By James R. Hagerty and Ruth Simon
From The Wall Street Journal Online

As the housing market cools, Americans are confronting a problem that was easy to ignore during the boom: inflated appraisals of home values.

Critics inside and outside the appraisal business have long warned that many appraisals are unrealistically high. That's partly because generous appraisals help loan officers and mortgage brokers, who often choose the appraiser, complete more deals. If a home is appraised at less than the buyer offered, the deal is likely to fall through.

Inflated appraisals didn't matter much when home prices were rising at double-digit rates, since market values would quickly catch up. Now, however, prices are leveling off in many places and falling in some. Some homeowners are finding that the market value is below what past appraisals led them to believe.

For sellers, that can mean being forced to drop their asking prices. Some people hoping to refinance, meanwhile, may be unable to lock in new loan terms because they have less equity in their homes than they thought. Lenders and mortgage investors, too, could take a hit if it turns out the collateral backing their loan is worth less than expected.

Most homeowners have enough equity in their homes so they don't need to worry much about whether past appraisals were realistic. But dubious appraisals are a risk for the hundreds of thousands of people who in the past few years have bought homes with little or no down payment, or used almost all of their home equity to finance home improvements or other types of spending. That has left these people with little financial cushion to deal with rising interest rates.

"Now it's pay-the-piper time for people, and they're finding out they don't have the value in the house they thought they had," says John Taylor, president of the National Community Reinvestment Coalition, a Washington-based nonprofit that supports low-income housing.

Karen Ammon, who works for an auto-parts marketing company in Bloomfield Hills, Mich., bought her home in 2002 for $141,000. A year later, a lender encouraged her to refinance into a larger loan that would let her pay off credit-card debt. The appraiser chosen by the lender had great news: Her house was now valued at $175,000. She had room to raise her total mortgage borrowings to $165,000.

Now monthly payments on the adjustable-rate loan she received in 2003 are rising in line with the general level of interest rates. So Ms. Ammon wants to refinance into a fixed-rate loan. But when she tried to refinance, she couldn't do so because several appraisers valued her home at around $148,000 -- or about $15,000 less than she owes in mortgage debt.

Appraisals are only opinions, and appraisers often disagree on the value of a home. But wide discrepancies can mean that at least one of the estimates was unrealistic. No one can say how many appraisals are unreliable. Still, Iowa Assistant Attorney General Patrick Madigan, who coordinates with law-enforcement officials from other states on mortgage-related issues, believes the deliberate inflation of appraisals is "widespread" among loans to subprime borrowers, or those with flawed credit histories. Jacquie Doty, an executive at Freddie Mac, a big provider of funding for home mortgages, predicts that inflated appraisals will lead to more foreclosures.

In the 1980s, inflated appraisals were one factor in the loan losses that sank many savings-and-loan institutions that were holding collateral worth less than they believed. Today, most loans are sold to investors and risks are more spread out, making it less likely that poor appraisals would cause lenders to collapse. But many people in the real-estate industry believe the appraisal system is overdue for reform, and investors who buy loans are asking tougher questions about appraisal procedures.

Complicating matters for homeowners is the weakening housing market. In October, when Melinda and Steve Welch refinanced the loan on their four-bedroom home in Centreville, Va., the property was appraised at $682,000. Later they cut the price to $595,000, and recently accepted a bid around that level.

Built-In Conflict

The appraisal system has a built-in conflict of interest. Appraisers often are hired by loan officers or mortgage brokers, whose compensation depends on how many loans go through. Appraisers, dependent on loan officers for their livelihoods, say they often feel pressure to come up with a number that will allow a home purchase or refinancing to proceed.

Eric Randle, an appraiser in the Los Angeles area, says he frequently receives faxes from loan officers asking whether he could appraise a specified home at a certain level. The implication is that an assignment will be forthcoming only if he's willing to hit the desired number. Mr. Randle says he declines to work on those terms.

One of Mr. Randle's appraiser friends recently received a fax from Eric J. Roberts, a mortgage loan officer in Bakersfield, Calif., for Pinnacle Financial Corp. The scrawled fax message listed an address in Los Angeles and said, "I need 2 get to 750K for this Appraisal. If not please provide a value range or call me."

Mr. Roberts declined to comment. Doug Long, chief executive officer of Orlando, Fla.-based Pinnacle, said he didn't think Mr. Roberts did anything wrong but added, "The wording could have been better."

Consumers often play along with dubious appraisals. Danny Wiley, an appraiser in Nashville who is a member of the national Appraisal Standards Board, in May was asked by a lender to appraise a condo in Spring Hill, Tenn. The buyer had offered to pay $139,000, but the contract required the seller to pay $10,000 toward the buyer's closing costs. In effect, Mr. Wiley says, the price had been inflated by $10,000 to allow the seller to provide money to help the buyer cover closing costs.

Mr. Wiley estimated the value at $129,000, the same price at which numerous identical units in the same complex had recently been sold. That should have killed the deal. But Mr. Wiley says the sale later went through, apparently after the lender found another appraiser willing to value the condo at $139,000. Mr. Wiley declines to identify the parties involved in the transaction, citing client confidentiality.

Federal law governing appraisals dates to 1989, when Congress passed legislation aimed at preventing a recurrence of the savings-and-loan crisis. That law leaves licensing and regulation mainly to the states, but many of them don't provide much funding for oversight.

T.J. McCarthy, chairman of the Illinois Real Estate Appraisal Licensing Board, says the state's appraisal regulatory agency is "severely understaffed." As a result, he says, the backlog of unresolved complaints is so large that rogue appraisers sometimes can retain their licenses for years while awaiting regulatory action. The Texas agency responsible for monitoring appraisers has just three investigators, all part-time, and is so stretched that staff members answer the phone only in the afternoon. As part of a broader push to improve legislation of mortgage lending, Congress is discussing provisions that would tighten regulation of appraisers.

Some lenders use appraisal-management companies to create a Chinese wall between the appraiser and the loan officers. But appraisers say these companies often choose the cheapest and fastest appraiser rather than the most qualified. "You get someone who is not intimately familiar with the local marketplace because they are willing to do it for less," says Jeffrey Jackson, chairman of the appraisal firm Mitchell, Maxwell & Jackson in New York.

Rise of Mortgage Brokers

Another problem is that -- unlike in the 1980s, when current mortgage law was enacted -- around half of all mortgage loans are made through brokers rather than directly by closely regulated lenders. Mortgage brokers are lightly regulated in most states, and appraisers say brokers often apply pressure. Joseph Falk, chairman of the legislative committee of the National Association of Mortgage Brokers, says brokers shouldn't pressure appraisers to distort value estimates. But he advises appraisers to create and enforce their own ethical standards.

Lenders often play down the issue. Tim Doyle, an official of the Mortgage Bankers Association, says he sees no "broad" problem with inflated appraisals, outside of criminal rings engaged in fraudulent mortgage deals. Even though mortgage lenders typically sell loans to investors shortly after making them, the lenders have an incentive to ensure those loans are backed by property valued at least as much as the loan balance, Mr. Doyle says. Investors can force the lenders to buy back a loan if it goes into default and the appraisal was fraudulent, he says.

Even when all parties want an honest appraisal, that can be hard to achieve. In making their value estimates, appraisers rely heavily on "comps," or prices paid recently for similar homes nearby. But those prices may be misleading. For instance, builders of new homes sometimes include in the sale prices such items as landscaping or contributions toward loan fees or settlement costs. Such "concessions" are rarely broken out in the sale price listed in public records, though. So the resulting inflated price can become a misleading "comp" for nearby homes.