The Federal Housing Administration (FHA) recently announced it will require second appraisals for properties it suspects have inflated values when under consideration for a Home Equity Conversion Mortgage (HECM).

One trend driving this policy change is the extreme loss severity experienced in the HECM portfolio for loans going to claims.

“I’d like to share with everyone the process FHA undertook to develop this new policy,” FHA’s Deputy Assistant Secretary for Single Family Housing Gisele Roget told Valuation Review. “There is appraisal bias and appraisal inflation that was discovered by HUD’s (U.S. Department of Housing and Urban Development) Office of Policy Development and Research (PD&R), which is HUD’s great internal ‘think tank’ analyzing all areas of housing. In 2017, PD&R published a paper titled, ‘Reverse Mortgage Collateral: Undermaintenance or Overappraisal?’ in HUD’s CityScape Journal.

“The loss severity experienced in the HECM portfolio and its impact on the HECM portfolio’s economic value drove the need for further research and review into areas that could be impacting those losses including overvaluation at origination due to appraisal inflation,” Roget added. There was a wealth of research looking at appraisal bias that notes when you don’t have arm’s length transactions (i.e. a sale) there is a moral hazard for inflated home values for both refinance mortgage loans and HECM loans. This factor is what was really driving this policy decision.”

However, the heaviest concentration of overinflation – or appraisal bias – found by HUD came at the height of the housing crisis more than a decade ago.

The PD&R paper, Roget said, included a number of interesting findings – one that reverse mortgage loans were more likely to originate at the peak of the market in states which experienced dramatic house price appreciation. The biggest years for originations and appraisal inflations came at its peak period in 2008 and 2009.

Additional research was commissioned by FHA to further investigate appraisal inflation. HUD’s Office of PD&R used sales records obtained from the Federal Housing Finance Administration (FHFA) and compared all of FHA-HECM loans to sales data, and again found appraisal inflation was at its highest in 2008-2009. From 2016 to 2018, the rate of inflation stabilized to 4 percent. Further analysis which researched the same conclusion was conducted by FHA’s Office of Risk Management and FHA’s actual contractor.

“Based on HUD findings and further investigation including three independent sources, we believe, and have certified there was appraisal inflation for HECM loans and it was at its highest in 2008-2009,” Roget said. “Since that period, there’s been an increase as far as self-policing (HVCC, AMCs) to regulate appraisal practices.  However, there is an understanding that HECMs are vulnerable to over-inflated appraisals. In light of this fact, published HUD research and additional FHA analysis, we had to take action.”

FHA Commissioner Brian Montgomery said during a media call that cases of appraisal bias in the HECM program spiked at the beginning of the housing crisis, noting that home prices were harder to predict at that time.

Montgomery added that data gathered by HUD uncovered the extent of the impact of appraisal bias.

“We know that the appraisal bias – specifically inflated appraisal values on HECM properties – was more common than we initially thought,” Montgomery said.

Montgomery noted that other actions intended to improve the HECM program’s financial situation, such as instituting principal limit factor (PLF) reductions, proved ineffective.

“We’ll be able to follow [HECM appraisals] by lender, so we’ll be looking at patterns – are some lenders farther outside the tolerances than others – so we think this is a good quality control tool, regardless of where we would be from an actuarial standpoint,” Montgomery said, adding that the agency plans to reassess its findings after a year.

He also said it would be hard to predict how many HECM applications would be flagged as needing a second appraisal going forward.