Banking on unreal estate - the appraisal scam.

• Author: Weiss, Kenneth

When Richard Hewitt was poring over financial records of the ailing Community Savings & Loan in Bethesda, Maryland, his eyes fell upon a troubling list of approved real estate appraisers. As a federal banking investigator, Hewitt knew some of the listed appraisers had "very fine reputations:' But strangely, each of the reputable names was crossed out. Scribbled in the margin next to them were the words, "Do not use."

One of the blacklisted appraisers later told Hewitt that Community's subsidiary, Equity Programs Investment Corporation (EPIC), had asked him to use an unethical method to establish the value of a 200-unit condominium complex. EPIC wanted him to ignore the fact that the condos were both vacant and located in an area notorious for its vast number of unoccupied condominium projects-two characteristics that can greatly diminish property value. When the appraiser declined to set market value "out of context," EPIC officials struck him from the list and turned to someone else.

Hewitt stumbled on the list while investigating a wide-reaching scandal involving shaky EPIC property loans and the downfall of Community Savings. This peculiar list shows more than just

' another element of the EPIC collapse, which has forced 20,000 homes into foreclosure, rattled the mortgage industry, and threatens investors with hundreds of millions of dollars in losses. It provides a rare glimpse inside perhaps the biggest con in the real estate industry: grossly exaggerated appraisals. Although previously tolerated as an improper but innocuous part of the real estate game, it is now becoming clear that bogus appraisals were a major cause of the collapse of EPIC, as well as hundreds of savings and loans and banks such as Continental Illinois, the largest failure of all. In the past three years, 322 savings and loans have failed or had serious financial troubles because of faulty or fraudulent appraisals, according to the Federal Home Loan Bank Board. And, incredibly, even though massive over-appraisals have contributed to case after case of bank and S&L failures, most federal regulators are turning their heads, insisting it is only a minor part of the banking crisis. Setting up the con

An unbiased, accurate appraisal is the cornerstone of a good realestate loan. Lending institutions rely on professional appraisers to determine the market value of property and hence the true value of the collateral being offered for the loan. If the appraiser is on target, bankers know the value of the property will be enough to cover the loan in the event the borrower stops paying.

But the nation's 150,000 to 250,000 appraisers aren't always on target. Not surprisingly, most of the inaccuracies fall on the side of inflating the value of property rather than diminishing it. Some of it is simply sloppy work. But more often than not, over-appraisals are deliberate schemes that benefit the real estate investor, the developer, the appraiser, and sometimes the lender but end up hurting the rest of us when the plan unravels.

Here's how it works. Let's say a Houston developer has built 100condominiums in a particular neighborhood. He sells 90 of them for $100,000 apiece before the local real estate market takes a steep downturn. Prices plummet and for six months the panicked developer is unable to sell the last ten units, which are uncomfortably close to a noisy intersection. As an inducement to potential investors, the developer agrees to chop $10,000 off the cost of each of the remaining condos through some financial gymnastics that effectively lower the interest rate on the loan. He does this by paying $10,000 to a lender, who in turn lowers the interest rate for a real estate loan. With those incentives in place, a real estate speculator pledges to buy the last ten units.

The speculator and the developer then work together to turn the decline in real estate value to their advantage. They call in an appraiser, an independent consultant who is supposed to examine the property, its surrounding area, and its financial history to determine the property's market value. Most likely the appraiser has worked with them before and knows what's expected. The appraiser sets the value of each condo at $100,000, ignoring the market decline and the fact that the units are being sold, in effect, for $90,000.

With that appraisal in hand, the condo buyer goes to the local savings and loan. For collateral he offers property valued at $100,000, even though its actual worth is $90,000. Eager to lend money and perhaps even complicitous in the planning of this deal, the S&L officer accepts the $100,000 figure. Because the $10,000 reduction to the buyer comes in the form of an interest discount, not an out-and-out price cut, the lender can pretend that the value is $100,000 and use the inflated appraisal to validate the fiction. The S&L...