Sunday, September 28, 2014

REO and Foreclosure AVM – The Homequant Way 

Most banks and mortgage houses have been buying AVM values from the leading vendors to cater to their needs in the front-end and mid-end. 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.

Here are some of the reasons why specialized REO and foreclosure AVMs ("Foreclosure AVM") would be needed to address the fast-growing needs of this market segment:

1.  An Overall Discounting Factor is Only a Surface Correction

Let’s say, 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 entire 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 would try to rationally work through their inventories.

Of course, today, foreclosures are more wide-spread, extending from the prior sub-prime and Alt-A into the prime portfolios. Therefore, they require more specialized valuation, including Foreclosure AVMs. The high-end trophy properties should not be subjected to any AVM’s, instead professionally hand-worked.

3.  Foreclosures will Plague Prime Portfolios for Several More Years

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 Foreclosure AVMs geared exclusively towards that segment would be mandatory.

In fact, everyone from the traditional AVM houses to the listing services to the national brokerage houses has realized 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.

The Practical Aspect
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 Multiple Regression Analysis (MRA) 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.

However, to develop Foreclosure AVMs, the experts at Homequant derive modeling samples from the foreclosure-related universe only, to avoid having to distort the final values by applying some heuristic discounting factors. When the AVMs are developed as such, the final values are more in line with that segment of the market, addressing especially the sub-markets which inherently deviate from the median market.

To bolster the sample size, they often group and model multiple contiguous markets together; for example, if the local MLS covers three counties, they tend to model them together drawing all of their foreclosure and short sales into the mix. Obviously, it’s always easier to generate sales samples in those Metropolitan Statistical Areas where foreclosures are more common.

Traditional AVMs require significant amount of GIS and spatial analysis to define and quantify non-fixed planes and pocket areas. Those variables are then added to the MRA model, along with the fixed neighborhood variables. Since foreclosures are more clustered and/or pocket-oriented, the concept of non-fixed planes does not take form.

Therefore, instead of the traditional three-stage MRA model – additive, multiplicative/log-linear and GIS – they use a two-stage model structure for Foreclosure AVMs.

IWhen the foreclosure pockets within the model could be clearly identified and defined (using Latitude & Longitude), they are then introduced in the equation as linearized clusters or pockets. Any more GIS/Spatial analysis tends to be overkill.

The generally accepted quality metrics like Coefficient of Dispersion (COD), Price-related Differentials (PRD) are unnecessary. Instead, they encourage their clients to review the output quality by forming a valuation review group consisting of internal foreclosure experts, selling brokers and AMCs (when involved).

In any case, the objective of the 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 Foreclosure AVM values are compared to their traditional counterparts, they will be significantly lower in a market-meaningful manner.

The lenders holding large inventories of REO and foreclosures (late stage) would also be better served with the proposed Foreclosure AVMs, not only to price their portfolios more accurately, but to prevent appraisal frauds as well. Those AVM values should be used as control values to trigger the Supervisory QC.

Simply put, the incoming REO appraisals must be compared against the AVM values and those that deviate from the internally acceptable range (say, +/- 20%) must be flagged for the Supervisory QC. Without such internal controls, those portfolios would be susceptible to appraisal frauds. AMCs should also use a similar approach to score and rank their appraisers.

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