October 3, 2007
Real Estate Flipping
I am still perplexed at how easily real estate flippers got away with false appraisals on overvalued land. The banks loaned too much based on the true value of the underlying collateral and the seller's walked with the excess cash (often repeating the process as buyer then seller in the next cycle). In the simple case the lending bank has a strong interest in checking the accuracy of the appraisal (or hiring its own reliable appraiser) before loaning money on a land purchase and taking back a mortgage. Some argue that structured finance dilutes everyones incentive to check for fraud. The argument notes that the bank sells the paper to a special purpose vehicle (SPV) and the SPV sell securities to investors. The risk of fraud is borne by the investors who do not or cannot check on the validity of any appraisals. The investors rely on rating agencies to rate the default risk and the rating agencies are operating under conflicts because they are paid by the SPV and get consulting fees from the SPV. The bank (and the originating broker) and the SPV no longer care because they take fees and pass on the risk. The investors end up holding the bag. The argument seems overly simplistic. Most SPVs sell tranches and the lowest tranche, the so-called equity tranche, is not rated and very risky. Those who buy the equity, usually hedge funds, have an increased risk of loan defaults and should therefore have an increased incentive to monitor the quality of the loans. Indeed, one could argue that the equity buyers and a stronger incentive than a bank that does not sell the paper to check on the default risk in the loans because the hedge funds took more risk with each default. There were long time rumors in the market of real estate flipping. Why did the hedge funds not check out the rumors, or at least price the equity to account for the rumors? Moreover, many of the same banks that passed on the risk to the SPV then bought SPV securities in their own hedge funds (and those funds are now in distress). Why did the banks not have the proper incentive, when purchasing back the paper, to make sure the paper that went to the SPVs they invested in was sound? In short, I continue to be baffled by stories of easy money (made even by gangs of thugs) on real estate flipping that overvalued land in the appraisals.
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