Bulletproofing Valuations: Insured AVMs Provide a New Level of Risk Protection By: David Keller, MBA, CMB, and President, National Mortgage Systems            No lender wants to see a foreclosure and REO sale of a property that was overvalued at loan origination. The direct hit from selling for less than the note, compounded by expenses that accrue between early delinquency and the final sale, cuts deeply into profitability. With mortgage fraud in the billions and home prices dropping across the country, mortgage-backed securities firms know that REO sale losses can spoil investor returns. This reality understandably causes investors to be very wary when buying lenders’ aggregated loan pools. Though there are multiple scenarios and players, every foreclosure and loss comes down to incorrect collateral valuation, incorrect assessment of borrower’s ability to pay throughout the life of the loan, or a combination of the two—with borrower fraud, employment layoffs, and property value downswings thrown into the mix. Valuation problems, common in fraud cases, lead straight to foreclosure losses, yet can be difficult to spot ahead of time. Automated Valuation Models (AVMs), while excellent for preventing overvaluation due to transaction pressure, may not detect certain fraud-related issues that can significantly affect price. Brokerprice opinions (BPOs) are a more expensive alternative and a valuation method increasingly used by criminals to perpetrate fraud. The third valuation option is a full appraisal, which can be lengthy and expensive for many mortgages, especially refinancing and equity loans.                         Insured AVMs: What they are Since profits can ultimately depend on collateral valuations, insuring their accuracy is the one way to know with complete certainty that the LTV is fully insured at the time the loan was made. Insured AVMs do just that—they guarantee the property valuation. The insured AVM operates similarly to other types of insurance: the lender pays a premium that insures against losses when there is an overvaluation error. Loss coverage is typically available from $50,000 to $500,000, covering equity loans as well as original and refinanced mortgages. It’s important to note that a high-quality insured AVM covers any loss type if the insured AVM  overvalued the property. The overvaluation itself does not have to be the cause of your loss in order for a claim to be made. In other words, the loss is covered if the insured lender a) suffers a loss for any reason and b) the insured AVM overvalued the property. It’s also important to remember that the insured AVM insures the property’s value at the time the insured AVM was run. The insured AVM is not a guarantee that the property’s value may not go down subsequently. Market conditions, such as a major employer leaving town, may cause that property and others in that area to go down due to circumstances that occurred after the insured AVM report was run. If a loss results due to declining property values occurring after the insured AVM was run, and the insured AVM was accurate when run, the loss will not be covered. Claims examples include a range of common and uncommon loss scenarios:             A lender pays for an insured AVM with loss coverage up to $150,000 and issues a 90 percent mortgage based on the $300,000 insured AVM valuation returned. The buyer defaults on the $270,000 loan, the lender forecloses and must sell the distressed property for the $220,000the market will bear. A retrospective appraisal shows that on the date the insured AVM was run the property was only worth $250,000. The lender files an insurance claim providing evidence of the overvaluation error and recovers the $50,000 loss plus all expenses incurred during the foreclosure and REO sales process.    A homeowner who owes $150,000 on the original mortgage obtains a $50,000 equity loan, taking the combined loan-to-value (CLTV) to 100 percent of the insured AVM value of  $200,000. Unfortunately, the AVM did not detect that the home sits on a newly declared EPA Superfund site and is effectively unsellable. The borrower defaults on the $50,000equity loan, the equity lender files a claim which includes a retro-appraisal that shows the EPA declaration and valuation error and recovers the full $50,000 loss, plus expenses.    A buyer pays $250,000 cash for a rental home seriously vandalized by evicted tenants and refinances the home with the lender using an insured AVM value of $400,000 to make a 100  percent CLTV loan, the price associated with comparable neighborhood homes in average condition. The buyer pockets the $150,000 cash, leaving the lender holding an REO property requiring significant repairs. The lender secures a retro-appraisal showing that the true value was $250,000, files a claim against the insured AVM, and recovers the $150,000 loss plus associated expenses. As with other insurance policies, insured AVM premiums are based on the amount of coverage desired. In general, an insured AVM premium costs a small fraction of what you would pay for a standard appraisal and as little as half the cost of a BPO. Insured AVMs offer the added benefit of speed that makes AVMs so attractive to lenders.         Secondary Market Benefits Clearly, originating, refinancing and equity lenders benefit directly from being able to insure against valuation-related losses. Moreover, they can reasonably expect to benefit from mortgage-backed securities (MBS) bond buyers who may be less likely to reject loan pools and willing to pay more for an MBS pool that has added loss protection provided by insuredcollateral values. These credit-enhanced pools then create better performing MBS bonds, benefiting investment firms and their investors. At the May 2007 MBA National Secondary Market Conference, an MBS buyer from a major California pension fund commented that “all things being equal,” their fund will pay more for an MBS pool made up of loans with insured collateral values. Similarly, the managing director of a major rating agency predicted that “ratings for loan pools with insured AVMs will go up in the foreseeable future.” Some originating lenders are planning to add the insured AVM along with an appraisal to the HUD-1 and have the borrower pay for both. “Perfectly allowable,” says attorney Grant Mitchell who helped write the Real Estate Settlement Procedures Act (RESPA) rules before leaving HUD.           Caveat: All Insured AVMs Are Not Created Equal Just as the term “health insurance” covers a wide variety of policies; insured AVMs come in many shapes and sizes. Some insured AVMs are not AVMs at all, requiring additional special certifications, such as property inspection reports or other forms of field reviews, essentially negating the speed and cost benefit inherent in the AVM approach.  It’s also wise to research possible exclusions before purchasing any valuation coverage. Some insured AVM coverage is very narrow, excluding coverage for AVMs that do not meet certain confidence levels and for losses resulting from such common causes as borrower fraud, natural disasters, and eminent domain decisions. Conditions involving straw buyers, property flipping, and other tactics used by fraud rings could be excluded. Likewise, if a borrower intentionally applies for a mortgage on a property soon to be destroyed for the construction of a new freeway and the insured AVM doesn’t detect the eminent domain decision, some AVM insurers could void coverage. Homes destroyed by forest fires, tornados, floods, etc., before or after the AVM is run may also cause an exclusion by some. First American CoreLogic was among the first companies in the country to offer insured valuations and continues offering the broadest use and coverage. The company uses the industry’s most comprehensive AVM cascade made up of 18 different AVMs, running each address through the cascade to select the most accurate valuation, and fully warranting theresulting AVM valuation regardless of the AVM’s assigned confidence rating. The company does not exclude coverage when there is borrower fraud, natural disasters, or eminent domain decisions. First American CoreLogic’s insured AVM even protects against losses suffered when the secondary market rejects a loan with disagreement of the property value as one of the reasons. The insured AVM claim pays the difference between what the rejecting secondary market paid for the accepted loan, and what a scratch and dent investor paid for the rejected loan. “Our insured AVMs provide our customers with a unique level of assurance by backing our collateral valuations with insurance protection. We obviously have to be confident about our valuation models to do this,” says Steve Schroeder, executive vice president of risk management for First American CoreLogic. “We also believe that insuring lenders and secondary market buyers against loss will help strengthen the mortgage industry and further protect it against fraud.” For comments and further discussion please contact the author, David Keller at dKeller@nationalmortgagesystems.com.