Lines of defense in the management of risks related to real estate guarantees

As we all know, home appraisal is an integral part of the loan process that helps Americans on their journey to home ownership. It’s an honor to play such an important role, but it’s also important to remember that lending programs must follow strict practices to protect lenders and their investors from collateral risk. This series of articles explores the role of appraisal review processes in the risk system in the mortgage lending format for 1-4 family real estate. Throughout, I’ll touch on current evaluative review practices and processes, measuring change through observations, and a glimpse of what’s to come.

In practice, the mortgage lender and mortgage aggregator/investor place risk management on three lines of defence. The first includes the development and use of processes to ensure that regulatory and policy requirements are met by the business unit originating the mortgage products. This part of the program focuses on maintaining the independence of appraisal processes and ensuring that the appraisal obtained by the lender meets the requirements of the specific loan product. The second is an internal control function, which owns the policies and risk framework and advises on controls and implementations to ensure policy requirements and objectives are met. The third is when parties outside the lender’s business unit (eg, auditor, investor, regulator) review the effectiveness of controls and practices.

This three-part series will focus on the first two lines of defense in valuation risk management with a more in-depth focus on valuation review processes.

The assessment exam

The 7th edition of the Appraisal Institute’s Dictionary of Real Estate Appraisal defines appraisal review as “the act or process of forming an opinion about the quality of another appraiser’s work (that is, (i.e. a report, part of a report, or a combination thereof) that has been made as part of a valuation or valuation review engagement. Although this definition is offered in the context of real estate appraisal practice, the question that comes to mind is: Can an assessment review be conducted by a person or process that is not part of an assessment practice?

If you look at current regulatory guidelines and stakeholder policies, it is clear that an assessment can be reviewed by someone without an assessment credential when it is an internal process and the outcome of the process does not create an opinion on the market value of for credit granting purposes. Where the appraisal review provides an estimate of value, including an agreement of value, most states will require a certificate of appraisal.

Many lenders and appraisal management companies have appraisers on staff to meet state requirements and to have a level of expertise to draw on for complex issues. However, many lenders, especially small lenders or non-bank lenders, will not have accredited appraisers on staff to carry out their review process and will rely on appraisers to provide appraisal review in as an evaluation service.

Appraisal review processes are necessary because the lender must have a full understanding of the security provided for a mortgage loan or line of credit. Although the current risk of default remains at historically low levels, lenders and investors need to stay strong to prepare for economic downturns and increased defaults.

The objective of any assessment review, whether developed internally or external to the business unit, is to ensure that the assessment report obtained in association with a credit application contains sufficient information for the lender to make a credit decision.

Most loan appraisal review policies and procedures are formulated to conform to two sources. The first source is published written evaluation requirements for loan programs through stakeholders such as HUD/FHA, Veterans Administration, and Fannie Mae and Feddie Mac. The second source is the Interagency Real Estate Appraisal and Evaluation Guidelines, the source that regulated banks and credit unions should follow to ensure that their appraisal programs, including the appraisal exam, are sufficient to make comply with the lending regulations that apply to home loans.

Quality control and quality assurance

Assessment reviews are present in two distinct processes within an institution’s risk management system: quality control and quality assurance. Often the two terms are used interchangeably, but they are distinctly different processes.

While both terms speak of processes and activities, quality control focuses on analysis and inspection, and is in place to ensure that the quality is at a specified level to maintain the product produced. Quality assurance, however, focuses on monitoring and evaluating the manufacturing process, to ensure that quality standards are met and maintained. Essentially, quality assurance is a testing program to ensure that quality control processes are working as intended. Whether you manufacture an automobile or a mortgage, the manufacturer must exercise quality control and be assured that the quality is consistent.

In conclusion, the appraisal review process is an integral part of a lender’s risk management program by fulfilling the level of due diligence necessary to inspire confidence that business practices meet safety and soundness objectives for the lender and associated investors. Without this trust, the lender risks a loss to the business and the ability to participate in a system focused on managing systemic risk in mortgage lending. The next article will focus on the steps a lender will use when developing their quality control and quality assurance programs.