Risk Management, Collateral Assessment and the Appraisal
By Charlie Elliott, Jr., MAI, SRA

The concept of risk management seems to be on the minds of most everyone in the mortgage industry today. The FDIC hosted a conference on the subject last year and many other industry players are promoting the subject.

While appraisals play an important role in reducing the risk of an individual loan, the scope of risk management is much broader, one of almost infinite proportions. Not only does the single appraisal have its role to play, but all of the appraisals which appraisers do contribute to the sum total of the broad definition of risk management, however this is only a drop in the risk management bucket. Today’s financial institutions must also navigate through a maze of state and federal banking regulations, not to mention all of the other laws and rules other businesses must comply with in order to keep risk at a tolerable level. It can be scary just to think about all of the things that can go wrong within a financial institution that subjects its stockholders to risk. Most, if not all, have complete departments devoted to what is typically called “compliance.” In most cases this department’s first responsibility is not simply to comply with all laws and rules with which the organization is bound, but first to know about all of them and to interpret them.

In the case of the wellness of people, many health experts are subscribing to the theory of holistic medicine. This is especially true of preventive methods since any of a number of health problems can spell death to a person. These include, but are not limited to, diseases of the heart, lungs, brain, kidneys and other vital organs. Similarly, the health of a financial institution is dependant upon many factors, including liquidity, profitability, borrower creditworthiness and adequate collateral. If the heart is considered to be one of, if not the most, critical organs in the health of a person, adequate collateral is likely one of, if not the most important element in the health of a mortgage, mortgage company or the mortgage industry. Stated another way, adequate collateral is a critical piece of the risk management pie in the kitchen of the mortgage company.

Given that the appraisal is a material piece of this risk management pie, let’s expand this concept further and analyze the many variables of which we are confronted with. It is not sufficient to simply say that each mortgage loan needs an appraisal. Issues, such as the quality of the appraisal, how the appraisal is used, the number of appraisals and the confidence factor assigned to the appraisal, are all among the many issues faced by lenders when using appraisals as tools for risk management. Inherent within the term risk management is an acknowledgement that mortgage loans are not without risk. Most mortgage companies make large numbers of loans, which helps to spread out the risk and permits the acceptance of some borrowers and properties not considered to be perfect risks. Those borrowers considered higher than average risks are charged higher than average fees, which helps to mitigate the effect of their participation in the loan pool.

As appraisers and collateral consultants, we are not dealing with the borrower’s credit history, the borrower’s income, loan-to-value ratios, the solvency of the mortgage company, interest rates, unemployment, or the NASDAQ. While all of these factors impinge upon the risk associated with the health of a financial institution, they are all outside of the realm of whether the property is properly collateralized.

The appraiser’s role in preparing an individual appraisal is contained and restricted to that of the individual property and those influences surrounding it, a somewhat micro approach to risk management. Most financial organizations view risk more in a macro way, one that encompasses larger numbers of properties. They concern themselves less with the value of a single property and more with that of multiple properties, which they have in their loan portfolio. Also to be considered are such issues as the product inventory, management policies, loss experience and alternative assessment tools used. As the number of foreclosures has increased with the slowing economy and the loosening of credit policies, federal regulators have recently expressed concern about the risk management policies of financial institutions.

All financial institutions should have a collateral-assessment-risk-management policy designed to address the risk associated with the loans, which they make. This is in addition to a separate and more-broad macro-risk-management policy, which addresses risks not associated with the collateral of loans. It is like a screening process to eliminate problem loans prior to their occurrence. The policy, in most cases, is not, and should not be, one of the off-the-shelf varieties.

Each financial institution is different having special needs unique only unto itself. For example, the lender that warehouses most of its own loans may very well have reason to have a different policy than the entity that sells most or all of its loan production on the secondary market. An institution that is experiencing a high loss ratio, due to a slow local economy, will find it necessary to have different collateral-assessment policies than that of an entity making loans where the economy is booming. A bank which has plenty of excess liquidity will find that its collateral-assessment policy may be more aggressive than that of an institution which is close to its limits as imposed by federal regulators. Those organizations finding their market to be very competitive may find it necessary to subscribe to a policy, which permits limited appraisals, offering a lower and more competitive cost in a shorter time frame.

In summary, in today’s very complex and competitive sociological, financial, political and legal environment, financial institutions find themselves more dependent than ever upon a collateral-assessment program that not only helps manage the organization’s risk exposure but also lends itself to meeting the competitive demands of today’s borrowers. Given all of the constraints of the mortgage business, a collateral-assessment-risk-management policy emphasizing the unique requirements of each financial institution is a must. The traditional appraisal of which we are most familiar is only one of many tools, which may be used as a hedge against risk.

Charlie W. Elliott, Jr., MAI, SRA, is President of ELLIOTT® & Company Appraisers, a national real estate appraisal company. He can be reached at (800) 854-5889 or at charlie@elliottco.com or through the company’s Web site at www.appraisalsanywhere.com.