Although lacking in popularity, it appears that automated appraisals have obtained their intended results. Urban Institute (UI) researchers Laurie
Goodman and Jun Zhu found the changes have helped to lower default rates. They suggest
that, in turn, some lender processes and potentially pricing should be changed
as well.
The two looked at the characteristics of three broad categories of
mortgages:
- Purchase mortgages, used to buy a home.
- Rate and term refinance
mortgages, used to reduce the interest
rate or extend the length of an existing mortgage.
- Cash-out refinance mortgages,
which are obtained when a homeowner wants to tap the equity that has
accrued in their home.
It has been assumed, based on loan
characteristics like loan to value (LTV) ratios, debt-to-income (DTI) ratios and
FICO scores, that rate and term mortgages carried the least risk and that purchase
and cash-out refinances would default at about the same rates. However, an
earlier study by UI found that actual performance of the loan types did not
match the assumptions. In reality, purchase mortgages defaulted the least,
followed by rate and term refis, and then cash-out refis, which defaulted the
most.
There was a pervasive belief that
appraisal bias, especially towards no-transaction refinances, contributed
significantly to the housing crisis.
That lead to greater scrutiny and a significant re-evaluation of the
appraisal process.
Freddie Mac and Fannie Mae (the
GSEs) have adopted automated valuation models (AVMs) which use mathematical
modeling, drawing on a huge database of recent transactions complete with
property characteristics, to generate an estimated sales price. Goodman and Zhu
say this has made for more accurate appraisals.
The AVMs have enabled Fannie Mae and Freddie Mac to share concerns with
lenders about an appraisal prior to the execution of a mortgage, allowing the
lender to take corrective action.
The authors write in UI's Urban Wire blog that these developments
were predicted to decrease the expected default rate on all refinanced
mortgages, which were particularly susceptible to appraisal fraud. The data
reveals that this has indeed been the case. The industry's risk assessment and
management abilities have improved overall and, accordingly, have decreased the
expected default rate on all mortgages.
While purchase mortgages are still
the least risky and cash-out refinances default with the greatest frequency the
differential has been narrowing. That,
the authors say, is exactly what should be expected, as appraisals have become
more reliable, AVM models have improved, LTV ratios have become more accurate,
and the default differentials have narrowed.
They used regression analyses to
examine the difference in risk characteristics inn loan originated between 2000
to 2009 and the 2010 to 2017 vintages. They
controlled for factors that could drive defaults, i.e. LTVs, DTIs, FICO scores,
interest rates, loan balances, and indicators for single-family,
owner-occupied, and issue years. They also included indicators for rate and
term refinances and for cash out refinances. Purchase loans served as the
reference category.
The rate and term refinances were 51
percent riskier than purchase loans in the first period but only 11 percent
riskier for more recent loans. Cash-out
refinances were 96 percent riskier in the first instance and 55 percent riskier
in the second. In other words, while the
loan characteristics still suggested that cash-out refinance mortgages would be
the riskiest and purchase mortgages the least risky, the relative risk of
the loans had narrowed.

The GSEs and FHA use their
proprietary automatic underwriting systems to decide which loans to approve
using model-based inputs on the riskiness of a given set of loan
characteristics. The authors say that their results suggest that there has been
a structural change in the systems which has lowered defaults, especially on
refinance loans. While the models used
in these underwriting systems are not public, the authors say their results suggest
an update and a recalibration may be in order.
They also say that knowing the
default rates for these loans has implications for the proposed capital
standards for the post conservatorship GSEs and implications for pricing in the
interim. The capital standards, as they are currently proposed, require a 1.3-times
premium for rate and term refinances and a 1.4-times premium for cash-out
refinances. They suggest that the cash-out refinance premium may be fair or a
bit low and that the rate and term premium is too high.