The Financial Institutions Reform, Recovery, and Enforcement Act was enacted to bolster the lax regulation that contributed to financial distress in the banking industry during the 1980s and beyond. But many in the industry criticized the act for its onerous excesses in the opposite direction. Almost any transaction remotely related to real estate invoked numerous no-exception rules and reporting requirements. Compliance began consuming substantial corporate resources and management time.
Recently, however, the pendulum has swung sharply again.
On June 7, the Federal Reserve System, Federal Deposit Insurance Corp., Office of Thrift Supervision, and Office of the Comptroller of the Currency jointly published amendments to regulations related to real estate appraisal. The most publicized of these changes involved raising the threshold triggering the need for an appraisal.
These amendments also made other substantial changes relating to when an appraisal is required, when an evaluation is required, and appraisal standards.
By coincidence, the appraisal industry also has just clarified its standards regarding how properties are appraised and how valuation results are reported. Finally, proposed banking legislation would reduce the frequency of regulatory examinations for some institutions.
Together, these changes present financial institutions With tremendous opportunities to reduce the transaction and holding costs associated with real estate-related transactions. The regulatory pendulum has swung back far enough that many lenders will find that their own internal standards now exceed government requirements.
However, prudent lenders must consider how far to take their new freedom. Meeting only the minimum compliance standards could entail excessive business risk and additional regulatory scrutiny.
The thrift bailout law previously required an appraisal by a state-approved appraiser for virtually every transaction over $100,000 in which a lien on real estate was taken. That minimum has now been raised to $250,000 in most cases.
Less publicized is the expansion in situations no longer requiring appraisals. For example, the "abundance of caution" exception is more broadly defined. Under prior regulations, an appraisal would be required unless the terms of the loan would be identical with or without the real estate collateral. Now, no appraisal is required, even when real estate collateral entities the borrower to more-favorable loan terms, unless income from the real estate will be the primary source of loan repayment.
The new rules also allow lenders to extend or refinance credits without an appraisal, provided there is no obvious and material deterioration in the market or the collateral, or no new moneys are advanced other than to cover closing costs.
Perhaps the most significant exemption concerns residential properties. The new regulations further clarify that transactions meeting the qualifications for sale to a federal government agency or sponsored agency (e.g., Fannie Mae or Freddie Mac) are no longer subject to additional regulatory appraisal requirements, beyond those mandated by these agencies.
In fact, any residential asset having an appraisal meeting the Fannie Mae or Freddie Mac requirements does not need a FIRREA appraisal, even if the asset itself does not qualify for sale to these agencies.
This option could be welcome relief to financial institutions, because these form appraisals are considerably less onerous. However, lenders might be especially cautious in applying this exemption too broadly, as it could invite undue business and regulatory risk.
Although regulations now are less stringent, business prudence might dictate that an appraisal be performed in some circumstances when not strictly required, such as on high-risk property. Lenders will want to maintain internal standards that preserve the confidence of their regulators.
The amended regulations also change the standards that appraisals for federally related real estate transactions must meet. The key standard remains compliance with the set of rules appraisers must follow in determining and communicating conclusions of value. However, regulators now allow appraisers to deviate from certain guidelines, provided the departure does not compromise the reliability of the appraisal and the departure is clearly communicated to the client.
Before the recent amendments, banks could not accept such appraisals. This is one of the reasons appraisals became both more lengthy and more expensive. Every report, even for small, simple properties, had to be written to standards and specifications designed for large, complex properties..
In addition to allowing deviations, nine of the previous 14 appraisal standards written directly into the law have been deleted, some redundant and others excessively burdensome.
Moreover, the appraisers' rulebook has been changed with respect to reporting requirements. Effective July 1, 1994, it defines three allowed forms of appraisal reports depending on the amount of detail presented and explained: self-contained, summary, and restricted.
The self-contained report, which corresponds to the former full-narrative appraisal, requires that all relevant information be described. By contrast, the summary and restricted reports are far slimmer and less costly than the former voluminous mandated appraisals.
Nevertheless, restricted reports may be too abbreviated for most lending situations. The law still requires that reports "contain sufficient information and analysis to support the institution's decision to engage in the transaction." Many in the appraisal industry believe that restricted reports will be found to fail the "sufficient information" test and, therefore, should not be used when an appraisal is required.
The new real estate appraisal regulations provide lenders with considerably more flexibility to develop internal standards befitting their own circumstances. However, the potential to cut compliance costs must be weighed against associated business risks. Under the old rules, strict compliance with regulations enforced business caution. The new rules are not as protective. Institutions may no longer rely on the regulations to dictate an appropriate level of prudence.
Regulators, too, will be finding their center in the coming months and years. As lenders test the more relaxed regulations, regulators will be observing with a keen eye to ensure that safety and soundness standards are being met.
No doubt, regulators will fine-tune many of these standards over time as the industry's business practices evolve.
By making the appraisal a more useful and effective document, the revised regulations also could help restore appraisals as an integral part of the decision-making process, rather than just one more regulatory hurdle to clear in the transactions process.