everyone from the traditional AVM houses to the listing services to the national brokerage houses will soon realize that the foreclosure markets are not short-lived or temporary. Actually, the overall housing market has become semi-permanently bimodal (primary and foreclosure), requiring significant back-to-the-drawing-board valuation re-engineering. Hopefully, a new generation of specialized AVM houses would take advantage of this market void and position their brands appropriately.

Under the traditional AVM development process only the recent arms-length sales (often aided by the discounted seasoned listings to simulate the most recent market) are used to create representative sales samples to develop models and are then applied on to the populations the samples are derived from. In other words, the traditional modeling samples ignore all foreclosure and short sales. Now that the foreclosure market has widened across all geographic and value strata, the need for mutually exclusive foreclosure AVMs is no longer theoretical – they are essential in order to address the critical and fast-growing needs of that market segment. 
However, to develop such specialized foreclosure AVMs, experts must consider deriving modeling samples from the foreclosure-related universe only, to avoid having to fudge the final values by applying some heuristic discounting factors. If the AVMs are developed as such, the final values would be more in line with that segment of the market, addressing especially the sub-markets which inherently deviate from the median market. 
Of course, to bolster the sample size, multiple contiguous markets may be grouped and modeled together; for example, Long Island MLS covers three counties - Nassau, Suffolk, and Queens, so they could be modeled together drawing all of their foreclosure and short sales into the mix. In any case, the objective of the specialized foreclosure AVM is to manage and mitigate losses so these AVM values do not have to be as surgical as the traditional AVM's. When those new foreclosure AVM values are compared to their traditional counterparts, they will be significantly lower in a market-meaningful manner. That, of course, is the point.


Sid Som MBA, MIM
Homequant Inc.

Note - This book is available on Kindle (Amazon - query 'Sid Som').

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