Dale Stinton - NAR


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John McCrocklin White Paper

Determining Collateral Value & Tracking Performance: A Guide to Real-Time Value & Market Stabilization

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Dale Stinton - NAR

  1. 1. America’s Financial Crisis Determining Collateral Value & Tracking Performance: A Guide to Real-Time Valuesm & Market Stabilization By John H. McCrocklin, ALC, CRB, CCIM john@mccrocklin.com / (512) 914-7227 Written July 7, 2009 Amended January 26, 2010 ©John H. McCrocklin, 2009, 2010
  2. 2. TABLE OF CONTENTS I. EXECUTIVE SUMMARY…………………………………………….. 1 II. INTRODUCTION.……………………………………………………… 2 III. IDENTIFICATION OF THE PROBLEM..……………………………. 3 IV. THE VALUATION DECISION………………………………………... 3 V. IDENTIFICATION OF PROCEDURAL ERRORS………………….. 9 VI. ACHIEVING ELECTRONIC MONITORING……………………….. 12 VII. REAL-TIME VALUEsm – FIELD TEST 1………………...…………… 18 VIII. THE SOLUTION…………………………………………………………. 19 IX. BEST PRACTICES - COMMERCIAL REAL ESTATE……….…….. 20 X. BEST PRACTICES - RESIDENTIAL REAL ESTATE……….…….. 23 XI. GEOCODING…………………………………………………………….. 25 XII. OPEN SYSTEM ARCHITECTURE……………………………………. 27 XIII. REAL-TIME VALUEsm – FIELD TEST 2……………………………… 28 XIV. IMPLEMENTATION……………………………………………………. 29 XV. PHASE-IN………………………………………………………………… 30 XVI. SUMMARY……………………………………………………………….. 31
  3. 3. Real-Time Valuesm EXECUTIVE SUMMARY One of the most significant challenges facing our financial and real estate markets today is that of valuation. During the Thrift Bailout of the 1980’s the Resolution Trust Corporation (RTC) was responsible for overseeing a $180 billion bailout. During that process Congress “called for better information systems in general, and for better information systems for securities portfolios and real estate owned in particular. Three of the eight specific management reform goals were: to develop an effective system to track and inventory real estate assets; develop a process to update, on a quarterly basis, the value of assets under receivership; develop a program for examining one- to four-family mortgages and for marketing such loans on a pooled basis.”1 These systems were never implemented or adequately addressed. “As a result of the lack of real estate based information systems a discrepancy of nearly $7 billion in assets between the ledger maintained at the RTC and the ledgers in 92 different receiverships existed.”2 This issue should have been corrected in the 1980’s in order to prevent the costly reoccurrence we have encountered again today. A requirement should have been established for the country’s financial institutions to track the data elements of its assets and collateral in a Real-Time Valuesm format. No regulatory changes were made implementing Real-Time Valuesm assessment as a requirement. Today we have a bailout that has twenty times the number of assets with six times the dollar volume, in comparison to the 1980’s, to assess and manage. The Financial Accounting Standards Board (FASB) issued Financial Accounting Standard (FAS) 157, Fair Value Measurement, in 2007 in an effort to require publicly traded institutions to mark their assets to market value. The problem with this accounting standard is that it did not anticipate the problems caused by bulk “market-based” assessment of real estate. It ignored the unique data sets of individual assets and resulted in a less than market representation of value. Due to the significant losses that remain unrecognized by the country’s financial institutions, Congress successfully lobbied for the suspension of FAS 157. The FASB responded by “temporarily” suspending FAS 157 in April 2009. As a result, we have over $2.8 trillion dollars of assets at the five largest financial institutions in the country that have not been “marked-to-market.” This is shrouding the balance sheets and real financial condition of all financial institutions in the country today. Without a “mark-to-market,” process our real estate markets will not find a bottom in order for a recovery to begin. In order to achieve a stable recovery for both the financial and real estate markets we must eliminate the flawed process of tracking only the financial data elements of a loan after it is underwritten and originated at a financial institution and instead expand the process to include the data elements of the underlying collateral in order to be able to rapidly assess its Real-Time Valuesm. As loan portfolio collateral and Owned Real Estate (ORE/REO) data is collected by the institution, improvements will be seen in enhanced data population, more accurate collateral 1 Davison, Lee. “The Resolution Trust Corporation and Congress, 1989-1993 PART II: 1991-1993.” FDIC Banking Review (2007): pgs 3, 24. 2 Davison, Lee. “The Resolution Trust Corporation and Congress, 1989-1993 PART II: 1991-1993.” FDIC Banking Review (2007): pg 10. Page 1
  4. 4. Real-Time Valuesm assessment in terms of Real-Time Valuesm, improved data distribution and collaborative sharing both internally and externally on a local, regional and national basis in a very security-rich environment. These enhancements will improve the management, oversight and decision process in the proactive management of these assets while providing a high level of transparency and accomplishing the disclosure requirements sought by the FASB. Failure to address this issue, and the compulsory implementation of the Real-Time Valuesm methodology on a phased-in basis, will result in a recurrence of another overwhelming and distressed financial cycle in the future which would be a third and potentially final strike against our financial and real estate markets. Your attention is called to this report which outlines and substantiates Real-Time Valuesm methodology and the valuation process. INTRODUCTION The United States and the World are in a financial crisis of unparalleled proportions as a result of the credit crunch which has pushed the global economy into a recession. While a combination of factors, including: the end of the speculative Dot-com bubble, the subprime mortgage debacle, the credit default swaps, a lack of public confidence in the economy and capital markets, a deterioration of liquidity in the money markets and falling real estate values, all contributed to our economic decline, some parallels to the insolvency and failure of the Federal Savings and Loan Insurance Corporation in the mid 1980’s, are evident. The percentage of scheduled items to total assets for the 9th District Federal Home Loan Bank in Dallas in late 1988, exceeded 19.16% with the State of Texas alone in excess of 20 percent meaning that one out of every five loans, made through the Thrift industry in Texas, was either a scheduled item, non-performing, or in foreclosure. The level of defaulted and non- performing assets was not restricted to Texas. The level of non-performance was reflective of the financial services industry across the entire nation then just as it is today. The major difference is that 9.47% of all loans are non- performing across the country and there are 10 to 11 times as many non-performing and foreclosed assets today, with that number potentially doubling in the next four years, as there were in the 1980’s and the average individual asset values today are far less than they were then. This increased number of non-performing and foreclosed assets has created intense asset management pressure on financial institutions, their ability to maintain Tier 1 capital Page 2
  5. 5. Real-Time Valuesm requirements and their ability to originate loans today. These pressures indirectly impact the real estate market. IDENTIFICATION OF THE PROBLEM This position paper has been developed to: (1) examine the valuation decision and whether the resulting value should be Arbitrary, Static or Real-Time Valuesm; (2) identify the procedural errors in methodology for tracking the collateral value as well as the lack of internal and external collaboration for collecting; and, (3) disseminating the collateral’s unique property characteristics in relationship to the market in order to achieve a Real-Time Valuesm as a loan’s performance changes category or responds to market fluctuations. It also identifies the steps that must be implemented to eliminate the continued recurrence of the problem. THE VALUATION DECISION One of the most significant challenges facing our financial and real estate markets today is that of valuation. During the Thrift Bailout of the 1980’s, regulatory oversight identified the need to transition from Regulatory Accounting Principles (RAP) to Generally Accepted Accounting Principles (GAAP). However, the change still did not have the comprehensive impact it intended because of the loose interpretations of the Financial Accounting Standard Board (FASB) pronouncements by the Thrifts. Page 3
  6. 6. Real-Time Valuesm As an example FAS 15, Troubled Debt Restructuring, was used to create cash-flow mortgages while moving non-performing assets to the performing category during the 1980’s. This accounting change did nothing to improve the market value of the asset while accomplishing the change in accounting classification. In most cases this action simply forestalled the inevitable. The environment was also exacerbated by the use of the Federal Home Bank Board’s Net Worth Certificates, akin to an unsecured promissory note, which were used to prop up failed institutions thereby prolonging the recognition of failure and the cost to cure. However, changes were implemented to correct some of the procedural errors that were made in the 1980’s. The Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance Corporation (FDIC), and the Office of Thrift Supervision (OTS) enacted the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) in an attempt to correct many of the procedural errors that had occurred. Title XI of FIRREA required the agencies to adopt regulations on the preparation and use of appraisals by federally regulated financial institutions. Real estate appraisals were required to be performed in writing in accordance with uniform standards by professionals subject to State supervision. Section 304 of the Federal Deposit Insurance Corporation Act of 1991 required that each regulated institution formally adopt and maintain a written lending policy for real estate in Page 4
  7. 7. Real-Time Valuesm order to be consistent with “safe and sound banking practices.” The required lending policy was also to include “an appropriate real estate appraisal and evaluation program.” Appraisers were required to be free of conflicted interest in the property being appraised. Training and licensing procedures were created for appraisers in their respective states. These much needed changes greatly aided the underwriting process. However, regulators stopped short of minimizing future loan defaults because the appraisal and evaluation process only reflects the present value at the time the loan was underwritten. The appraisal does not minimize or eliminate future risk because the value of the collateral is “static” at a given point in time. The Economic Recovery Tax Act (ERTA) of 1981, an example of legislative risk, created 15-year straight-line cost recovery schedules for real estate improvements which were later extended to 27.5-year straight-line schedules for residential and 39.5-year straight-line schedules for commercial property with the enaction of the Tax Reform Act of 1986. This seemingly inconsequential change devalued commercial properties overnight by as much as 40%. The original appraisal value had become static in relationship to the collateral’s current value after the legislation was enacted. Source: Dr. Mark Dotzour, The Real Estate Center The most significant deficiency, and enabling factor of the Thrift Crisis of the 1980’s, was not addressed. This deficiency was not part of the underwriting process but an inadequate Page 5
  8. 8. Real-Time Valuesm monitoring methodology or process that occurred after the loan was originated. The deficiency was exposed when a performing loan became classified, non-performing or owned real estate (ORE/REO). The focus turned from monitoring a performing loan to monitoring the underlying collateral or security for the loan once the performance of the loan was called into question. The case has never been more prevalent than with the current Mortgage Backed Securities (MBS) markets as interests have been partitioned off with borrowers left in the dark as to the who the ultimate decision maker for their loan is. The participation or securitization of these loans has mutually intensified the problem for both borrowers and lenders. Institutions today are still ill-prepared to monitor assets as they change accounting classification due to a serious lack of technological infrastructure and collateral data collaboration which is required to collect and evaluate current market information and demographics from real estate practitioners in order to provide a Real-Time Valuesm or dynamic value assessment for the loan or collateral in question. Real-Time Valuesm is the value resulting from methodology applying the collaboration of practitioner driven market, financial, demographic, psychographic, retail and geographic data to the defined data elements of the subject asset or collateral, identified by Best Practices Standards, in order to produce a Real-Time or dynamic value in lieu of existing data that may be market- based versus asset specific or static. In addition to these identified deficiencies, are those created by the current regulatory environment that required the implementation of FAS 157, Fair Value Measurements, which was imposed for the admirable purpose of providing broader and more accurate disclosure of asset values, on balance sheets, to the public. FAS 157 was implemented in 2007 and applied to asset valuation until its temporary suspension in April of 2009 after the FASB heeded to the pressure from Congress. The temporary suspension of FAS 157 allows institutions to reclassify “toxic” assets as “underperforming” or “exceptional” if the financial institution believes it can hold the asset for an extended period while the collateral value improves enough to eliminate the risk of loss or write down. This holding period is completed without the reservation of incurring loss reserves on the institution’s capital account and balance sheet. Page 6
  9. 9. Real-Time Valuesm Source: Dr. James P. Gaines, The Real Estate Center According to FASB, before the issuance of FAS 157 there were divergent definitions of Fair Value with little guidance for the resolution of resulting discrepancies. These discrepancies added to the intricacy in the implementation of GAAP standards for Fair Value calculations. Under FAS 157, which many consider as the “Mark-to-Market” rule, valuation techniques are supposed to be consistent with the correlation of the Market, Income, and Cost Approaches utilized in the determination of the asset’s Fair Market Value. However, FAS 157 emphasizes that Fair Value is “market-based” rather than “asset specific" and that the firm completing the evaluation must focus on the price that would be received to sell the asset rather than the price that would be paid to acquire the asset. This approach is applied to all assets, including real estate, and by definition would result in lower or more conservative values than those dictated by the market. The short coming of this approach is that it applies a standard assumption(s) to the entire portfolio regardless of the uniqueness of the asset. With regard to real estate based collateral this approach renders the assumptions and resulting value as “arbitrary” because it is the data elements of the specific asset, which are not considered, that create a uniqueness that must be evaluated in order to determine its ultimate individual value. This is the reason that many people refer to the Fair Value approach as “Mark-to-Make Believe”. In order to overcome the shortcomings of FAS 157’s Fair Value assessment, an examination of the specific asset must be completed. The institution should start with the electronic capture of specific collateral based information from the appraisal that is completed Page 7
  10. 10. Real-Time Valuesm during underwriting. This would allow the institution to update static information to Real-Time Valuesm through electronic collaboration with practitioners in the field. With the current suspension of FAS 157, the market encounters a double edge sword. On the beneficial side, the suspension: reduces the number of non-performing “toxic” assets, improves liquidity by reducing loan losses allowances, allows time for the real estate market to recover and improves the institution’s capital account and balance sheet. The unconstructive impact: shelters the recognition of loan losses, prevents “toxic” assets from being sold, inhibits the recovery of the real estate market which cannot find a floor without the disposition of foreclosed and non- performing assets, reduces available capital for new loans by increased charges for loss reserves and cloaks the real financial health of the financial institution. During discussions in the summer of 2009, the Financial Accounting Standards Board (FASB) discussed increasing disclosure requirements for publicly traded companies. FAS 166, Accounting for Transfers of Financial Assets, was passed in order to bring off-balance sheet items such as MBS back onto the balance sheets of financial institutions. This would have required new valuations, Mark-to-Market, for the MBS and Commercial Mortgage-Backed Securities (CMBS) assets with the institution establishing contributions to their loss reserves and a reduction in Tier 1 capital for any reductions in book value. On March 11, 2010, the FDIC passed a Safe Harbor rule temporarily exempting some MBS and CMBS assets from these new disclosures. The FASB appears anxious to step up public disclosure via Mark-to-Market policy implementation. FASB is presently discussing the reinstatement of FAS 157 while the FDIC has openly discussed circumventing FASB guidelines by returning to Regulatory Accounting Principles and internal oversight. Real-Time Valuation would provide the transparency sought by FASB in place of FAS 157 Fair Value as it pertains to real estate based assets including MBS and CMBS pools. Page 8
  11. 11. Real-Time Valuesm IDENTIFICATION OF PROCEDURAL ERRORS Once a loan has been underwritten and originated the lender’s job is straight forward as long as there has been no obvious or material change in market conditions and/or the physical aspects of the real estate collateral to a point that would threaten its continued affirmative performance. During favorable economic conditions and real estate markets, the lender incurs minimal risk and minimal requirements to fulfill in monitoring the collateral value. With our current economic conditions the determination of risk requires more oversight and proactive versus reactive management. In that respect, today is not any different than the 1980’s during the Thrift Crisis. Institutions then (as well as today) ignored the need to constantly monitor their loan portfolio’s collateral asset value. This was especially true in the early 1980’s with the passage, within a six year period, of three major tax acts that each had a different consequence on the market value of real estate. In order to better understand where an institution has maximum exposure on a loan, the overall loan origination process needs to be reviewed. Page 9
  12. 12. Real-Time Valuesm During the origination process the financial institution generally reviews: the borrower’s credit reports and FICO score rating, confirms available capital for servicing the loan and as well as potential capital reserves, debt to income ratios for individuals or debt coverage ratios for commercial projects, the title commitment, easements and exceptions, the earnest money contract, if the property is being purchased, the condition of the collateral, the appraisal completed on the proposed collateral, a boundary survey showing easements, encroachments and improvements of the property, any existing or potential leases including the financial strength of the tenant and the rate and term of the leases, construction documents, any requirements for mortgage guaranty insurance, tax incentives for the borrower, credit enhancements, the property casualty insurance, environmental issues where they may potentially exist, and overall market conditions. This process is thoroughly documented from initiation to completion of origination. The flaw that existed in the 1980’s, which still exists today, is that the financial institution doesn’t convert all of the data into an electronic monitoring system for tracking the collateral and its current Real-Time Valuesm. Because many institutions don’t warehouse their loans they don’t see a need to track collateral data long term. When the loans are sold individually or in pools, the responsibility generally transfers to the new owner or transferee. The purchasers of these loans generally get nothing more than the ability to electronically assess the performance of the loan payments while all the underwriting files on the collateral are transferred in a hard copy or an electronic document management format. The cost of conversion of the collateral data to a usable and trackable electronic format using unique data fields, acts as an impediment to inhibit the purchasers of these loans or pools of loans from completing an extensive conversion of the data. The lack of conversion eliminates the ability of the owner to calculate the Real-Time Valuesm of the collateral value when market fluctuations occur. This is most critical where loans are non-recourse, as they are in 99% of the CMBS pools. Page 10
  13. 13. Real-Time Valuesm The purchasers of these portfolios, as well as financial institutions that warehouse their loan portfolios track a limited number of asset data fields once the loan is originated. At a minimum these fields would include: o Loan Amount; o Interest Rate; o Payment Amount; o Frequency of Payment; o Payments Made; o Origination Date; o Maturity Date; o Principal and Interest Payments; o Loan Balance; o Mortgagor’s Credit Score; o Ad Valorem Property Taxes; o Property and Casualty Insurance; o Collateral Address; o Borrower; o Performance; o Loan Participants; o Mortgagor SSN; o Performance; o Delinquency. These are financially related fields provided to allow management to determine if the loan is in conformance with the terms of the promissory note and deed of trust securing its payment when it was originated. This information has nothing to do with the underlying collateral that provides the security for repayment of the loan. If the terms of the loan are not being met, management is not in the position to electronically assess the Real-Time Valuesm of the underlying collateral as market conditions fluctuate with the overall economic conditions. Management must rely on a review and manual update of the original underwriting file for what could be thousands of assets. John Naisbitt pointed out in Mega Trends that America is no longer a country focused on Industry, “the new source of power is not money in the hands of a few but information in the hands of many.” The United States has become a nation where collection, control and distribution of data are the key to success. Visionaries like Bill Gates, Steve Ballmer, Jim Page 11
  14. 14. Real-Time Valuesm Manzi, Ray Ozzie, Steve Jobs, Larry Ellison and others, directed our convergence into the information age. Unfortunately financial institutions have been too slow to change their cultural landscape to adapt to the information age. The majority of the detailed collateral data which could assist management in the decision making process, when market values fluctuate or economic conditions turn unfavorable, is rarely (if ever) converted into an electronic format. ACHIEVING ELECTRONIC MONITORING OF MARKET VALUE The inability to electronically tract the market value of collateral assets is not a new problem. On April 10, 1990, Mr. David Cooke, Executive Director of the Resolution Trust Corporation was presented with a proposal entitled the Strategic Tactical Asset Management Plan (STAMP). STAMP outlined a plan which would have allowed the RTC to electronically track assets and the Real-Time Valuesm of collateral for classified and non-performing loans as Page 12
  15. 15. Real-Time Valuesm well as ORE/REO that were under RTC supervision. The RTC ultimately took no action on the plan. In the 20 years since that proposal was submitted to the RTC, no action has been taken by the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Office of Thrift Supervision or the United State Treasury to eliminate this deficiency within our financial markets. However, I am aware there are a number of organizations, both within organized real estate and outside of it, that are very focused on this detailed collateral data and how to capture it. It is entirely possible that the RTC workout of 20 years ago, and the pain and suffering that accompanied it, could have been shortened by years with the advent of delivery mechanisms having the ability to monitor detailed collateral data and determine its Real-Time Valuesm on a periodic basis. Given today’s environment, which is even more fragile, the opportunity these organizations are pursuing in order to accelerate this “workout period” is compelling. Page 13
  16. 16. Real-Time Valuesm Closer inspection of the Uniform Residential Appraisal Report (URAR), Fannie Mae Form 1004 provides over 150 unique data elements about the collateral and additional fields about the comparable sales. This data is categorized by: o Subject Data; o Contract Data; o Neighborhood Data; o Site Data; o Improvements; o Sales Comparison Approach to Value; o Cost Approach to Value; o Income Approach to Value; and o PUD/Homeowners Association Data (HOA). If this data were maintained in an electronic format from origination, management would be in a position to immediately address concerns of its Board of Directors, regulators, shareholders, potential purchasers and other interested parties as the market fluctuations occur. Practitioner based competence in the real estate profession should be sought for property- centric data sets of information on properties including: o Public Records and Tax Assessment Data; o Liens; o REO Properties; o Foreclosures; o Notice of Default; o Permits; o Zoning; o School District Data; o Neighborhood and Demographic Information; o Geocoding Data; o Psychographic and Retail Information; o Aerial and Satellite Imagery. Page 14
  17. 17. Real-Time Valuesm This information can turn the results of advanced search and valuation features into consumer level reports and graphs, including: o Property History; o Valuation o Disposition Pricing o Market Trends and Activities Forecast; o Consumer Based Demographics; o Neighborhood Data. This information would enhance the user’s ability to provide timely and relevant information to the financial institutions on current market conditions in order to determine the Real-Time Valuesm of individual assets or portfolios of assets. The statistical analysis of this information would allow the institutions to create an estimated Real-Time Valuesm for a property based on a variety of market-based factors. An automated Real-Time Valuesm model could be developed and used by lenders to make a preliminary determination in underwriting, or for a collateral-based loan or for a portfolio level analysis after the loans are originated. While this information would not provide a formal appraisal prepared by a licensed appraiser it would facilitate the appraiser and the appraisal process with arms length market information on an as-needed basis. This process would be capable of assisting financial institutions with the determination of an asset’s Real-Time Valuesm on a periodic basis but this is predicated upon the institution initial capture, electronically, of the collateral information from the appraisal during underwriting. When discussing the conversion of collateral data into an electronic format, consideration must be expanded to also include commercial real estate. Commercial real estate assets are by definition far more complex because of the distinct disciplines, income producing capacity and greater risk. Page 15
  18. 18. Real-Time Valuesm Source: Realty Trac Unlike residential properties there are multiple categories distinguishing the type of assets: o Office; o Retail; o Industrial; o Multi-family; and o Land; each with multiple subcategories. Commercial appraisals are typically narrative reports that do not have a defined form such as the URAR form that exists for residential appraisals. In order to efficiently tract the collateral information on commercial assets, the data sets need to be expanded to potentially include up to 400 unique data elements on an individual commercial property. Page 16
  19. 19. Real-Time Valuesm The depth of information is much greater as lenders have to review the asset’s individual attributes as well as external characteristics and market conditions affecting the collateral. These attributes include but are not limited to: o Financial Analysis; o Highest and Best Use Analysis; o Location Characteristics; o Site Attributes; o Linkages; o Physical Characteristics; o Market Analysis & Feasibility; o Demand Analysis; o Competitive Supply; o Environmental Site Assessments; o Leases; o Storm Water Retention and Water Quality; o Civil Engineering Reports; o Geological Site Assessment; o Endangered Species; o Wetlands and Other Environmental issues; o Specialty Districts (e.g., Tax Increment Finance Zones, Free Trade Zones) o Other Reports - Specific To Commercial Product Type. Although commercial and residential real estate are succinctly different, each can be effectively monitored, evaluated and housed in the same repository. This is accomplished through the creation of tailored data tracking sheets which are designed for the specific type of real estate. Technology has existed for 20 years that would allow the conversion of hard copy data to an electronic format for the purpose of tracking collateral value or ORE/REO. In late 1989, Jim Manzi, President of Lotus Development Corporation in Cambridge, MA, brought to the market a new product, Lotus Notes®, developed by Ray Ozzie, Iris Associates. Lotus Notes® was a very innovative distributed database environment designed to get users to work collaboratively in teams by managing and distributing shared data in a secure server environment. Lotus Notes® utilized a Windows® operating environment and had a graphical user interface (GUI) with “what you see is what you get,” WYSIWYG, reporting that made it very popular with users. It set the standard for what would become “open system architecture.” Page 17
  20. 20. Real-Time Valuesm Users could create their own customized reporting using Lotus Script®, simple conditions and statements similar to macros commands found in electronic spreadsheets, without having to call on their IT departments. This ability radically changed the way businesses operated. Data could be collected locally and pushed up from a server environment to a mainframe computer system or with the use of application program interfaces (API) pulled down from the mainframe to the local server level thereby creating extensive two way communication of data which was shared collaboratively. Lotus Notes® also had a very strong security-rich encryption key that made the U.S. Government, including the Central Intelligence Agency, as well as many financial institutions comfortable with its operating environment. It was deployed extensively at many money center banks in the 1990’s. The Lotus Notes® platform revolutionized the collection and distribution of informational databases in a server environment and with collaborative sharing of information. REAL-TIME VALUEsm - INITIAL FIELD TEST 1 After the RTC failed to seriously consider or adopt STAMP, Real Estate Asset Information Management Systems, RE/AIMS, a Texas corporation, partnered with Lotus® as the third Alliance Partner with Lotus Notes®. RE/AIMS wanted to prove a collateral based tracking system like STAMP would work and could be very cost effective. In 1991, RE/AIMS field- tested this technology for one of their clients on the portfolio of a failed thrift, Bright Savings Bank, which was under RTC control. As the market value of the collateral for Bright’s loan portfolio dropped, the assets were defaulted and foreclosed by Bright. Bright ultimately failed and was taken over by the RTC. The RE/AIMS system, ATTACK®, was designed to track over 1,200 unique data elements for multi-family residential and commercial real estate assets that had been originally collateralized as part of Bright’s commercial loan portfolio. With nothing more than a list of the assets, pricing and location, representatives from RE/AIMS physically drove to each asset in the portfolio and gathered detailed information on the assets using a notebook computer. The end result after two weeks of electronic data collection was, when printed, over five volumes of information detailing the individual attributes of the assets. The volumes created for each category of real estate were about eight inches thick each when printed. When the entire portfolio was bid, the high bid was developed from the automated system RE/AIMS developed utilizing Lotus Notes® as an operating platform. Page 18
  21. 21. Real-Time Valuesm The winning bid was not awarded to the RE/AIMS’ client because the other bidders protested to the RTC believing that there had to have been some type of inside information provided about the assets to RE/AIMS. This assumption was based on the volume of market data, the five volumes, which had extracted about the portfolio’s assets. In actuality, the winning bid was based on the most advanced technology available and professional practitioner driven methodology, Best Practices, which allowed for the determination of the Real-Time Valuesm of the assets. With the amount of data that had been collected, RE/AIMS had the ability to compare the original book value of the assets with the current discounted market value and make a series of sensitivity studies employing different holding and exit strategies in order to perfect a maximum bid. Analysis could be applied on individual assets as well as the portfolio as a whole, something that had previously been unachievable at the time due to a lack of unique asset data. This ability provided a Real-Time Valuesm on the former collateral that had converted to ORE/REO. None of the other bidders had that advanced technological capability or capacity to evaluate the portfolio with this type of approach. While Lotus Notes®, aka Domino®, technology is not an exclusive solution to the current problem, it evidences that the technology to implement Real-Time Valuesm methodology has existed for the past 20 years and has only improved over that period. Data can be pushed or pulled from mainframe computers to allow data migration to integrate into a user friendly distributed database server environment with teams of individuals working collaboratively to solve the problem of tracking collateral asset value. Today’s collaboration technology allows financial institutions the opportunity to seek knowledgeable third party allied practitioners in local markets for the purpose of evaluating and maintaining current market data in a secure environment. We must transition from old standards to a new technological platform in order to restore public confidence in our financial system while giving management the tools necessary to be proactive versus reactive in its management processes. THE SOLUTION In order to implement a Real-Time Valuesm system for collateral today, a FIRREA-like regulation needs to be implemented establishing real estate industry Best Practices standards for methodological and market data collection as well as technological standards for use determining Page 19
  22. 22. Real-Time Valuesm the Real-Time Valuesm of individual collateral assets including those both on- and off-balance sheets, e.g. performing loans, non-performing loans, ORE/REO, MBS, CMBS, etc. Because financial institutions carry their MBS and CMBS portfolios as off-balance sheet items, the legislation would provide a level of needed transparency to the public. This action would be in line with the intent of FAS 166, Accounting for Transfers of Financial Assets, and FAS 167, Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets and Interests in Variable Interest Entities, which has been circumvented by the FDIC’s Safe Harbor Protection for Securitizations, enacted March 11, 2010. The legislation needs to establish three distinct standards: (1) Best practices methods for Commercial Real Estate; (2) Best practices methods for Residential Real Estate; and (3) The requirement to implement minimum standards for technological integration of collateral and ORE/REO data in Open System Architecture. Implementation of these three standards will automatically result in a major benefit, transparency of the review and evaluation process. The benefit would be applicable to financial institutions, shareholders, the government and the public. BEST PRACTICES – COMMERCIAL REAL ESTATE According to BusinessDictionary.com, “Best Practices methods are methods and techniques that have consistently shown results superior than those achieved with other means, and which are used as benchmarks to strive for.” Evaluation of commercial real estate calls for making many technical asset-based and market-based decisions, often involving the selection of the “Best Practice” choice from a group of possible options. Some of these decisions are very complex, and ideally, an expert would be utilized in the process. These decisions often involve the balancing of many identified real estate asset attributes or features that create a uniqueness to the property that must be distinguished from others in the market in order to determine their contributory value to the asset being evaluated. Page 20
  23. 23. Real-Time Valuesm Most questions are relatively simple and straightforward to the expert, and can be easily answered. But non-experts may not be able to find the answer with adequate confidence and understanding to proceed. If the expert is not available, decisions get delayed or are made poorly. Even when experts are available, they may spend so much of their time on routine problems, that they are not able to spend time on the complex problems that actually require their talents and experience. For example, evaluating an income producing commercial real estate property requires consideration of quantity, quality and durability of the income stream that is produced or the ability to produce an income stream if the property is unimproved. Unless one has advanced practitioner driven training, it is more likely that an expert will be required for a recommendation. Within the commercial real estate field, there are educational institutes that provide nationally and internationally recognized commercial real estate curriculums that focus on: o Investment Analysis; o Market Analysis; o User Decision Analysis; and o Investor Decision Analysis. Topics within the educational curriculum include property types, leasing, financial analysis, terminology and methodology, demographics, psychographics, calculator and computer usage. This type of educational curriculum and the resulting knowledge gained by professional practitioners and the resulting creation of professional networks of similarly educated users has been endorsed by Fortune 500 companies nationally as well as internationally as the benchmark for Best Practices. As a result of these Best Practices, resulting technologies focus on the “three” most important things about commercial real estate. In the 1970’s the three most important things were “Location, Location and Location”. In the 1980’s importance migrated to “Timing, Timing Page 21
  24. 24. Real-Time Valuesm and Timing” with the collapse of the stock and capital markets in 1987. With the current worldwide financial crisis the three most important things in commercial real estate today are: (1) Location – Where; (2) Timing - When; and, (3) Demographics – Who, What, How and Why. It’s difficult to emphasize just one of these issues. However, Demographics utilizing Geographical Information Systems (GIS) based solutions are clearly the most critical in the decision process. Best Practices would include utilizing practitioners with access to maps, topographic data, aerials, demographics, business reports, consumer spending habits, traffic counts, linkage, flood mapping, market data with over 400 available reports for query on an individual property. Additional access would be available to: (1) Market Data for studies while defining trade area, highest and best use, demand analysis, supply analysis, economic base identification, competitive supply, capital market conditions, needs-analysis (GAP), population distribution, workforce characteristics, lifestyle (tapestry study); (2) Site Location Data for evaluation and feasibility studies including property attributes, characteristics, linkages, political influences, industry gap analysis, market profiles, comparison reports, trade area definition, population characteristics and trending, industry sector plotting; and, (3) Census Data Reports, all of which utilize GIS software. This information allows the user to determine whether the markets are in appreciation, stagnation or decline. Based on need, the information may also identify alternative uses that may be used for renovation or transfer in the type of use of the property. Best Practices methods for Commercial Real Estate would provide uniform practitioner driven data entry sheets with a set of 400 to 500 unique data elements for tracking collateral and REO/ORE on a Real-Time Valuesm basis making the results more accessible, far easier to use Page 22
  25. 25. Real-Time Valuesm and much less prone to errors. These data fields would allow for Real-Time Valuesm assessment on an as needed basis. BEST PRACTICES – RESIDENTIAL REAL ESTATE From a methodological perspective, the system design for tracking and updating residential real estate is a relatively straight forward implementation if the proper tools are available and existing data elements can be leveraged. The majority of the detailed collateral information on residential assets is already obtained during the appraisal process on a Uniform Residential Appraisal Report (Form 1004). By design Best Practices stay on the cutting-edge of technology. Practitioners applying Best Practices methodology are compelled to provide equal or greater levels of both valuable information about the property and interpretation and guidance in an increasingly complex marketplace because they have recognized and documented the challenge of technology empowered consumers who rely on research from multiple sources in order to educate themselves; sometimes months before beginning the process of buying or selling real property and the impact it has on the market. This information and expertise will allow Practitioners to be the trusted advocates for both the institutions and clients they serve. Properly implemented Best Practices will result in the industry’s most powerful information source, making users more efficient, and allowing its representatives to focus on customer service, generating more opportunities for the management, monitoring and exchange of residential real estate property. The majority of the detailed collateral information on residential assets is already obtained during the appraisal process on a URAR appraisal form. If the URAR form was converted into an electronic entry system entered directly by the appraiser, the financial institutions could receive the appraisal data in electronic format which would automatically create an electronic record for the collateral with over 150 data elements on each specific asset. Best Practices would include utilizing Practitioners with access to subject data, contract data, neighborhood data, site data, improvements, PUD/HOA data, multiple listing service data, GIS technology, aerials, census data reports, consumer data, school data, linkage, flood mapping, Page 23
  26. 26. Real-Time Valuesm market data and other available industry resources to determine the collateral’s present Real- Time Valuesm. Contemporary business enterprise data storage initiatives have resulted in the creation of better integration and reporting of historical Consumer Information. Companies typically struggle to operate in the Real-Time environment required for “online” marketing success today. A majority of businesses lack tools and expertise to use their data to predict and optimize marketing activities and identify opportunities. Sophisticated data analytics vendors, some of which offer integrated Real-Time systems, are overcoming these challenges, finding innovative ways to put Real-Time data to use for more effective marketing. Consumer Information will become more and more important in the future as evaluation is expanded to include credit behavior, preferences, attitudes and actions to distinguish the informers from decision makers. The ability of the institution to provide detailed collateral information to an allied practitioner in the field for the updating of market-based information would give management an excellent overview of their individual assets as well as their entire portfolio’s Real-Time Valuesm. It would also provide a level of transparency between the institution, regulators and the public never before available. Source: Dr. James P. Gaines, The Real Estate Center Page 24
  27. 27. Real-Time Valuesm GEOCODING One aspect that could assist financial institutions greatly and expand their tracking capacity would be the geocoding of the collateral for use with a Geographical Information System (GIS). Using GIS, to geocode the collateral’s location would also allow the institution to see the concentration and clusters of its assets within a given market. This would allow them to determine the impact of potential acquisitions or dispositions of their collateral on a particular neighborhood or sector of a community, state or region within the country. It could also impact management’s decisions for underwriting, workouts or loan modifications utilizing interest rate, principal or payment reductions based on Real-Time Valuesm updates. More importantly it would make the institutions more aware of when a market stabilized or changed in an increasing or declining direction. An example of the benefits of geocoding was completed by the City of Chula Vista, CA, in November of 2008. Although the City of Chula Vista is not a financial institution, they had similar problems resulting from declining real estate markets. Source: ESRI Page 25
  28. 28. Real-Time Valuesm The city, which has a population of approximately 200,000, had undergone expansive growth in the past decade. When residential housing market values fell, the city found itself dealing with over two thousand foreclosed assets. In 2007 the city passed the Residential Abandoned Property (RAP) ordinance in order to force institutions to sustain certain maintenance standards on their foreclosed collateral in order to prevent blighted properties which could have discouraged potential buyers of adjacent properties thereby reducing the property values in some of the city’s neighborhoods. The city decided to build a web site based on ArcGIS Server. This allowed them to spatially enable the RAP data they maintained. Previously the city had no way to identify clusters of foreclosed properties. They were able to view data in layers including parcel boundaries, city boundary, census tracts, and ZIP code boundaries. They used Google “balloon pins” to indicate which assets were in compliance with the city’s RAP ordinance. This information was provided in a wireless format to city code enforcement officers in the field which streamlined the process and increased officer’s productivity. The ArcGIS system shows the power of technology at work today. If this technology were used in conjunction with full appraisal data from the URAR form, financial institutions would be in a position to spatially see the location and concentration of their assets, comparable sales, trends within the market and Real-Time Valuesm. Further it would empower the institutions to directly engage third party allied practitioners utilizing tools such as RPRTM or CCIMREDEX, both of which possess geocoding capability, for updating market information. Mr. Charles A. McClure, III, CCIM, 2009 President of the CCIM Institute and Mr. Jack Dangermond, President of ESRI, made a proposal during the summer of 2009 to the Federal Deposit Insurance Corporation to geocode all the FDIC’s assets in order to assist management, monitoring and tracking of the FDIC’s assets. This information could be critical to tracking and assessment as well as marketing efforts to dispose of the assets as potential purchasers could review the concentration of assets within a local market for individual or bulk acquisition. Geocoding should be a requirement for not only all financial institutions, but all government and government sponsored entities, such as Fannie Mae, Freddie Mac, the Department of Veterans Affairs (DVA), the Department of Housing & Urban Development (HUD), the Government Services Administration (GSA) and large insurance companies. Page 26
  29. 29. Real-Time Valuesm Geocoding should be applied not only to non-performing assets but performing loan collateral as well as corporate or department owned assets. A spatial review could easily identify local, regional or national areas in need of advanced monitoring due to volatile or unstable market conditions. It would also be helpful in reviews with government regulators as providing Real- Time Valuesm versus data that has become outdated or static. This process could set a transparent standard in place of the suspended FAS 157 Fair Value standard while providing appraisers more accurate market data as they complete their certified appraisals on a periodic basis as needed. It should be noted that this would provide a significant benefit as the lack of appraisals were cited by the FDIC in the latest material loss reviews of failed banks. Another requirement that would be extremely helpful in restoring public confidence is a single repository for residential ORE/REO and another for commercial assets, each with a GIS interface. OPEN SYSTEM ARCHITECTURE The automation solution will not be a singular solution for financial institutions because of open system architecture. BusinessDictionary.com defines Open System Architecture as “Vendor-independent, non-proprietary, computer system or device design based on official and/or popular standards. It allows all vendors (in competition with one another) to create add-on products that increase a system's (or device's) flexibility, functionality, interoperatability, potential use, and useful life. And enables the users to customize and extend a system's (or device's) capabilities to suit individual requirements. Also called open architecture.” Best Practices methods therefore would endorse open system architecture as a standard. Lotus Notes® or Domino® software and its client software options is one example of an affordable open architecture option that could deliver reliable, security-rich messaging and collaboration of data and environments that would help the institution enhance the productivity of staff and contractors while streamlining the business processes on data collection and tracking to improve overall responsiveness on their loan portfolios and in determining Real-Time Valuesm for collateral assets. The implementation of electronic data systems for tracking collateral and ORE/REO assets can require collaboration capabilities that can be deployed as core or enterprise infrastructure, a business application platform or both. Tools could also include integration of ArcGIS solutions and document management systems such as Adobe® to maximize the Page 27
  30. 30. Real-Time Valuesm productivity of the institution. The ultimate system design will be based on the institutions existing system architecture in order to minimize costs and maximize collaboration. REAL-TIME VALUEsm FIELD TEST 2 In the early 1990’s after the automation of the Bright Savings Bank commercial real estate portfolio, several projects involving Real-Time Valuesm were completed for financial institutions, government agencies and individuals that involved the conversion of paper or hard copy files to electronic format for the purpose of tracking ORE/REO or investment assets. These conversions ranged from networking desktop CPU’s with servers that interfaced with mainframes with the bilateral exchange of collateral based data to the conversion of data from spreadsheets transferred into a distributed server environment with replication of the data for collaborate use by teams of participants. These processes involved the creation of property data sheets with unique fields based on the asset’s classification (e.g., residential, multi-family, land, office, industrial or retail). The results were cost effective and efficient. The electronic conversion allowed groups of people to collaboratively develop a comprehensive review of the portfolio. Properties could be broken out singularly or in a portfolio level view. Once the data was entered, users had the ability to model the portfolio or individual properties using an abundance of disposition scenarios. In one case, which involved tracking the assets, both real estate and non-real estate, of a Securities Company accused of operating a Ponzi scheme, the collected data assisted the United States Securities Exchange Commission (SEC) and the Federal Bureau of Investigation (FBI) in securing 254 federal indictments that had been targeted against each of the two principals of the firm. Also, 256 federal indictments that were not targeted when the investigation began were also secured as a result of the ability to effectively track the Real-Time Valuesm of the thousands of real estate assets and investments that had been made and compare those with financial projections that had been made and delivered to investors. The only thing that would have improved this capability at the time would have been an ArcGIS interface and demographic information. Page 28
  31. 31. Real-Time Valuesm The most difficult part of electronic conversion is getting management to recognize the need for a cultural change in the way their business is transacted. IMPLEMENTATION While the conceptual foundation for implementation of FIRREA-like legislation to provide Real- Time Valuesm updates on collateral for loans is highly justified, there are multiple justifications for phasing into this requirement. In the 1980’s, during the “Great American Thrift Bailout”, there were approximately one million foreclosed assets that were being handled for disposition by the FSLIC, FDIC, RTC, FADA and the Southwest Plan Thrifts. There were very simple and straight forward rules for clearing an asset out of an ORE/REO portfolio. The bulk of these assets were commercial in nature as a result of the Garn-St. Germain Depository Institutions Act and the Economic Recovery Act of 1981. As ORE/REO was cleared by the respective agencies or financial institutions, it was marketed and generally purchased by a public that was confident that the downward spiral had subsided. By comparison today, there are close to 11 to 12 million foreclosed and non-performing assets with the majority of those residential in description as a result of the subprime mortgage debacle. It is anticipated that another 8 to 10 million properties will be foreclosed by the end of 2012. The sheer number of assets puts incomparable pressure on the financial institutions and regulatory entities holding these assets. As a result of the failure of these loans, loan loss reserves and capital have been used to support the financial viability of the institutions. Many of these institutions would not have the funds to implement collaborative based tracking systems for their loan portfolios, classified, non-performing and ORE/REO at one time. The rules for dealing with non-performing assets are not as clear today as they were in the 1980’s. The Troubled Asset Relief Program, TARP, and the Term Asset-Backed Securities Loan Facility, TALF, and other programs designed to allow borrowers to request and complete workouts on non-performing assets have made the process more complex. Recent reports show lenders are forcing the sale of properties without taking title 70% of the time. These complexities do not instill the same consumer confidence within the investment market today to purchase assets in bulk as we saw with pools of assets in the 1980’s. The current consumer Page 29
  32. 32. Real-Time Valuesm confidence index shows that public confidence is unstable and the public is not willing to invest in the market in large increments. Source: Dr. Mark Dotzour, The Real Estate Center It is recommended that the first step for these institutions be the implementation of a tracking system for their scheduled, classified, non-performing or ORE/REO assets. This should include a GIS solution for geocoding individual assets and tracking their concentration within local, state and regional markets. This will allow the institution the ability to determine Real- Time Valuesm needed to provide management as well as regulatory authorities with a comprehensive overview of the financial viability of their portfolio and assets. PHASE-IN For those institutions or agencies that are still financially viable, the FIRREA-like compulsory requirements should be phased-in for existing loans over a period of five years, since the average home loan life expectancy is approximately 4.7 years, with the most distressed assets dealt with first. The phase-in would require all new loans to comply with the new standard in addition to converting 20% of the existing portfolio per year for tracking Real-Time Valuesm for Page 30
  33. 33. Real-Time Valuesm collateral based assets. The phase-in should prevent a financial panic while stabilizing both the real estate and financing markets allowing the public to recognize when the market has ultimately reached bottom potentially enticing trillions of dollars of un-invested investment capital off the sidelines and into the market. This increased activity should stabilize and improve the market allowing the institutions time to perfect the value of other distressed assets without flooding the market. If institutions were to convert their ORE/REO assets into a Real-Time Valuesm tracking system they would be in a position to sell singular assets or handle bulk sale dispositions of assets with confidence that they should be able to achieve targeted yields based on the input they received directly from the market. Buyers in theory should also be more knowledgeable which should ultimately lower their anticipated risk of the unknown as well as their desired discount rates. This format would also establish greater ability to confidently market assets through the highly trafficked commercial repositories of listing data. SUMMARY As a result of improved collaborative procedures and more accurate Real-Time Valuesm assessment with government oversight, public confidence should be restored as management is seen to be more transparent as well as better equipped technologically in its evaluation of collateral assets in order to project where the markets are and where they are projected to go. Unfortunately, we as a country have not heeded the warnings of John Naisbitt and others pertaining to the gathering, distribution and collaborative use of information. This process empowers the holder to make the most judicious decisions available. However, we have elected, by our inactions, to forego these opportunities to improve the way we operate. The current approach of limiting the size of financial institutions in order to eliminate institutions from the “Too Big to Fail” category will not be successful unless the government corrects the underlying collateral and ORE/REO valuation issue. We must change our corporate culture and way of doing business in order to survive. America has been through the “Great American Thrift Bailout” of the 1980’s and now the “Subprime Debacle” of the 21st century. If we were baseball players, the count would be no balls and two strikes. We cannot risk a third strike. The time for change and implementation is now. Page 31